Microeconomic principles

Microeconomic principles

Question 01-Government Actions on Markets

  1. Tax is a levy charged on a good or service for the Government to earn revenue. At times it is charge to prohibit usage of a good or service due to its negative effects to the economy. In reference to the case study, the below graph represents tax imposed on the supply side of good with high sugar content.

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Figure 1: Impact of taxes on sellers of foods with high sugar content

  1. When tax is imposed to sellers, the supply curves shifts up (from SS to S’S’) by the amount of tax imposed. As well, this makes the market equilibrium to shift from QP to Q1P1 reducing the quantities demanded for goods with high sugar content from Q to Q1 due to price increase from P to P1. The price increase, leads to consumers’ access to lesser quantity of the same product at higher prices than they used to before tax imposition hence it becomes a burden.

  2. The graph below demonstrates the effects of tax of goods with high sugar content on buyers.

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Figure 2: Graph showing the impact of taxes on buyers of goods with high sugar content

  1. Once the levy is enacted on the consumers (buyers), the demand facing producers shifts downwards by the amount of tax and for this case from Q0 to Q1 because of reduction of consumers’ purchasing power from P0 to P1 as a result of tax imposition of the goods leading to surplus in supply.

The tax incidence doesn’t depend on who the levy is imposed to since:

If it is levied to consumers, they reduce quantity demanded to producers hence producer must reduce the price of the goods to get the consumers to buy. Conversely, if the levy is on producers, the additional cost is passed to consumers increasing the products’ price. Price elasticities of either demand or supply influence tax incidences in that; if price elasticity of supply if lower than that of demand, the tax befalls to the producer and the vice versa.

Question 02-Elasticity and Efficiency

  1. Consumers will purchase more of a commodity if its comparative price decreases. This kind of relationship provides a ripe ground for economists to analyze price variations’ responses by consumers. The responsiveness of consumers to price changes measures price elasticity of demand hence the definition; proportionate variation in demand resulting from price changes (AS Markets & Market Systems). The following formula is used to calculate price elasticity of demand.

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Goods are inelastic if price increase doesn’t affect quantity demanded, while goods are elastic if consumers demand less upon price increase. For perfect elastic goods, a change in price causes demand to reduce to zero.

  1. Factors that influence price elasticity of demand include;

  1. Substitutes: Consumers can easily move to another good with similar level of satisfaction in the event the price of their preferred good changes. For the case study, consumers may prefer goods with less sugar content as substitutes or result to home-made goods to serve a similar purpose.

  2. Time: After price changes, consumers do not respond immediately as they do not immediately notice the change, however, in the long run, the demand for the goods tends to decrease since the consumers have an opportunity to alter their spending patterns.

  3. Necessity and luxury: When goods are vitally necessary, price changes do not affect their demand as consumers will purchase it any price while for goods perceived luxurious, consumers do not necessarily need them to live hence their price elasticity of demand tend to be elastic. Most goods with high sugar content could be luxurious hence consumers can live without them, for this case study they might be affected by this factor.

  1. Role of price elasticities of demand in determining the size of the burden to consumers

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Figure 3: Graph showing partial equilibrium incidence of tax on goods with high sugar content

When tax is imposed on goods with high sugar content, ceteris paribus, the demand for such goods decreases. The entire incidence of the tax initially involves getting the consequences on the cost of goods consumers pay as well as the price producers/sellers of the products receive. The above figure 3 indicates that in a single market –‘Partial equilibrium’ situation, tax effect analysis would be complex since both the price consumers would pay and the price producers would receive is prone to the effects of the tax policy. When tax is imposed on consumers, the product’s price rises bringing down their demand for the good. while when imposed on sellers, their costs increase hence decreasing their supply leading to increase in products’ price resulting to a reduction in quantity consumers demand, this further leads to a reduction in price that sellers can sell at-cyclical effect. The burden of the price change is squarely on consumer as depicted in figure 3 where tax imposition results to consumer paying more for the good regardless of how much the producer/seller gets

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Figure 4: Approximation of equivalent variations: Consumer surplus and Producer surplus

The above figure 4 shows reduction of consumer surplus due to tax imposed in figure 3. A change in price due to tax leads to reduction of the stripped area due to the demand curve flattening i.e. when a consumer can flex, the elasticity of demand is of higher magnitude. This is more visible in the long run since consumers of goods with high sugar content will change their spending habits significantly with time. The dotted area indicates reduction in producer surplus, as producers become more flexible, the supply curve tends to be flatter (more elastic) as the spotted area of tax burden becomes smaller. The burden sharing of consumers vis-a-vis producers is depended on comparative elasticities of demand and supply of the commodity. Producers can flex better to consumers hence more tax will be forwarded to consumers, making consumer bear the tax burden alone (Rosen and Gayer, 2008).

  1. Allocative efficiency

This is the state of economy where consumer preference are represented during production, that is, goods and services are produced such that every unit provides marginal benefit to the consumer equivalent to the marginal cost of producing it. Price of unit product equals marginal cost in an efficiently allocated single priced model (Markovits and Richard,1998).  Social surplus is optimized to shun deadweight loss- society’s value to produce an output less the value of inputs utilized to produce it. The economic scenario that, the tax could be allocated efficiently is deemed to be for the producers to appraise the producer surplus resulting to the increase in price due to tax. Such estimation necessitates the producers to be in the know of the deadweight loss and supply the optimal market demand.

Question 3: Consumer Theory

  1. Indifference curves of close substitutes

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Figure 5: Graph representing goods which are close substitutes for Pablo

When two goods are close substitutes such as Good L and Good H, there exists a higher degree of substitutability (tending to unity) between them. The gradient of the indifference curves is almost same as depicted in figure 5 above between the ranges A-C meaning that, the Marginal rate of substitutability of L and H is almost the same at all points along the indifference curve.

  1. Indifference curves of Good and bad

When a product is ‘good’, much of it is desired to less of it, while when a good is ‘bad” less of it preferred to more. Downward sloping indifference curves, convex to the origin represent such a relationship of goods. When a good is bad, consumption of such a good lowers his satisfaction while a consumption of a ‘good’ product increases his satisfaction.

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6: Graph representing indifference curves of ‘good’ and ‘bad’ goods for PatriciaFigure

From the figure above, movement to the right indicates more of good H which reduces consumer satisfaction hence in order to keep the level of satisfaction unceasing; the quantity of Good L must be kept high

  1. Normal indifference curves take the shape as below diagram

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Figure 7: Graph of Indifference curves exhibiting close substitute’s relationship for Peixiao

Indifference curves are curves that represent consumption package that satisfy a consumer at the same level. A consumer will equally be happy (indifferent) with combinations at points A through C lying on indifference curve I1. But will get higher satisfaction with goods on higher indifference curve I2. The gradient at any point of the indifference curve represents the MRS (marginal rate of substitution) defined as the degree at which consumers are ready to swap good L for good H, for our case in figure 7. Alternatively, Marginal rate of substitution can also be defined as the amount of a good a consumer would compensate for giving up a unit of the other. Indifference curves have four main characteristics.

  1. They bow inward

  2. They do not cross

  3. They slope downwards

  4. Higher ones are more preferable

Diminishing marginal rate of substitution postulates that marginal rate of substitution reduces downwards the indifference curve. A consumer choosing between good L and good H at any point, say C the gradient (Change on in units of good L against change in units of good H) is negative. This translates to consumer facing diminishing rate of substitution, that is, the more he or she consumes of good H relative to good L, the fewer good L he/she is ready to trade off for good H. The indifference curve exhibit diminishing rate of substitution because along the curve, a consumer must give up one good to gain the other as long as the combination gives him/ her the same level of satisfaction.

  1. Graph showing utility maximization

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Figure 8: Graphical representation of Peixiao’s utility maximization

Question 04-Consumer Theory

  1. Utility maximization is based on the premise of budget constraint. Peixiao may desire combinations of goods on a higher indifference curve because their level of satisfaction is equally higher but may end up on or below his feasible set (budget set). Combining the budget set and indifference curves determines the optimal choice (maximum utility) the consumer must make. The point of utility maximization is the point of tangency of the highest possible indifference curve and the feasible set. At that point, the good H and good L have marginal rate of substitution same as the comparative price, where the rate of trade within is the same as that in the market. A change in income will affect the feasibility set and hence shift it either outward (for an increase) or inward (for the case of decrease). When that happens, Peixiao will find new optimum point.

  1. Effect of tax on goods with high sugar content

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Figure 9: Graph showing effect of tax on the consumption of goods with high sugar content

  1. Graph showing how demand curve is derived from points of consumer optimums.

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Figure 10: Demand derivative as a result of tax

  1. Substitution and Income effects.

The change realized in consumption resultant from price change is referred to substitution effect. Due to the price change, the consumer moves to a different point within the indifference curve with a dissimilar marginal rate of substitution. This is well demonstrated in figure 11 between points A and B, point B has two characteristics, i) it is within the same indifference curve as initial consumption bundle and ii) it is a point where the feasible set is parallel to the new budget constraint tangent to first indifference curve

Income effect is as a result of change resulting from price variation causing the consumer to move from one indifference curve to another, from either lower to a higher indifference curves or vice versa. In figure 11 it is well illustrated by the movement from B to C. As a result of tax imposed on goods with high sugar content, the consumer becomes worse off, hence he buys less of the good H, on the flip side, goods with low sugar content becomes relatively cheaper hence he can buy more of that.

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Figure 11: Graphical representation of substitution and income effects

Question 05-Externalities

  1. An externality is an uncompensated cost or benefit resulting from actions of other people/parties. They exist in two forms; Negative or positive. A Negative externality will affect another party adversely while positive one’s effect is beneficial to the other party.

In the case study, the harm on the rest of the society caused by sugar consumption is a negative externality. With no sugar consumption, there exists no harm on the society due to health concerns while as more persons consume sugar, their health deteriorates resulting to unmerited costs to cater for their medical bills.

  1. Demand and supply curve illustrating externality

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Figure 12: Demand and supply curve showing externality as result of sugar consumption

  1. Quantities produced and utilized (consumed) in the market equilibrium are efficient in that, it maximizes the consumer and producer surplus. Due to the harm caused by consumption of sugar (negative externality) the external societies’ cost of goods with sugar production is higher than cost of goods with sugar producers. An equation representing negative externality would be ‘ Externality =Private costs –Social costs

  1. Solutions government can utilize to correct this externality include imposition of tax to raise private costs to social cost consequently government raises revenue. The government can impose a regulation controlling quantities of goods with high sugar levels produced through quotas or bans.

Question 06-Externalities

  1. The externality in this case is positive because the by-standing villagers are benefiting from by products resulting from production of goods with high sugar levels. The by-standers did not influence the production of the by-products but comes as benefit to them since they are utilizable in their environmentally friendly business. Since the by-products are of importance and are positively contributing to their businesses, the externality is positive.

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Figure 13: Graph showing positive externality resulting from consumption of goods with high sugar content

  1. In this case the social benefit of producing goods with high sugar levels exceeds the benefit consumers of the same goods realize. This is well represented by the following equation; Social costs-Privates costs= External costs( externality)

  2. The government can introduce incentives like subsidies in attempt to internalize the positive externalities. Alternative, industrial policy implementation in the economy aiming at promoting technology utilizing industries can work in the regulation of positive externality.

Question 07-Research Question

  1. Characteristics of a perfectly competitive markets

  1. Products sold are identical and bears no brand names

  2. Firms do not control prices rather are price takers. This is because the product prices are purely depended on the forces of demand and supply hence individual firms have no choice than take the equilibrium price.

  3. The firms have a small share in the market

  4. Buyers are fully informed on products and prices, information freely flows to every participant hence minimal risk taking. Entrepreneur mandate is limited

  5. Firms can freely enter or leave the industry

  6. No transport costs incurred

  7. There is no government involvement

Looking at the global supply chain of sugar, perfect competition is exemplified at retailing stage of the sugar, the products at this point are identical, their market share is challenged since they are so many and competition is high because of their numbers, they are free to retail the product or not, no transport costs involved and the government doesn’t get involved in the process of trade.

  1. Microeconomic principles 14

Figure 14: Photo of a Kongowea market in Kenya- Mombasa

The market is characterized by large number of traders selling bulb onions resultantly; the price is determined by the forces of demand and supply hence not fixed. They do not incur transport costs since farmers bring the onions to the market for wholesale traders to buy. The government does get involved in the trade rather service charge to keep the market ground friendly. The traders are free to enter and free to exit the market; decisions not felt by consumers because of their size in number, consumers are fully informed of the market prices every moment.

  1. Characteristics of monopoly market

  1. The firm is a single seller, industry and firm are same. In monopoly, a single seller gives all the goods or services demanded serving the whole market.

  2. The product is unique with no close substitutes. Products traded are hybrid, demanded by a larger group of the market and have no competition

  3. The firm determines the price, that is, it has control over price since it can determine quantities to be supplied

  4. No free entry nor exit, other interested seller are restricted due to high barriers of entry

  5. It maximizes profits. This is made possible by deficiency in competition hence a monopoly firm can change price above what would be feasible in a competitive market

At the global supply chain for sugar, refinery level closely exhibits the characteristics of a monopoly since the firm is designed to produce sugar only, the price is determined at the refinery stage taking into consideration of cost of production. It is not so free to enter or exit due the investment costs and government regulation.

  1. Kenya power and lighting company is the sole parastatal licensed to distribute electricity power in Kenya. Due to this, it enjoys all the benefits of a monopoly since there exists no competition in the power supply market. It sets prices because it can control supply. Though the Kenyan population can tap wind and solar energy for electricity, they find themselves using the Kenya power product since solar and wind is not sustainable for them. Kenya power cannot exit the market since it is the single supplier of the product, it’s exit would mean no power to the entire country, which would be for the detriment of the economy.

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Figure 15: Kenya power and lighting company staff installing powerlines

Question 08-Research question

Characteristics of a monopolistic competitive market (Monopolistic competition)

Monopolistic competition is one kind of imperfect competition where large number of producers sell differentiated products by either brand or quality. Due to the degree of differentiation, the products are not perfect substitutes. In this type of market, engaging firms takes prices quote by their competitors while ignoring the results of its own prices on the prices of the competitor firms. Where governments are coercive, monopolistic competition are granted license to operate as a monopoly by the government.

Main characteristics of monopolistic competition include

  1. There is a good level of product differentiation

The products dealt with are differentiated but not to the extent that they do away with substitutes. The market exhibit a positive cross price elasticity of demand within the goods. The goods dealt with play same basic functions however they have difference in form, style, packaging and quality, characteristics that differentiate them from each other.

  1. The firms are many

There exists of a big number of firms in every monopolistic competition same to the side line ready to enter. The big number gives the market freedom to determine prices without regard to prices of other firms-single firms’ actions impact the market negligibly.

  1. No costs involved on entry of exit

In the short run, there are minimal costs incurred to enter or exit the market which tends to diminish in the long run. There are several other firms in the waiting to enter with unique product aiming at maximizing profits. Firms incapable of meeting their costs can exit with no liquidation costs.

  1. Making of decision is independent

Every monopolistic competition decides on terms of trade independently regardless of the decision’s effects on the competitors. The analogy here is, the actions of single firm has negligible impact on the entire market demand hence individual firms can independently choose a cause of action without due regard to the others.

  1. Powerful in the market

Monopolistic competition have some level of market power, the firms have control on exchange terms and conditions. The monopolistic firm can decide to raise price without necessarily losing customers and vice versa. They enjoy an elastic demand curve.

  1. Information is not perfect

Buyers and sellers do not have all the information on demand or supply.

The retailing stage of global supply chain of sugar closely relates to monopolistic competitive market. The characteristic huge number of seller with varied sugar products resulting from packaging, style, type and quality (white, brown, and molasses) identifies well with monopolistic competition. Retailer can decide to set prices without regard to its effects on the completion.

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Figure 16: The tooth paste industry in Australia

The toothpaste industry exemplifies characteristically a monopolistic competition. They all serve the same basic purpose-cleaning the mouth, but are to a big extent differentiated on brand name, ingredients, quality, pricing, packaging and form. Every firm in the monopolistic competition has the independent freedom to set their prices without regard to prices of other competitors. Information on demand and supply of the products is not readily available for consumers of this product. Already in the captioned photo, there are sixteen brands from different producers an indication of a big number of firms producing toothpaste-major characteristic of monopolistic competition.

c) Characteristics of oligopolistic competition

Oligopoly is a kind of market where the commodity is traded by few sellers hence individual seller can determine or control prices. Due to the size of the sellers, they control a bigger portion of the supply side.


  1. Power of monopoly

Since the number of firms is small, they control a bigger market share resulting to control of prices and output.

  1. The firms are interdependent

In oligopoly, a handful of firms exist producing same or differentiated products. Because of the small number, each has a large market share hence can influence price and output. Resultantly, a firm cannot ignore the actions of the other in price determination and output because of the market share they individually control hence they must work interdependently.

  1. The attitude of the firms conflict

The attitudes of the firms’ conflict twofold, the firms are well informed of demerits of mutual competition while they pursue maximized joint profits hence the need to form collusions. On the flip side, the pursuit of own profit lead to conflict.

  1. Small number of firms

There exists a small number of firms, an example, the Indian automobiles exemplifies oligopolistic type of market.

  1. Product nature.

Pure oligopoly results from products which are homogenous while impure from differentiated products.

  1. Wide market for products

In oligopolistic market, there exists a large number of product users leading to a high demand.

  1. Unstable demand curve

Because of the interdependence of the firms, any individual firm’s action must be considered and hence keep affecting the demand curve of the market.

The distribution stage of sugar supply chain closely identifies with oligopolistic structure. The distributors are few and must consult each other before actions are taken.

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Figure 17: The Automobile market in India

The automobile industry in India is dominated by few firms such as Mahindra and Tata as the major manufacturers of automobiles. They command large market share in India and also in the export market hence actions on price and output of either of the firms must be noted by other rival firms within the market.


“AS Markets & Market Systems: Price Elasticity of Demand.” Retrieved 2nd October 2016 from www.tutor2u.net/economics.

Australia toothpaste industry photo. Retrieved 3rd October 2016 from https://www.google.com/searchq=photos+of+toothpaste+industry+in+australia&espv=2&biw=1242&bih=606&tbm=isch&tbo=u&source=univ&sa=X&ved=0ahUKEwikmrqhsb7PAhUIOCYKHcqKB9kQ7AkIQw

Kenya power and lighting company photo. Retrieved 3rd October 2016 from http://www.the- star.co.ke/news/2016/01/21/nairobi-central-coastal-region-hit-by-blackout-kenya power_c1281052

Markovits, Richard (1998). Matters of Principle. New York: New York University Press

Markovits, Richard (2008). Truth or Economics. New Haven: Yale University Press. 

. Rosen, Harvey S., & Gayer T., (2008). Public Finance New York: McGraw-Hill, Irwin.