MICROECONOMICS NOTES

ECO 151

CONSIST OF:
CHAPTER 5: ELASTICITY

CHAPTER 6: UTILITY

CHAPTER 8: PRODUCTION AND COST

CHAPTER 9: PERFECT COMPETITION

CHAPTER 10: IMPERFECT COMPETITION

Definitions
Elasticity- is a measure of responsiveness or sensitivity.

Slope- are the movements (points) along the supply or demand curve.

Elasticity coefficient- is the ratio of the percentage change in quantity demanded to the
percentage change in the price.

Price elasticity of demand- is the percentage change in the quantity demanded if the price of
the product changes by 1 per cent.

Income elasticity of demand- measures the responsiveness of quantity demanded to change

in income.

Inferior good- is a product whose demand decreases when people’s incomes rise. E.g. public
transit options, cheap cars, store-brand products and inexpensive food.

Luxury goods- are defined as goods that have an elasticity above one with respect to
income.

Cross elasticity of demand- measures the responsiveness of the quantity demanded of a

particular good to changes in the price of a related good.

Price elasticity of supply- measures the responsiveness of the quantity supplied of a product
to changes in the price of the product.

Utility- is the level of satisfaction a household gets from consuming goods or services.

Weighted marginal utility- is the marginal utility per unit divided by the price unit (MU/P).

Corporation- is a large group of companies under the control of the same group of people.

Explicit costs- are the monetary payments for the factors of production and other inputs
bought or hired by the firm.

Implicit costs- are those opportunity costs that are not reflected in the monetary payments.
Include the costs of self-owned or self-employed resources.
Opportunity cost- is the cost of using something in a particular way is the benefit forgone by
not using it in the best alternative way.

Normal profit- is the minimum return required by the owner(s) of the firm to engage in a
particular operation.

Economic profit- is the additional return to the owners of the firm, over and above the
opportunity cost of their own inputs (over and above normal profit). Also known as: excess,
abnormal. Supernormal or pure profit

Production- is the physical transformation of inputs (factors of production, intermediate

goods) into output (products).

Fixed input- is an input whose quantity cannot be changed in the short run.

Variable input- is one whose quantity can be changed in the short run as well as the long
run.

Production function- is the relationship between quantity of inputs and the maximum
output that can be obtained from these inputs.

Fixed cost- is defined as cost that remains constant irrespective of the quantity of output
produced. Also called: overhead costs, indirect costs or unavoidable costs.

Variable costs- is defined as the cost that changes when total product changes (it represents
the cost of the variable input).

Returns of scale- refers to the long-run relationship between inputs and output.

Economies of scale- refer to the relationship between costs and output and specifically to a
decline in unit costs as output expands.

Economies of scope- refers to the cost savings achieved by producing related goods in one
firm rather than in two separate firms.

Collusion- occurs when two or more sellers enter into an agreement with each other to limit
competition between or among themselves.

Industry- is the collection of firms that supply a specific product in the market.
NOTES
CHAPTER 5: ELASTICITY

Elasticity is defined as the percentage change in a dependent variable (the one that is
affected) if the relevant independent variable (the one that causes the change) changes by
1%.

Elasticity= (Percentage change in dependent variable ÷ Percentage change in independent

variable)

Four types of elasticity

 The price elasticity of demand

 The income elasticity of demand
 The cross elasticity of demand
 The price elasticity of supply

THE PRICE ELASTICITY OF DEMAND *

Price elasticity of demand is the percentage change in the quantity demanded if the price of
the product changes by 1 per cent, and it is concerned with the sensitivity of the quantity
demanded to a change in the price of the product. Q d = f(PX). The dependent variable is the
quantity demanded and the independent variable is the price of the product.

Price elasticity of demand = ep = percentage change in the quantity demanded of a

product/percentage change in the price of the product.
In (b) the reduction in price is greater and the increase in quantity is smaller than (a). a
rightward shift (increase in supply) of the supply curve will lead to a decrease in the price
and an increase in the quantity demanded.

Important aspects and implications of the definition of price elasticity of demand:

 It uses percentage changes and not units, i.e. uses relative change, not absolute
changes. Absolute- prices are expressed in monetary terms (rands, pounds, euros).
 Elasticity coefficients enable us to compare how consumers react to changes in the
prices of different goods and services, such as matches, motorcars, meat.
 The measured price elasticity of demand has a negative sign (in this book we ignore
the negative sign). When the price increases, the quantity demanded falls and when
the price decreases, the quantity demanded increases.

Calculating price elasticity of demand

Formulas used:

ΔQ P
 Point elasticity formula- e p= × (this is used to calculate the price elasticity of
Q ΔP
demand if the price change is relatively small.
( Q2−Q1 ) ÷ ( Q1 +Q2 )
 Arc elasticity formula- e p= (used for larger price fluctuations)
( P2−P1 ) ÷ ( P1 + P2 )
 We use the average of two quantities and the average of two prices to calculate
percentage change. We ignore the negative sign by taking the absolute differences
between Q2 and Q1 and between P2 and P1.

Price elasticity of demand and total revenue (or total expenditure).

The price elasticity of demand can be used to determine by how much the total expenditure
by consumers on a product (which is also the total revenue of the firms producing that
product) changes when the price of the product changes.

Total expenditure by consumers on a product equals total revenue of firms for that product.

The effect of a price change on total revenue

o Price elasticity of demand > 1 – TR increases as Q increases.

o Price elasticity of demand = 1 – TR reaches a maximum.
o Price elasticity of demand < 1 – TR falls as Q increases.
This diagram is a downward-sloping linear demand curve.

Important results illustrated by the table and figure 5-2:

 As long as the price elasticity of demand is greater than one, total revenue TR
increase as the quantity sold Q increase.
 TR reaches a maximum when the price elasticity of demand is equal to one.
 When the price elasticity of demand is less than one, TR falls as the quantity sold Q
increases.

Table 5-1 The demand for cappuccinos and TR from cappuccino sales
Five categories of price elasticity of demand

 Perfectly inelastic demand (ep = 0)

 Inelastic demand (ep lies between 0 and 1)
 Unitarily elastic demand or unitary elasticity of demand (ep = 1)
 Elastic demand (ep lies between 1 and ∞)
 Perfectly elastic demand (ep = ∞)
Category Meaning Effect on TR=PQ when P
changes
Perfectly inelastic demand Q does not change when P TR changes with P in the
changes. same direction as P; there is
an incentive for suppliers to
raise prices.
Inelastic demand Percentage change in Q is TR changes with P in the
smaller than percentage same direction as P; there is
change in P. an incentive for suppliers to
raise prices.
Unitary elastic demand Percentage change in Q is TR remains unchanged.
equal to percentage change
 in P.
Elastic demand Percentage change in Q is TR changes in the opposite
greater than percentage direction to change in P;
change in P. there is thus an incentive for
suppliers to lower prices.
Perfectly elastic demand Indeterminate (unknown) Q When P increases, Q falls to
demanded at given P; zero; TR therefore also falls
nothing demanded at a to zero.
fractionally higher price.

Determinants of the price elasticity of demand

Substitution possibilities

 If there is a large number of close substitutes, the greater is the price elasticity of
demand; demand is ELASTIC.
 Increase in price- leads to substitution effect- consumers switch to relatively cheaper
substitute goods.
 Example: if the price of train tickets go up, substitute by now taking a taxi. The easier
it is to swap, the more elastic the demand for train tickets are.

The degree of complementarily of the product

 With highly complementary goods, the price elasticity of demand tends to be low-
demand is INELASTIC.
 Example: cars and tyres, petrol and cars, CDs and CD players.

The type of want satisfied by the product

 Necessities such as medical care, basic food, petrol and electricity are inelastic- they
don’t respond much to changes in price.
 Luxuries such as swimming pools, entertainment are elastic- they can respond to
changes in price.

The time period under consideration

  Demand tends to be more price elastic in the long run than in the short run.
 Example: with the increase in price of crude oil in 1970s, people could do little in the
short run. But in the long term could develop fuel efficient cars to decrease the
demand for petrol.

Durability

 The more durable the good, the more elastic the demand tend to be.
 Example: can put off buying new products for longer period if the price of the
product has increased.

The proportion of income spent on the product

 The greater the proportion of income spent on a product, the greater the price
elasticity of demand will be- demand is ELASTIC.
 Example: changes in prices of products like salt and matches may not change the
quantity demanded much, because they only constitute a small proportion of the
consumers’ income. But goods such as rent and insurance payments that take up a
larger proportion of income may be more elastic.

Number of uses for the product

 The greater the number of uses of a particular product, the greater the price
elasticity of demand will tend to be.

Addiction

 Very addictive products will have low piece elasticities, because price doesn’t matter
as along they have what the product that they want they are willing to pay for that
product.
 For completely addicted consumers it may be perfectly price elastic.

OTHER DEMAND ELASTICITIES *

Elasticity is a measure of responsiveness that can be applied to any casual relationship
between two variables.

Income elasticity of demand

Income elasticity of demand is concerned with the sensitivity of the quantity demanded if
the income of consumers changed. Qd = f(Y)

ey = (percentage change in the quantity demanded of the product/ percentage change in

ΔQd Y
consumers’ income) = ×
ΔY Qd

income elasticity of demand may be positive or negative:

o A positive income elasticity of demand means that an increase in income is

accompanied by an increase in the quantity demanded of the product concerned. Or
a decrease in income is accompanied by a decrease in the quantity demanded.
o Goods with a positive income elasticity of demand are called normal goods (classified
as luxury or essential goods).
o A negative income elasticity of demand means that an increase in income leads to a
decrease in the quantity demanded of a good concerned. Or that a decrease in
income leads to an increase in the quantity demanded.
o Goods with a negative income elasticity of demand are called inferior goods.

0 < ey < 1 – normal goods, essential goods (the ey is greater than zero but less than one)

ey > 1 – normal goods, luxury goods

ey < 0 – inferior goods

Cross elasticity of demand

Cross elasticity of demand is concerned with the sensitivity of the quantity demanded due to
a change in the price of a related product. Qd = f(Pg).

The quantity demanded of a particular product also depends on the prices of related good.
When two goods are unrelated the cross elasticity of demand will be zero because cross
elasticity of demand measure change in related goods.
EC = (percentage change in the quantity demanded of product A/ percentage change in the
ΔQ ⅆ A PB
price of product B) = ×
ΔP A Qd A

0 < eC – substitute

eC < 0 – complements

eC = 0 – unrelated goods

THE PRICE ELASTICITY OF SUPPLY *

Price elasticity of supply is the ratio between the percentage change in the quantity supplied
of a product and the percentage change in the price of the product.

eS = (percentage change in the quantity supplied of a product/ percentage change in the

price of the product)

Different categories of supply elasticity

 Perfectly inelastic supply (es = 0)

 Inelasticity supply (0 < es < 1) – es is greater than 0 but smaller than 1)
 Unitary elasticity supply (es = 1)
 Elasticity supply (1 < es < ∞)
 Perfectly elasticity supply (es = ∞)
The determinants of the price elasticity of supply

Time that has elapsed since the change in price

 Short-run – inelastic, since suppliers don’t have sufficient time to respond to price
change.
 Long-run – they can adjust their levels of production in response to changes in price.
E.g. if the maize price increases, farmers need a full growing season to adjust their
production to the price increase.

Price expectations

 Expectations of higher prices will result in increased supply.

  Reductions in price that producers regard a temporary will tend to lead to an
inelastic response.
 Elastic, if producers perceive a price reduction as being a long-term phenomenon,
they will reduce their production capacity.

Stockpiling or excess capacity

 Products that can be stockpiled have more elastic supply than perishable goods.
 Firms with excess production capacity will be able to respond more quickly to a price
increase than firms that are operating at full capacity.

Availability of inputs

 If essential inputs are not available, firms cannot increase their outputs in reaction to
an increase in the price of their product.

CHAPTER 6: Theory of demand: THE UTILITY APPROACH

UTILITY *

Utility is the degree of satisfaction that a household or consumer derives or expects to

derive from the consumption of a good or service.

 Purpose of consumer behaviour is maximisation of utility, given the available means

and alternative consumption possibilities.
 The utility of a particular good or service is the degree to which it satisfies human
wants.
 However, a particular good does not have a unique, measurable utility which applies
to all consumers.
 Tastes and wants vary amongst consumers.

Cardinal and ordinal utility

Cardinal utility involves the idea that utility can be measured in some way. Ordinal utility
involves the ranking of different bundles of consumer goods and services in order of
preference.

Utility approach to the analysis of consumer behaviour:

  Is based on the assumption that a consumer can assign values to the amount of
satisfaction (utility) that he or she obtains from the consumption of each successive
unit of a consumer good or service.
 It is also assumed that it is possible to compare the utility of different consumer
goods and services quantitatively. i.e. it is based on notion of cardinal utility.

MARGINAL UTILITY AND TOTAL UTILITY *

Marginal utility is the extra or additional utility that a consumer derives from the
consumption of one additional unit of a good.

Total utility is the sum of all marginal utilities. As long as marginal utility is positive, total
utility will increase. It reaches a maximum when marginal utility is zero and then decrease
when marginal utility becomes negative.

Disutility is a negative utility.

Law of diminishing marginal utility (sometimes called Gossen’s first law)- states that the
marginal utility of a good or service eventually declines as more of it is consumed during any
given period.

o When the marginal value is lower than the previous average value, the average value
falls.
o When the marginal value is equal to the previous average value, the average value
remains unchanged.
o When marginal value is greater than the previous average value, the average value
increases.

CONSUMER EQUILIBRIUM IN THE UTILITY APPROACH *

The aim is to obtain the highest attainable level of total utility.

For a given income and a given set of prices of goods and services, a consumer will be in
equilibrium if he or she obtains the maximum possible total utility.

The consumer is in position to arrange his/her wants in order of importance (based on

his/her tastes) according to a list known as the scale of preferences.

Examine the weighted marginal utility to determine combination maximum.

Example:

To obtain the consumer’s equilibrium position we must determine which combinations are
affordable and at which of these combinations the weighted marginal utility (MU/P) is the
same for all the goods in question.

When the weighted marginal utilities are equal and Winnie has just spent her available
M U B M U M M UR
income (R120), she is in equilibrium. = =
PB PM PR

(10B + 30M + 20R) = R120

10(5) + 30(1) + 20(2) = 120

Two conditions that have to be met for the consumer to be in equilibrium: (law of equalising
the weighted marginal utilities or Gossen second law)

1. The combination of goods purchased has to be affordable (equal to the income).

2. The weighted marginal utilities of the different goods must be equal.

The rate at which the consumer is subjectively willing to exchange the two goods must be
M U A PA
the same as the rate at which the goods are exchanged in the market. =
M U B PB
DERIVATION OF AN INDIVIDUAL DEMAND CURVE FOR A PRODUCT *

Demand curve shows the quantities demanded of a good or service at different prices.
CHAPTER 8: Background to supply: PRODUCTION AND COST

INTRODUCTION *

Types of firms

individual proprietorships, partnerships, companies, cooperatives, trust and public

corporations.

Not all firms function in exactly the same way. Individual proprietorship often produce one
good or service, a large company or corporation usually produces a variety of products with
inputs purchased in different markets.

The goal of the firm

 We assume that all firms seek to maximise profits.

 Other goals or objectives include things like dominating the market (biggest market
share).
 People related to the firm may have different objectives e.g.
o Owners may want to maximise profits
o Managers may want to expand firm size
 Profit is an important objective of privately owned firms- if firms are not profitable,
they cannot continue to exist in the long run.

Profit, revenue and cost

Profit- is simply the surplus of revenue over cost. R/C

Total revenue (TR)- is simply the total value of its sales and is equal to the price(P) of its
product multiplied by the quantity sold (Q). TR = P x Q

Average revenue- is equal to total revenue (TR) divided by the quantity sold (Q). AR = TR/Q

Marginal revenue (MR)- is the additional revenue earned by selling an additional unit of the
ΔTR
product. M R =
ΔQ

Profit maximisation is where difference between total revenue and cost is at a maximum.

Short run vs long run

Short run is the period during which at least one of the inputs is fixed.

Long run is the period that is long enough for the firm to change the quantities of all inputs
in the production process and the process itself. In the long run all the inputs are variable
(changeable).

The difference between the short run and the long run depends on the variability of the
inputs and not on calendar time.

COST AND PROFIT *

Cost

Accountants usually consider explicit costs only. However, Economists consider both implicit
costs as well as explicit costs (opportunity cost).

Accounting costs = Explicit costs

Economic costs = Explicit + Implicit costs

Total cost is the cost of producing a certain quantity of the firm’s product.

Average cost is the total cost (TC) divided by the number of units of the product produced
(Q). AC = TC/Q

Marginal cost is the addition to total cost (change in TC) required to produce an additional
ΔTC
unit of the product (change in Q). MC=
ΔQ

Profit

Accounting profit is the difference between TR from the sale of the firm’s product(s) and
total explicit costs. AP = TR – Explicit costs

Normal profit is equal to the best return that the firm’s resources could earn elsewhere and
forms part of the cost of production. TR = TC

Economic profit is the difference between TR from the sale of the firm’s product(s) and total
explicit and implicit costs. EP = TR – TC (explicit and implicit costs)

 Economic profit, if TR > TC

 Normal profit, if TR = TC
  Economic loss (negative economic profit), if TR < TC

PRODUCTION IN THE SHORT RUN *

Costs are determined by the prices and productivity of various inputs used in the production
process.

Simplifying assumptions made in analysing production in the short run:

 The firm produces only one product.

 All units of inputs are homogeneous.
 The inputs can be used in infinitely divisible amounts.
 The production function is given and therefore cannot be changed.
 The prices of the product and of the inputs are given.
 Firms uses fixed inputs, and one variable input.

The law of diminishing returns states that as more of a variable input is combined with one
or more fixed inputs in a production process, points will eventually be reached where first
the marginal product, then the average product and finally the total product start to decline.

COSTS IN THE SHORT RUN *

In the short run a firm’s costs consist of fixed costs and variable costs.

Measures of Total cost:

Total fixed cost (TFC)- is the total cost from all the units of the fixed inputs. TFC= cost of fixed
input x units of the fixed input

Total variable cost (TVC)- is the total cost from all the units of the variable input. TVC= cost of
variable input x units of the variable input

Total cost (TC)= TFC + TVC

Measures of average cost:

 Average fixed cost (AFC)= TFC/TP (total product)

 Average variable cost (AVC)= TVC/TP
 Average cost (AC)= TC/TP
Total fixed cost remains unchanged when total product increases, therefore, marginal cost is
always zero and marginal cost is always equal to marginal variable cost.

AFC falls as output increases. AVC falls, reaches a minimum and then increases. AC also falls,
reaches a minimum and then increases. Both AVC and AC reach a minimum where they are
intersected by MC.

The relationship between production and cost in the short run

  A firm’s cost structure depends on the productivity of its inputs, meaning the shape
of the unit cost curves (MC and AC) is determined by the shape of the unit product
curves (MP and AP).

PRODUCTION AND COSTS IN THE LONG RUN

The law of diminishing returns does not apply, because there are no fixed inputs in the long
run.

Decisions that will affect the cost of production:

 Returns of scale- refer to a situation in which all inputs increase by the same
proportion (in the case of diminishing marginal returns only the variable input
increases).
 Economies of scale, a firm experience this if the costs per unit of output fall as the
scale of production increases.
 Economies of scope
 Long run average costs

CHAPTER 9: Market structure 1: PERFECT COMPETITION

MARKET STRUCTURE OVERVIEW

THE EQUILIBRIUM CONDITIONS

Firms operating in any market structure want to maximise profit.

Two decisions that have to be taken in any firm:

 The firm must first decide whether or not it is worth producing at all.
 If it is worth producing, the firm must determine the level of production (the
quantity) at that profit is maximised or losses minimised.

The shut-down rule: A firm should produce only if total revenue is equal to, or greater than,
total variable cost (which include normal profit). It can also be called the start-up rule,
because it does not just indicate when a firm should stop producing a product, it also
indicates when a firm should start (or restart) production. A firm should produce only if
average revenue is equal to, greater than average variable cost (per unit of production).

Production should take place in the long run only if total revenue is sufficient to cover all
costs of production. In the short-run, if total revenue is just sufficient to cover total variable
cost.

The profit-maximising rule: profit is maximised where the positive difference between total
revenue and total cost is the greatest. Per unit of production, profit is maximised where
marginal revenue is equal to marginal cost (MR = MC)

If MR > MC, output should be expanded

If MR = MC, profits are maximised

If MR < MC, output should be reduced

PERFECT COMPETITION

Perfect competition occurs when none of the individual market participants (buyers and
sellers) can influence the price of the product. In perfect competitive markets all the
participants are therefore price takers- they have to accept the price as given and can decide
only what quantities to supply or demand at that price.

Perfect competition exists if the following conditions are met:

  There must be a large number of buyers and sellers of the product- the number must
be so large that no individual buyer or seller can affect the market price.
 There must be no collusion between sellers- each seller must act independently.
 All the goods sold in the market must be homogenous- there should be no reason for
buyers to prefer the product of one seller to the product of another seller.
 Complete freedom of entry and exit- buyers and sellers should have complete
freedom to enter or exit the market.
 All the buyers and sellers must have perfect knowledge of market conditions.
 There must be no government intervention influencing buyers or sellers.
 All the factors of production must be perfectly mobile- factors of production must be
able to move freely from one market to another.

THE DEMAND FOR THE PRODUCT OF THE FIRM

Under perfect competition the price of a product is determined by the supply and demand.
No firm will charge a higher price than the prevailing market price because it will then lose
all its customers, nor will the firm gain anything by charging a price that is lower than the
existing market price.

The demand curve for the product of the firm is a horizontal line at the market price
(perfectly elastic). At a higher price the quantity will be zero, since consumers will be able to
purchase the product at a price of P1
Under perfect competition the firm receives the same price for any number of units of the
product that it sells. MR = AR = P.

TR = P x Q; under perfect competition, each additional unit sold therefore increases total
revenue by the price of the product. The total revenue curve can be represented by a
straight line, with a sole equal to the price of the product.

Example:

THE EQULIBRIUM OF THE FIRM UNDER PERFECT COMPETITION

The firm does not have to make any pricing decisions, it can only choose the output
(quantity) at which it will maximise its profits (or minimising its losses).

 How do firms decide whether, and how much of a good they should produce if the
want to maximise profit?
 Economic profit = TR – TC

Any firm maximises its profit (or minimises its losses) where MR = MC = P (since each unit of
output has to be sold at the market price, over which the individual firm has no control).
The profit-maximising rule in the case of a perfectly competitive firm can therefore also be
stated as P = MC (since MR = P).

Losses are maximised at Q1 (that is the point where MC stops being above MR, MR = MC).
Profits are maximised or losses are minimised at Q2 (where MR = MC along the rising part of
the MC curve).

When MR is above MC, any increase in production (quantity) will still bring additional profits
to the firm.
A firm should expand its production as long as MR > MC, up to the point where MR = MC (at
which point profit will be maximised). If it continues producing beyond that point, MR will
be lower than MC and the firm’s profit will fall.

Different possible short-run equilibrium positions of the firm under perfect competition
  Economic profit, if AC is below AR, MR = MC = AR.
 Normal profit, if AC = AR, MR = MC = AR.
 Economic loss, if AC is below AR, MR = MC = AR.

THE SUPPLY CURVE OF THE FIRM AND THE MARKET SUPPLY CURVE

A firm maximises its profits where MR = MC, provided that AR (the price of the product) is
sufficient to cover average variable cost (AVC).

If P (=AR) lies above the minimum AVC the firm will continue production in the short run. If it
lies below the minimum AVC, the firm will close down.

The firm’s supply curve is the rising portion of the firm’s MC curve above the minimum of its
AVC curve at point b. If the price is P5, the firm will not produce at all. If the price is P 4, the
firm will be at its close-down point. If the price is P, the firm will minimise its economic
losses.

The supply curve slope upward because the MC curve slope upward, that is, because MC
increases as output increases (law of diminishing returns). The market supply curve is
obtained by adding the supply curves of the individual firms horizontally.

LONG-RUN EQUILIBRIUM OF THE FIRM AND THE INDUSTRY UNDER PERFECT COMPETITION
The industry will be in equilibrium in the long run if all the firms are marking normal profits
only.

If the firm is making a normal profit, no firm will have an incentive to exit or enter the
market.

If the existing firms are making economic profits, new firms enter the industry, and the
market curve shifts to the right (increase in supply).
If the firm is making economic loss (AR < AC), some firms exit the industry, the market curve
shifts to the left (decrease in supply).

Economic loss in a competitive industry is a signal for the exit of loss-making firms; the
industry will contract, driving the market price up until the remaining firms are covering
their total costs (until normal profits are earned).