CHAPTER ONE

INTRODUCTION

METHODOLOGY OF MICROECONOMICS

Economics is formally defined as the ‘‘study of the allocation of scarce resources among
alternative uses.’’ This definition stresses that there simply are not enough basic resources (such
as land, labor, and capital equipment) in the world to produce everything that people want.

Microeconomics refers to the study of the economic choices individuals and firms make and of
how these choices create markets.

Models are simple theoretical descriptions that capture the essentials of how the economy works.

Much of microeconomics consists of simply applying a few basic principles to new situations. We
can illustrate some of these by examining an economic model with which you already should be
familiar— the production possibility frontier. This graph shows the various amounts of two goods
that an economy can produce during some period (say, one year).

Production possibility frontier

It is a graph showing all possible combinations of goods that can be produced with a fixed amount
of resources. For simplicity assume that a country has same resources to enable her produce only
two goods, namely beans and maize. If all resources are used to produce beans, OA units will be
realized worth zero (0) units of maize. On the other hand, if all resources are used to produce
maize, OB units will be produced with zero (0) units of beans. Thus the line joining point A and
B is the production possibility frontier (PPF) or curve.

The figure below shows all the combinations of two goods i.e. maize and beans that can be
produced with the economy resources. For example, 10 units of maize and 3 unit of beans can be
made, or 4 units of maize and 12 units of beans. Many other combinations of maize and beans can
also be produced, and the figure below shows all of them. Any combination on or inside the frontier
can be produced, but combinations of food and clothing outside the frontier cannot be made
because there are not enough resources to do so.

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 Beans (bags)

Maize (bags)

The production possibility frontier shows the different combinations of two goods that can be
produced from a fixed amount of scarce resources. It also shows the opportunity cost of producing
more of one good as the quantity of the other good that cannot then be produced. The opportunity
cost at two different levels of production of a good can be seen by comparing points A and B.
Inefficiency is shown by comparing points B and C

This simple model of production illustrates six principles that are common to practically every
situation studied in microeconomics:

a) Resources are scarce. Some combinations of food and clothing (such as 10 units of food
together with 12 units of clothing) are impossible to make given the resources available.
We simply cannot have all of everything we might want.
b) Scarcity involves opportunity costs. That is, producing more of one good necessarily
involves producing less of something else. For example, if this economy produces 10 units
of beans and 3 units of maize per year at point C, producing 1 more unit of clothing would
‘‘cost’’ one-half unit of food. In other words, to increase the output of clothing by one unit
means the production of food would have to decrease by one-half unit.
c) Opportunity costs are increasing. Expanding the output of one particular good will
usually involve increasing opportunity costs as diminishing returns set in. If beans output
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 were expanded to 12 units per year, the opportunity cost of maize would rise from one-half
a unit of beans to 2 units of beans. Hence, the opportunity cost of an economic action is
not constant but varies with the circumstances.
d) Incentives matter. When people make economic decisions, they will consider opportunity
costs. Only when the extra (marginal) benefits from an action exceed the extra (marginal)
opportunity costs will they take the action being considered. Suppose, for example, that
the economy is operating at a place on its production possibility frontier where the
opportunity cost of one unit of clothing is one unit of food. Then any person could judge
whether he or she would prefer more beans or more maize and trade at this ratio. But if,
say, there were a 100 percent tax on beans, it would seem as if you could get only one-half
a unit of beans in exchange for giving up maize—so you might choose to eat more of beans
and eat less of maize. Or, suppose a rich uncle offers to pay one-half your beans costs.
Now it appears that additional beans only costs one-half unit of maize, so you might choose
beans, even though true opportunity costs (as shown on the production possibility frontier)
are unchanged.
e) Inefficiency involves real costs. An economy operating inside its production possibility
frontier is said to be performing ‘‘inefficiently’’. Producing, say, 4 units of beans and 4
units of maize would constitute an inefficient use of this economy’s resources. Such
production would involve the loss of, say, 8 units of beans that could have been produced
along with the 4 units of maize. When we study why markets might produce such
inefficiencies, it will be important to keep in mind that such losses are not purely
conceptual, being of interest only to economic researchers. These are real losses. They
involve real opportunity costs. Avoiding such costs will make people better off.
f) Whether markets work well is important. Most economic transactions occur through
markets. As we shall see, if markets work well, they can enhance every-one’s well-being.
But, when markets perform poorly, they can impose real costs on any economy—that is,
they can cause the economy to operate inside its production possibility frontier. Sorting
out situations where markets work well from those where they don’t is one of the key goals
of the study of microeconomics.

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HOW ECONOMISTS VERIFY THEORETICAL MODELS

The main purpose of studying economics is to sort out bad models from good ones. There are two
methods used to provide test of such economic models;

a) Testing assumptions: It looks at the assumptions upon which a model is based, i.e. it
verifies economic models by examining validity of the assumptions on which they are
based. Assumptions can also be tested with empirical evidence. For example, economists
usually assume that firms are in business to maximize profits.
b) Testing predictions; It uses the model to see if it can correctly predict real-world events,
i.e. It verifies economic models by asking if they can accurately predict real-world events.
For instance Milton Friedman explained that in order to decide if a theory is valid, we must
see if it is capable of explaining and predicting real-world events. The real test of any
economic model is whether it is consistent with events in the economy itself.

OVERVIEW OF MATHEMATICAL CONCEPTS IN MICROECONOMICS

Variables: These refer to the basic elements of algebra, usually called X, Y, and so on, that may
be given any numerical value in an equation.

Functional notation: A way of denoting the fact that the value taken on by one variable (Y)
depends on the value taken on by some other variable (X) or set of variables. For instance, 𝑌 =
𝑓(𝑋) which reads Y is a function of X, meaning that the value of Y depends on the value given to
X. This functional notation conveys the idea that ‘‘X causes Y.’’ The exact functional relationship
between X and Y may take on a wide variety of forms. Two possibilities are:

1. Y is a linear function of X. In this case 𝑌 = 𝑎 + 𝑏𝑋

Where a and b are constants that may be given any numerical value. For example, if a=3 and b=2,
this equation would be written as 𝑌 = 3 + 2𝑋

2. Y is a nonlinear function of X. This case covers a number of possibilities, including

quadratic functions (containing 𝑋 2 ), higher-order polynomials (containing 𝑋 3 , 𝑋 4 , and
so forth), and those based on special functions such as logarithms. For instance 𝑌 = 10 +
𝑋 − 2𝑋 2 − 𝑋 3

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Independent variable: In an algebraic equation, a variable that is unaffected by the action of
another variable and may be assigned any value.

Dependent variable: In algebra, a variable whose value is determined by another variable or

set of variables.

Marginal effect: The change in Y brought about by a one unit change in X at a particular value
Δ𝑦
of X. (Also the slope of the function.). For instance,𝑌 = 3 + 2𝑋, then =2
Δ𝑥

Average effect: The ratio of Y to X at a particular value of X. (Also the slope of the ray from
𝑌 3
the origin to the function.). For instance, 𝑌 = 3 + 2𝑋, then = +2
𝑋 𝑋

Interpreting Slopes:

The slope of the relationship between a cause (X) and an effect (Y) is one of the most important
things that economists try to measure. Because the slope (or the related concept of elasticity)
shows, in quantitative terms, how a small (marginal) change in one variable affects some other
variable

For example, suppose a researcher discovered that the quantity of oranges (Q) a typical family
eats during any week can be represented by the equation:

𝑄 = 12 − 0.2𝑃

Where P is the price of a single orange, in shillings

The most important use for calculus in microeconomics is to study the formal conclusions that can
be derived from the assumption that an economic actor seeks to maximize something. All such
problems reach the same general conclusion—that the dependent variable, Y, reaches its maximum
𝑑𝑦
value (assuming there is one) at that value of X for which 𝑑𝑥 = 0

In any economic model, it is important to differentiate between variables whose values are
determined by the model and those that come from outside the model. Variables whose values are
determined by a model are called endogenous variables (‘‘inside variables’’), and those whose
values come from outside the model are called exogenous variables (‘outside variables’). In many

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microeconomic models, price and quantity are the endogenous variables, whereas the exogenous
variables are factors from outside the particular market being considered, often variables that
reflect macroeconomic conditions.

To illustrate this distinction, we return to the simultaneous model specified in Equation 1A.22 but
change the notation so that P and Q represent the price and quantity of some good. The values of
these two variables are determined simultaneously by the operations of supply and demand. The
market equilibrium is also affected by two exogenous variables, W and Z. W reflects factors that
positively affect demand (such as consumer income), whereas Z reflects factors that shift the
supply curve upward (such as workers’ wages). Our economic model of this market can be written
as;

𝑄 = −𝑃 + 𝑊

𝑃 =𝑄+𝑍

When we specify values for W and Z, it becomes a model with two equations and two unknowns
and can be solved for (equilibrium) values of P and Q. For example, if W = 3, Z = -1, the solution
is P = 1 and Q = 2.

A Simple Model
Let’s consider a simple supply-demand model for crude oil. This model seeks to explain two
variables: The price of crude oil per barrel (P, measured in dollars) and the quantity of oil produced
(Q, measured in millions of barrels per day) according to the equations:
Demand 𝑄 = 85 − 0.4𝑃
Supply 𝑄 = 55 + 0.6𝑃
Solving these equations simultaneously yields: 85 − 0.4𝑃 = 55 + 0.6𝑃 which gives P=30 and
Q=73

THE BASIC SUPPLY-DEMAND MODEL

It is a model describing how a good’s price is determined by the behavior of the individuals who
buy the good and of the firms that sell it.

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The basic supply-demand model of price determination is a staple of all courses in principles of
microeconomics in fact, this model may be the first thing you studied in the course. Here we
provide a quick review, adding a bit of historical perspective.

Adam Smith and the Invisible Hand

The Scottish philosopher Adam Smith (1723–1790) is generally credited with being the first true
economist. In The Wealth of Nations (published in 1776), Smith examined a large number of the
pressing economic issues of his day and tried to develop economic tools for understanding them.
Smith’s most important insight was his recognition that the system of market-determined prices
that he observed was not as chaotic and undisciplined as most other writers had assumed. Rather,
Smith saw prices as providing a powerful ‘‘invisible hand’’ that directed resources into activities
where they would be most valuable. Prices play the crucial role of telling both consumers and
firms what goods are ‘‘worth’’ and thereby prompt these economic actors to make efficient choices
about how to use them. To Smith, it was this ability to use resources efficiently that provided the
ultimate explanation for a nation’s ‘‘wealth.’’

Because Adam Smith placed great importance on the role of prices in directing how a nation’s
resources are used, he needed to develop some theories about how those prices are determined. He
offered a very simple and only partly correct explanation. Because in Smith’s day (and, to some
extent, even today), the primary costs of producing goods were costs associated with the labor that
went into a good, it was only a short step for him to embrace a labor-based theory of prices. For
example, to paraphrase an illustration from The Wealth of Nations, if it takes twice as long for a
hunter to catch a deer as to catch a beaver, one deer should trade for two beavers. The relative
price of a deer is high because of the extra labor costs involved in catching one.

Smith’s explanation for the price of a good is illustrated in Figure (a). The horizontal line at P*
shows that any number of deer can be produced without affecting the relative cost of doing so

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 a) b)

To Adam Smith the relative price of a good was determined by relative labor costs. This is shown
in the left-hand panel where relative price would be constant unless something altered the costs.
In the Ricardo model in the right hand side, the concept of diminishing returns occurs where
relative prices rises as quantity produced rises.

The Concept of Diminishing Returns

It was developed by Ricardo where he believed that labor and other costs would tend to rise as the
level of production of a particular good expanded. He drew this insight primarily from looking at
the way in which farmland was expanding in England at the time. As new and less-fertile land was
brought into use, it would naturally take more labor (say, to pick out the rocks in addition to
planting crops) to produce an extra bushel of grain. Hence, the relative price of grain would rise.

Diminishing returns states that the cost associated with producing one more unit of a good rises
as more of that good is produced

Marginalism and Marshall’s Model of Supply and Demand

Features of Marginalism

1. They emphasized the marginal, i.e. the net additional point of change as the most
crucial for decision-making and possibly borrowing from Ricardo’s theory of rent, for
instance where he had maintained that in their investment decisions, investors always
considered the marginal unit of land. They used the concept of
‘margin’ to explain economic phenomena.

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 2. They also emphasized the micro rather than macro approach of the classical. For
instance, marginalists emphasize more on individual consumers, individual price levels
and markets and not so much on the aggregate.
3. Their approach of an economy was from the perspective of pure competition. They
believed in the existence of perfect competition. In fact, it was from them that the theory
of the firm took root. It was their belief that with a purely competitive situation, it was
the activities and decisions of the smallest consumer or purchaser that reflected on the
aggregate situation.
4. Their analysis of consumer theory emphasized ‘demand’ as the most important factor
in price determination, i.e. they overlooked the supply side in price determination.
5. Marginalists further believed that an economy will always attain equilibrium if all
things are equal and there are no interferences. As such, the economy always is having
a tendency to move towards full employment equilibrium, price equilibrium, etc. And
that even when distortion arises they could only last in the short-run but in the long-
run, the economy would adjust itself for equilibrium.
6. They assume rationality of individual consumers especially in the area of increasing
marginal utility. They also emphasized that the individual was able to weigh alternative
forgone in his consumption of consumer goods and services and so was then able to
rationally allocate his resources.
7. They emphasized their classical position on laissez faire especially that they were
disposed to pure competition, as such, they also did not support governmental
intervention in economic phenomenon.

Marshall’s Model of Supply and Demand

Given his background in Mathematics, Marshall was able to combine the determinants of demand
and supply and arrive at equilibrium price, as that price where supply matches demand.

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Marshall believed that demand and supply together determine the equilibrium price (p*) and
quantity (𝑞 ∗ ) of a good. The positive slope of the supply curve reflects diminishing returns
(increasing marginal cost), whereas the negative slope of the demand curve reflects diminishing
marginal usefulness. P* is an equilibrium price. Any other price results in either a surplus or a
shortage.

Market Equilibrium

The demand and supply curves intersect at the point p*, q*. At that point, p* is the equilibrium
price. That is, the price at which the quantity demanded by buyers of a good is equal to the
quantity supplied by sellers of the good. At this price, the quantity that people want to purchase
(q*) is precisely equal to the quantity that suppliers are willing to produce. Because both
demanders and suppliers are content with this outcome, no one has an incentive to alter his or
her behavior. The equilibrium p*, q* will tend to persist unless something happens to change
things.

Marginal utility of demand

In his analysis, Marshall has shown that marginal utility of a thing, any individual diminish with
every additional unit of the thing consumed. He was also able to derive the law of demand, i.e. that
the more the quantity of a commodity offered for sale, the lower the price that would be bought
and vice-versa. Furthermore, that the lower the price, the higher the desire of people to acquire it.
He contended that the demand function was not necessarily based on the law of diminishing
marginal utility but on balancing marginal utilities. Marshall also showed that marginal utilities

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are highest for low income earners than for high income earners giving that the more commodity
one has at his disposal, the lesser the marginal utility of that particular commodity. He has thus
advocated for a narrowing of income differentials in society, arguing that by so doing, the marginal
utility of the entire society would be raised. He is also credited with the concept of consumer
surplus where he has argued that consumers do enjoy a surplus and deriving from the marginal
utility analysis he showed how this surplus was obtained by using this analysis.

From diagram 1 above, consumer rent is in triangle DFA, while producer rent is in triangle AFS
and Producers’ expenses is trapezium ASOH. Since DD1 is also MU, it indicates declining
marginal utility for the consumer as he consumes more of the same commodity

Short-run and Long-run Concepts: Marshall is also credited with introducing short- run and
long-run concepts in economic analysis, arguing that the shorter the period, the greater the
influence demand exerts on value and price. He thus defined the short-run as that period during
which supply is not able to respond to any sudden increase in demand while he referred to long-
run as that period long to allow changes in supply and demand.

Non-Equilibrium Outcomes

The smooth functioning of market forces envisioned by Marshall can, however, be thwarted in
many ways. For example, a government decree that requires a price to be set in excess of P*
(perhaps because P* was regarded as being the result of ‘‘unfair, ruinous competition’’) would
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prevent the establishment of equilibrium. With a price set above P*, demanders would wish to
buy less than Q*, whereas suppliers would produce more than Q*. This would lead to a surplus
of produc-tion in the market—a situation that characterizes many agricultural markets. Similarly,
a regulation that holds a price below P* would result in a shortage. With such a price, demanders
would want to buy more than Q*, whereas supplies would produce less than Q*.

Change in Market Equilibrium

The equilibrium in the figure above can persist as long as nothing happens to alter demand or
supply relationships. If one of the curves were to shift, however, the equilibrium would change. In
the figure below, people’s demand for the good increases. In this case, the demand curve moves
outward (from curve D to curve D0). At each price, people now want to buy more of the good. The
equilibrium price increases. This higher price both tells firms to supply more goods and restrains
individuals’ demand for the good. At the new equilibrium price of, supply and demand again
balance at this higher price, the amount of goods demanded is exactly equal to the amount supplied.
The opposite is also true when supply curve shifts.

Effects of shifts of demand/supply curve on equilibrium

The equilibrium price will fall on increase depending on the direction in which the shift have taken
place.

a) Shift in Supply

Price
D0
S0
S1

Excess
supply

pe

p1
S0

S1 D0

0 Qe Q1 Q2 Quantity

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 An increase in supply is represented by a shift to the right.
 Initial equilibrium price and output is p e and Qe , respectively

 At this initial price p e with an increase in supply means output increasing to Q2 while demand

remains Qe .

 Therefore we shall have excess supply.

 To encourage consumers to consume more of the good, adjustment will be such that prices
decline. Prices will continue to decline until a new equilibrium price p1 is realized.

 Therefore the new equilibrium prices and output will be p1Q1

 Notice, because of all in prices to p1 , quantity demanded will increase from Qe to Q1 .

Therefore we can conclude by saying that an increase in supply leads to low price and to
increase in quantity demanded

b) Shift in Demand

Price

S
D1

D0
p2 Increase in demand

pe
D1
D0
S
0 Qe Q2 Q1 Quantity

 Suppose we assume that consumer income has increased. This will lead to the shift of
demand curve to the right from D0 D0 to D1

 The effects will be the disturbance of equilibrium from p e Qe and creation of excess

demand over supply Q1  Qe 

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  This is so because it will take the producers’ time before they produce enough to meet this
excess demand.
 Because of this short-term shortages prices will be pushed upwards towards
 From the law of demand and supply we know that as price increase demand will decline
and supply increase.
 This will continue until a new equilibrium point is attained  p2 Q2 
 It should be noted that before this new equilibrium point was attained there was a lag. This
could be because of inferior technology that could not allow production to take place on
time to avoid shortage. Another reason could be imperfect knowledge about the market
conditions. If consumers could have perfect knowledge on alternative sources of product
such shortage could not arise.

How disequilibrium concept is applied

The disequilibrium concept can be applied on the cob- Web model.

THE COBWEB THEORY

This model is used to trace the path form disequilibrium to position of equilibrium. One cause of
disequilibrium is lagged responses which is caused by increased in demand.

The cobweb model assumes that producers’ output plans are fulfilled but with a time lag. That is,
if a producer is a farmer, he cannot within the short-run increase his output just because the market
is offering very good prices.

This is so because of the nature of the products. The time between planting and harvesting is long
enough risk and uncertainty to prevail.

Thus, producers are assumed to base their production decisions on the previous period’s prices.
However demand depends on the prevailing prices in the market.

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