Economics s4 Notes - Docx .PDF 2

ECONOMICS FOR SENIOR FOUR GS.
GISOZI I
We must be competent in economic theories to solve the economic issues (scarcity)
PREPARED BY: BIKORIMANA Eugene Tel 0789220704
Academic year 2020-2021

TABLE OF CONTENTS
UNIT1. BASIC ECONOMIC CONCEPTS AND THE IMPORTANCE OF ECONOMICS

UNIT2: FUNDAMENTAL PRINCIPLES OF ECONOMICS
UNIT3: NATURE AND SCOPE OF ECONOMICS
UNIT4: EQUATIONS AND FRACTIONS IN ECONOMICS
UNIT5: THEORY OF DEMAND
UNIT6: THEORY OF SUPPLY
UNIT7: EQUILIBRIUM AND PRICE DETERMINATION
UNIT8: ELASTICITY
UNIT9: CONSUMER THEORY
UNIT10: PRICE MECHANISM
UNIT11: INTRODUCTION TO THE THEORY OF PRODUCTION
UNIT12: INPUT-OUTPUT RELATIONSHIP (PRODUCTION FUNCTION)
UNIT13: THEORY OF A FIRM
UNIT14: THEORY OF THE COST
UNIT15: REVENUES AND PROFITS OF A FIRM
Prepared by BIKORIMANA Eugene Tel 0789220704

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TOPIC AREA 1: GENERAL INTRODUCTION TO ECONOMICS
UNIT1. BASIC ECONOMIC CONCEPTS AND THE IMPORTANCE OF ECONOMICS
1.1. MEANING AND ORIGIN OF ECONOMICS

. Economics is derived from two Greek words:
Oikos means “a house”
Nomos means “a manager” as a whole meaning economics means “a house manager”.
All typical households in a Greece had (still have) problems of managing scarce resources, they
therefore had and still have to economize. Household have limited resources and unlimited
needs, this leads to a need to devise means to satisfy all the needs with the limited available
resources. It is this scarcity and unlimited needs that give rise to the discipline of economics .It is
about managing scarcity. So economics as a discipline arises out of scarcity
Various economists have defined economics differently

- According to Lionel Robbins (1935) defined economics as “a science which studies human
behavior as a relationship between ends and scarce means which have alternative uses.
- According to Adam Smith: “It is the study of nature and cause of wealth of nations.
- According to J.S. Mill” Economics is a practical science of production and distribution of
wealth and problems involved in production and distribution.”
-According to Alfred Marshall: Economics is the study of mankind in the ordinary business
life.
From the above definitions, many economists consider Robbins’ definition to be the most
appropriate because:
- It give fundamental cause of economic problems, such as unlimited needs, and scarcity of
resources
- His definition emphasized scarcity as a foundation of economics
- Man’s problem is not accumulating wealth, but satisfaction of human needs
Generally, economics is a social science, which study how man attempt to solve the problem
of unlimited or endless needs and wants by using limited resources.
N.B: Without scarcity there would be no economics, there would be no needs to economize,
there would be no need to allocate scarce resources.
1.2. IMPORTANCE OF STUDYING ECONOMICS

Economics helps students to:
 To pursue their chosen careers in banking, management, commerce etc.

 To understand the basic economics concepts and principles.

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 To participate effectively in the development of their country.
 To assist in the formation and implementation of economic policies (on inflation,
unemployment, government spending) needed for the rapid economic growth and
development.
 To understand the need for international trade among countries and how each country
faced with scarcity of resources.
 To understand how to use the scarce economic resources in order to improve on the
wellbeing of the society.
 To know common economic problems faced by society like unemployment, income
inequality, population explosion.
 To give knowledge about various institutions and how they interact, how they operate,
services delivered their roles.
 It prepares students for employment.
 Etc
1.3. BASIC TERMS USED IN ECONOMICS

1.3.1 Wealth
It is the stock of assets available to an individual or group of individuals or country at a

particular period of time.
Characteristics of wealth
 It is relatively scarce.
 It provides satisfaction i.e. it possess utility.
 It has money value that is it can be expressed in monetary terms.
 Wealth can be used to produce more wealth.
 Its ownership is transferrable that is, it can be exchanged.
Forms of wealth
a. Social wealth: This refers to all public assets such as public road, public libraries.
b. Individual wealth: This refers to the assets or wealth held privately by an individual.
c. Business wealth: This refers to the wealth of business organizations at any particular
time.
1.3.2 Resources
Resources: Refers to all productive inputs used to produce goods and services; they are
used to produce goods and services.

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Types of resources
A) Natural resources: These resources occur naturally within the environment.
Examples include: air, land, minerals etc.
B) Human-made resources: These are resources created through the action ofhuman
beings. They include materials like cars, hoes, pen etc.
C) Human resources: These is a set of individual who make up the workforce of an
organization, business sector or the economy
D) Renewable resources: These are resources that can be used repeatedly without
being depleted. Examples includes: Solar energy, wind energy, geothermal energy etc
E) Non- renewable resources: These resources that can be depleted in nature once
they are used. Example include: Petroleum, coal, gold etc
1.3.3. Price
Price: is the relative value of an item on the market expressed in monetary terms.
Types of price
A) Market price: this is any price existing on the market at a particular period of
time regardless of how it is determined
B) Equilibrium price: This is the price established in the market when quantity
demanded is equal to quantity supplied.
C) Normal price: This is the long run established price after a long period of price
fluctuation
D) Reserve price: This is the minimum price acceptable to a seller to part with a
commodity
1.3.4. Economic agents
Economic agents: are the major decisions making units in the economy. They include:
A) The household: this is a group of individuals under one roof who take joint
decision on their own venture
B) The firm: This is a smallest unit of production, which employ factors of
production to produce goods and services.
C) The state: This institution has both political and economic power to influence
resource allocation and distribution. it is the agent that regulates the activities of
the household and the firm

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D) Foreign sector: This includes export and import. It is responsible for the
expenditures on gross domestic product.
1.4. DIFFERENCE BTWEEN NEED AND WANT AND BETWEEN GOODS AND
SERVICES.
1.4.1 : Needs are those humans desire whose satisfaction is necessary to sustain life.
They include food, shelter, clothes etc.
1.4.2 : Wants are those humans desire whose satisfaction makes life more comfortable,
enjoyable and pleasant. They include cars, telephone and other luxuries
Characteristics of wants
 They are unlimited

 They are complementary
 They have different degree of urgency
1.4.3: Welfare: refers to the provision of minimal level of wellbeing and social support for all
citizens. Level of welfare is indicated by the quantity and quality of Goods and services that a
person can access.
1.4.4: Commodities: These are products that created by the use of factors of production.
Commodities are categorized into as either goods or services.
1.4.4.1: Services
Services: Are intangible items or things that satisfy non-material wants.
Forms of services
 Direct services: these are services that directly benefit an individual person. They
include education; sport, medical care etc
 Indirect services: These are services the individual benefit from indirectly or
commercially. Such services facilitate business activities. They include banking,
insurance , transport , advertising etc
Characteristics of services
 They are intangible. Services can neither be seen, felt nor touched.
 Its provision require use of service providers like a teacher , doctors etc
 It cannot be stored to be consumed in future time.
 It cannot be transported from one place to another. Only a service provider can move or
transported to another area.
1.4.4.2: Goods
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Goods: Are tangible items that satisfy human desire. For example food, clothes, pen etc
Types of goods
 Free goods: is a good which exist in abundant such that there is no opportunity cost to
produce it, no price to consume it.
 Economic or commercial goods: This are goods, which are scarce in supply. It require
payment.
Characteristics of economic goods
 They have opportunity cost.
 They are marketable
 They have money value
 They are relatively scarce
 They provide satisfaction to the consumer
 They are transferable in terms of ownership
 Private good: this is a good exclusively owned by an individual or a firm and the
consumption by one consumer prevents simultaneous consumption by other consumers.
 Public good: it is collectively owned and its use is non-exclusive, it is available for use to
all people. The consumption of a public good by one individual does not reduce the amount of
the same good available for consumption by others.
Public good is characterized by non-divisibility i.e it is provided in its totality, non-rivalry
i.e there is no competition in consumption, non-excludability i.e it is difficult for the supplier to
exclude anyone who does not pay for the commodity from enjoying.
 Inferior goods: these are goods that people reduce or even stop consuming when their
incomes increase.
 Giffen goods: they are named after Sir Robert GIFFEN who first identified them. A
Giffen good is an inferior good for which a rise in its price makes people buys even more of the
product.
 Intermediate goods: these are goods which have not yet reached their final stage of
production and cannot therefore be directly consumed to provide utility. They can be used as
inputs into the production process to produce finished goods.
 Final goods: these are goods whose production process is complete and are ready to be
used. They provide direct satisfaction to users in their present form.
 Consumer goods: a consumer good is any tangible commodity purchased by households
to satisfy their needs and wants.
 Capital (producer) goods: they are also called producer goods; these are goods that
have been produced for use in the production of other goods.
 Merit good: This is a good which is essential to the society and its consumption should
be encouraged. Example Education

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 Demerit good is a goods whose consumption is considered unhealthy, harmful or
socially undesirable and its consumption must be discouraged otherwise if left to market forces,
it would be over consumed.
 Substitute goods:these are goods which serve the same purpose
 Complement goods: these are goods, which are to be combined in order to satisfy
people’s needs.
Examples: shoe and polish; car and fuel; camera and photographic firm; a pen and paper.
 Luxury goods: these are goods whose demand and consumption increase as their
price increase.
5. ECONOMIC ACTIVITIES AND ECONOMIC SYSTEMS

1. Economic Activities
Economic activities are activities that involves production, distribution and
consumption of goods and services at all level within the economy.
Sectors of production in economy

 Primary level of production: It involves extraction of raw materials fro the nature.
Example: mining, agriculture, fishing etc
 Secondary level of production: It involves transformation of raw materials into finished
goods that can satisfy human wants. Example: manufacturing industries
 Tertiary level of production: It involves provision of services. Example: transport ,
communication, banking, insurance, tourism, etc
2. ECONOMIC SYSTEMS
Economic system refers to the general organization and structure of an economy. It deals with
ownership, control and allocation of resources and general distribution of goods and services in
the economy. There are 3 major economic systems.
 The free enterprise / laissez faire/ capitalist economy
 The command/ planned/ socialist economy.
 -The mixed economy
Free market economy (unplanned economy, laissez faire, free enterprise or
capitalist economy)
This refers to an economic system in which private individuals own resources and freely
undertake the production and distribution of goods and services, guided by the price of those
goods and services. Under this system, private individuals make decision on what to produce,
who to produce it, for whom to produce, when to produce and where to produce through the
price mechanism without government intervention.
Feature of free market economy
 There is private ownership of property and factors of production

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 There is no government intervention in economic decision. The economic decision like
what , where , when and how to produce are determined by force of demand and supply
 There is profit motivationthe production process.
 There is a lot of competition in the economy. This is because production is profit
oriented.
 There is freedom of choice in the economy since government has limited control
 Price is determined by market force of demand and supply.
 Advantages of the free marked/unplanned economy
 the system is automatic and does not require government intervention
 there is consumer sovereignty i.e. producers produce basing on consumers’ choice
 firms work hard in order to get profits
 Efficiency allocation of resources.
 freedom of entry and exit in the production process thus a competition
 flexibility in production since there is no laws fixed by government
 etc.
 disadvantages of the free market system
 unequal distribution of income
 prices act as an indicator of what to produce, therefore there is lack of goods demanded
by poor people
 The market does not correct the problems such as inflation, unemployment…
 Social costs such as pollution
 Inflation and unemployment due to the use of capital intensive technology
 High duplication of goods and service due to lack of government intervention.
 Exploitation of consumer by profit motivated firms in form of high price
 Creation of monopoly as inefficient firms are being driven out of mar
 Socialist or Planned economy / Command economy
A planned economy is an economic system where decisions and choices about allocation and
use of resources is directly made by the government
Under this system, the government makes decisions on economic questions because it is fairer
in the allocation of resources and knows better what is in the best interest in the people.
Planned economy emphasizes more on allocation benefits and general wellbeing rather than the
requirements of single individual
Features of planned economy
 There is public ownership of all productive resources such as land.
 Government take all decisions on Production, resource allocation and distribution.
 There is no freedom of individuals to operate their own enterprise.
 The major economic activities in the economy aim at offering services to citizens.
 Advantages of planned economy
 Production of necessary goods especially for the poor people
 Planned economy ensure economic stability
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 Wages are paid according to the importance of the work or services delivered
 It reduce income inequality
 It avoids the production and consumption of demerits goods
 It eliminates individuals profit motives in producing goods and services
 The system avoids duplication in production of goods and services
 Etc.
 Disadvantages of planned economy
 Planners cannot detect consumer preferences, shortage…
 Wastage of resources
 Planned economy does not encourage research innovations and inventions
 lack of competition thus government firms become inefficient in production both quality
and quantity
 the system eliminates consumer sovereignty
 planned economy favor political corruption
 Increase administrative cost on the side of the government.
 Mixed economic system
An economic system that integrates features of two or more economic systems. Resources are
owned by the state and the private individuals, both private and government participle in taking
economic decisions
Note that in practice, there is no pure capitalism or pure socialism i.e all economies are mixed.
The classification to either capitalism or socialism depends on the extent of government
intervention in taking economic decisions.
Features of mixed economy
 Ownership of resources is by both the government and the private individuals

 Resources allocation is by both the government and forces of demand and supply
 There is existence of indicative planning
 Production is for both profits and welfare maximization
 Co-existence of both the public and the private sector
UNIT2: FUNDAMENTAL PRINCIPLES OF ECONOMICS

2.1. Definition of the fundamental principles of economics
 Scarcity: refers to limitedness of resources relatively to human wants. In economics

sense, scarcity means that the available resources are not sufficient to satisfy human
wants .Scarcity arise because human wants are unlimited yet the resources are limited.
 Choice: refers to making a rightdecision about different possible options. Because human
wants are unlimited and the resources are limited, a choice must be made on what wants
to satisfy immediately and what to satisfy later, what to satisfy now and what to forego.

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 Opportunity cost: This refers to the next alternatives foregone when the choice is made.
It also arises because of scarcity.
Example: by buying a car, one can forego a house when resources are not enough to buy both.
The opportunity cost of having one car would be the number of houses that you forego.
This is a result of scarcity and choice when choice is made it means some wants are left
unsatisfied they are foregone .The immediately alternative foregone when choice is made is
called opportunity cost. Briefly, opportunity cost is what you miss when you make a choice.
2.2. Production possibility frontier (opportunity cost/ transformation curve)
It refers to a locus of points showing possible combinations of two commodities that can be
produced when all resources are fully and efficiently used.
Assumptions of PPF
 It assume that only two commodities are produced

 It assume that level of technology is fixed and constant
 It assume that all resources are fully utilized
 It assume that similar resources will be used to produce both of the twogoods
The following figure illustrates the production possibility frontier:

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Commodity
Y (coffee)
Figure 1 by
Alexis
A (X1,Y1)
Y3
Y2 B (X2,Y2)
Y1 C(X3,Y3)
0 X1 X2 X3
Commodity
X(cotton)
The above figure illustrates the following economic concepts:
 Scarcity: resources are scarce leading to a country to do not produce both two
commodities at maximum level and cannot produce beyond its PPF
 Choice: a country choose which product to produce more than an other
 Opportunity cost: while increasing production of one commodity, it will sacrifice some
units of the other commodity. And if it produce at point A , it sacrifice to produce at point B. if
it produce at point B, it sacrifice to produce at point C
 Efficiency in production: this is illustrated by points on the curve that show efficient
utilization of resources, points inside the curve show that some resources are not utilized
(underemployment or inefficiency), points outside the curve are not attainable by using
available resources.
 Economic growth: it is illustrated by the shift of production possibility curve outward
(to the right). It means that there is an increase in resources and hence an increase in
commodities produced. This is illustrated by the following figure:
Commodity
Y
Figure 2 by
0 Alexis
Commodity
X

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The outward shift of the PPF is caused by the following factors:
 The improvement in technology through innovations and inventions. Innovation refers to
the improvement on the existing techniques and methods of production while Invention refers
to the total discovery of new techniques and methods of production.
 Increase in labor force
 Improvement in the existing infrastructure
 Political stability
 Discovery of new resources in the economy
 Increase in capital stock
 Improvement in entrepreneurial skills
 Increase in the efficiency of workers
The inward shift of the PPF indicate economic decline.

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It is caused by the following factors:
 Lack of new natural resources

 Decline in invention and innovation which lead to production of few and poor quality
products
 Lack of new markets that encourage production of more goods and services
 Lack of skilled labour
 Decline in investment as a result of poor entrepreneur skills

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MAIN TYPES OF
UNBIASED PPF
Commodity
Y
Figure 2 by
0 Alexis
Commodity
X
Unbiased PPF shift on both sides favoring both two commodities
Economic questions
 What to produce: here the firm decide on the nature of good to produce. It may be
capital or consumer goods
 How to produce: here producer think on which method of production to be used in
production process. It may choose to use capital intensive or labour intensive.

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 When to produce: here the producer think on favorable period of production. The good
period of production, is when demand for goods and services is high.
 Where to produce: Here producer think on better location of his or her firm. The good
location for the firm is near raw materials, market and transport links.
 For whom to produce: Here producer think on target consumers for his or her products.
It may be young, old, rich, poor , peoples who will consume his or her products
UNIT3. 1. THE NATURE AND SCOPE OF ECONOMICS

This refers to the limit to which economic problems can be discussed. In addition to what is
implied in the definition, the following should be noted about the scope of economics:
 The subject matter of economics: this covers all aspects of economic activity such as
production, exchange, consumption, and distribution of commodities.
 Economics is both an art and a science
As an art, it study human beings and decisions they make to influence economic
environment of the society they live in. As a science, it is a systematized body of
knowledge, which may use observation and experiment, and it uses a scientific method
and research to prove right or wrong.
 Economics is related to other social sciences such as political science, sociology,
psychology…this is why the problems in these sciences affect economic conditions of any
country.
3.2. Positive and normative economics

 Positive economics is a branch of economics which study economic variables the way
they was, are or will be. It is about facts in real life.
 Normative economics is a branch of economics which study economic variables the
way they ought to be. It depends on individual’s opinion.
Examples:
 Unemployment should have been below 4 : Normative economics

 Unemployment was 4 : is a positive statements
3.3. Economic variables

A variable: is a factor that can change. A variable can be measured. Examples
include: price, amount of output produced etc.
 Endogenous variable: originate within the economy and can be controlled

 Exogenous variable: originate from outside the economy and cannot be controlled

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Branches of Economics
i) Microeconomics: Is a branch of economics that studies individual units of the economy.
It look at how this single units function individually. Such units may be households, firms, price
of commodities etc.
ii) Macroeconomics: This branch of economics studies broad aggregates and how they
affect the economy as a whole. Such aggregates are: international trade, national income,
unemployment, inflation, economic growth etc.
REVIEW QUESTIONS
1. Briefly explain what economics is about. Why do you study economics?

2. What are the scopes of economics?
3. Explain the basic principles of economics
4. Explain an invisible hand according to Adam SMITH
5. What are the characteristics of public goods?
6. Explain the following concepts: PPF, Wealth, Commodities
7. Distinguish between private goods and public goods
8. Explain different economic systems

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UNIT4: EQUATION AND FRACTIONS IN ECONOMICS
4.1EQUATION IN ECONOMICS
Linear Equation
This refers to the mathematical representation that expresses a simple relationship
among or between variables. It means that it is made up of either one or more variables.
In economics, linear equation describes relationship between variables (dependent or

independent variables).
For instance; Q = 154 - 2P

Where: Q= Quantity demanded (dependent variable)
P= price of a unit (independent variable)
Or Q = 60 – 3P + 4Y
Where: Q= Quantity demanded of a commodity
P= Price of a commodity
Y= Income of a consumer
In economic analysis, linear equation explains the economic relationships and
phenomena of demand, price and consumer income. By following the law of demand;
on the first equation when the price increases the quantity demanded of a commodity
decrease.
P Q
0 154
1 152
2 150
10 134
77 0
If the seller sold the commodity at a price of 77 Rwf the quantity demand would be
zero. It means that no one would be willing to buy at that high price.
On the second equation, there is a demonstration of positive relationship (+4Y) between
disposable income of consumer and the quantity demanded where there is a negative
relation (-3P) between the price of a commodity and the quantity demanded.
The equation that relates two variables can be described:
Where; Qd = quantity demanded Qd = a - bP
P = Price of the commodity
a = quantity demanded at zero price
b = constant of proportionality
By following the law of supply, the following equation can be used to describe the
relationship between Price and quantity supplied:
QS= a + bP
The bigger the value of P, the bigger the value of Qs; when the value of P is zero no
quantity is supplied into the market.

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Another equation shows the relationship between income and expenditure; because it is
known that people spend from their income. The expenditure changes when income
also changes.
C = a + bY
Where: C = consumption expenditure
Y = Income
a = autonomous consumption at zero income
b = the realistic relationship between the income and consumption expenditure
Exercises of revision
a) A mathematical model below was formed to relate the income of individuals and
their personal expenditures in a given year.
C = 35 + 0.4Y
i. Find the consumption expenditure of an individual who earned 2000 Rfw
that year
ii. What was the consumption expenditure for a person who never earned
anything that year?
iii. What would have been the income of a person whose consumption
expenditure is 335 Rfw?
b) An economic researcher did a study on the demand of beef in certain market and
came up with a mathematical linear equation that describes the daily demand of
beef and its market price for all consumers in that market.
Relating the quantity of beef demanded (Qd) in kilograms and the price (P) per
kg in Rwf, he developed an equation:
Qd = 10 – 0.75P
i. How many kilograms of beef should someone demand on average in a
week if the price of a kg is 5Rwf?
ii. What price level would make people buy zero kgs of beef from that
market?
iii. What would be the quantity demanded if the beef was given free to each
individual for a day?
Linear graphs examples: explanation
Non- Linear Equations
Polynomial
This refers to an equation that expresses a dependent variable in terms of an
independent variable with power greater than one.
For example: Y=
Y=
In economics, we use polynomials to describe some relationships which do not have

direct or straight relationships between variables.
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The relationship between the cost and level of output:
AC = 3 where AC= average cost and Q = Quantity (level of output)
The relationship between two commodities A and B produced by using the available
resources:
A = where A is level of output for product A
b is output level for product B and n is a constant which is the value of A when
b=0
Logarithmic Equations
These describe logarithmic content of at least one of the variables. These equations are
applied in national statistics and indices in economic analysis.
Y = log x
These equations are commonly applied in studying the population growth of an
economy with time. Here, a mathematical equation can be developed to show the
relationship between the population size of the country and the time in years.
P = 2 log x or P =
Where, P is population and X is the time or number of years.
In trying to keep or trace and make predictions for proper national planning, a country
develops a national model for forecasting the population of a country for some years.
Exercises
1) Relating the number of people in millions and the period of time in years, the
model;
P = 123 + n log (1+n) 2 represents the population of a certain country starting
with the year 2000,
Where P = population size (in millions)
n = number of years
i. What was the size of population in 2000?
ii. What is the predicted number of people that country will have in 2010?
2) A national PPF was designed with a mathematical model to relate the efficient
output levels of two commodities A and B using the available fixed resources.
The following model was developed:
A=
Where, A represents the units of commodity A and B the units of commodity B
in tons.
i. If the country decides to produce 200 tons of commodity B that year, that would
be the tones for A?
ii. What if the country decides not to produce any quantity of B that year, how
many tons will they produce for commodity A?

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Graphs
A graph is locus of points showing combinations of variables in question. Graphs are
used by the economists to visually see the relationships between variables or just some
form of behavior.
The graph is divided into four parts each part is called a quadrant. There is a point of
origin that intersects the X and Y axes.
Quadrant II Quadrant I
Quadrant III Quadrant IV
Note that the first quadrant shows the positive values of both x and y. it is called the
positive quadrant. Generally, the economic theories deal with the positive quadrant.
Linear graph
This refers to a straight graphical representation (line) of a linear equation.
The form of linear equation is
Where P = price
Qd = quantity demanded
n = the value of P when Qd is Zero.
m = the slope of the line.
Price
P = n - mQd
0 Quantity
The slope of linear equation

If a line is given with any two points and, we can find the slope of this line as follows:
The slope
Or
Exercises
1. When the price of bread in KAREMBO supermarket is 2 Rwf per unit, and consumers
are willing to buy 10 breads per week on average. If for the same commodity,
consumers are willing to buy 15 breads per week when the price reduces to 1 Rwf per
bread. Find the mathematical relationship between the price of bread and the quantity
demanded in KAREMBO supermarket.

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2. For every 1 Rwf increase in price of kilogram of coffee in Rwanda, coffee farmers
increase their supply of coffee in their supply markets by 30 kgs. When a kg of coffee is
20 Rwf, an average coffee farmer in Rwanda supplies 300 kgs per month, develop a
mathematical equation to relate the supply of coffee in the local markets of Rwanda and
the price per kg in Rwanda francs for economic analysis.
Graphs and required values

When the graph is well plotted, it can be used in economics to predict future or past
values or between two given values. When given initial values (2 of them) we can plot a
line. Then we can find any value of the valuables given the value of the other.
Exercises
In ZAZA market, when the price of rice is 2000 Rwf per kg, an average consumer buys 3
kgs and when the price is 2500 Rwf per kg, an average consumer buys only 2 kg.
i. Represent the consumers’ demand curve on a graph
ii. Use it to estimate the number of kilograms this consumer would buy if the price
was at 3000 Rwf
iii. Form the linear equation of this demand curve.
Non-Linear Graphs
These are graphs that represent the relationship between variables by joining them form
a locus.
Example: the Production Possibilities Frontier (PPF), indifference curves, the average
fixed cost curve and the average cost curve.
The use of non-linear curves or graphs in economics
i. They help us to determine the maximum value of operation (production) and
satisfaction (consumption).
ii. To slop and to know the relationships between economic variables in question at
different levels of consumption, production and other situations.
iii. To predict the growth, whether negative or positive
iv. To make economic analysis and decisions.
Linear Simultaneous Equations

These are a set of linear equations that describes the same variables.
Example;
In economics, a set of linear equations describes the variables such as quantity

demanded of commodity and its price.
Where: Qd = quantity demanded

P = price per unit
And the linear equation of quantity supplied of commodity and its price may be formed

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Where: Qs = quantity supplied
P = Price per unit
We assume that Qd = Qs = Qe in equilibrium quantity
Methods of solving linear simultaneous Equations

1. Substitution method
2. Elimination method
3. Crammer’ s rule
4. Matrix/ determination/ inverse method
5. Row reduction method
Exercise
i. In RWAMAGANA market, the relationship between the supplies of juice was
studied against the price per bottle. The economic researcher came up with a
linear relationship between the two variables as where Qs stands for the quantity
of bottles supplied and P is the price per bottle of juice in Rwf.
Another study was done in the same market about the quantity demanded of
that same juice relating to its price. The following linear relationship was found
where Qd represents quantity demanded in terms of bottles and P is the price
per bottle. If there is equilibrium in the market, what would be the equilibrium
quantity and price?
ii. The demand and supply equations of beer have been given as: and . Find the
equilibrium price and quantity of beer in that market.
Differentiation of Linear and Quadratic Functions
A mathematical form of expressing a linear characteristic like ax+b is called a linear
expression.
Exemple: 2x + y
3x + 4
2y + 3z + x
If we express only one value with its dependent variable, we form a function
Example:
The function may be a quadratic expression when it is a polynomial with a highest

power of two.
Example:
Differentiation is the process of obtaining the derivative function.

, the derivative function is
Exercises
1. If find the differentiation of y.
2. Find the differentiation of
3. Find the derivative of the following:

Page 23
The differentiation is applied in economics for the following reasons:
1. To compute the marginal values of output revenue
2. To determine the marginal consumption, marginal profits and marginal
products when the firm is determining the maximum and minimum
optimization.
3. To compute the optimum level of output given the variable and fixed costs.
Fractions In Economics
It is an expression of numbers with a numerator and a denominator.
Example:
Exercise: the cost of producing a notebook is of the total revenue carried from its sales.
If the total cost incurred by Mr. Gakwenzire to produce 10 notebooks was 8000 Rwf,
what was his profit?
Ratio
It is a mathematical fraction expressing the values of given variables or quantities.
A ratio can be expressed in two ways:
Or a: b
Example: in spending her income, BELYSE shares it into consumption and savings. The
ration of her monthly savings to her disposal income is 3:10. If her ratio of tax to
disposable income is 2:8 what is her gross income given that she spends 140,000 Rwf on
consumption every month after paying tax?
Absolute Value
It refers to the measure of quantity irrespective of sign of direction or nature.
Proportions, Percentages and Reciprocals

Proportion is a fraction of a given numeric quantity.
A percentage is a proportion expressed out of 100.
A reciprocal of a number is written as; that is, re-write the given numerator as a
fraction with 1 as its number.
Exercise
The proportion of the people that fall in the working group in this country is . 20% of
the non-working group is above their retirement age. Out of the remaining group, a
proportion of are full time students out of which 80% are still in primary level. If the
country has 3 million females taking a proportion of of the retirement group; then how
many people are in secondary schools and higher education institutions and are full
time students?
Average
It is a measurement of central tendencies. It is used in economics to calculate the unit
contribution of a factor of production to total output, the unit of production, the price
per unit of sale and average consumption.

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Exercise
If a soft drink factory employs labor of 40 individuals in the production of 3,000 crates,
calculate the personal/unit/average contribution of labor in that production process in
terms of crates?
Index Numbers
They measure the relative changes in price, quantity, value or some other item of
interest from one time period to another.
The value in relation to some fixed point in time, it is called the base period. They are
often used to show overall changes in a market, an industry sector and the economy.
Indices can be calculated with any convenient frequency, like:
 Yearly, say G.N.P (Gross Domestic Product)
 Monthly, say unemployment figures
 Daily, say for stock market prices. Index values are measured in percentage
since the base value is always 100.
A Simple Index Number

This measures the relative changes in just one variable.
Example:
According to the Bureau of Harbor of statistics in February 1999, the average hourly
earnings of productive workers were $11.47. In July 2005, it was $16.07. What is the
index of hourly earnings of productive workers for July 2005 based on February, 1999?
Solution
Let the index be P
Given: base period/ base year February 1999
FORMULA
The reasons of converting data into indices

 To express a change in diverse group of item
 It is easy to assess the trend in a series composed of exceptionally large numbers
Page 25
 It is used also at national level analysis
 To compare the cost of aggregation of items in two different time periods.
Types Of Indices
1. Un-weighted indices
In un-weighted induces, we relate a single variable, say, price and construct an index
for it. This type of indices basically has three sub-groups:
 A simple index number: This means the relative change in just one variable. This
has the basic calculation of the index number, that is
 A simple average of relative index: This is an index number that averages the
simple index numbers for all the items.
Where P is the simple average of relative index

Pi is the individual simple index number for item i
n is the number of those items
Exercises
The national data of aviation records recorded the following information showing the
number of passengers using the national airways to various destinations in 100s in
some financial year. Using the destination of NAIROBI as the base, calculate simple
indices for all other destinations and find their simple average of relative index.
Destination Passengers
Dar-Es-Salam 150
Nairobi 122
Cairo 91
Mombasa 134
Landon 70
Los Angeles 120
Casablanca 54
 Simple aggregate index: it is used to study the same variable for two or more
periods.
Where, P is the simple Aggregate index

Pti is the value of item in the period t
Poiis the value of item in the base period
2. Weighted indexes
Here, item’s contribution to the total value is valued by weighting each of the item’s
contribution to the given variable.

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There are different approaches used in weighted indexes,
 Laspeyres’ Index
Where, P = price index
Pti = the value/ price of the current period of items
Poi = the value/ price of the base period of items
Qoi = the quantity of the base period for items
Qoi = the quantity of the current period.
 Paasche’s Index is given by:
 Exercises
Given below are the aggregate prices and quantities of food items in two years of 2002
and 2008 in Rwf:
ITEM 2002 2008
Price Quantity Price Quantity
White bread (cost per kg) 0.77 50 0.89 55
Eggs (dozen) 1.85 26 1.84 20
Milk (gallon) 0.88 102 1.01 130
Red delicious apples (1000 pound) 1.46 30 1.56 40
Orange juice (gallons) 1.58 40 1.70 41
Coffee (tonnes) 4.40 12 4.62 12
1. Determine a weighted price index using the Laspeyres method taking 2002 as the
base year
2. Determine a weighted price index using the Paasche’s method taking 2002 as the
base year
3. Using both methods, find the weighted price indices of eggs in 2005 basing on
1995 figures.
 Fisher’s price Index

Laspeyres’ Index tends to overweigh goods whose prices have increased whereas
Paasche’s Index tends to overweigh goods whose prices have gone down. This index
came up in attempting to offset these shortcomings.
 Value Index
 Consumer Price Index (CPI): this describes the changes in prices from one
period to another for a market of goods and services.
Uses of Consumer Price Index
 It allows consumers to determine the effect of price increases on their purchasing
power.
 It is an economic indicator of the rate of inflation in the economy
 It computes real income.
Note that when a simple index is about the price, it is called the simple price index

Page 27
Price relatives (PR): This is a figure which measures the relative changes in the prices of
a single commodity between the base year and the current year.
It is referred to as the price relative because it relates the prices of the same commodity
between the two periods.
Base year: this referred to the year in which prices are stable as compared to other
years. The base year is given an index of 100 which is used as reference figure to
indicate whether there has been a fall or rise in the price of a particular commodity.
Simple Price Index (average Price Index): this is a figure which measures the relative
changes in the prices for a number of commodities between the base year and the
current year
Weighted Price index: this is the result of the price relatives and the weights attached to
the commodities indicating their degree of importance.
Average weighted index: this is the ratio of the sum of the weighted indices to the sum
of the weights.
Example
Study the table below showing a country’s price indices and answer the questions
follow:
Commodity 1995 Average 1995 1998 1998 simple Weight Weighted
kg/ liters price (Rwf) simple average price index index
price (Rwf) price (Rwf)
Sugar (kg) 800 100 1 000 - 3 -
Salt (kg) 450 100 600 - 5 -
Maize (kg) 220 100 400 - 6 -
Meat (kg) 700 100 1 200 - 2 -
Fuel (liters) 550 100 950 - 4 -
Calculate:
a.) Simple price index for 1995
b.) Weighted price index for 1995
c.) Average weighted price index for 1995

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TOPIC AREA 2: MICROECONOMICS
2.1. PRICE THEORY

UNIT 5: THEORY OF DEMAND
Introduction to price theory

1.1. Meaning and types of price
The price is the relative monetary value of a commodity in a given market at a given
time.
Types of price
 Absolute price: is the value of a commodity expressed in units of currency. It is
also the value of good or service expressed in units of money.
Example: the price of sugar is Rwf 500
 Relative price: is the value of a commodity in terms of another.
Example: the price of sugar is half that of rice.
1.2.Meaning and types of market

Market is an arrangement/ place in which sellers and buyers meet to exchange goods
and services against money.
Types of Markets
 Competitive (perfect) market: this is the market where buyers and sellers have
no ability to influence the price in the market. Prices are determined by the
market forces of demand and supply.
 Imperfect market: this is the market where buyers and sellers have ability to
influence the price set in the market by either controlling supply or demand
 Commodity market: this is a market where goods and services are traded.
 Factor market: this is the market where factors of production are exchanged. For
example land, labor, capital, entrepreneurship.
 Sport market: This is the market where goods and services are traded for
immediate delivery.
 Future (forward) market: this is a market where commodities are traded for
future delivery.
 Capital market: this is a market where financial products are traded. Examples
of financial products traded here are shares, securities like bonds etc
 Foreign exchange market: this is a place where currencies are traded. The major
players are banks, and forex bureaus
 Free market: this is a market where the forces of demand and supply operate
freely without any interference in determining prices.

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1.3. Methods or ways of Price determination in the market
 Haggling (bargaining): This is where the buyer negotiates with the seller for the
suitable price of the commodities. During this method, the seller keeps on
reducing the prices and the buyer keeps on increasing until the agreed price is
reached.
 Auctioning (Bidding): this is where a seller (auctioneer) offers the goods for sell
and requests for bids (offers) from buyers. The highest bidder takes the
commodity.
 Fixing by treaties (agreements): this is where representatives of buyers and
sellers come to an agreement to fix the price of the commodity. The price remains
fixed for a given time but the agreement can be renewed and prices can be
changed.
 Government determination (legislation): this is where government fixes the
price of the commodity. The government can either fix the minimum or
maximum price.
 Price leadership: this is where a large and low cost firm in the industry fixes the
price of a commodity which has to be followed by other small firms. This firm
normally has a large share of the market.
 Price fixing by cartels: a cartel is an organization of firms producing and selling
similar products. These firms come together and fix one price at which they have
to sell the commodity to the consumers.
 Interaction of the force of demand and supply: this is where the price in the
market is determined by the forces of demand and supply . when demand
exceed supply, price will increase while when supply exceed demand the price
will be low.
 Resale price maintenance: this is where the producer (manufacturer) fixes the
price of commodity at which sellers (retailers) have to sell to the final consumers.
The price is usually written on the commodity.

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1.4 Factors determining or influencing price in the market
1. Cost of production: if producer spent more in production of a certain commodity, he
will charge high price for that commodity to recover what he spent and to get profit.
But if he spent less money in production process, he will charge low price for the
commodity
2. Level of competition: if there is many sellers selling the same product, there will be
high competition among them that will lead to low price for the commodity. While in
case competition is limited, for example in case of monopoly the price will be high.
3. Government policy: Government can influence price by fixing maximum and
minimum price
4. Demand and supply of a commodity: If demand is greater than supply, the price will
be high and if the supply is greater than demand, the price will be low.
5.Type of products: Processed commodities fetch high price than unprocessed ones,
also branded products are expensive than unbranded products
6. Quality, Fashion, Season etc
5. DEMAND
1. Meaning
As we saw it “Demand is the desire and willingness backed by the ability to buy a
product at a given price.”
So, economically we talk about demand when there is also the ability to buy that is the
effective demand. A Latent demand, this is a desire that is not backed by ability to buy.
If you want something and have the money to pay for it, you are willing to pay for it
that particular time, it is called effective demand.
If you have a desire but do not have money to pay what you desire at the given price, it
is called latent demand
Market demand: this is the total demand for all consumers of a particular commodity
in the market at a given price
Aggregate demand: this is the summation of the demand of all purchasing units in all
sectors of the economy.
Aggregate demand=C+F+G+(X-M) where C=consumer expenditures. Total
consumption by households on consumer goods
F= expenditures made by firms on capital goods and services

G= government expenditures on health, education, security etc
X=Exports (foreign expenditures on locally produced goods and services
M=imports (local expenditures on foreign goods and services)

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2. Determinants of Demand
The quantity demanded of a commodity, at any time depends on various factors

(determents of demand).
 Price of commodity: When price of a commodity increase, quantity demanded
decrease and when price decrease, quantity demanded increase.
 Income of the consumer: As the incomes of consumer increase they are able to
buy more goods and so demand increase on the other hand, when consumers’
incomes reduce, demand for goods and services also reduces.
 Price of other commodity: The amount of commodity demanded can be
affected by changes in price levels of related commodities in two ways:
-complements: These are commodities that are consumed together or jointly
.Example: shoe and shoe polish , Paper and pen, car and fuel
When the price of shoes falls, people buy more shoes and more shoe polish, this
means that the increase in price of one commodity cause a decrease in the quantity
demanded forits complements. And a decrease in price of one commodity cause an
increase in quantity demand of its complements.-substitutes: These are the commodity
that serve the same purpose and the user can conveniently change from one to another
(tea& coffee) the increase in price of tea leads to an increase in the demand of coffee and
a decrease in price of tea cause a decrease in quantity demand of coffee
 Size of population: A large population result into high demand while a lower
population size lead to a decrease in demand.
 Government policy: The government can encourage consumption of given
particular commodity by subsidizing production of particular commodity,
more so, if it is necessary. This leads to a fall in the price of that commodity and
its demand increases. And it can discourage its consumption by increasing tax
on it, which lead to higher price and low demand for the commodity.
 Sex: When a particular sex in population increases, demand for certain
products preferred by that sex increases.
 Education: Demand for goods and services will be different in a given
population because of their difference in the level of education. Like demand
for newspapers will increase in an area dominated by educated peoples and
low where most peoples are illiterates
 Season: The demand for some commodities fluctuates seasonally. For example:
the demand for seeds is high during the planting period. And demand for rain
coats is high during rainy season compared to sunny season
 Taste and preferences: The change in tastes in favor of commodity causes an
increase of demand and when taste change against a commodity, its demand
reduces.
 Price expectations: When people expect prices to increase in the near future,
they buy more products to use in present time to avoid suffering product
shortages in future. And when price is expected to decrease in future, they buy

Page 32
few for the current period waiting to buy more for the coming period when
price will be low
 Age: When the composition of the population is dominated by a given age
group, demand is influenced accordingly.
 Rates of advertisements: Highly advertised commodities tend to have a high
demand compared to the product which is not advertised.
3. The Law of Demand

The law of demand states that keeping other factor constant (ceteris paribus), the higher
the price of a commodity, the lower the demand for that commodity and the lower the
price, the higher the demand of that commodity.
The law of demand can also be stated as follows:

The higher the price, the lower the quantity demand, and the lower the price, the
higher the quantity demand.” Ceteris paribus”
Ceteris Paribus
This concept is a Latin phrases or concept meaning “other factors remain constant” We
use it to show that our statement, law, theory or analysis stands if we assume all those
factors do not interfere.
4. Demand Schedule
This refers to a table that shows the various quantities of commodities that are
demanded at different price levels. Demand schedule is classified into
 Individual demand schedule: that refersto a table that shows the relationship
between price and quantity demanded of a commodity individually. As the price
increases, the quantity demanded reduces, vice versa in conformity with the law
of demand.
Example:
Price of sugar John Alice Mark Total
500RFWS 10 kg 6 kg 7 kg 29 kg
550 RFWS 8 kg 5 kg 6 kg 19 kg
600 RFWS 6 kg 4 kg 5 kg 14 kg
 Market demand schedule: Is therefore a table that shows the total quantities
demanded by all consumers in the market at different price levels.
Price of sugar(Rfws) Quantity(kg)

500 27
550 19
600 14

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Demand Curve
Demand curve is a graphical representation of the relationship between the price of a
commodity and the quantity demanded of that commodity. To draw it, we plot price of
commodity on the Y-axis and the quantity demanded on the X-axis. The normal
demand curve slopes downwards from left to right. This is because of the law of
demand: When price increases, quantity demanded decreases and when price reduces,
quantity demanded increases, ceteris paribus. The demand curve may be linear or
nonlinear demand curve.
Example:
price
price
D D
P2 Non linear
P3 demand curve
Linear
demand curve
P2
P1 D
D
P1
Q2 Q1 quantity Q3 Q2 Q1 Quantity

Page 34
Illustrations: Demand schedule and demand curve

Page 35
5. The Demand Function
The demand function is a statement of the technical relationship between quantity
demanded of a commodity and those determents of demand.
 
Qdx  f p , p , Y , T , S , G,...
x n 1
Where: Qdx = Quantity demanded of commodity x
p =Price of commodity x
x
p =Price of other commodity

n 1
T = Tastes and preferences
S = Season
G = Government policy
When any of these factors ( p ,p ,) changes the quantity demanded of the
x n 1
commodity x also change.

Page 36
SLOPES OF THE DEMAND CURVE
The law of diminishing marginal utility and the slope of the demand curve
a. The law of diminishing marginal utility state that as an individual consumes

more of a commodity, the marginal utility got from consuming an extra unit of a
commodity, keeps on decreasing
Marginal utility: refers to the extra satisfaction a consumer get from consuming an
extra unit of a given commodity. In economics satisfaction is also called utility.
B. The slope of the demand curve
The demand curve slopes downwards from left to right. This curve shows the law of
demand. It shows that at higher price, quantity demanded reduces and at low price,
quantity demanded increases.
Reasons for a normal demand curve or reason why a normal demand curve slopes
downwards from left to right is as follows:
a) Real income effect
b) Substitution effect
c) The law of diminishing marginal utility
d) Consumption behavior of low income earners
e) Several use of the commodity
a. Real income effect
Here, an increase in the price of a commodity reduces the buyers’ real incomes as well
as purchasing power of money income leading to low quantity demand and a fall in
price leads to an increase in real income which lead to high quantity demand.
Example:
Income of peter Price of soda Qd of soda
1000 Fr 500 Fr 2 bottles
1000 Fr 1000Fr 1 bottle
1000 Fr 250 Fr 4 bottles
b. Substitution effects
Here, as price increase, demand reduces because the consumers switch their demand
to relatively cheaper substitutes
Example:
Tea Coffee
Price Qd Price Qd
400 Fr 100 kg 400 Fr 100 kg
500 Fr 60 kg 400 Fr 140 kg
p Qd P constant Qd

Page 37
When price of one commodity increases quantity demanded of that commodity
reduces, and for its substitute’s commodity whose price remained constant, the quantity
demanded will increases.
c. The law of diminishing marginal utility: the higher the satisfaction derived from
consuming an extra unit of a commodity, the higher the price that the consumer is willing
to offer. And the lower the satisfaction derived, the lower the price that consumer is
willing to offer.
4. Consumption behavior of law income earners: the low income earners usually
buy less when the price is high and buy more when price is low. This is because
the income is not enough to cover the amount of a commodity they would wish
to purchase especially when prices increase.
5. Several use of the commodity: if a commodity is used for several purpose when its price
increase its demand decrease that is they used it for important purpose. For example
electricity
TYPES OF DEMAND
a) Derived demand: This refers to demand for a commodity not for its own sake
but due to demand for another commodity. Example: demand for factors of
production comes as a result of demand for goods and services that these factors
of production help to produce . Example, the increase in demand of sugar cane
will be as a result of an increase in sugar demand .It means that demand for
sugar cane is derived from the demand of sugar respectively
b) Joint demand/complementary demand (twin demand): is a demand for
commodities that are used together. Increase in demand for one commodity lead

Page 38
to increase in demand for another and vice versa. Example: the increase in
demand for sugar leads to increase in demand for tea leaves and vice versa
c) Competitive demand: is demand for commodities that are close substitutes of
each other and therefore serve the same purpose. Example: Beans &peas an
increase in demand of one leads to a decrease in quantity demand of the other.
d) Composite demand: is a demand for a commodity that has multiple uses
Example: The total quantity demanded of water depends on water demanded for
washing, cleaning, drinking, etc.
e) Independent demand: is a demand of commodity that does not depend on any
other commodity. Simply this is demand for commodities which are not related
at all. A change in demand of one do not affect demand of another. Example is
sugar and mattress.
ABNORMAL DEMAND CURVES

These are demand curves which do not obey the law of demand of sloping downwards
from left to right. This causes exception to the law of demand. These circumstances can
be observed for:
- Demand for Giffen goods
- Demand for goods of ostentation/ luxuries
- Demand for necessity
- Expectation of future price change
- When consumer is ignorant of the market condition.
- When there is a depression
a. Expectation of future price change
A price increase is taken as indicator of even higher price increases in future and
this induces people to buy more for present time and as consumers anticipate a
considerable decrease of price in future, they postpone their purchases (purchase
low) and wait for low prices in future, this is contrary to the law of demand.
b. Demand for necessity

As the price of necessity changes (typical necessity is salt) its demand remains constant.
This makes it an abnormal demand curve

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Price
P2
P1
P3
Q1 Quantity
c. Demand for Giffen goods
As demand for Giffen goods rise as their prices increases and demand decreases when
price falls.
The demand curve for Giffen goods is abnormal at lower prices
d. Demand for ostentation/luxury/snob/Veblen goods

These are category of goods demanded by those who want to emphasize their social
and economic status by showing off what they consume. Such goods fulfill their
purpose only when they are expensive. As their price increases, demand also increases.

Page 40
The demand curve for a snob goods is abnormal at higher prices
e. When consumer is ignorant: when consumer is ignorant about the price, quality
and packaging, an increase in price may be taken to mean an increase in quality
making the consumers to buy more. Also a consumer who is not aware of
availability of substitutes he or she may be forced to purchase a good at higher
price irrespective of the existence of its substitutes which are cheap
f. When there is a depression: An economic depression is a downturn in economic
condition of a country. This occur when the level of economic activities slows
down, income is low, unemployment is high, aggregate demand is low and
production is low. During that period even if price of a given commodity
reduces, its quantity demand may not increase. This is because consumers
capacity to buy is limited
‘5.2.11. CHANGE IN DEMAND VERSUS CHANGE IN QUANTITY DEMANDED
Kalisa purchase 6 kg of potatoes per month at 200 Fr per kilo. The price of potatoes
reduces to 150 Fr per kg. As a result, Kal
isa increases the quantity of potatoes bought from 6kgs to 8kgs / month as is shown
below:

Page 41
Fig A:
A co mand
in de e in
(incre e)
Price
ntrac
pric
An e and
as
(fall
tion
in de rice)
D
xtens
in p
a
m
200
ion
b
150
c
100 D
6 12 8
Quantity
The movement from point a to b on the demand curve above is called change in
quantity demand.
When the price of potatoes has not changed but because it is school holidays and the
size of kalisa’s family has expanded, he has to buy 12 kg of potatoes. This is called
changed in demand as illustrate below: Example B:
D1
Price
D
D2
c a b
200
D1
D
D2
6 8 12
Quantity
The change in figure A is called change in quantity demanded and this change is
caused by the change in the commodity’s own price.

Page 42
The change in figure B is called change in demand and this is caused by a change in
other determinants of demand a part from price as shown by the demand function.
 
Qdx  f Px ; Pn1 , Y , T , S , G,...
Change in Change in demand

Quantity demanded
UNIT.6: THEORY OF SUPPLY

6.1 meaning of supply
As we have seen later, the supply is differing from production because it is a part of
production that is put on market for buyers. Supply can be defined as amount of goods
and services available in the market.
Quantity supplied: refers to the amount of a particular commodity that producer or

supplier is willing and able to bring to the market for sale at a given price
6.2. Determinants of supply

 Price of competitively supplied products (prices of related commodities)
 Price of the commodity itself
 Price of products that are supplied together (jointly supplied)
 Number of producers on the market that supply the same commodities
 Availability of factors of production used to produce their price
 Level of technology
 Government policy
 Season
 Objectives or goals of firm (sales maximization or profit maximization )
 Gestation period (the time lag between a decision to produce and when a
product actually comes into the market. Short or long period).
6.3. The law of supply

The law of supply state that, the higher the price, the higher the quantity demand and the lower
the price, the lower the quantity supply ceteris paribus.
Reflection question: Why do suppliers bring more quantities to the market at high price
than at low price?

Page 43
6.4. Supply schedule and curve
The supply schedule is a table that shows the relationship between quantity supplied
and price
FRW f Quantity supplied (kg)
700 8
800 10
900 12
Supply curve: is a graph that shows the relationship between quantity supplied and
price of a commodity.
The supply curve plots the quantity supplied of a commodity alongside its price
Price
S
P2
P1
S
Q1 Q2 Quantity
As the price increases, quantity, supplied increases and vice versa
6.5. The supply function

It is shows the technical relationship between quantity supplied of a commodity and the
determinants of supply
QSX = f (PX 1, Pn-1, C, G, S, T, D,,, )
QSX=Quantity supplied of a commodity
PX 1= price of a commodity x
Pn-1= prices of other commodities
C= cost of production
G= govt policy
S= season
T= technology
D= demand
6.6. Individual supply curve Vs market supply curve

Following the law of supply, the normal supply curve slops upwards (from left to right)
Example:
Price of products Qs of A Qs of B Qs of C
100 7 8 9
150 9 10 11

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Total 16 18 20
Individual supply curves of A, B and C
Price Price
Price
C
A S B
S 150 S
150 150
100 100
S S 100
S
9 Qs 8 10 Qs 9 11 Qs
7
Market supply curve of A and B

Price
150 S
100
S
16 18 Qs
6.7. Abnormal (exceptional) supply curves
These are curves that do not respect / obey the law of supply of sloping upwards and
take different shape from the normal.
Condition under which we can have abnormal or regressive supply curve

1. Backward bending supply curve of labour
The labour has an abnormal supply curve. The supply curve of labour bends backward
at higher wage. When labour is paid high wage there is a tendency for workers to
reduce the number of hours worked per day.

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Wages
Su
pp la
ly bo
cu ur
rv
e
of
a
W3
W2
W1
L1 L2
L3 Labour supply
As wages increase from W1 to W2 supply of labor increases from L1 to L2. Beyond

wage W2, an increase in wages reduces labor supply.
Reasons for backwards bending supply curve of labour
 Presence of target workers: when wage increase, workers achieve their target
quickly and start working less hours.
 Leisure preference: at high wage, workers tend to like more of leisure than
work, so they work for less hours.
 When there is insecurity in the area of work: insecurity in the working areas
threaten labour at the level that he or she may reduce his or her hours of
working.
 Progressive tax: this tax discourage peoples to work since it increase as personal
income increase.
 Inflation: this discourage people to work since as wage increase lead to increase
in price hence no improvement in standard of living.
 Marginal utility of income which decrease as wage increase

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2. Fixed supply in short run
The producer will organise resources accordind to the time available. If time is
too short to allow producer to increase factors of production so that supply willl
also be increased, the supply will remain constant even if price increase. In this
case the curve appear as follow:
p s
p2
p1
0
Qd Q
From the above graph, as price increase from P1 to P2, quanity demand
remained constant at Qd because time is short for the producer to increase
supply.
6.8. Change in supply Vs change in quantity supply
Change in supply appears when quantity supplied changes due to a change in other
determinants of supply other than price of a commodity whereas change in quantity
supplied appears when quantity supplied changes because the price of a commodity
has changed.
 
Qsx  f Px ; Pn1 , C, G, S , T , D,...
Change in Change in supply

Quantity supplied
N.B: LEAVE A SPACE FOR GRAPHS
Types of supply
a.) A competitive supply: this is the supply of two commodities that use the same
resources such that an increase in production of one reduce the resources
available for the production of another hence reduction in its supply.Example: an
increase in the production of ghee reduces the supply of milk.
b.) Joint supply: this is a supply of two or more commodities that are produced
together such that the increase in supply of one leads to the increase in supply of
another. Example: beef and hides

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UNIT 7. EQUILIBRIUM AND PRICE DETERMINATION
7.1 Meaning of equilibrium price and equilibrium quantity

Equilibrium price refers to the market price where quantity demanded is equal to the
quantity supplied. At that price, the amount of commodities brought to the market by
suppliers is wholly bought by the buyers, leaving no excess or shortage on the market.
Equilibrium quantity: this is quantity bought at equilibrium price where quantity
demand equal to quantity supply
Equilibrium point: this is the point at which quantity demand equal quantity supply
Determination of market price by forces of demand and supply
In a competitive market, prices are determined by interaction of the forces of demand
and supply. This is graphically illustrated as shown below:
NB: INSERT NEW PROPER GRAPH
Price
Pe= Equilibrium price

Qe= Equilibrium quantity
E
Pe
S D
0
Q1 Qe Q2 quantity
 At high price OP2 supply exceeds demand and therefore a surplus of Q1Q2 is
created. When the supply is in excess, the producers decrease the price in order
to sell the surplus (excess) and the process of equilibrium is restored in the
market at point E.
 At lower price OP1, quantity demanded exceeds quantity supplied therefore a
shortage Q1Q2 is created which forces the producer (seller) to increase the price
until the equilibrium point is attained at point E.

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7.2EQUILIBRIUM EQUATIONS
At equilibrium Qd=Qs
Quantity demanded Quantity supplied

2-4p 2p-6
24-6p P+10
P+36 4p+21
Use the function in the table to determine whether there is equilibrium in each set of
equations
7.3 EFFECTS OF CHANGES IN DEMAND AND SUPPLY ON EQUILIBRIUM
UNIT 8. ELASTICITY
8.1. Definition of key term

 Elasticity: is the degree of responsiveness of a dependent variable to a change in
an independent variable.
8.1.1. Elasticity of demand

There are three quantifiable determinants of demand that are derived from the major
types of elasticity of demand.
 Price of the commodity: price elasticity of demand
 Income of the consumer: income elasticity of demand
 Price of related goods: cross elasticity of demand
Qdx  f p , p
x n 1

, Y , T , S , G,... Income elasticity
Price elasticity of demand
Cross elasticity of demand
1.1. Price elasticity of demand: is the degree of responsiveness of quantity
demanded of a commodity due to a change in the price of that commodity.
When the price of commodity changes its demand changes also; the degree of
responsiveness of quantity demand of a commodity due to the change in commodity’s
own price is called price elasticity of demand.
Formula:
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑 𝑜𝑓 𝑡ℎ𝑒 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦
PED= (-)
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦
Qd P
This may be simplified to PED= (-)  /
P Q
Qd : Change in quantity demanded (new/current or previous quantity)

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p : Change in price (new/ current-old / previous price)
P: Original/initial Price
Q: Original/initial quantity
PED= Price elasticity of demand
Example: Given the price of beef increased from 2000frw to 2500frw per kg and as a
result, quantity demanded reduced from 4 kg to 2 kg. Calculate the price elasticity of
demand for beef.
Solution:
(Q2  Q1) P1 (2  4) 2000

=(-)   
( P2  P1) Q1 (2500  2000) 4
−2
=(-)500 =2
The price elasticity of demand is 2

Exercises: given the table below, calculate the price elasticity of demand for goods X, Y
and Z.
X Y Z
Original price 700 700 700
New price 1400 1400 1400
Original quantity 15 10 10
New quantity 11 5 10
1.2. Categories of elasticity of demand

a) Elastic demand: is elastic when a small change in price causes a
proportionately bigger change in quantity demanded i.e. ∆QD>∆P&∞>PED>1
Price
D
P1
P2 D
Q1 Q2
Quantity
b) Perfectly elastic demand: is when price is constant and quantity demanded
changes infinitely i.e. PED=∞ or indeterminate

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Price
D D
P1
Q1 Q2 Q3
Quantity
c) Inelastic demand: When a big change in price causes a proportionately small
change in quantity demanded. i.e ∆P>∆Q &>0PED<1
Price D
P1
P2
D
Q1 Q2
Quantity
d) Unitary elastic demand: is when the percentage change in price causes the
same percentage change in quantity demanded. i.e. PED=1 & ∆P=∆Q
Price
P1
P2
D
Q1 Q2
Quantity

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e) Perfectly inelastic demand : is when a change in price doesn’t affect quantity
demandi.e PED=0
Price
P1
P2
D
Q1
Quantity
1.3. Determinants of price elasticity of demand
Elasticity of demand varies from product to product and from time to time
depending on many variables. The followings are reasons why elasticity varies:
- Price of complements
- Availability of substitutes
- Degree of importance
- Size of the consumer’ income
- Speculative demand (expectation of price increases in future because of
security)
- Time and degree of necessity
- Habit and cost of switching between products
- Durability of product and brand loyalty.
- several use of the commodity
1.4. Practical applications of price elasticity of demand
The concept of price elasticity is essential to:
The government, the producer and the consumer.
a. To the producer
 Price elasticity of demand help the producer to decide whether to increase or
decrease price: if price elasticity of demand is elastic, producers ‘total revenue
increase when the price is reduced. But if it is inelastic, the producer’s
revenues will increase when price is increased.
 Price elasticity of demand help a monopolist to practices price
discrimination: a lower price should be charged in a market where price
elasticity of demand is elastic and a high price should be charged where price
elasticity of demand is inelastic
 Price elasticity of demand help the producer to determine wage level for his
workers: When demand is inelastic wage should be increased as price
increases.

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b. To the government
 Price elasticity of demand help government in currency devaluation: in
order for devaluation to succeed elasticity of demand and supply for both
imports and exports should be elastic.
 Price elasticity of demand helps government to decide which commodity to
tax: if the aim of tax is to reduce consumption of a particular commodity the
government should tax more the commodity with elastic demand. If the aim
of tax is to increase government revenues, the government should tax more the
commodities of inelastic demand
 Price elasticity of demand the government to determine the tax incidence:
 When demand is elastic, the tax burden is shared by both the consumer
and the producer. However, the producer bear the biggest proportion of
the tax burden.
 When demand is inelastic, both producer and consumer share the tax
burden but the consumer bear the big burden.
 When demand is unitary: both consumer and producer share the tax
burden equally
 When demand is perfectly elastic: the producer will bear the tax burden
alone.
 When the demand is perfectly inelastic: the consumer will bear the tax
burden alone.
c. To the consumer: it help him or her to determine his or her expenditure by
looking at price change
Income elasticity of demand

In the determinants of demand, there is income of consumer (y) when a consumer’s
income changes, quantity demanded also changes.
Income elasticity of demand: is the degree of responsiveness of quantity demanded
of a commodity due to a change in the consumer’s income.
Percentage changeinde mand Q Y
Formula: YED   
Percentage changeinin come Y Q
Example: Kalisa’s income increased from 6000fr to10000fr. As a result of this change,
Kalisa’s demand for sugar reduced from 10 kg to 6kg. Calculate a
Kalisa’s income elasticity of demand for sugar.
Q Y (6  10) 6000  4 6000  24000
Solution: YED         0.6
Y Q (10000  6000) 10 4000 10 40000

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Interpreting income elasticity of demand
Elasticity Explanation Types of goods

Zero A change in income cause no change in Necessity
demand
Positive An increase in income increases demand, a Normal goods
decrease in income , decreases demand
Negative An increase in income ,reduces demand , a Inferior goods
decreases in income , increases demand
As a result, type of good for Kalisa’s demand is inferior good
Exercise: Given changes in income and quality for three products A, B and C.
calculate the income elasticity of demand and categorize the results.
Income Qd A Qd B Qd C
35000 6 8 8
47000 6 12 8
What type of goods are A, B and C?
Cross Elasticity of Demand

This refers to the degree of responsiveness of quantity demanded of one commodity
due to changes in the price of another commodity.
Q
CED  X
 PY
 PY Q
X
 Commodities X and Y
- When CED is positive Substitute goods
- CED is negative Complements goods
- CED is zero No relationship between X and Y
Exercises: Study the table below showing the price and demand for two commodities
A and B.
Price of A and B 150 230
Quantity of A 8 kg 6 kg
Quantity of B 12 kg 14 kg
a) Calculate the cross elasticity of demand between commodities A and B

b) What type of commodities are A and B?
Arc elasticity of demand: refers to average elasticity between two point a and b on the
demand curve.
Qd ( P1  P 2) / 2
Formula: AED  
P (Q1  Q2) / 2

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Elasticity of supply
Elasticity of supply measures the degree of responsiveness of quantity supplied due to
a change in any of its determinants.
Price elasticity of supply

It is a measure of the degree of responsiveness of quantity supplied due to change in
commodity’s own price.
Formula:
Qs P
P.E.S  
P Q
Example: The price of sugar at ZAZA increased from 500fr to700fr and as a result,
KANEZA increased supply from 50 kg to 100 kg .Calculate the price elasticity of supply
for sugar.
Qs P (100  50) 500 50 500
Solution: PES       2
p Qs (750  500) 50 250 50
Definition of price elasticity of supply
 When Pes > 1, the supply is price elastic
 When Pes < 1, the supply is price inelastic
 When Pes = 1, the supply is perfectly inelastic
Interpretation of price elasticity of supply
(a) Perfectly inelastic supply ()

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Price
S
P2
P1
P0
S
0
Q0 Quantity
In this case quantity supplied doesn’t respond to changes in price. For example the
supply of agriculture products in the short run.
(b) Inelastic supply (

Price
S
P2
P1
P0
S
0
Q0 Q1 Q2 Quantity

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In this case, a big proportionate change in price leads to a small proportionate change in
quantity supplied.
(c) Unitary supply (

Price
P2
P1
0
Q1 Q2 Quantity
In this case, a percentage change in price leads to equal percentage change in quantity
supplied.
(d) Elasticity supply (
Price
S
P2
P1
S
0
Q1 Q2 Quantity
In this case, a big proportionate change in quantity supplied is due to a small
proportionate change in price.
(e) Perfectly elastic supply

Page 57
Price
S S
P0
0
Q0 Q1 Q2 Quantity
In this case, at constant price, quantity supplied increase. This situation is not applicable
in the real world.
Determinants of elasticity of supply

o Time that supply can be adjusted (long & short)
o Gestation period of the product (length of production process)
o Degree of availability of factor inputs
o Cost of production
o Nature of the product (commodity)
o Objective of the firm
o Quantity and quality of technology used to produce
o Laws within the country
o Storage facilities and existing stocks.
unit 9 .Consumer theory
Utility
Consumer is a person who uses goods and services to satisfy his/her wants. His major
objective is utility maximization
Utility is the satisfaction on consumer gets from consuming a commodity. The

commodities are used because of satisfaction get from them for every unity of a
commodity consumed, the consumer get satisfaction (utility).
Utility is a measure of relative satisfaction derived from the consumption of a

commodity. It is measured in utile. There is also a disutility which is to negative utility
or satisfaction lost by consuming more units of a commodity.
Utility is affected by the following factors:
 The consumption of various goods and services

 Possession of wealth
 Spending of leisure time

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Marginal utility is the additional satisfaction that a consumer gets from the
consumption of an additional unit of a commodity. This law of diminishing marginal
utility states that as a person / individual consumes continuously to diminish with each
additional unity consumed. Marginal utility tends to diminish for each successive units
consumed.
Example: suppose that you are thirsty you need a drink if you buy soda , juice, and the
second and you take also the third, these juice have the same brand the first is sweeter
than the second, the second is sweeter than the third . It means the utility is diminishing
with each additional juice you take.
This figure shows that the utility derived from each successive unit of a product
consumed continue to decline when it reach zero. For each unit the buyer is willing to
pay a price depending on the expected utility. As utility declines, the price the buyer is
willing to pay also reduces.
Marginal utility refers to satisfaction derived from consumption of an additional unit of

a commodity.
Another example of total utility and marginal utility by using schedule of a commodity
Units of a Total utility Marginal utility

commodity (utils)
1 glass
st 11 12
2 glass
nd 16 7
3rd glass 20 5
4 glass
th 23 3
5 glass
th 23 0
6 glass
th 17 -6
Note that with the above table we get the marginal utility in the following way:
 When total utility is at maximized, (at 5th unit), marginal utility is zero
 When total utility is falling, MU is negative which means that the consumer
enjoys disutility or dissatisfaction.
 This is illustrated in the following figure:

Page 59
utility MU
Initial utility
12
7
Diminishing
5 MU utility
3
Zero MU
0 1 2 3 4 5 6 7 quantity
-6 MU
Different types of utility

a) Form utility: When utility is created and/ or added by changing the shape or
form or goods
b) Place utility: When the furniture is taken from the factory to the shop for sale.
c) Time utility: Harvesting for a few months and sells it when its price rises that
former has created the value of wheat.
d) Service utility: When teachers, doctors, lowers etc satisfy human wants through
their services
e) Possession utility: Utility is also added by changing the possession or a
commodity.
f) Knowledge utility: When the utility of commodity increases with the increase in
knowledge about its use. It is the creation of knowledge utility by advertising,
etc.
g) Natural utility: All free goods such as water, air, sunshine etc passes natural
utility they have the capacity to satisfy our wants.
Relationship between total and marginal utility
Total utility Marginal utility

- It is the sum of all utilities - It is just the additional utility
derived from each utility derived from one extra unity
consumed of a product consumed
- There is an increase of utility - The additional unit
when additional unit consumed provides
consumed disutility.
Relationship between marginal utility and demand

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Utility Price
mu D
3 3
2 2
1 1
D
2 Quantity 1 3 4 Quantity
1 3 4 2
Mu
This figure shows that the utility derived from each successive unit of a product
consumed continue to decline when it reach zero. For each unit the buyer is willing to
pay a price depending on the expected utility. As utility declines, the price the buyer is
willing to pay also reduces.
The law of diminishing marginal utility
This explains the shape of the marginal utility curve. This law states that as one
consumes more units of a commodity, after the bliss point or point of satiety, the
marginal utility diminishes.
The following figure illustrates marginal utility and the demand curve:

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utility
Bliss point
Total utility
0
quantity
The demand curve is a part of marginal utility curve where it is greater than zero or
positive. As MU diminishes due to the consumption of extra-units of the commodity,
the consumer becomes prepared to pay a low price as he can consume more units.
Therefore, the higher the quantity demanded the lower the MU and the lower the price
the consumer would be willing to pay.
Note that the consumer’s equilibrium is attained by using utility approach where:
Where a, b and n are various commodities, MU are their respective marginal utilities
and P are their respective prices. This is to mean that the consumer reaches equilibrium
when he gets equal satisfaction by spending an additional franc on any of commodities
(a, b…n) which he consumes.
Indifference Curves
As the marginal utility approach explains consumer’s behavior on assumption that the
consumer consumes only one commodity, the indifference curve approach assumes two
commodities.
An indifference curve is a graph showing different bundles of goods between which a

consumer is indifferent; the consumer has no preference for one bundle over another.
One can equivalently refer to each point on indifference curve as providing the same
level of utility for the consumer.

Page 62
Commodity y
IC
Y1 a
Y2 b
IC
0
X2 X1 Commodity X
This figure shows that utility derived from combination of two commodities are equal.
Briefly, an indifference curve is a combination of two commodities which yield the
same satisfaction to the consumer.
Consuming X2Y2 gives the same satisfaction as combination X1Y1. This is called
marginal rate of substitution (MRS)
This is expressed by the marginal rate of substitution (MRS) which the amount of one
commodity that has to be given up if the consumer is to obtain one extra unit of the
other commodity and keep at the same level of satisfaction.
This is illustrated by the following formula:
Where X is change of commodity X and Y is change of commodity Y.
Budget line
This is the illustration of all possible combinations of two goods that can be purchased
at a given prices and for a given consumer budget. This is because the amount of goods
that a person can buy depends upon their income and the price of the good.
Figure

Page 63
rice
20
Budget line
a b
0 50 beans
 A consumer with fixed income can only afford those combinations of

commodities that lie along the budget line.
 Combinations outside the budget line (like point “b”) are not achievable.
 Combinations below the budget line (like point a) do not optimally use the
available income.
If a consumer’s income increases, then the consumer is able to purchase higher
combinations of goods.
An increase in consumer’s income shifts the budget line to the right. If the income
reduces, the budget line shifts to the left. This illustrated below:

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Commodity Y
Y2
Budget line 2
Budget line 1
Y1
0 X1 X2 Commodity X
 An increase in income shifts the budget line from X1Y1 to x2y2.
A change in the price of commodity also shifts the budget line. If income is held
constant, and the price of one of the goods changes, then the slope of the curve will
change. In other words, the curve will pivot. This illustrated below:
Commodity Y
60
0 50 80 Commodity X
 The reduction in price of commodity X means that on a fixed budget, the

consumer can now purchase more units of the commodity whose price has
fallen. That is why the maximum quantity changes from 50to 80 units. For

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commodity Y whose price has not changed the maximum quantity remains fixed
at 60.
Consumer Equilibrium
A consumer must balance two things to reach equilibrium by balancing utility

represented by indifference curve and his /her income represented by budget line.
While the consumer may want to consume as much as possible and maximize
satisfaction he/she is limited by income. The consumer must therefore find a
combination of two commodities that provide the highest possible satisfaction. The
consumer therefore achieves equilibrium where the budget line is tangent to
indifference curve.
Consumer equilibrium on illustration:
Commodity Y
Y1
n p
Yo 0
IC3
m IC2
Bu IC1
d ge
tl
in
e
0 Xo X1 Commodity X
 X1Y1 is the budget line

 IC1, IC2 and IC 3 on budget line X1Y1 and so they are affordable by the consumer.
 Indifference curve IC1, is higher than indifference curve IC2 and so combination
of commodity X and Y that lie on IC1 give more satisfaction more than those lie

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on IC2. So, combinations o gives more satisfaction than combinations n and m,
though they cost the same.
 Point p on the indifference curve IC3is not affordable because it is above the
budget line.
 The consumer is in equilibrium consuming at point o on the highest indifference
curve IC1, and along the budget line.
 The consumer is therefore in equilibrium when the budget line is tangent to the
indifference curve. In the above case, this is at point o and the consumer uses
combination Xo and Yo.
Consumer surplus
It is the difference between what consumers are willing to pay for a good (equilibrium
price) and what they actual pay (maximum price)
Market price: is the economic price at which a product is sold on the market where as
Equilibrium price: is a price in the market that has been determined by demand and
supply.
Example of calculation:
Price
S
Co urplu
ns
s
um
900 D
er
s
600
D
300 S
10 20
A consumer surplus is a calculated by the formula of triangle:

1
Consumer’s surplus = b  h
2
20  300
It means: consumer surplus =  3000
2
The base is the quantity demanded at equilibrium
The height is the price difference between the equilibrium price and maximum price
1
Or consumer surplus = Qt( P max  Pe)
2
Qt= total quantity purchased at equilibrium price
Pmax= maximum price, Pe =equilibrium price

Page 67
Producer surplus
It is the difference between the minimum supply price that sellers would be willing to
accept and the price that is actually received
Price
S
600 D
400
Producer
surplus
D
100 S
30
quantity
It is calculated also by using the formula of triangle. The base is the quantity at
equilibrium and the height is the difference between price at zero output and
equilibrium price.
Social surplus
It is the total sum of the consumer surplus and the producer surplus combined.
Price mechanism (invisible hand)
The price mechanism refers to a system where by resources in an economy are allocated
by using the invisible hand of prices. Prices are determined by demand and supply
without intervention of government, there is a great independence of buyers and sellers
in allocation of resources and determination of price. This may be applied / operated in
free market economy only. Under this system, the objective of the producers is profit
maximization and consumers are utility maximization. There is consumer sovereignty
means the producers decide what to produce basing on consumer choices.
Advantages of price mechanism
 It requires no government intervention that makes it cheap to implement
 Efficiency utilization of resources by producers to satisfy the consumers
 Variety of consumers choices
 Research and innovation
 Efficiency of firms that expands industry /firms
 Encourages competition which results into better quality of products
 Encourages flexibility in business
 Leads to consumer’s sovereignty that takes consumer as a king /backbone of the
business

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Disadvantages of price mechanism
The following shortcomings and problems are caused by government intervention in
the price system.
 Goods and services are demanded by the rich (luxuries and not essential
commodities)
 Massive unemployment because the inefficient firms are forced to close down
 Price instability
 There is not allocation of public goods and no profitable goods and services
 Maximizing profit without thinking on human face
 Income imbalances and wasteful competition that duplicates production and
hence wastage of resources.
Solutions to problems of price mechanism

“Ways of reducing the defects of price mechanism”
a. Formation of consumers’ association so as to educate and sensitive them about
the quality of commodities brought in the market
b. Taxing the rich more and subsidizing the poor to reduce income inequalities
c. Government can fix the minimum and maximum price of the commodities
d. Subsidization of weak and small producers by the government
e. There is need for proper planning to reflect structural changes, detect future
needs of society through government intervention.
Price controls (price administration)
It refers to the act of government intervention in price mechanism by regulating the
prices of goods a resources there is no force of demand and supply to determine the
prices of commodities
Types of price control

a) Maximum price legislation (price ceiling )
b) Minimum price legislation (price floor)
c) Buffer stocking
d) Stabilization fund
e) Resale price maintenance
f) Rent control
g) Rationing
h) International commodity agreement
A. Price ceiling (maximum price legislation)
It is where government fixes price below the equilibrium price above which it is illegal
to exchange a given commodity. This is done in a period of scarcity on favor of
consumers
Advantages of price ceiling

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It protects consumers from being exploited by monopolists who aims at maximizing
profits by restricting output and changing high prices
 It enables the low income comers to acquire necessities commodities
 It helps to ensure equal distribution of income (reduce profit of producers and
expenditure of consumers )
 It helps to maintain price stability
 It helps o discourage harmful products production
 It help to discourage the exportation of expensive commodities by setting max
price
 It helps to reduce the cost of production
Disadvantages (demerits) of price ceiling
 It promotes excess capacity of production
 It promotes black marketing and hoarding of commodities
- Black market: is a market which involves the illegal exchange of
commodities at a price which violates the one set by government.
- Hoarding : refers to a situation where producers create artificial shortage
of commodity in the market so as to sell at higher price
 It encourages corruption and bribery in the process of exchange
 It encourages exploitation of workers by employers
 It reduces labor efficiency (by being paid low wage )
 It encourage, smuggling of goods to neighboring countries
 It is expensive to implement and supervise by the government
 It encourages strikes by workers
B. Price floor (Minimum price legislation)
This is where government sets the price above the equilibrium price below it is illegal to
exchange a given commodity.
B.1. Advantages (case for) price floor
 It helps to protect the producers from being exploited by consumers
 It encourages the production of goods & services in the economy
 It helps to create more employment opportunities
 The minimum wage fixed helps to improve on the efficiency of labor
 The minimum wage fixed protect the workers
 It promotes research
 Increase of government revenue
 It helps to maintain price stability
 It helps to minimize strikers by workers
 It helps to control rural –urban migration
B.2. disadvantages of price floor
 It leads to a fall in the purchasing power of low income earns.
 It leads to inflation in case the minimum wage fixed is very high
 It leads to excessive supply of goods and services
 It increases government expenditure in form of price controls

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 It encourages dumping (selling the commodities in the external market at lower
price that one charged in the local market)
 It creates unemployment in the labor market.
Rent control
This is where government fixes rent for houses so as to avail people with houses at
low rent and to check on exploitation of tenants by landlords.
Resale price maintenance
This is the case where producers fix prices on which consumers should buy
commodities.
Ex. News papers
Rationing
This is where people get scarce commodities which are sold at government prices. It is
done on the basis of “first come, first served”.
International commodity agreement
These are international organizations set by buyers (consumers) and sellers (producers)
to fix prices and quotas for commodities. They are mainly set up to control prices and
supply.
Ex. International Tea Agreement, International Coffee Organization
Buffer stock and stabilization fund
Buffer stock is a situation where government buys up a surplus, stores it and sells it
during the shortage period.
Advantages of buffer stock
 Producer’s revenue is stabilized

 The producer is encouraged to supply the commodity since the market is assured
 The consumers gain in the sense that once there is shortage they get commodities
from government
Disadvantages of buffer stock
 A buffer stock is expensive to operate

 It requires a market research
 It leads to exhaustion of resources when there is consecutive periods of scarcity
Stabilization fund

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This is done with intention of stabilizing producer’s income; it is done through a
marketing board or agency. In the cases of less than expected output which comes in
the market, the agency buys the commodity from the producers at low price but it sells
it at a high price and gets profit. If it is a greater output comes in the market, the price
reduces and producer’s revenue also reduces, in order to stabilize producer’s revenue,
the agency buys commodities at high price but it sells at a low price and gets a loss,
therefore there is income stabilization.
The loss is assumed to be offset by the gain during the shortage period.
Advantages of stabilization fund
 Producer’s revenue is stabilized

 It is cheap to operate
 The producer is encouraged to supply the commodity
Disadvantages of stabilization fund

 The consumer suffers from a shortage
 The agency can be affected by a continuous loss because of a persistent fall of
prices of agricultural output.
Price fluctuation (oscillations) of agricultural products
Price fluctuation: refers to the instabilities in the prices of agricultural products in the
economy. It is also the alternating rise and fall in prices regularly
Causes of price fluctuations of agricultural products
 Inelastic supply of agricultural products in the short run
 High degree of perishability
 Bulkiness of agricultural products
 Divergence between actual, and planned output
 Competition from artificial fibers
 Price inelastic demand for agricultural products
 Income inelastic demand for agricultural products
 Cob web theory. It explain that the high prices in the current period force the
farmers to produce more of the commodity in the next season this leads to excess
supply hence a fall in prices. In the current periods of low prices, farmers are
discouraged from producing more of a commodity in the next season hence an
increase in prices.
Ways of reducing price fluctuations of agricultural products
 The government can fix the minimum and maximum prices of these products
 Encourage the farmers to produce variety of products to reduce over production
of a particular products (diversification )
 Government can use buffer stock (is where marketing boards) government by
the surplus output from farmers, store it and sell it during period of scarcity.

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 Improvement in the storage facilities and in technology and in the transport
network
 Formation of farmers cooperatives and associations to educate the farmers about
the use of better farming methods
Effects of price fluctuations of agricultural products
The price fluctuations may lead to;
 Discouragement of farmers from barrowing
 Low standard of living of the farmers in the period of low prices
 Encourage rural , urban migration
 Fluctuation in the levels of employment especially in the agricultural sector.
COBWEB THEORY
To explore the argument of how is difficult to plan accurately the agricultural output,
the Cobweb theorem is used. At equilibrium, we expect that the quantity demanded is
equal to the quantity supplied, therefore the market clears. However due to unforeseen
bottlenecks or catastrophes, there is always a divergence between actual output and
planned output.
The cobweb theory postulates a situation in which there is an immediate response to a

change in price on the demand side but a delayed response on the supply side. The
farmer’s decision about how much they will plant will depend on the existing price but
the output will be received in the next season.
Types of cobweb theory
a. Divergent (Explosive) cobwebs
This is the case where prices fluctuate further away from the equilibrium every season.
The fluctuations become wider and this happens when supply is more elastic than
demand.
b. Convergent (Damped) cobwebs
Convergent cobwebs arise when prices continue fluctuating but always coming closer
to the equilibrium. As prices continue fluctuating, the difference between the high and
the low prices reduces and there is a tendency for prices to move towards equilibrium.
c. Regular cobweb model
The price fluctuations are constant; they neither move further away from equilibrium
nor move nearer to the equilibrium. This happens when the elasticity of demand is
equal to the elasticity of supply.

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2.2. PRODUCTION THEORY
Definition of production: production refers to the process of creating utility in goods

and services in order to satisfy human wants.
It is also a process of transforming raw materials into finished goods that satisfy the
requirements of the consumer.
Purpose of production: All goods and services we consume are these are the results of
production (shirt, shoes, food, soda, etc). Production plays a great role of creating utility
because it is only the physical transformation of raw materials into finished goods but
also to make these goods useful to man in order to satisfy his needs (utility).
Types of production (forms)
i) Direct production: refers to the production of commodities for one’s own
consumption (home use) (substance production).
Example:
- Planting cassava for foods at home
- Doctor treating own child
ii) Indirect (markets) of production: refers to the production of goods and services to
exchange them for money or other goods. Commerce is practiced under this form of
production.
Stages (levels) of production
Primary production: refers to the extraction of raw materials from their natural
environment (fishing, mining, lumbering, and farming).
Secondary production: this involves the transformation of raw materials into
finishing commodities which are ready for use.
- Manufacturing, processing, etc
- Production of sugar from sugar cane, chair from timber
- Bridge construction, house
Tertiary production: this is the production of services.

It is divided into:
- Commercial services: buying and selling distribution of goods and services,
insurance, banking, etc.
- Direct services: services rendered by doctors, teachers, news reporters on television
and others.

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Factors of Production
These are resources (inputs) required in the production of goods and services; Land,
labor, capital, and entrepreneurship.
Factor price: refers to the monetary rewards (payment) given to the factors (agents) of
production: rent, wages, interest and profits.
Classification of factors of production (goods)

Physical factors of production: these are tangible factors of production Example:
Land, Capital, buildings, machines, furniture, etc.
Nonphysical factors of production: these are intangible factors of production
Example: skilled labor (services), entrepreneurship.
Specific factors of production: these are factors of production which are only used
for a specific purpose and cannot be put to any other use.
Nonspecific factors of production: these are factors of production which can be used
to serve various purposes.
a. LAND
Land refers to all natural resources used in the production process. It includes soil,
minerals, forests, water bodies, etc.
The remand for land is rent
Characteristic of land
Its supply is fixed
Land is a gift of nature
It is occupationally mobile that is, it can be used for various purposes.
Land is not homogeneous for example some land is fertile and another is infertile
Importance of land
It is used for agricultural activities (hunting, farming and fishing).
Land acts as a ground for waste disposal
Land is used for construction of industries, roods, buildings, etc.
It is a sources of raw materials (fish, water, minerals, timber, etc)
It is a sources of fuel
It is a source of government revenue since it can be taxed
Land also provides beautiful scenery for tourism which is a source of foreign
exchange
b. CAPITAL
It refers to any man made resource which is used in the production process .Example:
machinery, buildings, money, clothes, etc.
Capital is used to produce other goods, reward is interest

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Types of capital
i. Real capital: (fixed capital) the physical assets used in the production of goods and
services. Example: machines, buildings, roods.
ii. Liquid (money financial) capital: capital which is in form of cash used as a means of
payments of goods (capital goods)
iii. Floating (circulating, operating/ working) capital: that is used in the day running of
the business activities. Example: buying raw materials.
iv. Human capital: refers to the productive qualities found in human beings. Example:
skills and knowledge
v. Overhead capital: refers to social and economic infrastructure or assets which
facilitate in the production process. Example: banks, insurance, etc.
vi. Public (social) capital: capital owned by the government on behalf of its citizens.
Example: hospitals, schools, roads, etc.
vii. Private capital: is the type of capital owned by private individuals. Example:
private cars, schools, businesses, etc.
There is also concepts of productivity of capital refers to output per unit of capital
employed in the production of goods and services in a given time and marginal
productivity of capital refers to additional output derived from employing an extra
unity of capital in a given time.
Capital accumulation (capital formation)

Is refers to the process through which the stock of capital increases overtime for
purpose of future investments (increase of savings, resources utilization, construction,
etc)
Factors of capital accumulation

- The level of savings
- Level of technology used in the production
- Level of development of social and economic infrastructure
Importance of capital accumulation

i) It leads to technological development
ii) It increases the standards of living
iii) It facilitates resources exploitation
iv) It helps to create employment opportunities
v) It helps to reduce on level of inflation in the economy
vi) It helps to solve the balance of payment problems
Determinants of reserve price

i) Degree of durability of the commodity

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ii) Cost of production
iii) Degree of liquidity preference
iv) Future price expectation
v) Quality of the commodity
vi)Levels of storage expense
c. LABOR
Labor refers to all human effort both mental and physical which is used in the
production process. Its reward is the wage.
1. Mobility of labor: refers to the case with which labor can be moved from one place of
work to another or from one occupation to another.
Types of labor mobility

Geographical mobility of labor: Labor can be move from one place to another. It
may be international or national.
Example: from Rwanda to Uganda, from Ngoma to Kigali
Occupational mobility of labor: labor can be moved from one occupation to another.
Example: from teaching to Nursing, from trading to banking
The occupational mobility of labor may be classified into two categories:

a) Horizontal mobility of labor: refers to the change of occupation
where no change occurs in the status of workers. Example: teacher of economics
becomes a teacher of entrepreneurship.
b) Vertical mobility of labor: refers to a change of occupation which
results into a change in the status of the workers.
2. Determinants of labor mobility:

The followings are the factors that may determine the movements of labor:
The length of the training period
The level of skills required for a particular job
High level of education in a country
The higher degree of specification
Age of the workers
Degree of instability in a country
Specialization
This refers to individual or organizations focusing on the limited range of production
tasks they perform best. The workers leave other tasks that they do not perform well, or
they are not skilled into perform others that they are better suited for them.
Forms of specialization

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Specialization by craft: This was earliest form; the families specialized in different
activities basing on location, fishing, hunting, farming, etc.
Specialization by process: people specialized in carrying out different stages of
production process.
Regional specialization: a certain region specializes in the carrying out an activity
which it can do best
International specialization: A country specializes in production of a commodity
and exchanges it with other countries which can’t produce it.
Advantages of specialization
Workers develop more skills in their specialization
It increases outputs and saving time
there is innovation, creation of tools to make their tasks even more efficient
it promote international trade
it encourages use of machines and workers become less tired.
Disadvantages of specialization
It leads to unemployment, market fluctuations limited skills of workers and loss of
craftsmanship.
D. The Entrepreneur
This refers to a person or a group of persons who undertake the task of organizing the
other factors of production in order to make production process. Entrepreneur is a
coordinator, risk taker, innovator and decision maker of the business enterprise.
Functions of entrepreneur
The entrepreneur is responsible to:
Start a business
Employ other factors of production such as Land, capital and labor
making arrangements for rewarding other factors of production.
making decisions concerning the business activities and allocation of resources.
Undertake the necessary innovation for the proper running of the business
Factors that influence the supply of entrepreneurs

The level of education and training, personal ability of the individuals, the level of
economics activities, the market size of commodities, the government policy in relation
to investment and the degree of political stability in the country.

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Some definitions:
# Labor supply: refers to the total number of hours that labor is willing and able to
supply at a given wage rate.
Example: in RWANDA labor supply is 8 hours per day
# Labor force: Consists of economically active persons who are usually between 18 and
64 years apart from fulltime students, disabled and houses wives
# Share: is a unit of capital contributed by each shareholder when starting the company
with the aim of making profit
# A stock: is a combination of shares contributed by shareholders to the company
# Dividend: is a profit earned on the shares by the shareholders of the company
# retained profit: profits earned by a company that are not shared by shareholders but
they are left to expand on the business
# Money market: is a market where short term financial assets are traded. Example:
treasury bills.
# Capital market: is a market where medium and long term financial assets are traded.
Example: bonds, shares
# Stock exchange market: is a market where stocks and shares are traded
Input-output relationship/ production function
Production function
The production function shows the relationship between output and the factors of production. We
assume that those factors of production are labor (L) and capital (K).
In a mathematical form, a production function is expressed as:
Q= f (K, L)
Planning periods
Planning period refers to the decision time frames of a firm; it involves the short run,
long run and the very long run.
Short run is a time period so short that the firm is unable to vary all its resources. In the
short run some factors of production like land, buildings, technology and services of top
management are fixed while others like labor are variable.
Long run is defined as the period long enough for all factors of production to be varied.
Very long run is a period when there are technological improvements that lead to
new and better quality products. Larger quantities of output are produced than
before.

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Product of the firm and consumption of goods and services
The theory of firm assumes that the firm’s primary objective is to maximize profits. The
firm must produce goods and services for sale. To get this a firm has to combine
different inputs and it must determine how much of each input to use in order to be
able to produce a given quantity if output.
a. Total product (TP)
This is the total output produced by a firm using factors of production. The shape of the
TP is shown in different figure and it reflects increasing marginal returns then a
decreasing marginal returns.
b. Marginal product (MP)
The marginal product of a factor of production is the change in the firm’s total output
that results from an increasing of that factor by one unit.
That is marginal product which is the change of total product over the change in
quantity of inputs; capital or labor. Therefore there would be marginal product of labor
or marginal product of capital.
Let us consider this table that summarizes the relationship between total product and
marginal product:
L K TP MP(L)
0 1 0 0
1 1 5 5
2 1 15 10
3 1 23 8
4 1 27 4
5 1 29 2
6 1 30 1
This table shows the MP of every worker that a firm hires.

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c. Average product (AP)
Average product named Average Physical Product (APP) is the quantity of total output
produced per unit of a variable factor input, holding other factor inputs fixed.
This is the average product which is the total product over a variable input (labor).
d. The law of diminishing returns
This law states that as successive units of a variable factor of production are combined
with factor of production, the marginal product of the variable factor will eventually
decline.
This is the reason why the MP curve first rises but eventually declines, it declines
because of the law of diminishing returns.
The law of diminishing returns assumes the following:

 The presence of a fixed factor; it assumes the short run period
 There should be a constant level of technology
 Factors of productions are equally efficient
 Factors of production are divisible and easy to vary in proportions in which they
are combined.
e. Returns to scale
Returns to scale show the relationship between inputs and output of a firm. Briefly, this
is explained as follow:
Increasing returns to scale When inputs are doubled, output is increased by more
than double
Constants returns to scale When inputs are doubled, output doubles
Decreasing returns to scale When inputs are doubled, output is increased by less than
double.
Example showing in mathematical terms increasing, constant and decreasing constant
to scale
K L Q
Increasing returns to scale 3 4 20
6 8 50
12 16 120

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Constant returns to scale 3 4 10
6 8 20
12 16 40
Decreasing returns to scale 3 4 20
6 8 30
12 16 40
THEORY OF THE FIRM

A firm: is a production unit under one management which organizer resources to
produce goods and services.
An industry: is a collection of firms dealing in related products. Example: plastic
industry, textile industry.
A plant: is a particular facility or building that is used to manufacture a product
Types of industry:
a. Rooted industries: these industries located near the source of raw materials
b. Footloose industries: these are industries, which can be located anywhere without
considering the source of raw materials or market
c. Tied industries: these are industries located near the market for their finished
products
Objectives of the firm

- Profit maximization
- Seles revenue maximization
- Good image
- Market expansion
- limiting entry of a new firm in the industry
- To improve social and economic welfare of its employees
- Long run survival in the market
Location of Firms (Industries)
This refers to the physical place where the business operates.
Factors affecting location of firms
A firm can be located where there are:
- Raw materials
- Power supply (power sources), electricity
- Transport facilities (roads, railway lines...)
- Market of finished goods
- Water supply, land and cheap labor
- Good political climate
- Economic infrastructure

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Localization of the firms
This refers to the concentration of many firms in a particular area
The factors, which influence the localization of firms
 Availability of ready market,
 Enough land,
 supply of skilled and unskilled labor and water supply
 Security and political stability
Merits of localization of a firms

 Creation of employment
 Development of infrastructure
 Urbanization
 Improved quality products due to competition
 Improved reputation of the area where firms are concentrated.
 Attract skilled labour in the area of concentration.
 Industrial expansion: there is growth of subsidiary industries to supply raw
materials to industrial sector.
Demerits of localization of a firm
 Regional imbalance
 Development of slums
 Rural urban migration
 Social problems like congestion, overpopulation, traffic jams, accident etc.
 Increased cost of living that result from shortage of essential commodities due to
increased demand
 Increased dependence: There is an over dependence on a particular areas for a
particular product.
 Exhaustion of resources due to being over exploited by many firms
THEORY OF THE COST
A Cost: Refers to expenses incurred by a firm in production process.
Types of costs:
a. Implicit (transfer) costs: These are the costs that are not included in the calculation of
profits of the firm by the accountants. Example: family labor, self-owned inputs, etc.
b. Explicit (Nominal / money) costs: cost that are included in calculation of profits of
the firm by the accountants. Example: cost of raw materials, transport, etc.
Explicitly can be:

Fixed (supplementary / overhead/ indirect) cost: cost that incurred by the producer
irrespective of the level of output they remain constant like land, buildings, vehicles,
etc.
Variable costs (prime/direct cost/ operating cost): costs that change with the changes in
the level of output.

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Example: raw materials, wages payments, electricity, etc.
Total costs=total fixed costs + total variable cost
Assume that implicit costs=0
When output is zero, there are no variable costs (TVC=0). It means, the producer has
not yet started producing.
SHORT RUN COSTS
The relationship between various costs of production
The relationship between costs curves is illustrated in the following figure:
TC
Y
Total cost TVC
Total variable
cost
COST
Total fixed
cost
TFC
0
OUTPUT X
Total cost of a business is thus the sum of total variable cost and total fixed cost or
symbolically TC= TFC+TVC. We may represent total cost, total fixed cost and total
variable cost diagrammatically.
VARIATION OF COSTS IN SHORT RUN

Average fixed costs (AFC): These are total fixed costs incurred in producing an extra
unit of output in a given time
AFC= TFC/Q

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Average variable costs (AVC): These are total variable costs per unit of output
produced in a given time.AVC= TVC/Q
Marginal Costs (MC): This refers to the additional costs resulting from the
production of an extra unit of output in a given time. MC=∆TC/∆Q
Average total costs (ATC/ AC): These are total costs incurred in production of one
unit of output in a given time.ATC= AFC+AVC OR TC/Q
Note: ATC=TFC/Q+TVC/Q= AFC+AVC
Figure of short run variable cost

MC
Y AVC
ATC
COST
AFC
0
OUTPUT X
This figure explains the following:
 The ATC, AVC, and MC curves are U-shaped because of the law of diminishing returns
 AVC curve is below the ATC (AV) curve because ATC = AVC + AFC,
 As the level of output increases, the ATC curve comes closer to the AVC because of the
continuous fall in AFC.
 It should be observed that the gap between the ATC and AVC becomes narrower as the
output increases since the AFC can never be zero in the short run;
 The ATC cannot intersect with the AVC curve.

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Long run average cost
The long run average cost is per unit cost of producing a good or a service in the long run where
all inputs are variable.
There is no average fixed cost because in the long run, all inputs are variable. In the short run,
average cost is U-shaped because of the law of diminishing returns, in the long run, the
average cost is also U-shaped because of economies of scale and diseconomies of scale.
SCALE OF PRODUCTION
Growth of firms refers to the process by which firms increase in their production,
profitability and size.
A firm can grow in two main ways. It can grow internally or externally. The source of
growth of a firm may be within a firm itself (internal) or from outside of the firm
(external).
a) Internal or natural growth of a firm (organic growth)
This is the firm expansion, which is done by using internal generated resources and
internally implemented strategies.
A.1. Internal growth or natural growth of firm strategies
These are changes that a firm undertakes internally to affect growth of a firm. The
internal growth of a firm strategies broadly deal with cutting costs, improving
efficiency , widening market and expanding financial and human resources.
b) External growth of a firm
External growth of a firm occurs when a firm grows by using external resources. These
are the ways that explain how a firm grows externally
Mergers
It refers to the mutual agreements between companies to join and form one bigger
company. This is a normally done for the businesses that are producing and selling the
same goods and services in order to reduce competition among themselves and be more
efficiency.
The reasons why the companies merge are the following:
 To gain economies of scale
 It is the quickest and easiest way to grow
 To asset the strip means the companies buy other companies to sell off the most
profitable assets and make profit
 Reduction of competition
 Simple survival: to continue in the market, the company may need to grow and
the easiest way is to buy others firms.
 Buying up other businesses is a form of investment

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Types of mergers
i) Horizontal merging (integration)
This occurs where two firms in exactly the same stage of production and producing
similar products join / merge to form the bigger one. For example two restaurant join
together to form the bigger one
ii.)Vertical merger: this is a type of merger where firms at different stage of
production and producing different products merge
iii. Forward merger

It is where a firm at a lower stage of production decide to merge with a firm at a high
stage of production. For example: a furniture maker maydecide to merge with a
furniture retail shop
iv. Backward merger
It is where a firm at a high stage of production decide to merge with a firm at a lower
stage of production.
Example: furniture maker may decide to merge with a supplier of timber
v. Lateral merger
It is where a firm merges with another firm that makes similar goods but which are not
in competition with each other
vi. Conglomerate merger
It is where firms, which produce commodities, which are not related at all, integrate. It
is also known as diversifying merger. For example, a restaurant may merge with a
studio.
Advantages and disadvantages of mergers
a. Advantages of mergers
 International competition: Merge can help firms to become competitive and able
to face the threat of multinational companies and compete on an international
level.
 Economies of scale: Mergers enjoy economies of scale since it increase their
capacity.
 Research and development: mergers are able to invest in research and
development therefore improve on methods of production.
 Increased efficiency: merging increase firms capabilities in terms of expertise,
and technical efficiency.
 Diversification: Conglomerate merger in which firms producing different
products integrate result into diversification of their production activities.
b. Disadvantages of mergers
 Diseconomies of scale: after merging firms experience some problems like that
of coordination and control which lead to reduction of profits.
 Limited variety of products offered to customers
 Higher price resulting from formation reduction of competition.

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 Formation of monopoly firms which exploit customers
 Unemployment resulting from layoff of some works
 Leadership issues.
Economies and diseconomies of scale

1. Economies of scale: These are benefits or gains (advantages) enjoyed by the firm
due to its expansion leading to a fall in average cost of production.
Two types of economies of scale are internal and external economies of scale
a. Internal economies of scale
These are benefits experienced by a single firm as a result of increasing its scale
of production. These benefits are not shared with other firms in the industry. It
consist of the following:
 Technical economies: as a result of expansion a firm become more efficient due
to specialization of both labour and capital, ability to use superior equipment, etc
 Managerial economies: as a result of expansion, a firm can afford better and
more elaborate management which a small firm cannot afford. It can employ
managers, engineers, accountants and others.
 Marketing economies: when a firm expand it can employ specialized marketers
to promote sales of its products hence lower cost and higher profits
 Financial economies: A large firm has more access to finance as compared to a
small firm since it can easily get loans and access stock exchange market.
 Risk and survival economies: due expansion a firm is in better condition to
handle risks as compared to a small firm.
 Research and development economies: When a firm expand, it can undertake
research, develop new designs and invent new products which cannot be
afforded by a small firm.
 Social and welfare economies: as a firm expands its scale of production, it is in
position to provide fringe benefits to its workers like better housing, medical
insurance and recreation which improve the efficiency of labour.
b. External economies of scale
These are benefit or advantages enjoyed by a firm as a result of the expansion or
growth of the industry. This benefits are shared with other firms operating within the
industry. These benefits include:
 Labour economies: when industry expand; labour of different skills are attracted
to that particular area creating more access to such labour by firms at low cost.
 Economies of cooperation: due to expansion of an industry , there are more
cooperation between firms which enable them to establish common service like
research centers etc

Page 88
 Development of commercial facilities : when industry expand, commercial
facilities like banking, insurance, transport and advertising are developed which
help small firms to survive in long run.
 Development of social and economic infrastructure: expansion of an industry
result into development of infrastructures like roads. Communication facilities,
etc which help to reduce average cost of production
 Economies of specialization:
 Transport economies
 Etc
2. Diseconomies of scale
These are disadvantages faced by a firm as a result of its expansion leading to
higher average cost of production.it is divided into internal and external
diseconomies of scale
a. Internal diseconomies of scale:
These are disadvantages faced by a firm as a result of its expansion. These problems are not
shared with other firms in the industry, they are experienced by a single firm. They include:
 Communication diseconomies: the expansion of the firm creates a very long chain of
command between departments and branches.
 Financial diseconomies: expanding firms require large amounts of funds for operations
and investments
 Marketing diseconomies: this is the lack of motivation where there is lack of interaction
between employees and employers; this may lead to wastage of resources and a lot of
output remains unsold.
 Quality control diseconomies: the expansion of the firm may lead to reduction in quality
and services which in turn lead to reduced sales and profits.
 Technical diseconomies: this is the case where machines wear away and some resources
must be put aside for capital maintenance.
b. External diseconomies of scales: These are disadvantages faced by a firm as a

result of the expansion of the industry. These problems are shared by the firms
operating within the industry. They include:
 Labour diseconomies: due to expansion of the industry, it is difficult to get

workers with appropriate skills resulting into higher wage and high cost of
production.
 Marketing diseconomies: as a result of expansion of the industry, competition
for market increase resulting into higher marketing cost and lower profits.
 High demand for law materials which increase cost of production
 Scarcity of land which increase rent, congestion hence higher average cost.
 Pollution diseconomies: due to expansion , there will be increase in pollution of
the environment around

Page 89
 High cost of transport and communication due to expansion of the industry.
UNIT 15: THE REVENUES AND PROFITS OF A FIRM

1. Revenue: refers to the total receipts (returns) received by a firm from the sale of a
given level of output at a given price in a given time.
Forms of revenues
A. Total revenue: (T.R) this is the total amount of money received by a firm from
the sale of its outputs.
TR= P x Q Where:
P: price of each of output
Q: total output (quantity)
B. Average revenue (A.R): refers to total revenue per unit of output sold.
. It is obtained by dividing total revenues by outputs.
AR=𝑇𝑅/𝑄 or PQ/Q Were AR= Average revenues, TR= Total revenues, Q= Total
outputs sold, P= Price
c. Marginal revenue (M.R): refers to the additional revenue resulting froman extra unit
of output sold
M.R=Change in total revenue / change in output i.e MR=∆TR/∆Q
Relationship between MR &AR under perfect competition and under monopoly or

imperfect competition
Under perfect completion AR=MR while under monopoly or imperfect competition

AR>MR.
Illustrations in explanations
2. Profits of a firm
Profit is the difference between the total revenues received by the firm and total incurred by the
same firm. A firm get profit when its average revenues is greater than its average costs.
Profit= total revenue- total cost
Types/ forms of profit
 Normal profit: This refers to the minimum level of profits which can maintain a firm in
business. It is realized when total revenue is equal to total cost or average revenues is
equal to average costs. It is also called zero economic profits/ transfer earnings or
supply price

Page 90
 Abnormal profit/ supernormal profits: this is profit earned by a firm which is over and
above the normal profit. Total revenue exceeds total cost or average revenues is greater
than average costs
 Subnormal profit: this is the profit earned by firms investing in risky ventures.
It is profits which is lower than normal profit. It is obtained where average cost is
greater than average revenues but average revenues is greater than average variable cost.
i.e. AC>AR>AVC
 Windfall profits: this is unexpected profits realized by a firm either due to an

abrupt increase in price or in demand for the products or an abrupt fall in cost of
production.
 Gross profits: this is the excess receipts over the cost of goods sold.
 Pure profit/ net profit: refers to residual profits left to the firm after deducting
all sundry expenses from gross profit.
Profit maximization of a firm
A firm maximize profits when its MC=MR and the MC curve should cut the marginal revenue
curve from below.
1. Profit maximization under perfect competition.
Under perfect competition, a firm cannot influence the market condition. It is therefore price
taker. It can only make decision concerning the output to be sold at prevailing market price.
From the above illustration, the firm maximize profits at point B where MC=MR and the profit
maximizing output is Q2 because it is greater than output Q1 and the equilibrium price is P
which is equal to average revenues and equal to marginal revenues

Page 91
Profit maximization under monopoly
Under monopoly situation, there is only one seller and the firm’s demand curve is downward
sloping to the right and the firm is price maker. Like the other firms , a firm under monopoly aim
at profit maximization and the profits are maximized where MC=MR and MC curve cut the MR
curve from below.
From the above illustration the firm maximize profits at point E where MC=MR and the profit
maximizing output Q is produced and sold at price P.
The role of profits in production
 It is a reward to an entrepreneur
 It provide a source of finance for investment and expansion
 It stimulates innovation and invention in business
 It promote efficiency in production and allocation of resources
 Promotion of the economic welfare of the firm
 It increase taxable capacity of an entrepreneur which lead to increase in government
revenues from taxation
 etc

Page 92

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ECONOMICS FOR SENIOR FOUR GS.

We must be competent in economic theories to solve the economic issues (scarcity)

PREPARED BY: BIKORIMANA Eugene Tel 0789220704

Academic year 2020-2021

UNIT1. BASIC ECONOMIC CONCEPTS AND THE IMPORTANCE OF ECONOMICS

UNIT4: EQUATIONS AND FRACTIONS IN ECONOMICS

UNIT5: THEORY OF DEMAND

UNIT6: THEORY OF SUPPLY

UNIT7: EQUILIBRIUM AND PRICE DETERMINATION

UNIT9: CONSUMER THEORY

UNIT10: PRICE MECHANISM

UNIT11: INTRODUCTION TO THE THEORY OF PRODUCTION

UNIT12: INPUT-OUTPUT RELATIONSHIP (PRODUCTION FUNCTION)

UNIT13: THEORY OF A FIRM

UNIT14: THEORY OF THE COST

UNIT15: REVENUES AND PROFITS OF A FIRM

Prepared by BIKORIMANA Eugene Tel 0789220704

UNIT1. BASIC ECONOMIC CONCEPTS AND THE IMPORTANCE OF ECONOMICS

1.1. MEANING AND ORIGIN OF ECONOMICS

Various economists have defined economics differently

1.2. IMPORTANCE OF STUDYING ECONOMICS

 To pursue their chosen careers in banking, management, commerce etc.

Prepared by BIKORIMANA Eugene Tel 0789220704

1.3. BASIC TERMS USED IN ECONOMICS

It is the stock of assets available to an individual or group of individuals or country at a

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1.3.4. Economic agents

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 They are unlimited

Services: Are intangible items or things that satisfy non-material wants.

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5. ECONOMIC ACTIVITIES AND ECONOMIC SYSTEMS

Sectors of production in economy

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Features of mixed economy

 Ownership of resources is by both the government and the private individuals

UNIT2: FUNDAMENTAL PRINCIPLES OF ECONOMICS

 Scarcity: refers to limitedness of resources relatively to human wants. In economics

Prepared by BIKORIMANA Eugene Tel 0789220704

 It assume that only two commodities are produced

The following figure illustrates the production possibility frontier:

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The above figure illustrates the following economic concepts:

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The inward shift of the PPF indicate economic decline.

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 Lack of new natural resources

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Unbiased PPF shift on both sides favoring both two commodities

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UNIT3. 1. THE NATURE AND SCOPE OF ECONOMICS

3.2. Positive and normative economics

 Unemployment should have been below 4 : Normative economics

3.3. Economic variables

 Endogenous variable: originate within the economy and can be controlled

Prepared by BIKORIMANA Eugene Tel 0789220704

1. Briefly explain what economics is about. Why do you study economics?

Prepared by BIKORIMANA Eugene Tel 0789220704

In economics, linear equation describes relationship between variables (dependent or