UNIVERSITY OF MAIDUGURI
Maiduguri, Nigeria
CENTRE FOR DISTANCE
LEARNING
MANAGEMENT
SCIENCES
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UNITS: 3
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201:
UNIT: 3
MICROECONOMICS II
MICROECONOMICS
II
ii
CDL, University of Maiduguri, Maiduguri
ECON 201:
UNITS: 3
Published
MICROECONOMICS II
2008©
All rights reserved. No part of this work may be reproduced
in any form, by mimeograph or any other means without
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This text forms part of the learning package for the academic
programme of the Centre for Distance Learning, University of
Maiduguri.
Further enquiries should be directed to the:
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P. M. B. 1069
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This text is being published by the authority of the Senate,
University of Maiduguri, Maiduguri – Nigeria.
ISBN:
978-8133-
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MICROECONOMICS II
P R E FA C E
This study unit has been prepared for learners so that they
can do most of the study on their own. The structure of the
study unit is different from that of conventional textbook.
The course writers have made efforts to make the study
material rich enough but learners need to do some extra
reading for further enrichment of the knowledge required.
The learners are expected to make best use of library
facilities and where feasible, use the Internet. References are
provided
to
guide
the
selection
of
reading
materials
required.
The University expresses its profound gratitude to our course
writers and editors for making this possible. Their efforts
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will no doubt help in improving access to University
education.
Professor J. D. Amin
Vice-Chancellor
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MICROECONOMICS II
HOW TO STUDY THE UNIT
You are welcome to this study Unit. The unit is
arranged to simplify your study. In each topic of the unit,
we have introduction, objectives, in-text, summary and selfassessment exercise.
The study unit should be 6-8 hours to complete. Tutors
will be available at designated contact centers for tutorial.
The center expects you to plan your work well. Should you
wish to read further you could supplement the study with
more information from the list of references and suggested
readings available in the study unit.
PRACTICE EXERCISES/TESTS
1. Self-Assessment Exercises (SAES)
This is provided at the end of each topic. The exercise
can help you to assess whether or not you have actually
studied and understood the topic. Solutions to the exercises
are provided at the end of the study unit for you to assess
yourself.
vi
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2. Tutor-Marked Assignment (TMA)
This is provided at the end of the study Unit. It is a
form of examination type questions for you to answer and
send to the center. You are expected to work on your own in
responding to the assignments. The TMA forms part of your
continuous assessment (C.A.) scores, which will be marked
and returned to you. In addition, you will also write an end
of Semester Examination, which will be added to your TMA
scores.
Finally, the center wishes you success as you go through
the different units of your study.
vii
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INTRODUCTION TO THE COURSE
Microeconomics II which is an extension of Microeconomics I offers a
detailed treatment of individual decision makings. It is concerned with how prices,
wages, and profits are determined in individual markets and for individual
commodities. It studies the maximization behaviour of individual economic agents
such as the consumer, firm and industry ie how a single consumer maximizes
satisfaction, how a single producer minimizes cost etc. It studies the behaviour of an
individual consumer, producer, firm industry, monopolist, monopsonist, oligopolist
or any single decision maker in an economy. Most microeconomic problems are
maximization or minimization problems that require objective or scientific analysis.
The objective of undertaking microeconomic analysis is to suggest or identify the
efficient means of resources allocation at a micro level, suggest a most efficient ways
of spending a consumer’s income, identify most efficient combination of factor
inputs to a producer, and recommend a most effective policy to a firm or industry.
However, microeconomics analysis is always based on certain assumptions which are
sometimes unnecessary. Examples are laissez faire, ceteri paribus, full employment,
full information, free mobility of factors etc. These assumptions are unrealistic in the
modern real world of life.
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PREFACE
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INTRODUCTION TO THE COURSE
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PRODUCTION THEORY
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4:
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SOLUTIONS TO EXERCISES
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TOPIC 1:
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1.0 TOPIC:
PRODUCTION THEORY -
1.1 INTRODUCTION
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1.2 OBJECTIVES
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1.3 IN-TEXT
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1.3.1
DEFINITION OF PRODUCTION THEORY
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1.3.2 THE CONCEPT OF SHORTRUN AND LONGRUN
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1.3.3 IMPORTANT CONCEPTS IN THE SHORTRUN PRODUCTION
THEORY
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1.3.4 THE LAW OF DIMINISHING RETURNS
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1.3.5 RETURN TO SCALE
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1.6
REFERENCE
MICROECONOMICS II
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1.0 TOPIC:
PRODUCTION THEORY
1.1 INTODUCTION
Production theory is a branch of economics which is concerned with the
analysis of the firm’s choice of quantities of inputs as well as its production
function, the prices of the inputs and the level of output it wishes to produce.
It concerns itself with the issues of combining various inputs given the state of
technology in order to produce a stipulated output. Its analysis is based on the
wish to use that set of quantities of inputs, which maximizes the overall cost
of producing a given output.
1.1
OBJECTIVES
At the end of this topic, students should be able to:
i.
Describe the difference between production theory and
production function.
ii.
Explain the concept of the short run and the long run of the
production theory.
iii.
Explain the concept of total product, average product, and
marginal product of labor and capital.
iv.
With the use of curves, demonstrate the three stages of
production.
v.
Discuss the relationship between return to scale, cost of
production and profit maximization.
1.3
1.3.1
IN-TEXT
DEFINITION OF PRODUCTION THEORY
Production function or theory can be defined as the relationship between
quantities of inputs and outputs. It shows the mathematical relationship between the
output of a good and the quantities of inputs required to make it. It defines the
maximum amount of output that can be produced with a given set of inputs.
Example, if there are two inputs labour (L) and capital (K), this relationship can be
stated algebraically as Q = f(L, K) where Q = output which depends on the quantities
of the two inputs. L = labour and C = capital.
In this case of a firm, the production function can be written as Q = f
(X1,X2,….,Xn), where Q is the output and XI, X2,….Xn are the inputs, eg labour
machinery, and raw materials used in the production process
A production function can be expressed in a linear or non linear form.
Example of a linear production function is Q = a1x1 +a2x2+……+ an xn; the a1,
a2, …an are numbers which tells us by how much output increases if the inputs to
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which they are attached increases by one unit, all other inputs remaining the same.
Also, the relationship of a production can be explained in the form of non linear
equation, eg Q = bo x1 b1 x2 b2 ….xn bn. This expression is often expressed as
Cobb Douglas production function, where there are two inputs labour(L) and Capital
(K).This production function can as well be expressed as Q = ALa Kb. This
expression preceding this shows that Q = output, x1, x2, …xn are factors of
production, and bo, b1, b2, … bn are the parameters of estimates. However, the
problem of production function is essentially the problem of selecting the right
techniques of production.
1.3.2
The Concepts Of Shortrun And Longrun In
Production Theory
The shortrun in production theory can be defined as that period of time
within which a firm is not able to vary all its factors of production. In the shortrun,
the quantities of one or more inputs remains fixed irrespective of the volume of the
output. The shortrun period may be one week, one month, one year, etc. This is the
period in which the firm may not be able to change the amounts of any of the inputs
it uses. The short run period therefore can be applied to any time period not long
enough to allow the full effects of some changes to have operated eg if two inputs,
capital and labour are the inputs used in the production processes. In this case, the
only shortrun input decision to be made by the manager is how much labour to
utilize, hence capital is fixed rather than variable. If capital is fixed represented by X,
then the production function is written as Q = f (KX, L), this means that Q = f(L). It
means that output changes depend on the variation of the input of labour (L).
The longrun on the other hand refers to the period long enough for the firm
to be able to vary the quantities of all of its inputs or factors of production rather
than just some of them. It is a period of time in which all the inputs are variable. This
period is important because it is long enough to permit the firm to choose the most
efficient combination of inputs to produce any given output. Note, fixed factor
inputs are inputs the manager cannot adjust in the shortrun, and variable factors are
inputs a manager can adjust to alter production.
1.3.3
Important Concepts in the Shortrun Production
Theory
1.3.3.1 Total Product (TP):
Total product is the maximum level of output that can be produced with given
amount of inputs.
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1.3.3.2 Average product (AP):
The average product is a measure of the output produced per unit of the
inputs. The average product of an input is the total product divided by the quantity of
the inputs used in the production of that output eg ApL = Q / L, where Q = output,
and L = unit of output of labour used in producing that output. The average product
of capital (APL) is APL = Q ∕ K, where Q = output and K= unit of capital used in
the production of the total output.
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1.3.3.3
MICROECONOMICS II
Marginal Product (MP);
Marginal product is the change in the total product due to change in one unit
of an input. The marginal product of an input is the change in the total output
divided by the change in quantity used of the input. The marginal product of labour
(MPL) is the change in total output divided by the change in labour.
MPL = ∆ Q ∕ ∆ L O or δ Q ∕ δ L, where ∆ or δ = change in the total
output and ∆ L or δ L = change in labour. For the marginal product of capital
(MpK), it is the change in total output divided by the change in capital
MPk = ∆Q ∕ ∆K or δQ ∕ δk, where ∆Q or δQ = change in total output and ∆k or
δk = change in capital
1.3.4
The Law of Diminishing Returns
The law of diminishing returns was discovered by David Ricardo and states
that as additional units of a variable factor are added to a given quantity of fixed
factors, with a given state of technology, the average and the marginal product of the
variable factor will eventually decline. This can be illustrated as in the table below.
Production With One Variable Input
Amount
Amount
Total product Average
Marginal
of capital (a) of labour (b) of output ( c) product(Q/L) (d) output(∆Q/∆L) (e)
5
0
0
5
1
10
10
10
5
2
30
15
20
5
3
60
20
30
5
4
80
20
20
5
5
95
19
15
5
6
108
18
13
5
7
112
16
4
5
8
112
14
0
5
9
108
12
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5
10
100
10
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On the above table, the total product Q is the column (e) which increases from
zero to a maximum of 112 per unit of time as more and more labour is added to the
fixed amount of capital (5). Also, the column (e) shows the marginal product of
labour. Unlike the average product in column (d), the marginal product increases
initially then falls and becomes negative. The marginal product becomes negative
when the variable input (L) exceeds 8 units. The marginal product is greater than
average product when average product is rising, equals average product when average
is at maximum, and less than average product when average is falling. By plotting the
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total average and marginal products the law of the diminishing return becomes
clearer.
From the above curve, the marginal product curve reaches its maximum at
point A. It is called the point of diminishing marginal returns. Also, the average
product (Ap) curve reaches its maximum at point B. This is called the point of
diminishing average returns.
On the diagram AP = Mp, when AP is at maximum. Total product is at
maximum when Mp is zero. The intersection of the marginal product at the peak of
the average curve demonstrates three (3) stages typical of most production process.
Stage One (1)
Stage one is the initial stage of increasing average returns where Mp exceeds
Ap. The total product first increases at an increasing rate then changes from
increasing to diminishing rate. The marginal product increases reach its maximum
and then start diminishing while average product increases and continuous increasing.
Worthy of note is that, stage one(1) is an inefficient stage of production for there are
no sufficient labour for the available fixed input, hence additional labour employed,
total product increases more than proportionately. Also, the fixed input at this stage
is not optimally utilized. Therefore, doubling the amount of variable input, output
would be more than doubled and there will be decrease in unit cost of producing
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output. The firm reduces cost by expansion or output hence realizes higher profits as
price remains constant in the market.
Stage Two (2)
This is an intermediate stage of diminishing average returns, where Mp is less
than Ap but Mp is positive. At this stage, total product continues to increase at
diminishing rate, reaches a maximum and then starts diminishing. The Mp continues
to diminish and becomes zero. The average product (Ap) reaches maximum where it
equals Mp and starts diminishing ad continues diminishing. At this stage (2) is the
efficient stage of production At this stage resources are utilized optimally as the fixed
input is used intensively hence more and more labour units are required to achieve
larger outputs.
Stage Three (3);
This is the terminal stage of negative marginal returns, where total product
declines. The marginal product is negative and average product continues
diminishing. Stage (3) is an inefficient stage of production because less output is
produced by using more of the input. This shows that production cost would be
higher in this stage. This stage depicts inefficiencies in the use of production inputs.
1.3.5
Return to Scale
Return to scale refers to the increases in output which results from increasing
the scale of some production activity. It describes how output changes when all
inputs increased by the simple multiple (eg double or tripled). It is an observation pf
production when the ratio between factors is kept constant but the scale of
production is expanded. When all factors of production are increased (labour, capital
etc) in the condition of constant techniques, three (3) production possibilities occur
(1) Output increase in the same proportion as the increase in the amounts of the
factors of production. (2) Output increases in greater proportion as compared to the
increase in the amounts of the factors of production. (3) Output increases in a smaller
proportion as compared to the increases in the amounts of the factors of production
eg if same quantities of all inputs used in producing a given output are increased by
same quantity eg 50% then output increased by a greater proportion for instance
55%, returns to scale is said to be increasing (increasing returns to scale). If output
increases in the same proportion (50%) then returns to scale are said to be constant
(constant return to scale); and if output increases by smaller proportion eg 45%,
return to scale is said to be decreasing (decreasing return to scale). Therefore, if
return to scale is increasing then a given proportionate change in output requires a
smaller proportionate change in quantities of inputs, hence cost will rise less than
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proportionately with output, implying a fall in cost per unit of output, ie a fall in
average cost. Similarly, decreasing returns to scale relates to changes in all inputs.
The usefulness of the concept of return to scale lies in the fact that it provides
information that is convenient in classifying particular types of technological
condition.
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1.4 SUMMARY
Production theory is the branch of economics which deals with the
determination of the firms choice of inputs given the production function while
production function expresses the relationship between inputs and the resulting
outputs. From this, the relationship can be linear or non-linear. The analysis of the
production function can best be explained within two periods. These are shortrun
analysis and longrun periods. In the shortrun analysis, three important products
concept arises: These are total product, average product and marginal product. And
with the use of these products curves, the three stages of production are analyzed.
This also revealed the performance of the production firm. This performance is
assessed based on the return to scale of production. This entails that the firm may be
producing at increasing return to scale, constant return to scale, or decreasing return
to scale. This serves a decision rule for the firm.
1.5 SELF ASSESSMENT EXERCISES
1.
2.
3.
(a)
(b)
(c)
(a)
Define production function?
What is production theory?
What is production function?
carefully, distinguish between the concept of short run and
Long run in production theory.
(b)
Explain what is meant by
i. fixed factor input
ii. Variable factor input
Explain the concept of
a.
constant return to scale
b.
increasing return to scale
c.
decreasing return to scale
1.6 REFERENCES
Alex B. E. (2005) Introductory Approach to Microeconomics. Emmanuel Concepts
Nigeria
Jhingan, M. L. (2002) Microeconomic Theory. 5th Revised & Enlarged edition.
Rano Shehu U. A. (2004), Introduction to Modern Microeconomics. First edition:
Bench Mark Publication Ltd. Kano. Nigeria.
1.7 SUGGESTED READING
Alex B. E. (2005) Introductory Approach to Microeconomics. Emmanuel Concepts
Nigeria
Jhingan, M. L. (2002) Microeconomic Theory. 5th Revised & Enlarged edition.
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Rano Shehu U. A. (2004), Introduction to Modern Microeconomics. First edition:
Bench Mark Publication Ltd. Kano. Nigeria.
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TOPIC 2:
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2.0 TOPIC:
COST CURVES
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2.1
INTRODUCTION
2.2
OBJECTIVES
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2.3.3 DERIVATION OF THE VARIOUS SHORTRUN COST
CONCEPTS -
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SUMMARY -
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COST CURVES
2.1 INTRODUCTION
The theory of cost derives from the theory of production. The decision of a
firm regarding production of a good is dependent on the cost of production.
It attempt to explain how costs change occur in response to changes in the
size of production. It further discusses how cost is related to some level of
production. The cost function when depicted graphically is often called the
cost curves. The theory of cost is therefore a necessary pre-requisite to any
understanding of how a firm chooses the level of output it will supply.
2.2 OBJECTIVES
At the end of the topic, students should be able to
i.
Explain the various concepts of costs
ii.
Discuss the difference between shortrun costs and
longrun cost concepts
iii.
Derive some concepts from the total cost
2.3 IN-TEXT
2.3.1
THE CONCEPT OF COSTS
2.3.1.1
EXPLICIT AND IMPLICIT COSTS
Explicit costs are the actual expenditure or spending of the firm to hire, rent,
or purchase the inputs it requires in production. It includes wages, rental price of
capital, equipment and buildings, purchase of raw materials and other charges.
Implicit cost on the other hand is the value of inputs owned and used by the firm in
its own production activity. It is the highest return that the firm could have received
from investing its capital in the most rewarding alternative use. It is sometimes called
the opportunity costs. It is also referred to as imputed costs and do not take the form
of cash outlay. It doesn’t reflect in the normal accounting practice as explicit costs
which involve cash payment.
2.3.1.2
PRIVATE COSTS AND SOCIAL COSTS
Private costs are the sum of the explicit and implicit costs; which firm incurs
in its decision regarding production of goods. Eg, cost of raw materials, wages,
interest payment on capital loans, tax payment and Imputed wages, while social cost
on the other hand are cost of some activity or output which are borne by society as a
whole. It is the total cost to the society on account of production of a commodity
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which includes both private costs and the external costs. It covers the cost in the
form of disutility created through air water, and noise pollution etc.
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2.3.1.3
MICROECONOMICS II
OPPORTUNITY COSTS:
Opportunity cost are costs which do not involve actual payment by a firm to
factors of production but seen as the value of the alternatives or other opportunity
which have to be forgone by a firm in order to achieve a particular thing.
2.3.1.4
ACTUAL COST MONEY COST
The actual cost or money cost in contrast to the concept of opportunity cost
refers to those costs which are actually incurred by a firm in payment for labour,
material, plant building machinery equipment transport etc. The total money
expenses recorded in the books accounts
2.3.1.5
ECONOMIC COST AND ACCOUNTING
COST
Economic cost involved explicit costs as well as implicit costs. Accounting
cost on the other hand considers explicit cost ie costs most often associated with the
cost of producing but ignores implicit costs. The basic difference between economic
costs and accounting costs is that economic costs includes not only the accounting
costs but also the opportunity costs of the resources used in production
2.3.1.6
HISTORICAL
AND
REPLACEMENT
COSTS
Historical cost are cost of an assets acquired in the past by a firm. It is used
for accounting purposes while, replacement costs are costs of an assets or outlays
which have to be made for replacing the same assets
2.3.1.7
SUNK COST
A sun cost refers to an expenditure that has been made and cannot be
recovered. It is a cost that is lost forever once it has been paid.
2.3.1.8
INCREMENTAL COST
This is a cost that refers to the change in total costs from implementing a
particular management decision, such as the introduction of a new product line, the
undertaking of a new advertising campaign, or the production of a previously
purchased component.
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2.3.2
MICROECONOMICS II
SHORT RUN COST CONCEPT
The short run costs derived from the costs of the firm in the short run, when
at least one factor is fixed. The short run costs are divided in to fixed and variable
costs. Ie TC = TFC + TVC, where TFC is Total Fixed Cost and TVC is Total
Variable Costs. This expression can also be written as TC = VC + FC. Therefore, the
short run Total cost is the sum of variable cost plus fixed cost.
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2.3.2.1
MICROECONOMICS II
Variable Costs (VC).
These costs that vary with the volume of output of a firm, and this cost is
always zero, when output is zero. It is a cost that keeps on changing with changing
output. It is expressed as a function of output. VC = f (Q), where VC is variable cost
and Q is output; it is the cost of raw materials, labour and other overhead costs.
2.3.2.2
Fixed Costs (FC)
These are costs that remained constant as output varies and are incurred even
when output is zero. Fixed costs usually include interest paid on capital borrowed,
cost of machinery, rent of a factory, building and depreciation costs. Fixed cost is also
known as supplementary cost. Quasi fixed cost is part of fixed cost. This cost is zero
when output is zero but assumed a certain value when output is increased above and
then remained constant for all output above the initial one.
2.3.2.3
Marginal Cost (MC):
This is the rate of change of total cost with respect to changes in output. It is
the cost of producing additional unit of output. It is the change in total cost divided
by the change in the output. MC = ∆TC ∕ ∆Q or δ TC ∕ δ Q, where ∆ or δ are
changes in total cost (TC) and output. The δ TC / δ Q gives the rates changes in total
cost as output change (slope). And the fact that difference between total cost and
variable cost is the constant cost (Fixed cost), a fixed marginal cost can be expressed
as
MC = ∆vc ∕ ∆ q or δ vc ∕ δ q or δ FC ∕ δ Q.
2.3.2.4
Average Total Cost (AC).
This is the total cost per unit of output or the ratio of the total cost (TC) to
the total output (Q). It is measured as AC = TC ∕ Q = TFC / Q + TVC ∕ Q = AVC
= AFC, where TC is the total cost Q = Output, TFC = total fixed cost, TVC is the
total variable cost, AVC is the average variable cost and AFC is average fixed cost.
The average variable (AVC) is the variable cost per unit of output or total variable
cost divided by output. It is given as AVC = TVC ∕ Q. The average fixed cost (AFC),
is the total cost per unit of output ie total fixed cost divided by output. It is given as
AFC= TFC ∕ Q or FC ∕ Q.
2.3.3
DERIVATION OF THE VARIOUS SHORTRUN
COST CONCEPTS
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The various shortrun cost concept can be derived from a firms shortrun cost
function. The shortrun cost function is a cost function that expresses the relationship
between output and costs known as cost function. It defines the minimum possible
cost of producing each output level when variable factors are employed in the cost
minimizing fashion. Suppose a firm has the following shortrun cost function.
TC = 30+5Q+ 0.3Q2+ O.O1Q3. The fixed cost is 30 and variable cost is 5Q0.3Q2+ 0.01Q3. The equation therefore, AC= TC ∕ Q = 30+ 5Q – 0.3Q2 + 0. 01Q3
∕ Q.
The Marginal Cost is MC = δ TC ∕ δ Q = 5 – 0.6Q + 0.03Q2.
AFC = FC ∕ Q = 30 ∕ Q, AVC = VC ∕ Q = 5Q + 0.03Q2 + 0.01Q3 ∕ Q, AVC = 5 +
0.03 + 0.01Q2
2.3.3.1
The
Shortrun
Curves
and
Their
Relationships
Cost function when depicted graphically is called cost curves. The
relationships between TC, VC and FC can be shown graphically as
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Output
On the curve above, the fixed cost curve is a horizontal line, representing the
same total of N30 as the output changes. The total cost curve lies above the variable
cost curve by the value of fixed costs at each output level: This means that even when
production is zero, fixed cost remains at N30. However, at 10 units of output level,
the fixed cost is equals the variable costs.
The relationships between average and marginal costs are shown graphically
below.
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2
MICROECONOMICS II
AFC declines continuously. This is the result of spreading the constant
overhead cost over increasing volume of output. The constant cost is being
divided by increasing output giving rise to declining unit cost.
AVC Is a U – Shape curve which declines at first as more output reduces unit
cost but rises towards AC because of the law of diminishing returns. Infact,
the shape of the average variable costs curve is determined by the principle of
diminishing returns. Infact the shape of the average variable cost curve help to
explain why the average total cost curve in the shortrun is U-shaped. At low
levels of output both AFC and AVC are falling, so that average total cost must
be falling. Such when AVC begins to rise after a given level of output, AFC is
falling enough to offset this rise in AVC.
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4
MICROECONOMICS II
MC cuts AVC and AC at their minimum points lying below both AVC and
AC in the range when it is falling and rising above it when it is increasing. This
happens because the marginal cost pulls the average cost towards its direction.
The U-shape nature of AVC and MC reflects the operation of the law of
variable proportions. The law of increasing returns operates in the downward
sloping left hand side portion of these curves; and diminishing returns take
over in the rising portion of the curves.
2.3.3.2
The longrun Cost Analysis
The basic feature of the long run cost is that enterprises do not have any fixed
costs. All costs are variable. In the longrun, firm can enter or leave, expand or
contract the scope of any operation, hence in the longrun, all costs are variable. In the
longrun, only longrun average costs exist. The longrun average (LRAC) curve shows
the minimum average cost for each level of output when all factor inputs are variable.
In the longrun plants of different size can be built hence , unique set of
shortrun cost curves exist for each possible plant size. Unlike the shortrun, where
some factors of production are fixed causing the average total cost curve to be Ushape. The law of diminishing returns does not apply to the longrun because in the
longrun, all inputs are variable. To show the relationship between shortrun and
longrun, assume that there are three (3) scale plants a firm can build and associated
with each plant is a shortrun average cost curves. The shortrun average cost curve are
SAC1, SAC2, SAC3.
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COST
(N)
SMC 1
SAC 3
SMC 3
SAC 1
LAC 3
SAC 2
SMC 2
a
Economics of scale
Dise conomics of scale
OUTPUT
Under the shortrun cost curve an envelope curve which reflects the plant sizes
associated with the average costs of producing each level of output is utilized. This
envelope curve is the longrun average costs curve (LAC) for the firm. The envelope
curve is tangent to the minimum point on each SAC curve. The LAC is tangent to
the lowest point ‘a’ on the SAC2. The associated output is 400 and this is the
optimum output. The plant SAC2 that produces this optimum output at minimum
cost is the optimum firm.
2.4 SUMMARY
The process of production starts some where at a point where decision is
made on the right factors to employ and by what units or combination for the
attainment of a desired level of output. However, as to how much it pays to hire a
given unit of capital or labour is very crucial for the producer to know cost functions
are derived directly from production function corresponding to each level of output,
to a level of cost. Based on this, the essential cost emphasized include explicit cost,
private and social costs, opportunity cost, money cost, economic and accounting
costs, historical and replacing costs sunk costs and incremental costs. These costs are
analysed in two phases, the shortrun and longrun cost. The relationship between
these costs are best analysed using the level of output purchased by the firm.
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2.5 SELF ASSESMENT EXERCISE
1.
2.
3.
Distinguish between
a.
Private cost and social cost
b.
Economic cost and accounting cost
Explain the following terms
a.
Sunk cost
c.
Variable cost
e.
Marginal cost
Given the TC= 30 + 5Q + 0.3Q2 + 0.01Q3
a.
Determine the fixed cost function
b.
Determine the marginal cost function, Average cost
function and the average variable cost function.
2.6 REFERENCES
Alex, B. E (2005) Introductory Approach to Microeconomics. Emmanuel Concept,
Ltd Nigeria.
Joe, U. U. (2003) Practical Microeconomic Analysis in African Context. Sibon books
Ltd Ibadan.
Koutsoyiannis, A. (2003) Modern Microeconomics. Second edition, Macmillan
press Ltd.
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2.7 SUGGESTED READINGS
Alex, B. E (2005) Introductory Approach to Microeconomics. Emmanuel Concept,
Ltd Nigeria.
Joe, U. U. (2003) Practical Microeconomic Analysis in African Context. Sibon books
Ltd Ibadan.
Koutsoyiannis, A. (2003) Modern Microeconomics. Second edition, Macmillan
press Ltd.
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TOPIC 3:
TA B LE
O F
C O N T E N TS
PAGES
3.0
TOPIC:
-
PRICING OF OUTPUTS IN MARKET
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3.1
INTRODUTION
3.2
OBJECTIVES
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3.3.1 PERFECT COMPETITION -
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3.3.2 SHORTRUN EQUILLIBRIUM
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3.3
IN – TEXT
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21
3.3.3 LONGRUN EQUILLIBRIUM
22
3.3.4 PURE MONOPOLY -
-
3.3.5 PROFIT MAXIMIZATION UNDER MONOPOLY
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23
3.3.6 PRICE DISCRIMINATION -
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25
3.3.7 MONOPOLISTIC COMPETITION
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26
25
3.4
SUMMARY -
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3.5
SELF ASSESSMENT EXERCISES -
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26
3.6
REFERENCE
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SUGGESTED READINGS -
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26
26
3.7
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PRICING OF OUTPUT IN THE MARKETS
3.1 INTRODUCTION
The theory of the firm is concerned with the explanation and prediction of
decision of the firms in respect of the rate output, price, level of utilization of
inputs, and changes in the production process. It is concerned with the
analysis of the firm’s output and pricing decisions. The underlying principle of
the theory of the firm is that each firm maximizes profit with full information
and complete certainty. The theory of the firm is usually discussed in terms of
market structure.
3.2 OBJECTIVES
At the end of this topic, students should be able to
i.
Lists and explain the assumption of perfect competitive
markets
ii.
With the aid of diagram or curves explain how output and price
are determined in the markets.
iii.
Define what monopoly is?
iv.
Describes how the monopolist determine its output and price
v.
Explain the difference between monopolist and monopolistic
competition.
3.3
3.3.1
IN TEXT
Perfect Competition
The perfect competition is a market where the following assumptions prevail,
many buyers and sellers in the markers. The number of buyers and sellers are large
that each relative to the total quantity of good traded those changes in these
quantities leave market price unaffected. The size of the buyers and sellers are large
that each cannot exert pressure on he market to influence price or quantity bought
and sold. In addition to the revenue which is just the price. Therefore, the marginal
revenue is the price.
1
Each firm in the market produces a homogeneous product, hence the
buyer is indifferent about choosing one or the other.
2
The buyer and sellers have perfect information in terms of the quality
and price the product.
3
There are on transport cost, hence all firms’ charges the same price.
4
There I free entry and exit from the market.
5
There is no interference (no identical interference) especially with the
activities of the buyers and sellers eg government price control.
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3.3.2
MICROECONOMICS II
Shortrun
Equilibrium
or
Shortrun
Profit
Maximization under Perfect Market
In the shortrun market competition, profit maximization under perfect market
requires that MC = MR, and that MC must be rising at the point where MC = MR,
while the firm will be operating at its minim um point of the shortrun average cost.
(SAC). This is demonstrated with an aid of diagram below.
PRICE COST
PER UNIT
SMC
SAC
SVC
T
P1
R
MR=P1
S
0
Q1
OUTPUT
The firm maximizes its profits by producing output Q1, where MC = MR =
P. The total revenue is defined by the area of the rectangle OP1TQ1, while total cost
is given by rectangle ORSQ1.The area OP1TQ1 minus ORSTQ1 equals the area.
P1TSR, the difference which equals the profit of the firm, shows that the firm is
earning a positive economic profit represented by the shaded area P1TSR. In the
shortrun, the perfectly competitive firm should produce in the range of increasing
MC where MC = P, to profit provided that P > AVC, but if P ‹ AVC, the firm should
shut down its plants to minimize its losses.
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3.3.3
MICROECONOMICS II
Longrun
Equilibrium
of
The
Perfect
Competitive Firm
The presence of the short run positive economic profit will attract new firms
in the industry. This results in increased production and competition bringing down
the price of the good, until the economic (abnormal) profit is eliminated. At this
point firms is in longrun equilibrium where total cost are covered and normal profit is
earned. The below graph depends the long run price and output determination.
PRICE COST
REVENUE
In the above diagram, P (= average revenue and marginal revenue) which is just equal
the average cost and marginal cost. Moreover, the output is produced at minimum
average cost. At this point, resource are efficiently utilized, more output is produced
and sold at lowest price
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3.3.4
MICROECONOMICS II
PURE MONOPOLY
Pure monopoly is a form of market organization in which there is a single
seller of a commodity for which there is no close substitutes. It occurs when
1. there is a single firm selling the good
2. there are on close substitutes for the good
3. entry into the industry is very difficult or impossible.
Pure monopoly is an opposite of perfect competition, since the monopolist is
the single or sole supplier of the good, he is in effect the industry. He faces the
market demand curve which is normally downward sloping from left to the right. The
demand curve shows the different prices the producer can sell different levels of
output. He has a control over the output and a price maker but cannot control and
set process at the same time, he either set price or allow consumers to determine the
quantity of output to be purchased the fact that average revenue is the total revenue
divided by the quantity of good. The demand curve therefore can be the average
revenue curve (AR). Faced with downward sloping AR curve the marginal revenue
which is extra revenue from the sell of extra unit of output. This shows that marginal
revenue MR must be less than AR (or price).
The conditions which give rise to monopoly is
1. increasing returns to scale
2. the ability if there firm to control the entire supply of raw materials
required to produce the commodity.
3. owning of patent by a firm which precludes other firms from producing
the same good.
4. the case of government franchise where by the firm is set-up to be the sole
producer and distributor of a good or service.
5. the case of merger and acquisition where by big firms enter into collusion
to control market supply.
3.3.5
PROFIT
MAXIMIZATION
UNDER
MONOPOLY
Under the pure monopoly the firm is the industry and faces the demand curve
which is negatively sloped. The demand curve is also referred to as AR curve. Faced
with downward sloping AR curve , the monopolist has to reduce the price of all units
sold in order to sell an extra unit of output. This means that the marginal revenue MR
which the revenue earned by selling extra unit of output must be less than average
revenue AR or the price.
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The profit – maximizing or best level of output for the monopolist is given at
the output at which MR = MC. Price is then read off the demand curve.
From the above curve, it could be seen that the best level of output is at the
point where MR = rising MC. At this best output level of Q2 Units, the monopolist
makes a point of P1-P3 per unit, ie the vertical distance between D and AC at Q2
units of output, and Q2 units of output times the P2-P3 profit per unit in total. The
monopolist therefore maximizes total profit at Q2 (P1-P3) when it produces and sell
Q2 units of output at the price of P1. At this point MR = MC = P2.As long as MR
exceeds MC the monopolist will expand output and states because doing so adds
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more to TR than to TC (and profit rise). The opposite is true when MR is less than
Mc.
3.3.6
PRICE DISCRIMINATION
Price discrimination involves changing different prices for the commodity
such as:
1. for different quantities purchased
2. for different classes of customers
3. in different markets.
Under price discrimination the monopolist can increase total revenue TR and
total profit from any given level of output and total costs.
In order for the monopolist to practice and benefit from price discrimination:
1. It must have knowledge of demand for its commodity by different classes
of customers or in different markets.
2. These demand curve must have different elasticity.
3. The monopolist must be able to separate or segment the two or more
markets and keep them separate.
An example of charging different prices for different quantities purchased by
customer can be seen in the activities of telephone companies. They may charge N15
each for the first 50 calls per units and N10 for each additional calls.
Also, price discrimination regarding charging different prices to each class of
customers is the prevailing practice of electrical power company charging a lower rate
to industrial users of electricity than to households because the former have a more
elastic demand for electricity hence there are substitutes eg generating their own
electricity. The markets are kept separately by different meters. Also, charging
different prices in different markets is found in international trade when a nation sells
a commodity abroad at lower price than in its home markets. This is referred as
‘Dumping’. This is applicable when the demand for the product abroad is elastic;
hence there are substitutes from other countries.
3.3.7
MONOPOLISTIC COMPETITION
Monopolistic competition is a market organization in which there are many
sellers of different product. It is a blending competition and monopoly. The
competitive element is he presence of large number of firms and easy entry. The
monopoly elements are the presence of differentiated ie similar but not identical
products or services. Product differentiation can be real or imaginary and can be
created through advertising. However, the availability of close substitutes severely
limits its monopoly power. Example of monopolistic competition are the prevalent
form of market organization in retailing grocery stores, gasoline stations dry cleaners
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etc in a close proximity of each other. This market is characterized neither perfect
competition nor by monopoly, but by elements of both.
The fact that the market is characterized by enough sellers each perceived a
downward sloping demand curve for its particular output. The action of each firm
tends to go unnoticed in the market place but each recognizes its own impact on
price.
3.4 SUMMARY
There are basically four organizational structure of the markets. These are
pure or perfect competition monopoly, monopolistic competition and oligopoly.
Both perfect competition and pure monopoly are polar cases within this market
spectrum. Their assumptions are far removed from their real world. The other two
markets structure imperfect and oligopoly are approximate and very closely to the
phenomenon observed in most world markets. These markets are differentiated in
terms of,
1. the number and size of the buyers and sellers of the products are different
2. the type of product bought and sold, standardized or homogeneous.
3. the degree of mobility of the resources ie the ease to which firms and
owners of input can enter the markets
4. the degree of knowledge that economic agents ie firms, suppliers of inputs,
and consumers have on prices, cost and even demand and supply
condition of the product.
3.5 SELF ASSESSMENT EXERCISE
1.
2.
3.
4.
3.6
State the assumptions of a perfect market
Explain the condition that must be fulfilled for shortrun profit
maximization under perfect market.
a.
what is price discrimination?
b.
state the requirements for a monopolist to practice and benefit
from price discrimination
Define monopolistic competition.
REFERENCES
Jhingan, M L (2002) Microeconomic Theory Vrinda publications (p) Mayer Vihar,
phase 4, Delhi
Alex, B. E (2005) Introductory Approach to Microeconomics. Emmanuel Concept,
Ltd Nigeria.
Joe, U. U. (2003) Practical Microeconomic Analysis in African Context. Sibon books
Ltd Ibadan.
Koutsoyiannis, A. (2003) Modern Microeconomics. Second edition, Macmillan
press Ltd.
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3.7 SUGGESTED READING
Alex, B. E (2005) Introductory Approach to Microeconomics. Emmanuel Concept,
Ltd Nigeria.
Joe, U. U. (2003) Practical Microeconomic Analysis in African Context. Sibon books
Ltd Ibadan.
Koutsoyiannis, A. (2003) Modern Microeconomics. Second edition, Macmillan
press Ltd.
TOPIC 4:
TA B LE
O F
C O N T E N TS
PAGES
4.0
TOPIC:
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PRICING OF FACTORS OF PRODUCTION
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27
4.1
INTRODUCTION
4.2
OBJECTIVES
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4.3
IN – TEXT
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4.3.1 DEMAND FOR AND SUPPLY OF LABOUR
28
4.3.2 SUPPLY OF LABOUR
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-
-
29
4.3.3 EQUILLIBRIUM OF A PERFECT COMPETITIVE FIRM 30
4.3.4 MONOPOLY AND MONOSPONY POWER
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-
31
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4.3.5 DETERMINATION OF EQUILLIBRIUM WAGE RATE
AND EMPLOYMENT
-
-
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33
4.4
SUMMARY -
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34
4.5
SELF ASSESSMENT EXERCISES -
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4.6
REFERENCE
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-
-
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SUGGESTED READINGS -
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34
34
4.7
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PRICING OF FACTORS OF PRODUCION
4.1 INTRODUCTION
The demand for factors of production in the process of production is
classified as derived demand. These factors are employed not for their sake
but for the sake of what they produce. Firms and industry demand for labour,
capital, and raw materials in the production process because of the finished
good demanded by producers is determined by the behavior of the producer,
the market organization and instititutional set-up of the economy where these
production process is practiced.
4.2 OBJECTIVES
At the end of this topic students should be able to:
i. explain how price of factors inputs are determined in perfect
competitive market
ii. explain the factors that determine the supply of factors
iii. state how price of factors are determined in the monopoly and
monopsony power markets.
4.3 IN-TEXT
4.3.1
DEMAND FOR AND SUPPLY OF LABOUR
Labour is unique is in the sense that it is supplied by human beings, whereas
the embodiment of all the factors is non-human.The pricing of these factors
,labour inclusive is due always to the way as it is done in perfectly competitive
market,i.e the forces of demand and supply determine their prices .The demand
for labour by a firm is fundamentally dependent on the level of wage rate.Given
the fixed level of tecnolgy ,a firm varies its employment of labour in such a way as
to maximse profit.Therefore the firm ensures that the wage rate is at least equal if
not less than the value of additional(marginal )unit of output i.e the value marginal
product (VMP)that labour helps to produce .This value is obtained by multiplying
the marginal product by the product price.
The demand curve for labour whichis the value of marginal product curve
slopes downward from left to right ,indicating an inverse relationship between
labour demand and wage rate.The firm will be willing to pay progressively lower
wage rateas marginal productivity falls.This is explained in the curve below.
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The slope of labour curve is given by the differential of labour demand
function with respect to wage rate that is.
Ld = f '(W) ie δ L ∕ δ W = W.
Ld = f '' (W) < 0 = δ L ∕ δ W < 0.
This Shows that total profit is maximized at a point where the marginal cost
of labour is exactly equal to the value of marginal product of labour.
i.e δ L ∕ δ X =W
= MCL = VMPL
4.3.2
SUPPLY OF LABOUR
In perfectly competitive market, it is assumed that no supplier of resource
(labour)can place enough of the given resources to influence prices.The supplier
of labour and indeed other resoures of factors of productions can be determined
at the disposal of those in charge of productive processes.The main determinant
of supply of labour in the firm is the wage rate.
The supply of labour by a single individual presents a trade off between his
desire to earn a wage for his present future consumption and leisure.The
opportunity cost of the wage he earns is the leisure he forgoes .So the supply
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curve of labour is upward sloping in a competitive labour market.The direct
positive relationship between wage rate and labour supply is depicted below.
The Slope of the labour supply curve is given by the differential of labour supply
function with respect to wage rate that is:
Ls = f '(W) ie δ L ∕ δ X = W.
Ls= f '' (W) >0 = δ L ∕ δ X >0.
4.3.3
EQUILIBRIUM OF A PERFECT COMPETITIVE
FIRM IN THE FACTOR MARKET
The demand curve for labour in a perfectly competitive market is a normal
curve, which slopes downward from left to right while the supply of labour for a
single firm in a perfectly competitive market, where the firm is a price taker is
perfectly elastic. This means that the firm simply pays, the market determined
wage rate. The equilibrium condition is depicted below where the perfectly elastic
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supply curve of labour at a wage rate of N3500 intersects the downward sloping
demand curve of labour.
WAGE RATE
LD
L
3500
Below the equilibrium level of employment that is of workers employment adds
more revenue to the firm than labour cost, while above the of workers, extra
employment adds more costs to the firm than revenue. Therefore, 7 workers
provide the profit maximizing empolyent level where the wage of N3500 equals
the value of marginal product of labour.
4.3.4
MONOPOLY AND MONOPSONY POWER
A Monopoly power is exhibited in the output of the market where he is faced
with downward sloping demand curve and a monopsony power is shown when
the monopsony firm is faced with an upward sloping supply curve for its inputs.
Therefore, the monopsony firm must offer higher factor price in the form of
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wage inorder to attract more factors. A competitive firm hires factors and pays
higher than the value of the marginal product they help to produce. Amonopolist
or monopsonist can not afford to to do this and maintain the same level of
employment as a perfect competitor. The monopolist marginal revenue falls
sharply than its average revenuen ie the demand curve. This entails that the
monopolist hires labour and pay them in line with his fast declining marginal
revenues. He pays marginal revenue product of labour (MRPL). A monopsonist
with increasing marginal cost as a result of the upward sloping supply curve of
labour tries to equate his marginal cost of labour (MCL) with the value marginal
product of labour (VMPL). However, ceters paribus, monopsonist is a price taker
in his output market.
The graph below shows the value marginal product of labour (MRPL),
schedules for two firms with the same technology.
Wage Rate
E3
L
e1
e4
e2
L1
L2
L3
L4
SL
Labour
It could be seen that both schedules slopes downward. This is because of
diminishing marginal productivity. The MRPL slopes more steeply because the
monopsonist firm is facing a downward sloping demand curve for its output
hence additional output reduces the price and hence the revenue earned on
previous units of output. He therefore sets MRPL equal to W0 and employs only
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L2 workers. A monopsonist also recognizes that additional employment bids up
wages for existing workers because he faces an upward sloping supply curve of
labour. He therefore, fixes MCL equal to VMPL, given that the price of his
product is competitively determined. He employs L3 units of labour at
equilibrium point e3. However, if the market is a monopolist type, with
downward sloping demand curve, he will set MCL = MRPL, and employ only L1
at e1 equilibrium point. If it were a perfectly competitive market, he will set
VMPL = W0, and employ L4 workers a equilibrium point which is the largest
level of employment than in the other two markets. In terms of profits
maximization the firms will ensure that the marginal cost of the last unit of labour
equals the marginal revenue earned from that last unit of labour. This analysis
shows that monopoly and monopsony power tend to reduce the firm’s demand
for labour.
4.3.5
DETERMINATION
OF
EQUILIBRIUM
WAGE
RATE AND EMPLOYMENT
The market supply of labour is the sum of all individual supply of across all
labour markets. The aggregate supply is positively sloped in the perfectly markets.
Higher wages induces more people to work and enjoy less leisure The demand for
labour is the sum total of individual firms’ employment. The labour demand is
inversely related to the wage and the market allow labour to earn just just the
market value of that additional output that it helps to produce. The intersection of
demand and supply curves of labour and indeed for all other factors of
production determine the equilibrium wage below other and indeed for all other
factors of production, determined the equilibrium wage and level employment.
The curve below illustrate the equilibrium wage W* and level of employment (full
employment) at N* and level of the employment (full employment) at N*
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SL
Labour
The demand for factors is a derived demand and the supply of factors (labour)
depends on the attitudes of individuals towards work and leisure. The market is
assumed to be self correcting., any excess supply above or shortage below will
corrected through the free play of the forces of demand and supply: The value of
the factor is determined by the forces of demand and supply. Each factor should
be paid the value of its marginal product if the goal of each firm or industry at
large is profit maximization.
4.4 SUMMARY
The demand for factor of inputs in production process is a derived demand
while the supply side of the factor inputs are generally the factor remuneration
and its opportunity cost in relation to leisure. The values or price of these inputs
are determined by the market forces of demand and supply especially in a
perfectly competitive market. In monopoly and monopsony markets, the prices of
these factors are determined is used on their value marginal product of labour or
capital (VMPL,K).Therefore, for profit maximization for all firms, the firms
ensure that the marginal cost of the last unit of the factors equals the marginal
revenue earned from the last unit of the factor.
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4.5 SELF ASSESSMENT EXERCISE
1.
2.
3.
Explain how price of factor input (labour) is determined in a perfectly
competitive market.
Discuss the factors that determine the supply of factors inputs in the
market
Explain the term ‘demand for labour’
4.6 REFERENCE
Shehu, U, A. R. (2004) Introduction to Modern Microeconomics. Benchmark
Publishers Ltd.
Jhingan, M. L. (2002) Microeconomic Theory. 5th edition.Vrinda
Publication (p) Ltd.
4.7 SUGGESTED READING
Alex, B. E (2005) Introductory Approach to Microeconomics. Emmanuel
Concept, Ltd Nigeria.
Joe, U. U. (2003) Practical Microeconomic Analysis in African Context. Sibon
books Ltd Ibadan.
Koutsoyiannis, A. (2003) Modern Microeconomics. Second edition,
Macmillan press Ltd.
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TOPIC 5:
TA B LE
O F
C O N T E N TS
PAGES
5.0
TOPIC:
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THE THEORY OF COMPARATIVE COST
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5.1
INTRODUCTION
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5.2
OBJECTIVES
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5.3.1 THE THEORY OF COMPARATIVE COST
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5.3
IN – TEXT
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5.3.2 ASSUMPTION OF THE THEORY -
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5.3.3 COST DIFFERENCES
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5.3.4 EQUAL DIFFERENCE IN COST -
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5.3.5 COMPARATIVE DIFFERENCE IN COST
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5.4
SUMMARY -
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5.5
SELF ASSESSMENT EXERCISES -
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5.6
REFERENCE
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SUGGESTED READINGS -
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THE THEORY OF COMPARATIVE COST
5.1 INTRODUCTION
The theory of comparative cost is based on the differences in production cost
of similar commodities in different countries. Production cost differ in countries
because of geographical division of labour and labour specialization in production.
And as a result of the differences in the geographical and specialization some
countries can produce certain goods at the lowest cost than others giving them
comparative cost advantages than other countries.
5.2 OBJECTIVES
At the end of the topic, students can be able to :
i.
Enumerate the assumptions of the theory of comparative cost.
ii.
Differentiate absolute cost advantage and comparative cost
advantage
iii.
Explain equal differences in costs.
5.3
IN TEXT
5.3.1
THE THEORY OF COMPARATIVE COST
The principles of comparative costs which was associated with David Ricardo
and later improved by John Stuart Mill, Cairns and Bastille was based on the
differences in production cost of similar commodities in different countries.
Production costs differ in countries because of geographical (climate, natural
resources geographical situation), labour specialization and efficiency. This situation
can make a country produce commodities at the lowest cost than other countries. In
this way a country can produce or each country specializes in the production of that
commodity in which its comparative cost of production is the least. Thus, when a
country enter into trade with some other countries, it will export those commodities
in which its comparative production cost less and imports those commodities in
which its comparative production costs are high. This is the basis of international
trade. It now follows that each country will specialize in the production of those
commodities in which it has greater comparative advantage or least comparative
disadvantage cost in the production of a good. A country can then export those
commodities in which its comparative advantage is the greatest, and import those
commodities in which its comparative disadvantage is the least.
5.3.2
ASSUMPTION OF THE THEORY
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1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
5.3.3
MICROECONOMICS II
There are only two countries say A and B.
They produce the same two same two commodities X and Y.
Tastes are similar in both countries.
Labour is the only factor of production.
All labour units are homogenous
The supply of labour is unchanged
The prices of the two commodities are determined by labour costs ie
the number of labour units employed to produce each.
Commodities are produced under the law of constant costs or return.
Trade between the two countries takes place on the bases of barter.
Technological know-how remains unchanged.
Factors of production are perfectly mobile within between the two
countries.
There is free trade between the countries (no trade barriers or
restriction).
No transport costs are involved in carrying trade between the two
countries.
All factors of production are fully employed in both the countries.
The international market is perfect so that the exchange ratio for the
two commodities is the same.
COST DIFFERENCES
Based on the above assumptions the theory of cost is explained by taking
these types of differences in cost; absolute, equal and comparative costs.
1. Absolute difference in costs; these absolute differences in costs occur
when a country produces a commodity at an absolute lower cost of
production that the other country. These absolute differences in cost can
be illustrated by the table below:
Table 5.1 Absolute Differences in Costs
Country
Commodity X
Commodity Y
A
10
5
B
5
10
The table above shows that country A can produce 10x or 5y with one unit of
labour and country B can produce 5x or 10y with one unit of labour. This shows that
country A has an absolute advantage in the production of X ie 10X is greater than 5X
and country B has an absolute advantage in the production of 10Y ie 10Y is greater
than 5Y. This can be expressed as, 10 X A ∕ 5X B > 1 > 5Y A > 10 B. Trade between
the two countries will benefit both the two countries. This is shown below.
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Production before trade
Production after trade
Gains from trade
Commodity
A
B
Total
(1)
X
10
5
15
Y
5
10
15
(2)
Y
20
20
X
20
20
(2-1)
Y
-5
+10
-5
X
+10
-5
+5
On the table, it is shown that both countries produce only 15 units of the two
commodities by applying one labour unit on each commodity. If country A were to
concentrate on the production or specializes in the production of commodity X and
both units of labour on it, its total production will be 20 units of X. Similarly if
country B were to specialize in the production of Y alone, its total production will be
20 units of Y. The combined gain to both countries from trade will be 5 units of
commodity X and commodity Y. The absolute differences in costs can also be
illustrated with the aid of a diagram.
YB
YA
0
XB
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The production possibility curves YA, XA is for country A. This shows that it
can produce either OXA of commodity X or OYA of commodity Y or OYA of
commodity Y. However, based on the curve, it is revealed that country A has
absolute advantage in the production of commodity X (OXA > OXB) and
commodity B has absolute advantage in the production of commodity Y (OYB>
OYA). This is the emphasis on comparative differences in costs
5.3.4
EQUAL DFFERENCE IN COSTS
Equal differences in costs arise when two commodities are produced in both
countries at the same cost difference. Suppose a country can produce 10x or 5Y and
country B can produce 8X or 4Y. In this situation with one unit of labour country A
can produce either 10X or 5Y, and the cost ratio between X and Y is 2: 1. In country
B, one unit of labour can produce either 8X or 4Y,and the cost ratio between the two
is 2:1 Thus, the cost of producing X in terms of Y is the same in both countries. This
can be expressed as
10X of A ∕ 8X of B = 5Y of A ∕ 4Y of B = 1.Thus, when cost differences are equal,
no country stands to gain from trade, therefore international trade is not possible.
5.3.5
COMPARATIVE DIFFERENCE IN COSTS
Comparative differences in costs occur when one country has an absolute
advantage in the production of both commodities, but a comparative advantage in
the production of one the commodity than in the other. The comparative cost
differences can be illustrated as below:
Table 5.2.
Country
A
B
Comparative Differences in Costs
Commodity- X Commodity- Y
10
10
6
8
On the table above, it shown that country A can produce 10X or 10Y and
country B can produce 6X or 8Y. In this situation, country A has absolute advantage
in the production of both X and Y, but has a comparative advantage in the
production of X; country B has an absolute disadvantage in the production of both
commodities but its least comparative is in the production of Y. This is seen before
trade, the domestic cost ratio of X and Y in country A is 10:10 (or 1:1), while in
country B, it is 6: 8 (3.4). If they are to enter into trade, country A’s advantage over
country B in the production of commodity X is
10X of A ∕ 6X of B = 5 ∕ 3 and in the production of Y is 10Y of A ∕ 8Y of B = 5 ∕ 4.
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Since, 5 ∕ 3 is greater than 5 ∕ 4, country A’s advantage is greater in the
production of commodity X hence, country A will find it cheaper to import
commodity Y from country from country B, in exchange for its commodity X.
Similarly, the comparative disadvantage of both commodities is a real fact. In the
same case of commodity X, country B’s position is 6X of B ∕ 10X of A = 3 ∕ 5 and in
the case of Y, it is 8Y of B ∕ 10Y of A = 4 ∕ 5, and since 4 ∕ 5 is greater than 3 ∕ 5,
country B has least comparative disadvantage in the production of Y. It will trade off
its commodity Y for commodity X of country A. This means that country A has a
comparative advantage in the production of commodity X and B has a least
comparative disadvantage in the production for both countries.
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5.4 SUMMARY
The theory of comparative cost was associated with Ricardo; however, the
theory was popularized by John Stuart Mill, cairns and Bastille. The theory was based
on the differences in production cost of similar commodities but in different
countries. This differential production cost formed the basis of international trade
which emphasized specialization in the production of commodities which a country
has a comparative production cost advantage hence export and import the
commodity that it has comparative cost disadvantage. This leads to mass production
of commodities for welfare maximization across countries through international
trade.
5.5 SELF ASSESSMENT EXERCISE
1. Discuss the theory of comparative cost advantage
2. What are the assumptions of the comparative advantage.
5.6 REFERENCE
Jhingan, M. L. (2002) Microeconomic Theory. Vrinda Publication (P) Ltd. B. S,
Ashish Complex Delhi.
Koutsoyiannis, A (2003) Modern Microeconomics, second Edition, Macmillan
Press Ltd London.
Bo Sodersten (1980) International Economics second Edition, Macmillan
Publishers Ltd.
5.7 SUGGESTED READING
Alex, B. E (2005) Introductory Approach to Microeconomics. Emmanuel Concept,
Ltd Nigeria.
Joe, U. U. (2003) Practical Microeconomic Analysis in African Context. Sibon books
Ltd Ibadan.
Koutsoyiannis, A. (2003) Modern Microeconomics. Second edition, Macmillan
press Ltd.
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SOLUTIONS TO EXERCISES
TOPIC 1:
1.
2.
3.
(a)
In economics, production means creation of utility. It can be defined as
the creation of wealth which in turns adds to society’s welfare.
Production requires certain resources called factor of production ie
things required for making a commodity. In this modern technology it
is called factor inputs.
(b)
Production theory is a branch of economics with the analysis of the
determination of firm choice of quantities of inputs given its
production functions, the prices of the inputs and the level of outputs
to be produced. It is concerned with the combination of various
inputs, given the state of the technology.
(c)
Production function is the relationship between inputs in the
production processes and resulting output. It shows the mathematical
relationship between quantity of output and the quantity of inputs
required to make it. It is stated as Q = f (L, K), Where Q = output
which depends on the quantities of inputs labour and capital.
a.
concept of shortrun refer to that period of time within which a firm is
not able to vary all its factors of production. In the shortrun, the
quantity of one or more inputs remains fixed irrespective of the
volume of output. The longrun on the other hand refers to the time
long enough for the firm to be able to vary the quantities of all of its
factor production. It is that period of time in which all inputs are
variable.
b.
Fixed factors are the factors of the inputs the manager cannot adjust in
the shortrun, while the variable factors are the factors or inputs a
manager can adjust to alter production.
When output increases in the same proportion as the increases in the amount
of the factors of production, it is called constant return to scale. But when
output increases in a greater proportion as compared to the increase in the
amounts of the factors of production, it is called increasing return to scale,
while when output increases in a smaller proportion as compared to the
increase in the amounts of the factors of production, it is known as decreasing
return to scale.
TOPIC 2:
1.
a. Private cost is an accounting or sum of explicit and implicit which
firm incurs in its decision regarding production of a good eg cost
of raw materials, wages interest payment on capital loans, wage
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payment to the producer, tax payment to the government,
depreciation etc. Social cost on the other hand is a cost of some
activity or output which is borne by the society as a whole. It
includes both private cost and the external costs. The external cost
is the cost of resources for which the firm is not compelled to pay a
price eg atmosphere, rivers, lakes etc.
b. Economic and Accounting cost: Economic cost is the sum of
explicit costs and implicit costs eg wages, and cost of raw materials,
property rent, etc. Accounting cost is the explicit costs ie direct
payments to labour and capital to produce output.
2.
a. Sunk Cost refers to expenditure made and cannot be recovered. It
is a cost that is lost forever once it has been paid.
b. Incremental Cost refers to the change in the total cost from
implementing a particular
c. Variable Cost: These are costs that vary with the output of the firm
and will be zero when output is zero. It is a cost that keeps on
changing with changes in quantity of output produced.
d. Marginal Cost: This is the rate of change of total cost with respect
to changes in output. It is the change in total cost divided by the
corresponding change in the output. MC = ∆TC ∕ ∆Q or δTC ∕ δQ
3. Given TC = 30 + 5Q + 0.3Q2 + 0.01Q3.
FC = 30 ∕ Q, MC = δ TC ∕ δQ = 5 + 0.6Q = 0.03Q2
VC = 5Q = 0.3Q2 = 0.013 ∕ Q = 5 + 0.3Q + 0.01Q2.
TOPIC 3:
1.
a. There is many buyers and sellers in the market of which each cannot
influence the price of the output in the market
b. Each firm in the market produces homogeneous or identical
standardized products
c. The buyers and sellers have perfect information on the quality and
price of the product.
d. There are no transport costs
e. There is free entry into and exit from the market. The entry or exit of
buyers and sellers ha no effect on the quantity of the product and price
f. There are no interference (no artificial interference).
2. The shortrun profit maximization of the firm under perfect competitive
market includes
(a)
the marginal cost must equals the marginal revenue (MC = MR)
(b)
the marginal cost must be rising at the point where MC = MR.
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(c)
3.
4.
the firm must be operating at the minimum point of its
shortrun average total cost curve (SAC).
Price discrimination is the charging of different prices for the same
commodity
(a)
for different quantities purchased
(b)
to different classes of customers
(c)
In different markets.
This assists the monopolist to increase total revenue (TR) and total
profit.
2.
The requirements include
(a)
it must have knowledge of demand for its commodity by
different classes of customers or different markets.
(b)
the demand curve must have different elasticity
(c)
the monopolist must be able to separate (or segment) the two
or more markets and keep them separate.
Monopolist competition is the markets organization in which there
many sellers of differentiated products. It is the blending of
competition and monopoly. The competition is as result of large
number of firms and easy entry. The monopoly is the result of
differentiated products or services which may be real or imaginary or
created by advertisement eg gasoline station, cleaners grocery stores
etc.
TOPIC 4:
The supply of labour is the aggregate supply of labour in the market while the
demand for labour which is a derived demand is the aggregate demand for labour
in the Markey. The demand for labour is inversely related to the wage rate ie the
higher the wage rate the lower the demand for labour and the lower the wage rate
the higher the demand for labour. The intersection of the demand and the supply
curve of labour and indeed for all factors of production determine the equilibrium
wage and the level of employment. This can be demonstrated below.
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e
SL
Labour
1. the rate is each factor should be paid the value of its marginal product if the
goal of each firm is profit maximization.
2. the factors that determine the supply of factor inputs in the market include,
(a)
The price level, which determines the purchasing power of money;
price increase reduces the purchasing power hence reduce supply of
factors.
(b)
Money wage; the size of the pay packet received determines the real
wage.
(c)
Regularity of work; a permanent job even if it carries smaller money is
considered better than a temporary job.
(d)
Nature of work; some jobs are Pleasants while some are not; and the
influence the supply of factors.
(e)
Better prospect such as a promise of better prospect of promotion in
the future, extra benefits such as well furnished houses Medical help
etc.
(f)
Social prestige attached to the work also affects the supply of factors.
3. The term ‘demand for labour ‘is unique in the sense that it is supplied by
human being The demand for labour is a derived demand hence labour is
demanded not for demand sake but the demand for the output produced by
labour. The level of demand for labour is analyzed both at the level of a single
firm or industry. The demand for labour by a single firm depends functionally
on the level of wage rate. Therefore, the demand for labour like any
commodity has its curve sloped downwards from the left to the right
indicating an inverse relationship between labour demand and wage rate.
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TOPIC 5:
1. The principles of comparative cost are based on the differences in cost of
similar commodities in different countries. The differences in production
cost may be as a result of geographical division of labour and specialization
in production. Equally important is are differences in climate, natural
resources, geographical situations and efficiency may result into differential
production costs. Therefore, if a country enters into trade, with other
countries, it will export those commodities in which its comparative
production costs are less, and will import those commodities in which its
comparative production costs are high.
2.
The assumptions of the comparative advantage is based on.
(a)
there are only two countries (A and B)
(b)
they produce the same two commodities (X and Y)
(c)
taste are similar in both countries
(d)
Labour is the only factor of production
(e)
All labours unit are homogenous
(f)
The supply of labour is unchanged
(g)
Prices of the two commodities are determined by labour costs ie
the number of labour units employed to produce each
(h)
Commodities are produced under the law of constant cost or
returns
(i)
Trade between the two countries take place on the basis of the
barter system
(j)
Technological knowledge remains constant.
(k)
Factors of production are perfectly mobile within each country
but are perfectly immobile between the two countries
(l)
There is free trade between the two countries and there being
no trade barrier.
(m) No transport cost are involved in carrying trade between the
two countries.
(n)
All factors of production are fully employed in both the
countries
(o)
The international market is perfect so that the exchange ratio
for the two commodities is the same.
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TUTOR MARKED ASSIGNMENT
1. Discuss the three stages that are typical of most production process in the
short run
2. Given that the demand curve for a firm’s product is
P = 40 – 0.005Q and that marginal costs are constant within the
relevant range of output at N10 per unit, where P = Price, Q =
Output. (a) Calculate the profit maximizing output (b) compute the
price the firm should charge.
3.
(a)
with the aid of a diagram, explain the long run equilibrium of
the perfect competitive firm.
(b)
4.
What is price discrimination?
Distinguish between comparative differences costs and equal
differences in costs
.
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