foundation of economics

8/4/2019 Foundation of Economics

1/27

ECO 1201FOUNDATIO OF ECONOMICS I

What is economics?

Economics as a discipline has been defined by various authors in so many ways. In

fact, some argued there are so many definitions of economics as there are economists.Adam Smith (1776) for instance defined economics as an enquiry into the nature and

causes of the wealth of nations. In other words, during his time the major concern is

how nation states acquire wealth and why are some nations richer than others. And to

Alfred Marshall, economics is the study of mankind in the ordinary business of life.

While J. S. Mill defined it as a practical science of the production and distribution of

wealth. Thus while J. S. Mill looked at economics as a scientific study, Marshall

looked at it as the study of human behaviour. Then a more modern definition is given

by Prof Lionel Robbins who looked at economics as a science which studies human

behavior as a relationship between ends and scarce means which have alternative

uses." This is a more accepted definition of economics. It is based on this definition

that modern economics is based upon the theory of scarcity and choice.

Economics as a social science:

The last definition above looked at economics as a science but a social science simply

because it employs scientific methods of enquiry in making its investigations. The scientific

methods of enquiry involves five stages; namely, (i) statement of the problem, (ii)

formulation of hypothesis, (iii) collection of relevant data, (iv) data analysis and

interpretation and (v) verification and conclusion. In the last stage the hypothesis is tasted

against the collected data to see whether the hypothesis can be accepted or rejected. If it is

accepted then a conclusion can be reached and a fact is established. And if it is the contrary

then the analyst goes on to collect more data and see whether a fact can be established. It is

these stages of scientific investigation that are employed by economics. And that is why it is

regarded as a science but a social science, because it deals human behaviour in allocating

scarce resources.

Basic Concepts of Economic Goods, Resources, Human Wants, Scarcity, Choice, Scale

of Preference and Opportunity Cost:

Economic Goods:

These are goods and services that we may make use of on daily basis, such as sugar, salt,

bread, motor car, wrist watch, handset, etc. These goods have three important characteristics

which include:

i) Scarcity: Economic goods are scarce. That is they are not available. They are notcommon such that they not free goods.

ii) Utility: Economic goods possess utility. In other words they can give satisfactionto the consumer when consumed.

iii) Command a price: Economic goods command a price. That is they can be boughtor sold in the market.


2/27

2

Thus, all economic goods possess the above three characteristics. That is, they are scarce,

they possess utility and they command a price.

Resources:

These are the factors of production such as land, labour, capital and raw materials thatare used in production. They are combined or organized by the entrepreneur to produce

economic goods for the satisfaction of human wants.

Human Wants:

This refers to the human desire to possess economic goods. This human desire is

unlimited according to conventional economics. In other words, human wants are unlimited.

Thus, human beings have unlimited wants.

Scarcity:

Scarcity means limited in supply. In other words, although human wants are

unlimited, the resources with which economic goods can be produced to satisfy these human

wants are limited. That is, resources are not available or are not enough.

Choice:

Since human wants are unlimited and resources are scarce, then individuals, business firms

and governments must make choices in allocating their resources to satisfy those wants.

Scale of Preference:

As we have learnt from above, human wants are many but resources with which goods

can be produced are scarce, it therefore necessary to make choices. To make choice possible

by individual consumers, business firms and government, these economic agents must

arrange their wants in order of importance or priority. This arrangement of unsatisfied wants

in their order of priority is what is called scale of preference. For instance, a particular student

may reveal his scale of preference as:

i) A house.ii) A car.iii) A job.iv) A wife.v) A handset.

What the above list is telling us is that according to this student, his most urgent need is to

have a house, then secondly a car. His third priority is to have a job. So in that order he listed

five of his most urgent needs in their order of importance which is called scale of preference.

Opportunity Cost:

This is the real cost. It is the cost of the forgone alternative. It is the sacrifice involvedin committing resources to use either by an individual, a business firm or by government. If


3/27

3

for instance, an individual consumer or a particular student has fifty naira with which he has

two choices due to limited resources. If this student wishes, he can buy a bottle of soft drink

after his lectures or he may reserve it and pay for his transport fair back home. Supposing he

chooses to buy a bottle of soft drink with his little money. The cost of that bottle of soft drink

in economics is not the fifty naira he paid. Rather he has sacrificed his transport fair andtherefore the cost is that he has to trek back home. That is the real cost of that bottle of soft

drink. Thus, in economics, the major concern in terms of cost is the opportunity cost not

monetary or accounting cost.


4/27

4

SECTION TWO

Demand and Supply Analysis

Demand for a commodity:

Demand for a commodity refers to the amount of that commodity that consumers are

willing and able to buy at a given price and specified period of time. It is want that is backed

by the ability to pay. It is also called effective demand.

Individual Demand Schedule:

This is a table that shows the relationship between price and quantity demanded of a

particular commodity by a particular consumer at a given period of time. In the table below,

this consumer is

Price (N) Quantity demanded of milk per week5 2

4 4

3 6

2 8

1 10

willing to buy less at a higher price and buy more at a lower price. In other words, the table

shows a negative or an inverse relationship between price and quantity demanded of milk per

week by this consumer. This table also indicates what is called the law of demand. The law ofdemand states that, all things being equal, the higher the price the lower the quantity

demanded, and the lower the price the higher the quantity demanded.

Individual Demand Curve:

This is a graphical representation of the individual demand schedule. The demand curve

below slopes downwards from left to right indicating the law of demand.


5/27

5

Market Demand Schedule:

A market demand schedule is the summation or addition of individual demand

schedules. In the table below an example of a market demand schedule is given. On this tablethe assumption is that individuals demand schedules for all consumers of milk per week are

added together. As this demand schedule shows, all consumers of milk in this particular

economy are willing to buy more at a lower price and buy less at a higher price.

Price Quantity by Quantity by Quantity by Total Quantity

By

(In Naira) Consumer A Consumer B Consumer C All Consumers

5 2 5 3 10

4 4 10 6 20

3 6 15 9 302 8 20 12 40

1 10 25 15 50

Market Demand Curve:

A market demand curve is the graphical representation of the market demand

schedule. In other words, when the market demand schedule is represented on a graph, it will

give us a market demand curve.

Factors Affecting the Demand for Commodities:

Several factors affect the demand for goods and services in an economy. Economic theory

recognizes the following factors:

1. Price of the commodity: The law of demand has shown that, all things being equal,the higher the price the lower the quantity demanded, and the lower the price the


6/27

6

higher the quantity demanded. In other words, there is an inverse or negative

relationship between price and quantity demanded of a particular commodity.

2. Prices of other commodities: A change in price of one commodity may also affectthe demand for other commodities. This effect may come in two different forms as

the two commodities may be related as either substitute goods or complementarygoods.

(a)Substitute goods: these are goods that compete for consumers income as theyserve the same purpose. A good example is fish and meat, coca-cola and pepsi,

fanta and mirinda, etc. An increase in price of meat, without any change in price

of fish, will lead to a decrease in quantity demanded of meat and an increase in

demand for fish. Also, a decrease in price of meat, price of fish remaining

constant, will lead to an increase in quantity demanded of meat and a decrease in

demand for fish.

(b)Complementary goods: these are goods that are consumed together. You cannotuse one without the other. A good example is motor car and petrol, tea and sugar,

tube and tire, bed and mattress, paper and biro, etc. An increase in price of motor

cars will decrease quantity demanded of motor cars and reduce the demand for

petrol without any change in the price of petrol. Similarly, a decrease in price of

motor cars will increase quantity demanded of motor cars and also increase the

demand for petrol without any change in the price of petrol.

3. Consumers income:A change in consumers income, all things being equal affectsthe demand for goods and services. And on this basis, commodities are categorized

into normal goods and inferior goods.

(a)Normal goods: These are goods that have a positive relationship with income ofthe consumer. In other words, the higher the income the higher the demand for

normal goods and the lower the income the lower the demand for normal goods.

All things being equal, an increase in consumers income leads to an increase in

the demand for normal goods and vice-versa. A good example of normal goods is

bread and butter and chicken as breakfast in the morning.

(b)Inferior goods: These are goods that have a negative relationship with income ofthe consumer. In other words, the higher the income the lower the demand for

inferior goods and the lower the income the higher the demand for inferior goods.

That is, all things being equal, an increase in consumers income leads to a

decrease in demand for inferior goods and vice-versa. A good example of inferior

goods is garri, amala, bean cake and pap, etc.

4. Taste or preference: A change in taste or preference of the consumer can also bringa change in demand for goods and services. When consumers taste changes in favour

of a commodity it will lead to an increase in demand for that commodity. This is the

kind of change that most firms try to achieve in managerial economics. Also, a

change in taste of the consumer against a particular commodity will lead to a decrease

in demand for that commodity without any change in price.

5. Number of consumers in the market: A change in the number of consumers in themarket also affects the demand for goods and services. The larger the number of

consumers in the market, all things being equal, the higher the demand for goods and


7/27

7

services. In some economic text books this is seen as population of a country, as

population is positively related to the number of consumers in a particular economy.

6. Change in weather condition: A change in weather condition also affects thedemand for goods and services. Weather condition may be favourable to the

consumption of certain commodities, and at the same time unfavourable to others.When it favours the consumption of a particular commodity, demand for that

commodity increases. In case it is unfavourable to consumption of such a commodity,

demand will fall. The demand for soft drinks tends to be higher in Nigeria during the

hot season of the year. During the cold season of the year, the demand for air

conditioners, refrigerators and fans tends to fall.

7. Price and income expectations: Expectations in prices and in incomes also affect thedemand for goods and services. When consumers expect their incomes or prices to

fall in the near future, they buy less now even if prices fall at the moment. And when

they expect their incomes or prices to rise in the near future, they will buy more even

if prices rise at the moment. In fact this effect will show that graphically the demand

curve becomes an abnormal demand curve, showing a positive relationship with price,

such the higher the price the higher the quantity demanded and the lower the price the

lower the quantity demanded. These are the effects of price and income expectations.

8. Government policy: A change in government policy with regards to taxes andsubsidies also affects the demand for goods and services. Taxes have the effect of

raising prices, while subsidies lower them. If government decides to impose taxes on

a commodity or withdraw its subsidies, the effect will be an increase in the price of

that particular commodity. Giving subsidies and or withdrawing taxes on the other

hand has the effect of lowering prices of goods involved.

Change in Quantity Demanded versus Change in Demand:

a) Change in quantity demanded: this refers to the movement along the same demandcurve due to a change in price all other factors held constant.

b) Change in demand: This refers to the entire shift of the demand curve to a newposition caused by changes in factors affecting demand with prices held constant.


8/27

8

Supply of a Commodity:

Supply of a commodity refers to the amount of that commodity that producers offer for sale

in the market at a given price and a specified period of time. Also like demand, supply is a

flow. It is measured per period of time.

Individual Supply Schedule:

This is a table that shows the relationship between price and quantity offered for sale in the

market by a particular producer at a particular time.

Price of a commodity (N) Quantity of milk supplied by one

producer5 10

4 8

3 6

2 4

1 2

In the above supply schedule, this particular producer is willing to offer larger quantities for

sale at a higher price and offers lower quantities at a lower price following the law of supply.

The law of supply states that, all things being equal, the higher the price the higher thequantity supplied and the lower the price the lower the quantity supplied.

Individual Supply Curve:

This is the graphical representation of the individual supply schedule. In other words when

we transform the above schedule on to a graph it will give us an individual supply curve

which is shown below.


9/27

9

Market Supply Schedule:

This is the summation or addition of individual supply schedules. In other words, when we

add all individual supply schedules of milk in Nigeria for instance, then we arrive at a marketsupply schedule for milk.

Price Quantity by Quantity by Quantity by Total Quantity

By

(In Naira) Producer A Producer B Producer C All Producers

5 10 25 15 50

4 8 20 12 40

3 6 15 9 30

2 4 10 6 20

1 2 5 3 10

Market Supply Curve:

Market supply curve is the graphical representation of the market supply curve. In other

words, when the market supply schedule is represented on a graph, the curve resulting from

this representation is called a market supply as shown in the diagram below.

Factors Affecting Supply:

a) Price of the commodity: All things being equal, the law of supply has shown that thehigher the price the higher the quantity supplied and the lower the price the lower the

quantity supplied. This is also depicted by an upward sloping nature of the supply

curve. Thus, price of commodity is the first important factor that affects the supply of

commodities.

b) Prices of other commodities: Prices of other commodities also affects the supply ofother related commodities. Especially those commodities that have a joint supply. By

joint supply we mean commodities that are produced together with other


10/27

10

commodities. Examples include petroleum refining and kerosene or gasoline. Increase

in price of petrol will increase quantity supplied of petrol, and at the same time

increase the supply of kerosene, or gasoline without any change in the price of

kerosene or gasoline, or any other related commodities that are produced together

with petrol.c) Changes in the prices of factors of production. An increase in the prices of factors ofproduction raises production costs and as a results supply decreases. A decrease in

these prices on the other hand increases supply.

d) Changes in weather condition. A change in weather condition favourable toproduction raises supply, while unfavourable weather lowers supply in the

agricultural sector.

e) Discovery of new sources of raw materials. When new sources of raw materials arediscovered, production cost tends to fall. As a result supply increases.

f) Government policy. Government policy may come in the form of taxes or subsidies.An imposition of tax or withdrawal of subsidy has the effect of raising production

costs, and consequently a decrease in supply. Withdrawal of taxes or giving subsidies

on the other hand lower production costs and as a result supply increases.

g) Improvements in technology of production. Technological improvements have theeffect of lowering production costs and saving time. When this happens, production

increases and thus, supply also increases.

h) Number of producers in the market. The larger the number of producers in the marketthe higher the supply of goods and services. And a decrease in the number of

producers reduces supply.

Changes in Quantity Supplied Versus Change in Supply:

a) Change in quantity supplied: This refers to the movement along the same supplycurve due to a change in price other factors held constant.

b) Change in supply: This refers to the entire shift of the supply curve to a new positiondue to changes in factors affecting supply, with price held constant.


11/27

11

Market Equilibrium:

A hypothetical market demand and supply schedules for milk per week:

Price (N) Quantity Demanded Quantity Supplied

5 10 50

4 20 40

3 30 30

2 40 20

1 50 10

In the schedules above quantities demanded and supplied are given for milk within a

particular week. It can be noted that on the above table at a price of N5 per unit, quantity

demanded is greater than quantity supplied. As a result there will be excess supply in the

market as the market has shown that quantity supplied is greater than quantity demanded.

This will force some producers to accept a lower price such as N4 per unit. At N4 quantity

demanded has increased to 20 while quantity supplied has declined to 40 all things being

equal. Still supply is greater than demand. Some producers will still be willing to accept a

lower price such as N3 per unit. At this price, quantity demanded has increased to 30 units

and quantity supplied has declined also to 30 units. This is the equilibrium price. Thus, at N3per unit, quantity demanded and quantity supplied are equal.

Elasticity of Demand:

Elasticity of demand refers to the measure of the degree of responsiveness of demand to

changes in factors affecting demand, such as price of the commodity, prices of other

commodities, consumers income, whether condition, etc. However, out of these factors

affecting demand, not all of them can be measured in economic terms. That is why elasticity

of demand is restricted to the first three factors mentioned above. And as such we have:

a) Price Elasticity of Demand: This is the measure of the degree of responsiveness ofquantity demanded due to a small change in price. Normally, when price changes, all

things being equal we expect quantity demanded also to change due to that change inprice. Price elasticity of demand is measured as


12/27

12

It can also be written as

or

, where means change in

quantity and means change in price, while Q stands for initial quantity and Pinitial price. To show how the coefficient of price elasticity of demand is computed let

us take an example. Supposing price of milk rises from N 10 to N 12 per unit and as a

result quantity demanded falls from 40 units to 30 units as shown in the table below:

Price of milk (N) Quantity bought of milk

(tins)

10 40

12 30

To calculate the coefficient of price elasticity of demand using the first formula we

find the %

change in quantity as: % in Q =

Then, % in P =

= 20%. And when we substitute in the formula we have

This means that the coefficient of price elasticity of demand is elastic, as it

is more than one. While going by the second formula we can be able to show that we will

arrive at the same answer. Going by the second formula, Q = 10, we neglect the negative

sign, P = 2, P = 10 and Q = 40. Now, substituting these values in the formula we arrive at

the following:

. Therefore,

= 1.25. Also, demand is elastic. This

means that quantity demanded is responding to the change in price by an amount more than

the change in price. Thus, price elasticity of demand can be elastic, unitary elastic, inelastic,

perfectly elastic or perfectly inelastic.

i) Elastic Demand:Demand is said to be elastic when a proportionate change in price leads to a more than

proportionate change in quantity demanded. And here as we explain above, thecoefficient of price elasticity of demand is greater than one. That is,

ii)

Unitary Elastic Demand:


13/27

13

Demand is said to be unitary elastic when a proportionate change in price leads to

an equal proportionate change in quantity demanded. And in this, the coefficient

of price elasticity of demand equals one. That is, .

iii) Inelastic Demand:Demand is said to be inelastic when a proportionate change in price leads to a less

than proportionate change in quantity demanded. The coefficient of price

elasticity of demand is less than one. That is,

iv) Perfectly Elastic Demand:Demand is said to be perfectly elastic when without any change in price, quantity

demanded is unlimited. And a small increase in price will move quantity

demanded to zero. In this case also, the demand curve is a straight line parallel to

the x-axis.

v) Perfectly Inelastic Supply:Supply is said to be perfectly inelastic when a proportionate change in price leads

to no change in quantity supplied. The coefficient of price elasticity of supply

equals zero.


14/27

14

Determinants of Price Elasticity of Demand:

1. Availability of Close Substitutes: The higher the availability of close substitutes themore elastic is the demand for a particular commodity. And alternatively, the lesser

the availability of close substitutes the more inelastic is the demand for a commodity.

2. Proportion of Expenditure Spent on a Commodity in Total Income. The larger theproportion of expenditure in total income of the consumer, the more elastic is the

demand for a commodity. Alternatively, the smaller the proportion of expenditure on

a commodity in total income of the consumer the less elastic is the demand for a

commodity.3. Necessities and Luxury goods. Generally, necessities tend to have inelastic demand

due to the pressure of using a particular commodity. These are goods that the

consumer cannot live without them. For example, salt, matches, petrol, etc. Luxuries

on the other hand tend to have elastic demand. These are goods that consumers can

survive without them. Examples are air conditioners, refrigerators, motor cars, etc.

4. Consumption habit. Habits are easy to form but difficult to break. Once aconsumption habit is formed for certain commodities, demand tends to be inelastic for

such commodities. Examples include cigarettes, kola nuts, coffee and alcohol.

Price Elasticity of Demand and Total Revenue:

i) Elastic Demand: When demand is elastic, a small increase in price leads to amore than proportionate decrease in quantity demanded, and as a result total

revenue falls. A small decrease in price on the other hand, leads to an increase

in quantity demanded by a greater proportion, and consequently total revenue

increases. Thus, it is advisable to lower price when demand is elastic. This can

be shown graphically.

ii) Unitary Elastic Demand: In the case of a unitary elastic demand, a smallincrease in price leads to a decrease in quantity demanded by an equal


15/27

15

proportion and consequently total revenue remain unchanged. Similarly, a

small decrease in price leads to an increase in quantity demanded by an equal

proportion, and as a result total revenue remain the same. Thus, when demand

is unitary elastic, it is advisable to leave prices unchanged. Graphically, it can

be shown as follows:

iii) Inelastic Demand: When demand is inelastic. a small increase in price leads to adecrease in quantity demanded by a smaller proportion and consequently total

revenue increases. A small decrease in price on the other hand, leads to an

increase in quantity demanded by a smaller proportion and as a result total

revenue decreases. It is therefore advisable to raise prices when demand is

inelastic.

b) Price-Cross Elasticity of Demand: This is a measure of the degree of responsivenessof quantity demanded of commodity X due to small change in the price of another

related commodity, commodity Y. In this, commodities X and Y are related either as

substitutes or as complementary goods. It is computed using the following formula:

x

y

y

x

xyQ

P

P

QE .

. This means that, the coefficient of price-cross elasticity of demand is

change in quantity of commodity x divided by a change in price of commodity y, and

then multiplied by the initial price of commodity y divided by the initial quantity of

commodity x. Here, however, we have to take note of the sign of the coefficient. If the

sign is positive, the two commodities involved are said to be complementary. While if

the sign of the coefficient is negative, the two commodities are called substitutes.


16/27

16

c) Income Elasticity of Demand: This is a measure of the degree of responsiveness ofquantity demanded due to a small change in income. In other words, it measures how

quantity demanded responds to a change in income of the consumer in the market. It

is computed using the following formula: ..Q

Y

Y

QE

y

That is, change in quantity

demanded of a particular commodity divided by a change in income of a particular

consumer, then multiplied by initial income of the consumer divided by the initial

quantity demanded of the commodity considered.

Price Elasticity of Supply:

This is the measure of the degree of responsiveness of quantity supplied due to a small

change in price. It is measured as a percentage change in quantity supplied divided by a

percentage change in price.

inP

inQEs

%

%. Alternatively, it can be calculated as:

Q

P

P

QEs .

, where Q is change in

quantity supplied, P is change in price, P is initial price and Q initial quantity. Then, thecoefficient of price elasticity of supply can be elastic, inelastic, unitary elastic, perfectly

elastic or perfectly inelastic.

Elastic Supply:

Supply is said to be elastic when a proportionate change in price leads to a more than

proportionate change in quantity supplied. And the coefficient of price elasticity of supply is

greater than one. That is, Es > 1. This can be shown graphically.


17/27

17

Unitary Elastic Supply:

Supply is said to be unitary elastic when a proportionate change in price leads to an equal

proportionate change in quantity supplied. And the coefficient of price elasticity of supply

equals one. That is, Es = 1. It can be shown graphically as follows:

Inelastic Supply:

Supply is said to inelastic when a proportionate change in price leads to less than

proportionate change in quantity supplied. And here, the coefficient of price elasticity of

supply is less than one. That is, Es < 1.

Perfectly Elastic Supply:

Supply is said to be perfectly elastic when without any change in price, quantity supplied is

unlimited. The supply curve here is a horizontal line which indicates that at a particular price

any quantity can be sold. And here, the coefficient of price elasticity of supply approaches

infinity. That is, Es= .

Perfectly Inelastic Supply:

Supply is said to be perfectly inelastic when with a proportionate change in price quantity

supplied remain the same. In other words, the supply curve is a vertical line, indicating that at

all prices, quantity supplied remain the same. Here, the coefficient of price elasticity of

supply is equals to zero. That is, Es = 0.


18/27

18

SECTION THREE

THEORY OF MARGINAL UTILITY

What is utility?

Utility refers to the satisfaction derived from consuming a commodity or service. According

to this theory, the satisfaction derived from consuming a commodity can be measured either

through the use of money or what is called utils as units of measuring utility. The theory is

formed upon certain assumptions.

The Assumptions:

The theory of marginal utility explains how the consumer behaves in the market given his

income and prices of all commodities and other relevant information about the market. These

assumptions include:

1. Rationality: It is assumed that the consumer is rational. He knows what is good to himand what is bad. And given his limited income and unlimited wants for goods and

services, he tries to maximize utility using his limited income.

2. Utility is measurable: The satisfaction derived from a commodity can be measured.Thus, utility is cardinal. Some suggested the use of money to measure utility, while

other argued that utility can be measured using its own units of measurement called

utils.

3. There is constant marginal utility of money. This theory assumes that marginal utilityof money is constant over the study period. The implication of this assumption is thatthe additional utility derived from an additional unit of money is the same both for the

rich and a poor person. This is not so in real life situation.

4. There is the existence of the law of diminishing marginal utility. The law ofdiminishing marginal utility states that utility derived from successive units of a

commodity consumed diminishes. This law is expected to hold under this theory

over the study period..

5. Utility derived depends on the units of the commodity consumed. This assumptionmeans that u = f(q1, q2, q3, q4 .......... qn).

Given the above assumptions, we can be able to show how the law of diminishing marginalutility works. This law is assumed to work under three important assumptions:

a) Units of the commodity consumed are homogenous.b) Taste of the consumer remains the same over the study period.c) There is no time interval between taking one unit of the commodity and the other.

An example of the above law can be depicted in the table below. On this table, units of

commodity X consumed over the study period are represented on the first column. In column

two, total utility derived, that is total satisfaction are represented. While column three

represents the marginal utility. The marginal utility is derived on this table by dividingchange in TU by a change in X. And mathematically this can be written as

That is,


19/27

19

change in total utility divided by a change in units of commodity X consumed by the

consumer and assuming that the above three assumptions hold.

Units of Commodity X Total Utility (TU) Marginal Utility (MU)0 0 -

1 10 10

2 17 7

3 21 4

4 24 3

5 24 0

6 22 -2

Graphical Representation of the TU and MU Schedules:

Equilibrium of the Consumer:

Given the earlier assumptions we have stated guiding this theory, the consumer triesto maximize his utility using his limited income in the market. And being rational, if MU x is

greater than Px, the consumer will buy more of commodity X. And if MUx is less than Px, the

consumer will buy less of commodity X. Therefore, the consumer will by an exact quantity of

commodity X only when MUx = Px.


20/27

20

SECTION FOUR

PRODUCTION AND THEORY OF COST

What is production?

Production refers to the transformation of inputs into output. It involves the creation

of both tangible and intangible goods for the satisfaction of human wants. Tangible goods

production involves the production of both consumer durable and non-durable goods such as

handsets, laptops, rice, bread, tomatoes, biscuits and eggs. Producer durable goods such as

machines, tractors and caterpillars are also part of tangible goods. While intangible goods

include transport services, legal services by a lawyer, medical services by a doctor,

construction works by labourers, as well as internet and other communication services

rendered in an economy for the satisfaction of human wants.

Factors of production:

Inputs that are combined, such as land, labour, capital and other raw materials are called

factors of production or agents of production. These inputs are combined to undertake the

production of goods and services by business firms.

a) Land: Land as a factor of production refers to all free gifts of nature obtainable fromthe earth surface. It consists of plots of land, farm lands, seas and rivers, forest and

forest reserves as well the atmosphere. Land as a factor of production has three

important characteristics that make it distinct from all other factors such as labour and

capital. One, it is a free gift of nature and there was no any human effort involve inmaking it what it is. Two, it is fixed in supply. In other words, the quantity of land in

a particular place remain fixed, as it cannot be increased. Three, land is immobile as a

factor of production, unlike labour and capital. It cannot be moved from one place to

another. That is, it is geographically immobile.

b) Labour: Labour refers to human mental and physical effort that is involved in theproduction of goods and services for the satisfaction of human wants.

c) Capital: Capital refers to wealth that is used in the production of other wealth. It isdivided into circulating capital and fixed capital. Circulating is simply the monetary

capital that is used in production for the purchase of factor inputs. In a bakery firm for

instance, money is reserved for the purchase of yeast, flour, sugar, oil, salt, firewood

and diesel. Then bread is produced and sold by the firm. The money realised from the

sale of bread produced is then used to pay for labour services and the purchase of

more raw materials to produce bread. Money therefore, keeps turning from money to

raw materials, from raw materials to bread, and then from bread to money again.

Thus, money keeps circulating. Fixed capital on the other hand consist of fixed factor

inputs such as machines, motor cars, shops and other buildings.

d) Entrepreneurship: This is the organizer of production. He organizes the factors ofland, labour and capital to undertake the production of goods and services for the

satisfaction of human wants. He takes all major decisions concerning production.Decisions dealing with what to produce, the production method to be followed as well


21/27

21

as where to locate an industry are all taken by the entrepreneur. He bears the

consequences of all investment decisions.

Short-Run/long-Run:

Short-run is the production period within which some factor inputs are fixed whileothers are variable. This period coincides with period when a firm is already in operation.

Long-run on the other hand refers to that production period within which all factor inputs are

variable. This period coincides with the planning stage in a particular firm. Within the

planning stage, that is a period or stage when a firm is planning to go into business, all factor

inputs are variable. Land can be increased and can be reduced. Likewise all other factors of

production can increased or reduced.

Law of Diminishing Returns:

The law of diminishing returns is a short-run law of production. It is also called thelaw of variable proportions. The law states that, successive addition of variable inputs into a

fixed amount of other inputs may increase output initially, but after a certain point it gives

less and less output.

Variable Factor

(L)

Total Product

(TP)

Average Product

(AP)

Marginal Product

(MP)

0 0 --- ---

1 100 100.0 100

2 210 105.0 110

3 330 110.0 120

4 430 107.5 100

5 520 104.0 90

6 600 100.0 80

7 670 95.7 70

8 720 90.0 50

9 750 83.3 30

10 760 76.0 10

11 740 67.2 -20

TP, AP & MP CURVES.


22/27

22

Supply of Labour:

The supply of labour in a particular country refers to the number of able bodied men

and women that are willing to work at the current wage rate at a particular time. The supply

of labour curve is an upward sloping curve just like the normal supply curve, but it relates

quantity of labour available for employment at a particular time to a given wage rate. Thus,

workers been rational, they supply more of their labour services at a higher wage rate than at

a lower wage rate. In other words, there is a positive relationship between the supply of

labour and the going wage rate. Therefore, all things been equal, the higher the wage rate the

higher the supply of labour and the lower the wage rate the lower the supply of labour.

Figure 4.1 Labour Supply Curve.

Factors Affecting the Supply of Labour in a Country:

a) The Wage Rate. All things being equal, there is a direct relationship between the wagerate and the supply of labour at a particular time. This means that the higher the wage

rate the higher the supply of labour and vice-versa.

b) The School Leaving Age: The higher the school leaving age the lower the supply oflabour in a particular country. And the lower the school leaving age the higher the

supply of labour.

c) Age, Sex and Culture: Age, sex and culture affects the supply of labour in a particularcountry. In terms of age, young people are more willing to supply their labour

services than old people. In fact, those who fall within the age of 0 14 years and 65

years and above are considered as dependent population. Whereas, those within the

age of 15 64 years are the active part of the population. Also, male workers are

more willing to supply their labour services than females. Due to culture also, male

workers supply more of their services than female workers.

d) Education and Training: Level of education and training acquired by workers alsoaffect the supply of labour in a particular country. This is because education and

training also affect the level of wage earn by a particular category of labour. In other

words, there is a direct relationship between the level of education and the level of

wage or income that goes to labour.

Mobility of Labour:

Labour mobility refers to the ease with which labour moves from one occupation to

another or from one location to another. It is the movement of labour both geographically and

occupationally. Geographical mobility deals with movement of labour from one location to


23/27

23

another, whereas occupational mobility is concerned with movement of labour between

occupations. Different factors affect mobility of labour in a particular country. Such factors

include age, sex, culture and education, particularly geographical mobility. In other words

male workers are more mobile than female workers, and in terms of age, young people are

more mobile than old people geographically. Occupationally on the other hand, unskilledlabour is more mobile than skilled labour.

Theory of Cost:

Cost refers to the entire expenses involved in the production of goods and services by

producers in a particular firm. These are monetary costs or accounting costs as economists

are mainly concerned with real costs or opportunity costs. The major cost concepts to be

treated here include Total Variable Cost, Total fixed Cost and Total Cost. Others are Average

Variable Cost, Average Fixed Cost, Average Total Cost and marginal Cost.

a) Total Variable Cost: These are costs that arise from the use of variable factors inproduction and in the short run. It is the cost of that arises from the use of raw

materials, stationeries, fuel, firewood in bakeries, etc.

b) Total fixed Cost: These are costs that arise from the use of fixed factors in production,particularly in the short-run.

c) Total Cost: This is the entire cost incurred in the production of a given quantity ofoutput. It is obtained by adding total fixed cost and total variable cost. Thus, TC =

TFC + TVC.

d) Average Fixed Cost: This ise) Average Variable Cost:f) Average Total Cost:g) Marginal Cost: This refers to an additional cost that arises from the production of one

more unit of output.

HYPOTHETICAL SHORT-RUN COST SCHEDULE FOR A FIRM

Output FC VC TC AFC AVC ATC MC

0 30 0 30

1 30 22 52

2 30 38 68

3 30 48 78

4 30 61 91

5 30 79 109

6 30 102 132

7 30 131 161

8 30 166 196

9 30 207 237

10 30 255 285


24/27

24


25/27

25

CHAPTER FIVE

THEORY OF THE FIRM AND MARKETS

What is a firm?

A firm refers to a single unit of production. For example, Gaskiya Textile in Kano is a

textile firm. An industry on the other hand refers to a group of firms that produce similar

products. All textile firms in Nigeria for instance make up the textile industry.

CHAPTER SIX

BUSINESS ORGANIZATIONS


26/27

26

Types of Business Organizations

Business organizations are generally categorized into three different forms. These are

the sole proprietorship, the partnership and the joint stock company.

The Sole Proprietorship:

This is the earliest and the oldest form of business organization. It is simply called

one-man business. It is that type of business that is owned, controlled and run by one person.

He provides the initial capital either from past savings, friends or relatives as the capital

requirement is usually small. He also decides on what should be produced, how and where it

should be produced. Thus, all major business decisions are carried out by the owner of the

business.

The Partnership

This is a type of business organization in which two or more persons join hands to form a

particular business entity.

Joint Stock Company

REFERENCES


27/27

Smith, Adam (1776), The Wealth of Nations.

foundation of economics

Documents