Department of Economics and Development Studies

DEPARTMENT OF ECONOMICS AND DEVELOPMENT STUDIES,

FEDERAL UNIVERSITY, KASHERE, P.M.B. 0182, GOMBE STATE

COURSE CODE: ECD 2201 COURSE TITLE: MICRO-ECONOMICS I

• Micro-economics theory
• Problem of scarce resources and allocation of resources in product and factor markets.
• Types of micro-economics: micro-static and micro-dynamics (Cobweb theory or model).
• Equilibrium concept: possibility of disequilibrium.
• Partial equilibrium and general equilibrium analysis.
• Supply and demand theories.
• Consumers’ behaviours.
• General equilibrium of exchange.

LECTURE I

Micro-economic theory is concerned with the analysis of price determination

and the allocation of scarce resources to specific uses. It is the allocation of scarce resources that determines what to produce, how to produce, etc. Generally, the following fundamental questions arise because of the basic problem of scarcity confronting an economy.

1. What goods are produced and in what quantities by the productive resources which the economy possesses?

2. How are the different goods produced? That is, what production methods are employed for the production of various goods and services?

3. How is the total output of goods and services of a society distributed among its people?

4. Are the use of productive resources economically efficient?

5. Whether all available productive resources of a society are being fully utilized, or are some of them lying unemployed and unutilized?

6. Is the economy’s productive capacity increasing, declining or remaining static over time?

The six questions listed above have been the concern of economic theory from time to time. All economies whether they are capitalist, socialist or mixed, must take decision about them. Economic theory studies how these decisions are arrived at in various societies.

It is worth mentioning that economic theory has been mainly evolved and developed in the framework of capitalist institutions where free market mechanism plays a dominant role in solving the above basic problems. Therefore, mainstream economic theory assumes free market system and explains how the above six problems are solved by it and with what degree of efficiency.

We shall explain below six problems and questions in detail and see how they are related to the problem of scarcity.

1. The Problem of Allocation of Resources:

The first and foremost basic problem confronting an economy is “What to produce” so as to satisfy the wants of the people. The problem of what goods are to be produced and in what quantities arises directly from the scarcity of resources.

If the resources were unlimited, the problem of what goods are to be produced would not have arisen because in that case we should have been able to produce all goods we wanted and also in the desired quantities. But because resources are in fact scarce relative to human wants, an economy must choose among various goods and services.

If the society decides to produce a particular good in a larger quantity, it will then have to withdraw some resources from the production of other goods and devote them to the production of the good which is to be produced more. The greater the quantity of a good which is desired to be produced, the greater the amount of resources allocated to that good. The question of what goods are produced and in what quantities is thus a question about the allocation of scarce resources among the alternative uses.

In a capitalist economy, decisions about the allocation of resources or, in other words, about what goods are to be produced and in what quantities are made through the free-market price mechanism.

Therefore, the relative prices of goods, which are determined by free play of forces of demand and supply in a free market economy, ultimately determine the production of goods and the allocation of resources.

2. Choice of a Production Method:

There are various alternative methods of producing goods and a society has to choose among them. Different methods or techniques of production would use different quantities of various resources.Thus, a society has to choose whether it wants to produce with labour- intensive methods or capital-intensive methods of production.More generally, the problem of ‘how to produce’ means which combination of resources is to be used for the production of goods and which technology is to be made use of for their production. Scarcity of resources demands that goods should be produced with the most efficient method. If the economy uses its resources inefficiently, the output will be less and there will be unnecessary loss of goods which otherwise would have been available.

The choice between different methods of production by a society depends on the available supplies and the prices of the factors of production. The criterion for the choice of a method of production should therefore be the cost of production per unit of output involved in various methods.

3. The Problem of the Distribution of National Product:

This is the problem of sharing of the national product among the various individuals and classes in the society. The question of distribution of national product has occupied the attention of economists since the days of Adam Smith and David Ricardo who explained the distribution of national product between different social groups such as workers and capitalists in a free market society.

Labour, land and capital are factors of production and all of them contribute to the production of national product and get prices or rewards for their contribution. Therefore, the personal distribution of income is greatly affected by the distribution of the ownership of property. A person who owns a large amount of property will be enjoying a higher income. In the free market capitalist economies because of the large inequalities in the ownership of the property there are glaring inequalities of income. As a result, the distribution of national product is very much unequal in capitalist economies.

4. The Problem of Economic Efficiency:

Resources being scarce, it is desirable that they should be most efficiently used. It is therefore important to know whether a particular economy works efficiently. In other words, whether the production and distribution of national product decided by an economy is efficient. The production is said to be efficient if the productive resources are allocated among production of various goods in such a way that through any reallocation it is impossible to produce more of one good without reducing the output of any other good. The production would be economically inefficient if it is possible by rearranging the allocation of resources to increase the production of one good without reducing the output of any other. Likewise, the distribution of the national product among individuals of a society is efficient if it is not possible to make, through any redistribution of goods, some individuals or any one person better off without making any other person worse off.

For attaining economic efficiency, product-mix, that is, allocation of resources among production of various goods should be in accordance with the preferences of people, given their incomes. If the economy is producing wrong-mix of goods, then through reallocation of resources among them it will be possible to make some people better off without any one worse off.

5. The Problem of Full Employment of Resources:

Whether all available resources of a society are fully utilized is a highly significant question because answer to it would determine whether or not there will exist involuntary unemployment of labour as well as of capital stock. In view of the scarcity of resources to satisfy all wants of the people, it may look strange to ask a question whether or not all available resources of a community are being fully utilized.

This is because resources being scarce, a community will try to use all the available resources to achieve maximum possible satisfaction of the people. Thus a community will not consciously allow the resources to lie idle. But in a capitalist free market society it so happens that at times of depression available resources are not fully utilised.

6. The Problem of Economic Growth:

It is very important to know whether the productive capacity of an economy is increasing. If the productive capacity of the economy is growing, it will be able to produce progressively more and more goods and services with the result that the living standards of its people will raise. The increase in the capacity to produce goods over time is called economic growth.

But the need for balanced equilibrium growth rate in the developed capitalist countries on the one hand and the urge to remove mass poverty, hunger and chronic unemployment in the developing countries after their achievement of political independence have once again aroused the interests of economists in the problems of economic growth and numerous growth and development models have been put forward.Some of these growth models such as Harrod- Domar model. Neo-classical growth models of Solow and Swan, Cambridge growth models of Kaldor and Joan Robinson etc. have been propounded to explain and analyse the growth problem of the industrialised developed countries. Likewise, to initiate and accelerate the process of growth in developing countries, the various theories and models of growth and development have been offered.

However, it is worth noting that till 1980s the concept of economic development generally implied the active intervention of the government and the public sector in the field of production. The trend all over the world today is to adopt market friendly approach to development. To what extent free-market economy approach would generate greater economic growth and ensure economic efficiency in the developing countries, only the future will tell.

Thus, microeconomics is the study of how prices are determined in both factor and product markets, and how efficiently the various resources are allocated to individual consumers and producers. The interrelation between product and factor markets through prices in Nigeria and other economies is shown below:

LECTURE II

TYPES OF MICROECONOMICS

Microeconomic theory can be divided into micro-static and micro-dynamic.

MICRO-STATIC

In micro-static, supply and demand relationships determine prices at a point of time which are also constant through time. Given a demand and supply functions as:

D=f(P)...... 1

S=f(P)...... 2

Where;

D is quantity demanded

S is quantity supplied, and

P is price

At equilibrium;

D=S. This micro-static is illustrated in the diagram below:

From the diagram above, the demand and supply curves intersect at point E where quantity demanded and supplied equals at the price OP. If quantity demanded and supplied remained unchanged, then equilibrium position will apply not only to the present but also to the future.

THE MICRO-DYNAMICS (THE COBWEB THEORY OR MODEL)

The cobweb theory or model is used to explain the dynamics of demand, supply and price over long periods of time, especially perishable agricultural commodities. As prices move up and down in cycles, quantities produced also move up and down in a counter-cyclical manner. Such movements are explained in terms of the cobweb because the diagram looks like cobweb.

Assumptions of Cobweb Model

1. The current year’s (t) supply depends upon the previous year’s (t-1) decision regarding output level. Hence, current output is influenced by previous year’s price, i.e. P(t-1).
2. The current period or year is divided into a week or fortnight.
3. The parameters determining the supply function have constant values over a series of periods.
4. Current demand (dt) for the commodity is a function of current price (pt)
5. The price expected to rule in the current periods is the actual price in the last year.
6. The commodity under consideration is perishable and can be stored only for one year.
7. Both supply and demand functions are linear.

The Model

The supply function is St and the demand function is Dt. The market equilibrium will be when quantity supplied equals quantity demanded: St=Dt.

Assuming that potato growers produce only once in a year. The market demand and supply curves for potatoes are represented by D and S curves as shown in the diagram below:

From the diagram, the price last year was OP and the growers decided the output OQ this year. But the potato crop is damaged by blight so that their current output is OQ1 which is smaller than the equilibrium output OQ. This leads to rise in the price to OP1 in the current period. In the next period, the growers will produce OQ2 quantity in response to the higher price OP1. An increase in supply will lower the price to OP2 and the growers will reduce the price to OQ3 in the third period. As a result, price will rise to OP3 which, in turn, will encourage the growers to produce OQ quantity. Thus, equilibrium will be established at point g where D and S curves intersect. So, these series of adjustments trace out a cobweb pattern a,b,c,d,e, and f which converged towards the point of market equilibrium.

LECTURE III

THEORY OF DEMAND AND SUPPLY

The much of microeconomic theory revolves around the concepts of demand and supply and the workings of the price system.

Demand is the relationship between the quantity of a product that consumers are willing and able to buy over some given period and its price, other things remaining the same. Quantity demanded of a product is the amount (number of units) of a product that an individual would buy in a given period and at the current market price. The amount of a product that an individual finally buy depends on the amount of product actually availablein the market and the prevailing market price.

On the other hand, the quantity supplied is the amount of a particular product that a firm would be willing and able to offer for sale at a particular price during a given time period. The quantity of a good that a single producer is willing to sell over a particular time period is a function of the price of the good and the producer’s costs of production.It is reasonable to expect an increase in market price, all things been equal, to lead to an increase in quantity supplied. There is linear or positive relationship between the quantity of goods supplied and price. This statement summed up the law of supply in economics. An increase in market price will lead to an increase in quantity supplied, and a decrease in market price will lead to a decrease in quantity supplied.

• Equilibrium concept: possibility of disequilibrium.

Market equilibrium

The condition that exists when quantity supplied and quantity demanded are equal is known as market equilibrium. At equilibrium, there is no tendency for price to change. The operation of the market clearly depends on the interaction between suppliers and demanders. At any moment, one of the three conditions prevails in every market: 1.The quantity demanded exceeds the quantity supplied at the current price, a situation called excess demand (disequilibrium); 2. The quantity supplied exceeds the quantity demanded at the current price, a situationcalled excess supply (disequilibrium) or 3; the quantity supplied equals the quantity demanded at the current price, a situation called equilibrium.

From the above figure, the market clears at P*and quantity q*. At higher price P1, a surplus develops, so price falls. At the price P2, there is a shortage, so price is bid up.

Px QDx QSx

6 20 80

5 30 60

4 40 40

3 5020

2 600

From the table above we can determine the equilibrium price and the equilibrium quantity for commodity. At the equilibrium point, there exists neither a surplus nor a shortage of the commodity and the market clears itself.Ceteris paribus, the equilibrium price and the equilibrium quantity tend to persist in time.

Meanwhile, we know that at equilibrium QDx =QSx, we can determine the equilibrium price and the equilibrium quantity mathematically.

Given that QDX is a function of price and the relationship is expressed as:

QDX=80-10PX, also given a supply function as follow:

QSX=-40+20PX

Therefore, at equilibrium

QDx = QSx

80 - 10Px = - 40 + 20Px

120 = 30Px

Divide both sides by 30

Px = N4(equilibrium price)

Replacing this equilibrium priceinto the demand equation and

the supply equation, we get the equilibriumquantity .

QDx = 80 - 10(4) QSx = - 40 + 20(4)

= 80 – 40 = - 40 + 80

= 40 (units of X) = 40 (units of X)

Adjustment to changes in demand and supply: comparative static analysis

What is the effect of a change in the behaviour of buyers and sellers, and hence in demand and supply, on the equilibrium price and quantity of a good? As the behaviour of buyers and sellers often does change, causing demand and supply curves to shift over time, it is important to analyse how these shifts affect equilibrium. This is referred to comparative static analysis. Comparative statics thus implies an instantaneous adjustment to disturbances to equilibrium.

Adjustment to changes in demand

You should know by now, that the market demand curve for a commodity shifts as result of a change in consumer’ income, their tastes, the price of substitutes and complements, and the number of consumer in the market.Given the market supply curve of a commodity, an increase in demand results both in a higher equilibrium price and a higher equilibrium quantity. While a reduction in demand has the opposite effect.

An increase in demand increases price and quantity exchanged, from P to P` and Q to Q`, respectively.

Adjustment to changes in supply

The market supply curve of a commodity can shift as a result of a change in cost, technology, resource prices, or weather conditions especially for agricultural produce. Given the market demand for the commodity, an increase in supply results in a lower equilibrium price but a larger equilibrium quantity. While a reduction in supply has the opposite effect.

An increase in supply decreasesprice and increases quantity exchanged.

Simultaneous shifts

When both the demand and supply curves shift, the effect on price and quantity will depends upon the direction of the shifts and their relative magnitudes. If both demand and supply shift left, the equilibrium quantity will decline. The changein the price depends upon the relative magnitudes of the shifts. If both demand and supply shift right, the quantity will increase. If supply and demand shift in opposite directions, the price change will be determined, but change in quantity will depend upon the relative magnitude of the shift.