Introduction to Economics

Chapter One: Definition of Economics and Methods of Economic

Analysis
1.1. Definition and scope of Economics
Before one is going to define the term economics it would be imperative to pose the following basic and
universal questions.
Why are some people rich and others poor? What is money supply and why is it important? How can
some countries produce goods and services so much more cheaply than others? Why do people worry about
inflation? Why do people bother about the government budget deficit? How can a community decide between the
conservation of a piece of land for recreation purposes or for development? And so forth.
Trying to reply to these and other similar questions forms the very essence of economic science.
Basically, there is no consensus among economists about a precise definition of economics. This is to say that
there are as many definitions of economics as there are economists. The following are the tip of the iceberg about
the definitions of economics given by different economists:
1. Economics is the study of how mankind runs the business of organizing its production and consumption
activities.
2. Economics is the study of wealth (possession).
3. Economics is the science of choice, which studies how people choose to use scarce or limited productive
resources to produce different goods and services, and to distribute them to various members of society
for their consumption.
4. Economics is the study of commerce among nations, which helps explain why countries export some
commodities and import some others.
5. Economics is the science of economizing.
The list is not exhaustible. However, the most elaborate and common definition of economics is that it is a
discipline or field of study, which is concerned with the efficient allocation of scarce resources in the
production, distribution and consumption of goods and services to satisfy human material wants.
1.2 Uses of Economics
The most conspicuous issue in economics is that human wants are unlimited while the resources available
to produce goods and services are limited. In economics, when we say goods they may encompass the following
concepts:
i) Economic good – any thing or object which is inherently useful, relatively scarce, and which
requires strenuous efforts to obtain. A good with positive price is economic good/scarce good.
Example:- minerals, land, …….etc.
ii) Consumer good – any economic good, which is used directly to satisfy human wants.
Example:- food, clothing, shelter
iii) Capital good – any economic good which is used in the production of other goods rather than
direct consumption. Therefore, unlike consumer goods, which are directly consumed, capital
goods are used indirectly in helping produce consumer goods. In this sense, capital only refers
to “goods that are used to produce other goods”. Capital is not completely used up in the
production process capital depreciates because of wear and tear from use (physical
depreciation) and obsolescence from changing technology (technological depreciation).
Example:- machine, buildings, tools, etc.
iv) Free good – any thing which is inherently useful, abundantly available, and which can be easily
obtained without much effort. A free good means everyone can enjoy as much as he/she wants
at zero price.
Example:- air, sunshine, water in a mountainous area.
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Economics is more concerned with economic (scarce) goods than free goods because for the latter there is no
problem of distribution or allocation.
The following are the most important scarce (limited) resources studied in Economics;-
1. Land: - land to economists means all natural resources bounty of nature usable in the production process.
This includes arable land, non-arable land, forests, minerals, soil, rivers, oceans, fisheries, oil deposits and
water resources. Thus, land refers not only to the surface of the earth but also to all gifts of nature, which
are usable in producing goods and services. The payment for land is rent.
2. Labour: - Labour is a broad term that the economist uses for all the physical and mental talents of persons
available and usable in producing goods and services in the production process. Note that labour does not
include any type of activity, which is done for leisure and for which a monetary reward is not provided. In
this case, wages are the monetary rewards for labour.
3. Capital:- Capital or investment good incorporates all tools, machinery, equipment, factory and storage
facilities used in producing goods and services. Investment is defined as the process of producing and
accumulating capital goods. Capital involves all man-made resources and wealth with the exception of
land. The distinguished character of capital is that it is produced in an economic system and is used as a
factor (input) for further production. And interest is the payment for this input.
4. Entrepreneurship:- Entrepreneurship or entrepreneurial ability refers to a human resource but with a
special set of talents that enable him/her to organize and manage the other resources to produce a product.
It is a special ability to undertake risk and organize a business. It is responsible for technogical advance
and economic growth. And its monetary value is profit.
1.3 The Subject Matter of Economics (branches of Economics)
Economics is studied under two major headings. In other words, there are two branches of economics:
Microeconomics and Macroeconomics. Microeconomics is a branch of economic analysis, which deals with the
economic behavior of individual decision-making units such as consumers, business firms and industries and with
the determination of quantities and prices in individual markets. It deals with how consumers (households)
behave, how business firms make choices, how income is distributed among family members and individual
components of an economy. Example:- the price of a specific product (output); the number of workers employed
in a given enterprise; the revenue of a particular business firm; the expenditure of a given family. In
microeconomics, we examine the “trees”, not the forest, “because the trees are small parts of the forest. In
contrast, macroeconomics is a branch of economic analysis, which dwells on the behavior of the economy as a
whole. It investigates the overall (aggregate) performance of the economy with respect to total production,
aggregate spending, employment, general price level, investment, foreign trade, the nation’s money supply and
other aggregate economic variables. Macroeconomics examines the “forest”, not the trees”.
1.4 Methods of Economic Analysis
Economists derive economic principles, which are useful in the formulation of economic policies
designed to solve economic problems. The procedures followed by economists are as follow:

Facts
Descriptive Economics: - is concerned with gathering facts relevant to specific
problems or aspect of the economy.
Principles or Theories
Theoretical Economics: - is concerned with generalizing about economic behavior.

Economic Policies
Policy Economics: - is concerned with controlling or influencing economic 2
behavior and its consequences.
The process of distilling principles/theories from the known facts is called inductive method (empirical method).
In inductive method, reasoning proceeds from particular to general or facts to theory.
Economists also set their tasks at the level of theory and proceed to the verification or rejection of this theory by
reference to facts. This method of economic analysis is called deductive method or analytical method. In
deductive method, reasoning proceeds from general to particular or from theory to facts. That is, deductive
method is a logical way of transforming a general truth into a particular truth.
In both methods, it is worthwhile to check the validity of the theory. This is so because the assumption that holds
true for each part taken separately may not hold true for the whole and what holds true for the whole may not be
valid for the part taken separately.
1.5 Positive Economics Vs Normative Economics
While descriptive economics contains quantitative and factual statements, normative economics entails value
judgment as to the desirability of some events. Thus, it has become necessary to make a clear distinction between
the economic analysis, which provides an actual description of the economic system, and the one, which involves
ethics and value judgment.
The method of economic analysis, which provides an actual description of an economic system is called Positive
Economics. Positive economics deals with the objective explanation of how the economy works. It tries to the
questions what was, what were and what will be.
On the other hand, normative economics entails one’s value judgment about how economic problems
should be solved in the economic system. Normative economics is policy economics and is thus not descriptive. It
attempts to answer the questions “what ought to be, or what should be?”
On the whole, positive economics is scientific and objective discipline whereas normative economics is
largely a branch of ethics.
1.6. Scarcity, Choice and the Production Possibility Frontier (PPF)
Economic scarcity refers to the basic fact of life that there exists only a finite amount of human and non-
human resources. In the face of scarcity, therefore, choice becomes an inevitable feature of life. Choice means
selecting alternative uses of scarce resources or setting priority. Scarcity forces people to choose among
alternative uses of economic resources because all other wants cannot be satisfied simultaneously. That is, scarcity
is the "coercion of choice". That is why economics is defined as the efficient allocation of economic resources to
produce goods and services to satisfy human material wants. Because resources are limited, the output produced
is limited, too. An economic choice, therefore, needs to be made as to what quantities of each product to produce.
Note here that all choices are not economic. For instance, whether to marry or not to marry is not an economic
choice and hence has nothing to do with economics. Thus, we will be mostly concerned with more conventional
economic choices involving the allocation of scarce resources.
The Production Possibility Curve (PPC)
Assumptions used in illustrating the PPF:
i) Efficiency of production: Doing the best with what is available is the central issue of economics and hence of
efficiency. In order to realize this desirable outcome, the economy should operate at full employment and
attain productive efficiency.
 Full employment means that all available resources are fully employed.
 Productive efficiency occurs when the production of one good cannot be increased without curtailing
the production of the other good.
ii) Fixed resources: - The quantity and quality of economic resources (land, labour, capital, and
entrepreneurship) available for use are fixed for a given period of time.
iii) Fixed technology:- Technology is constant at least for a very short analytical period of time. Otherwise, it
would be unrealistic to rule out technological advances for a long period of time.
iv) Closed economy:- Assume that the economy is closed in which there are no imports and exports (there is no
international trade).
v) Two products:- To simplify matters, assume also that our economy is producing just two products say, guns
(military goods) and tractors (agricultural goods).
Table 1.1 Production Possibilities of guns and tractors with full employment

Types of Products Alternative Production Possibilities

A B C D E F
Guns (X) hundreds 0 10 20 30 40 50
100 90 75 55 30 0
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 Tractors (Y) hundreds

100

.w
Tractors (y) hundreds

80

60
.U
40

20
PPF
0 10 20 30 40 50
Guns (x) hundreds
Fig. 1.2. Production Possibility Frontier (PPF)

From Fig 1.2, the following crucial points are worth describing:
 Points inside the PPF in general and point U in particular are attainable, but inefficient because some
resources are idle and by putting them to work, an economy can have more of both guns and tractors.
 Points outside the PPF in general and point W in particular are superior to any points on the PPF, but they are
infeasible in the short-run.
This is so because technology is constant in our assumption for a short period of time. Moreover, resources
are fixed both qualitatively and quantitatively.
 All points on the PPF are equally attainable and efficient. That is, an efficient economy is on its production
possibility frontier. Being on the PPF means that producing more of one good inevitably implies sacrificing
some of the other goods. The PPF depicts the menu of society’s choice.
 At points such as B, C, D and E tractors are transformed into guns not physically, but by the alchemy of
diverting resources from one use to the other. That is, by converting the use of resources from the production
of tractors to that of guns, an economy can have more of guns and less of tractors. Thus, any increase in the
production of one product necessitates a shift of resources from one production to another, for resources are
limited and fully employed.
 In Fig. 1.2, if all resources are allocated to the production of guns, X max ,5000 guns could be produced (point
F). On the other hand, if all resources are devoted to the production of tractors, Y max, 10,000 tractors could be
produced (point A). These are two extreme possibilities. Alternatively, by mixing the allocation of resources
to the production of guns and tractors such as at points B,C,D,E (1000 guns and 9000 tractors, 2000 guns and
7500 tractors, 3000 guns and 5500 tractors, 4000 guns and 3000 tractors)could respectively be produced.
 At any point in time, a full employment and full production economy must sacrifice the production of one in
order to get more of another. Therefore, the limitation of scarce resources implies the guns – tractors trade –
off.
Fig 1.3 Effects of Unemployment and underemployment on the PPF
Y
Tractors (Y) Hundreds

100
80
60
40
20 PPF1 (2000)
PPF2 (2001)

0 10 20 30 40 50 X
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 Fig 1.4 Effects of Economic Growth on the PPF
Y
200

100
Tractors (Y) Hundreds

80

60

40
PPF1 (2000) PPF2 (2002)
20
0 10 20 30 40 50 150
Guns (x) Hundreds
Fig. 1.4. Effects of Economic Growth on the PPF
1.7. Opportunity cost
Life is full of choices. Because resources are scarce we are incessantly deciding which goods we want to
buy or which activities we will pursue. Choice implies cost because a decision to have more of one thing implies a
decision to have less of another.

The opportunity cost of a decision arises because choosing one thing in the world of scarcity means
giving up something else. Thus, the opportunity cost of using resources in one way is the value of the best
alternative to which they could have been employed. Thus, opportunity cost is the value of the best alternative
opportunities forgone in order to be able to pursue the first action. For instance, the opportunity cost of car could
be the nuclear bomb production that must be sacrificed. Algebraically, opportunity cost.
the amount sacrificed of one good
=
the amount obtained of the other good
Table 1.5. Production Possibilities of Tanks and Farming Oxen
Types of products Alternative production possibilities
A B C D E F
Tanks (X) Thousands 0 1 2 3 4 5
Farming oxen (Y) Hundreds 15 14 12 9 5 0

15

14
Farming Oxen (Y) Hundreds

12
9
5 PPF
1 2 3 4 5
0 Tanks (X) Thousands
Fig 1.6. Production possibility Frontier (PPF) and Opportunity Cost

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In Fig. 1.6, the condition of production indicated by the heavily drawn line connecting 15 hundreds of farming
oxen and 5 thousands of tanks shows that if a given quantity of resources is employed to produce tanks and
farming oxen, it can either produce 5 thousand of tanks and nothing of farming oxen, or 15 hundreds of farming
oxen and nothing of tanks, or any combination of tanks and farming oxen along the line.
This line shows that to produce tanks, the economy must forgo the opportunity of producing some of the farming
oxen. This is called the opportunity cost of tanks in terms of farming oxen.
From Fig. 1.6, what is the opportunity cost of tanks when its production increases from 2 thousand to 3
thousand?
Answer:
Opportunity cost of tanks (from C to D) = amount sacrificed of Farming oxen
amount obtained of Tanks
Y
=
X
900 F .oxen  1200 F .oxen
=
3000Tanks  2000Tanks
 300 F .oxen
=
1000Tanks
= 300 F. oxen
1000 Tanks
Thus, the opportunity cost of producing 1000 additional tanks is the 300 farming oxen forgone.
From the above production possibility frontier, compute the opportunity cost of farming oxen when its
production increases from 5 hundred to 9 hundred.
Answer:
Opportunity cost of farming oxen (from E to D) = amount sacrificed of Tanks
amount obtained of farming oxen
X
=
Y
3000Tanks  4000Tanks
=
900 F .oxen  500 F .oxen
 1000Tanks
=
400 F .oxen
= 1000 Tanks
400 F. oxen
Thus, the opportunity cost of producing 400 additional farming oxen is the 1000 tanks given up.
The PPF illustrates three important concepts: scarcity, Choice and opportunity cost. Scarcity is implied by the
unattainable combinations of the PPF. Choice is implied by the need to choose among attainable combinations
of both goods. Opportunity cost is implied by the downward sloping of the boundary, which means that getting
more of something (in this case more of tanks) unavoidably entails less of something else (less of farming oxen
in the above illustration). Thus, the downward sloping of the production possibility frontier (PPF) can be
reflected through the opportunity cost, which is the amount of one product sacrificed in order to obtain one
extra unit of the other product, keeping all other factors constant.

2. Basic Economic problems and Alternative Economic Systems

2.1. Basic Economic Problems
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 Every human society-whether industrially advanced or economically backward-confronts three fundamental
and interdependent economic problems. More specifically, the following three questions need to be considered in
the face of the unavoidable imbalance between the limited productive capacity and the limitless human material
wants.
1) What goods and services are produced and in what quantities?
This question is concerned with the allocation of scarce resources among alternative uses. Should the economy
produce more consumption goods and few investment goods or few consumption goods and many investment
goods? What quantities of consumption and investment goods should the economy produce? What mix of goods
should be produced?
2) How are goods and services produced?
That is, by what techniques of production should the inputs be combined to produce the desired output?
Inputs are services or factors of production such as land, labour, capital and entrepreneurship that are used by
firms in the production process. Output is an array of useful goods and services that comes out of the production
process, which is either consumed or used for further production.
3) For whom are goods and services produced and distributed?
This refers to the problem of who gets how much of what is produced in the economy. Stated differently,
how is the national product to be divided among different individuals and members of the society? Are we to have
a society in which few are rich and many poor? In short, who is to enjoy the benefits of the nation’s goods and
services? Basically, there is no society where all members of the society enjoy the fruits of production equally.
Alternative Economic Systems
Economic systems are sets of organizational arrangements and institutions that are established to solve
economic problems. Today there exists an array of economic systems in the world. The three economic problems
faced by societies are universal, but the solutions vary from economy to economy.
In general, we can identify four (4) types of economic system:
1) Economies run by customs (Traditional Economies)
Customs are long-established ways of doing certain things. In traditional economies, the methods of
doing things are repeated generation after generation as per the customs. Things are done in the same way they
were done in the past. The basic economic questions such as “What to produce?, How to produce?, For whom to
produce?, At what prices to sell?” are resolved by traditions or longstanding rules.
2) Market (Capitalist) Economy
The market mechanism is a form of economic organization in which individual consumers and businesses
interact to solve the three central economic problems. Market economy is a system in which the critical role of the
private sector in development is highly recognized. The three fundamental economic problems are addressed in
such a manner that firms produce those goods and services that give the highest profit (the what), by the
techniques of production that are least costly (the how), and incomes are distributed based on the ownership of
means of production (the for whom).
The Merits of Capitalist Economy
The presence of competition under market economy leads to productive efficiency since it encourages
producers to innovate thereby bringing about social progress and economic prosperity in the economy. This is
because the capitalist economy ensures the twin freedom of producers and consumers leading to the production of
quality products and lowering costs and prices.
The Demerits of Market Economy
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 There are circumstances under which the market mechanism can fail to achieve an efficient allocation of
resources. This is often called market failure. The following are the shortcomings (failures) of the market
economy.
A) The failure of the price mechanism in pricing public goods and externalities
i) Public goods are those goods and services that are non-rival and consumed equally by everyone regardless
of payment for them. Public goods are those that provide non-excludable and non-rival benefits to all
people in a given society. Streetlights, national defense, highway, hospitals and others are good instances of
public goods because they benefit all people whether they pay or not for them. For example, if there is an
apple and A eats it, then B can not have an apple. However, if there is a public park and A uses it, it does
not exclude B's using it. The park is, thus, a public good, and an apple is not (it is a private good). Non-
excludability means it is technically impossible or extremely costly to exclude any individual from the
benefits of a good. Non-rivalry means that there is no rivalry among the consumers because the enjoyment
of the good by any one person does not reduce its availability for others. Private provision of these public
goods may not occur because the benefits of the goods are so widely dispersed across the population that no
single firm or consumer has an economic incentive to provide them. As private provision of public goods
will generally be insufficient, government must step in to provide these goods.
ii) Externalities (external costs or external benefits) are costs or benefits of market transactions that are not
reflected in the prices buyers and sellers use to make their decisions. Externalities or spillover effects occur
when firms or people impose costs or bestow benefits on others without those others receiving the proper
payments or paying the proper costs.
Externalities in consumption and production can be classified into two: positive externalities (external benefits)
and negative externalities (external costs).
1) Positive externality in consumption:- An example of this is vaccination. It helps not only the person
vaccinated but also the entire neighborhood that the person lives in by preventing the spread of
contagious diseases.
2) Positive externality in production:- An often quoted example is that of the production of honey.
Beekeepers try to put their beehives on farms because the nectar from the plants increases the production
of honey. The farmers also receive advantages from the beehives because the bees aid pollination of the
plants.
3) Negative externality in consumption: - Suppose a person rides a noisy motor cycle. The rider gets an
enjoyment from it (usually the greater the noise, the greater the enjoyment). But for other people living in
the neighborhood, the noise is a nuisance.
4) Negative externality in production: - A good example is air pollution caused by an industry in a
neighboring area, which the market mechanism fails to correct. The neighboring people incur the cost,
which is not part of their concern. Another source of negative externality arises from the fact that a
chemical firm dumping waste into a river can increase production costs for fishermen.
B) Income inequality and poverty
If the ownership of means of production such as land and capital is concentrated in the hands of a few
wealthy individuals, the masses will become poor while an elite class will earn most of the income.

C) Fluctuations of prices and unemployment

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 The fluctuations of prices and unemployment level are inherent problems that result from lack of
coordination of decision making in the economy. In other words, unemployment and inflation are the
social evils of capitalist economy.
3) Command (Socialist) Economy
A command economy is one in which resource allocation is determined by governments commanding
individuals and firms to follow the state’s economic plans. The socialist economic system is characterized by
public property ownership (in the form of state and cooperatives) and strict control of enterprises. All decisions
pertaining to production of output, techniques of production, determination of prices and distribution of goods and
services are made by government through central planning. Unlike the capitalist economy, in the socialist
economy the prime motive is public interest (social welfare) rather than profit.
The socialist economy has had the following merits.
1) Greater social welfare due to wider job opportunities and lesser income inequalities
Income disparities in the society are corrected through proper adoption of economic policies and their
due implementation. To be specific, the income differences between various sections of the society result
mainly from the differences in skills and efficiency of the individuals.
2) Absence of business fluctuations:- prices are stable for a long period of time. Employment levels are also
more or less stable. Because prices are stable over a long time, consumers can make an adjustment to their
consumption pattern.
3) Absence of private monopolistic practice:-This means private individuals and business firms do not exercise
monopoly power to own and control economic activities. Monopoly power exists in an economic system
when a firm influences prices by varying the quantities it sells.
However, the socialist economy is not immune to (free from) criticism and one drawback of the command
economic system is that because of a complete centralization of economic power in central planning authority,
there is no possibility of rational economic calculation by producers and consumers. Thus, socialism discourages
creativity in the massive population because major economic decisions are made from above.
4) Mixed (Hybrid) Economy
Real world economies fall between the extremes of market (capitalist) economy and command (socialist)
economy. In the mixed (hybrid) economy, the provision of private and public goods and services exists at the
same time. The basic economic problems are resolved by a mixture of government decisions and market forces of
demand and supply. The private sector (where decisions are made mainly by firms and households) functions
through the price mechanism and the public sector (where decisions are mainly made by government) is planned
and controlled by the state. Most of the world economies are mixed economies at present.
2.3 Major Decision Making Units and the Circular Flow of Economic Activities

Production, distribution, exchange and consumption of goods and services constitute the major economic
activities of society. Every organized society follows certain general principles in carrying on these activities.

The agencies through which these economic activities are performed are called the units of decision-making. The
following are the decision- making units (economic agents) of the system:
a) Households:

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 A household may be defined as a single person, or a group of persons or a conventional family who
live under one roof and make joint economic decisions. Households are economic decision-making units who
provide the economy with resources (in the resources market) and use the money paid for these resources to
purchase goods and services (in the product market) to satisfy their wants.
They are owners of resources such as land, labour, capital and entrepreneurship and they make decisions on
how to sell their resources to firms and government. Thus, households make sales decisions with regard to
selling productive factors and purchase decisions as regards purchasing material goods and services.
b) Business firms:
Business firms are decision-making units responsible for the employment of factors of production and the
production and sales of goods and services. Business firms make economic decisions on buying resources from
households in order to produce goods and services and selling their products to households and government. Thus,
firms make sales decisions relating to the sales of goods and services and purchase decisions relating to the
purchase of productive factors.
c) Government:
Government is an organization that has legal and political power to exert control over individuals,
business firms and markets. Government provides public goods and services such as national defense, public
health, streetlight and other infrastructure facilities and all these are financed through compulsory charges called
taxes.
Note that business firms and households are the major decision-making units in a simple model economy
in which the interplay of demand and supply plays the major (pivotal) role. In the modern economy, however,
the decision-making units are households, business firms and government.
To illustrate the interaction between households and business firm using the circular flow model:
a) Assume that the model is a closed system in which all incomes circulate between households and business
firms.
b) Assume also that we use two sectors model (households and business firms) as decision-making units.

Expenditure of firms Incomes of resource owners

Resources (Wage, Rent, Interest, Profit
Market
Resources Flow of resources

Households
Business Firms

Flow of goods & services Goods & services

Products Market Consumption Expenditure

Revenue of firms

Fig. 2.1 Two sectors model of a market economy

It is easy to comprehend from the bottom part of the simple model of the market economy that there are two
main flows in the economy. The first is called the real flow and it is the flow of goods and services from sellers
(business firms) to buyers (households). The second flow is called the money flow and it is the flow of money
payments from buyers (households) to sellers (business firms). These money payments become the money
incomes received by sellers.

10
 Products
market

Unemployment Benefits Subsidies

Taxes
Business
Taxes
Households Government
Firms
Government Services

Government Services

Resources
Market

Other things being the same as in the two sectors model, when government intervention becomes apparent the
circular flow model can be displayed as follows:
1) In the products market, goods and services flow from business firms to government and government
incurs consumption expenditure to business firms. Thus, government is also a consuming unit.
2) In the resources market, resources such as labour, land, capital and entrepreneurship flow from
households (resource owners) to government and government, in turn, makes factor payments to
households.
3) Government, being the sole provider of public goods, renders unemployment benefits and government
services to households and in turn collects taxes from them. Similarly, government grants subsidies and
renders government services to business firms and in turn collects taxes from them. A subsidy is a direct
or an indirect payment by a government to its country’s firms to make investing or selling abroad cheaper
for them and thus more profitable.
Fig. 2.2. Three sectors model of the Market Economy

3. MICROECONOMICS
11
 3.1. The Theory of Demand
There are two main forces that determine the price of a commodity in a market: demand and supply. The
actual price of the commodity is determined by the intensity with which potential buyers and potential sellers
operate in the market.
The theory of demand is concerned with the influence that potential buyers exert on price. The behavior of
potential buyers in a market is called demand and the amount of a commodity that buyers are willing and able to
purchase at a certain price in a given period of time, keeping all other influences constant, is called quantity
demanded. Demand exists only if someone is willing and able to pay for a good-that is, exchange dollars for a
good or service in the marketplace. Note that demand is an expression of consumer buying intentions – not a
statement of actual purchases. The phrase ‘ceteris paribus’ actually means that all other variables except the one
under consideration are assumed to be held constant.
Two fundamental assumptions we will make in learning the theory of demand are
i. Rational Behaviour:- Individuals are assumed to be rational: they know what is best for them and pursue what
is in their best self-interest.
ii. Consumer Sovereignty: Individuals make their decisions freely and that there is no coercion. They know what
is at stake. This rules out the Enlightened Ruler Principle of Governance-the government can make better
decisions for the populace than the populace themselves.
The most important factors, which influence an individual consumer’s demand for a commodity (d A) are:
a) The price of own commodity (PA)
If the price of a commodity rises, ceteris paribus, the quantity demanded of that commodity falls; if
the price of a commodity declines, all other factors being kept constant, the quantity demanded of that
commodity increases.
b) The price of substitutes (PS)
Any two or more commodities that satisfy similar needs or desires are known as substitute
commodities or substitutes. When two commodities are substitutes, an increase in the price of one
good causes an increase in the demand for another good. For example, chicken and beef, white teff
and red teff, coffee and tea and coca-cola and Pepsi-cola are substitute goods. If the price of white teff
falls, with constant price of red teff, demand for red teff falls and the vice-versa. Similarly, if the price
of coffee declines, the price of tea being the same, the demand for tea decreases, and the vice-versa.
In general, there exists a positive relationship between the price of a good and the demand for its
substitute or the price of substitute good and the demand for a commodity under consideration. It is
also essential to note that substitute goods need not be identical since identical products are called
perfect substitutes.
c) The Price of Complements (PC)
Complementary goods (complements) are any two or more goods, which go together and are used in
tandem. This means that the use of one commodity immediately necessitates the use of the other.
When commodities are complements, a decrease in the price of one commodity causes an increase in
the demand for another good and an increase in the price of a commodity results in a decrease in the
demand for the other. Film and camera, tea-leaves and sugar, gasoline and automobiles are good
examples of complements.

d) Change in household income and Wealth (I)

12
 An increase in consumer’s money income increases the demand for most goods whereas a fall in
consumer’s income tends to reduce the demand for these goods. In some instances, however, an
increase in consumer’s money income may decrease the demand for some commodities.
Commodities whose demand goes up when income is higher and whose demand goes down when
income is lower are called superior goods (normal goods). On the other hand, commodities whose
demand declines when income rises and whose demand goes up as income decreases are called
inferior goods (example; used clothes or second-hand products).
e) Consumer's tastes and Preferences (T)
A change in consumer’s tastes and preferences is more likely prompted by advertising or fashion
changes. For instance, the demand for fashioned goods increases, but with the passage of time, such
goods would be less preferred. In a nutshell, if the change in consumer’s tastes or preferences is
favorable to a product, the demand for the product at each price increases, ceteris paribus. On the
other hand, if the change in tastes is unfavorable to (away from) the product, the demand for the
product decreases.
f) Consumer’s expectation about future price change (E)
People may have expectation about future price changes and these may affect their decisions at
present. For instance, if they anticipate price for a given product to increase in the future, they buy
more of the product now to avert higher prices in the future.
In general, expectation of future price rise increases current demand for a commodity and expectation
of future price fall reduces current demand for it.

Therefore, the aforementioned determinants of demand can be expressed in a demand function using
mathematical form (* a function is a relationship between two or more variables) as follows:
dA = f(PA, PS, PC, I, T,E)

Table 3.1. An individual consumer’s demand schedule for commodity A

Price of commodity A (PA) Quantity demanded of commodity A (QA)
(Birr per unit) (Units Per Year)
10 40
9 50
8 60
7 70
6 80
5 90
4 100

Demand schedule can be represented most conveniently by a graph. The graphic representation or
depiction of the demand schedule is called an individual consumer’s demand curve. From the above demand
schedule, it is possible to draw the following demand curve of the commodity for an individual consumer.

13
 d
9
Price of commodity A (PA)

7
6

5
4
d
0 40 50 60 70 80 90 100

Quantity demanded of commodity A (QA)

Fig. 3.2. An individual consumer’s demand curve
The demand curve in Fig. 3.2 has only two dimensions: quantity demanded (on the horizontal – axis) and price
(on the vertical – axis). The demand curve slopes downwards from left to right exhibiting the negative or inverse
relationship between the price of commodity A and the quantity of demanded of commodity A. This important
property is called the law of demand. Thus, the law of demand states that the higher the price, ceteris paribus, the
lower the quantity demanded and the vice-versa.
Change in Quantity Demanded and Change in Demand
d"
Price d
Price d

P1 d'
e

f d d"
P2 d d
0 q1 q2 Quantity
Quantity demanded
Fig. 3.3. Movement along a demand curve Fig. 3.4. Shifts of a demand curve
In short, movement along a demand curve is a response to changes in price of own commodity whereas
shifts of the demand curve occur when the determinants of demand change (change in the price of substitutes,
change in the price of complements, change in consumer’s income, change in consumer’s tastes and consumer’s
anticipation about future price).
Market Demand
The market demand for a commodity is the sum total of all individual consumers demand for that
commodity. The market demand curve is derived by lateral summation of individual demand curves in the market
n
at alternative prices, during a given period of time. Mathematically, DM=  di where n= number of individual
i 1

consumers
The individual demand curves and the total market demand curve in the above numerical example can be
portrayed as follows:

Price Price Price

d1 14
 d2 4 d3
4 4
3
3 3

2 2 2
d1
d2
1 1 1 d3

0 1 2 3 4 0 1 2 3 4 0 1 2 3 4 5
Quantity Quantity Quantity
Demanded Demanded Demanded

Fig. 3.5. First consumer’s Fig. 3.6. Second consumer’s Fig. 3.7. Third consumer’s
demand curve demand curve demand curve

Price D
4

2
D
1

0 2 4 6 8 10 12
Quantity Demanded
Fig. 3.8. Market Demand Curve
3.2 The Theory of Supply
Economic theory also deals with the behaviour of sellers (business firms) that supply output in the market. In the
theory of supply, supply is the relationship between the price of an item and the quantity supplied by sellers, given
all other influences whereas quantity supplied (the amount of a commodity sold in the market) refers to the
quantity of a particular commodity that a firm (seller) is willing and able to offer for sale at alternative prices,
during a given period of time. Thus, like demand, supply is a relationship but not a fixed quantity.
The most decisive factors which affect an individual seller’s supply of a commodity (s A) are:
a) The price of the commodity itself (P A); If the price of a commodity goes up, ceteris paribus, the quantity
supplied of the commodity increases, and if the price of the commodity falls, all other factors being held
constant, the quantity supplied of the commodity declines.
b) The Price of Substitutes (PS); An increase in the price of a product reduces the supply of its substitutes and an
increase in the price of substitutes reduces the supply of a commodity under consideration, keeping all
other factors constant. In a similar manner, a fall in the price of a commodity raises the supply of its
substitutes and a decrease in the price of substitutes increases the supply of a commodity in question,
ceteris paribus. For example, an increase in the price of coca-cola, with constant price of Pepsi-cola

15
 would lead to a decrease in the supply of Pepsi-cola, and a fall in the price of Coca-cola, the price of
Pepsi-cola remaining the same, would bring about an increase in the supply of the latter.
On the whole, there exists an inverse relationship between the price of a commodity and the supply of its
substitutes or the price of a substitute commodity and the supply of the commodity under consideration.
c) The price of Complements (Pc)
A rise in the price of complements increases the supply of an alternative good and a fall in the price of
complements reduces the supply of the alternative good, keeping other factors constant.
For instance, when the price of car rises, the price of petrol being unaltered, the supply of petrol rises and
a fall in the price of car, the price of petrol being the same, would cause the supply of petrol to decline.
In general, there lies a +ve correlation b/n the price of a commodity and the supply of its complements or
the price of complements and the supply of an alternative product, holding others constant.
d) The cost of production (C)
If resource prices change, the supply of goods produced changes, too. For instance, a reduction in the
price of land and fertilizer will tend to increase the supply of corn. Similarly, if technology (the
knowledge that people have about how different things can be produced) improves, more goods can be
produced from the same resources. Thus, the supply of a commodity for an individual seller mainly
depends on the cost of production, which, in turn, depends on the prices of inputs and technological use.
If input prices are low and/ or the state of technology is advanced, the supply of a product increases. If
factor prices are high and/ or the state of technology is deteriorating, however, the supply of the
commodity falls.
e) Seller’s expectation about future price change (E)
What motivate business people for production are not only the current prices but also the anticipated
future prices. Businesses plan their production on what they expect prices to be. For instance, oil
producers might withhold some of their current oil to have more available for the future if they anticipate
oil price rise in the future. In general, expectation of future price rise induces business firms to produce
more and hence future supply will increase. But, if business people anticipate the price of a commodity to
fall, future supply will decline.
f) Taxes and Subsidies (TS)
Since most taxes are treated as costs by business firms, an increase in property or sales taxes will increase
the cost of production and reduce supply. Conversely, “subsidies are taxes in reverse”. If government
subsidizes the production of a product, it in effect lowers costs and increases supply.
The foregoing determinants of supply can be expressed in supply function using a mathematical form as:
SA= f(PA, PS, PC, C, E, TS)
This states that an individual seller’s supply of a commodity is a function of all factors in the parenthesis.
Assuming that all factors except the price of the commodity itself are held constant, an individual
seller’s supply of a commodity depends on its price. By varying the price of the commodity in question,
we get an individual seller’s supply schedule for the commodity.
A supply schedule is a table, which presents a positive relationship between the price of the commodity
and the quantity supplied of the commodity, during a specified period of time. In other words, a supply
schedule is a tabular expression of price-quantity supplied relationship.

16
 Tabele 3.9. An individual seller’s supply schedule for oil
Price of oil Quantity supplied of oil
(Birr/ litre) (litre/Month)
10 60
9 50
8 40
7 30
6 20
5 10
The price-quantity information of the supply schedule can also be conveniently represented by means of a
graph. Thus, the graphic representation of the supply schedule is called a supply curve for an individual
seller. Supply curves are upward sloping to the right whereas demand curves are downward sloping to
the right. Note that supply curve is the graphical counterpart of supply schedule.

10 s
9
8
Price per liter

7
6
5
0 10 20 30 40 50 60
Quantity Supplied (Units/month)
Fig. 3.10 An individual seller’s supply curve for oil
The supply curve slopes upwards from left to right reflecting a positive correlation between the price of a
commodity and the quantity supplied of that commodity. This important property is called the law of supply. The
law of supply that parallels the law of demand, states that larger quantities will be offered for sale at higher prices
and lower quantities will be sold at lower prices, ceteris paribus.
Change in Quantity Supplied and Change in Supply

s S'
P5 e
Price of commodity X (Px)
Price of commodity X (Px)

P4 d

P3 c S’

P2 b S'

P1 a
s S S
S"
S”

0 Q1 Q2 Q3 Q4 Q5 Quantity supplied of X Quantity

Fig. 3.1 Movement along a supply curve Fig. 3.12. Shifts of a supply curve

17
When only the price of the commodity itself changes and other determinants of supply (supply shifters) remain
intact, quantity supplied also changes. But the movement is along the same supply curve. Such a movement along
the same supply curve, which is triggered by the change in the price of the commodity itself, is called change in
quantity supplied (Fig. 3.11). On the contrary, if non-price determinants of supply except the price of the
commodity itself change, the supply curve shifts its position either to the left or to the right (Fig. 3.12.). If the
supply curve shifts to the right (s” s”), supply increases; if it shifts to the left (s’ s’), supply decreases. This kind of
shift in the position of the supply curve due to changes in other determinants of supply (except the price of own
commodity) is called change in supply. Thus, while movement along the supply curve is the result of change in
own price, shifts of a supply curve are brought about by changes in non-price factors (supply shifters).
Market Supply
The market supply of a commodity is the sum total of all individual sellers supply for that commodity. A
market supply curve is derived by a lateral summation of all individual sellers supply curves for each commodity
n
at each specific price, during a given period of time Mathematically, S M=  Si .Thus, the market supply of a
i 1

commodity depends on the number of sellers. For instance, because of high profits or in anticipation of high
profits, more sellers enter the production of a particular good and hence the supply of the good will increase. But,
with expectation of low profits or because of low profits, a small number of sellers engage in the production of a
particular product and hence supply will decline.
3.3. Market Equilibrium
A market, in plain language, is an arrangement wherein buyers and sellers of a commodity interact to
determine its price and quantity. Put differently, a market is an institution in which buyers and sellers are brought
into close contact for purposes of engaging in exchange.
Geometrically, equilibrium occurs at the point of intersection between the commodity’s market supply
curve and market demand curve. The price and quantity at which market equilibrium exists are respectively called
equilibrium price and equilibrium quantity. It is crucial to make a note that an equilibrium does not imply that
everyone is happy with the prevailing price or quantity. But, the equilibrium price and quantity reflect a
compromise between buyers and sellers. No other compromise yields a quantity demanded that is exactly equal to
the quantity supplied. At any price other than the equilibrium price, however, there will be either excess demand
or excess supply in the market and that is a situation of disequilibrium. Thus, whenever the market price is set
below or above the equilibrium price, either a market surplus or a market shortage will emerge.
Excess demand (shortage) is the condition that occurs when the price of the commodity is below the
equilibrium price as a result of which the quantity demanded surpasses the quantity supplied (Q D>QS), during a
given period of time. On the other hand, excess supply (surplus) is the condition that takes place when the price of
the commodity is above the market clearing price as the outcome of which the quantity supplied exceeds the
quantity demanded (QS>QD) during a given period of time. Thus, the prevalence of surplus or shortage of a
commodity in the market is a characteristic of disequilibrium condition.
A clear distinction has to be made between shortage and scarcity though the two notions imply lack of abundance.
Shortage is a situation in which the quantity demanded outweighs the quantity supplied at a price below the
market-clearing price. But, scarcity is more comprehensive that refers to a situation in which inputs or factors of
production are not adequate to produce goods and services to satisfy people’s material wants. Even though we live
in a world of scarcity, we do not necessarily live in a world of shortage. Thus, shortage is not synonymous with
scarcity.

18
 ILLUSTRATION ON MARKET EQUILIBRIUM

Suppose that there are 250 identical individual consumers in the market for commodity X, each with a demand
function given by dx = 6-Px and 50 identical producers of commodity X, each with a supply function given by s x
=5Px. Then,
a) derive the market demand function and the market supply function for commodity X.
b) compute the market equilibrium price and equilibrium quantity mathematically.
c) tabulate the market demand schedule and the market supply schedule for commodity X.
d) plot on the same set of axes, the market demand curve and the market supply curve for commodity X and
indicate the equilibrium point.
e) show whether surplus or shortage occurs at
i) P=2
ii) P=5
SOLUTIONS FOR THE ILLUSTRATION
a) market demand function = Dx = 250 (6-Px) = 1500 – 250 Px
market supply function = Sx = 50 (5Px) = 250 Px
b) At equilibrium, Dx = 1500 - 250 Px
D x = Sx = 1500-250 (3)
1500 – 250 Px = 250 Px = 1500 – 750
1500 = 250 Px + 250Px = 750 (Equilibrium quantity)
1500 = 500Px Sx = 250Px

Px = 1500 = 250 (3)

500 = 750 (Equilibrium quantity)
Px = 3.00 (Equilibrium Price)
c) Market demand curve and Market supply curve

D
6
S
Price of commodity X

5 ________Surplus _________

4
Equilibrium point
E
3

2 _______ Shortage ________

1
S D

0 250 500 750 1000 1250 1500

Quantity of X
Fig. 3.14 Market demand curve and market supply curve

d) i) At P= 2,
Dx = 1500 –250 (2) Sx = 250 (2)
= 1500- 500 = 500

19
 = 1000
Since Dx > Sx, shortage occurs with excess demand of 500 (i.e. 1,000 - 500 = 500).

ii) At P = 4,
Dx = 1,500 - 250(4) Sx = 250(4)
= 1,500 - 1000 = 1000
= 500
Since Sx > Dx, surplus occurs with excess supply of 500 (i.e. 1,000 - 500 = 500).
3.4A/ Effect of shifts in demand and supply on Equilibrium
Previously, it was brought to the kind attention of the learners that demand and supply may change in response to
the non-price determinants (shifting factors). In other words, demand and supply curves shift only when their
underlying determinants change, i.e. when ceteris paribus is violated. When either demand or supply or both
change owing to changes in any one of their determinants, the market equilibrium price and quantity in different
ways. The effect of shifts in demand and supply on equilibrium can be portrayed as follows:
D2
So
Do
Price of commodity X (Px)

P1 E2

PoD1 E0

D2

P1 E1
S0
Do
D1

0 Q1 Q0 Q2 Quantity of Commodity X

Fig. 3.15 Effect of shifts in demand on Equilibrium

In Fig. 3.15, if demand curve shifts outwards to the right (from D o Do to D2 D2), both equilibrium price and
equilibrium quantity increase. Equilibrium price increases from Po to P 2 and equilibrium quantity rises from Qo to
Q2. Equilibrium point changes from E o to E2. On the contrary, if demand curve shifts inwards to the left (from D o
Do to D1 D1), both equilibrium price and equilibrium quantity decline. Equilibrium price falls from Po to P 1
whereas equilibrium quantity drops from Qo to Q1. Equilibrium point declines from Eo to E1.
In a nutshell, other things being equal, an increase in demand has a price-increasing and quantity
increasing effect whereas a decrease in demand will have a price-decreasing and quantity-decreasing effect.
Thus, there exists a positive correlation between change in demand and the resulting change in equilibrium price
and equilibrium quantity.

20
 1. Effect of shifts in supply (assuming demand is constant)

S1
So
P1 E1
S2
Po Eo

E2
P2

So S2

S01 Q1 Qo Q2 Quantity of commodity X

In Fig. 3.16, if supply curve shifts outwards to the right (from S o So to S2 S2), equilibrium price decreases from P o
to P2, but equilibrium quantity increases from Q o to Q2. On the other hand, if supply curve shifts to the left (from
So So to S1 S1) equilibrium price increases from Po to P1, but equilibrium quantity deceases from Qo to Q1.
By and large, there is an inverse relationship between change in supply and the resulting change in equilibrium
price. However, the relationship between change in supply and the resulting change in equilibrium quantity is
direct.
3.4 B/ Effect of Government Economic Policies on Equilibrium
True enough, government economic policies exert an influence on both equilibrium price and equilibrium
quantity. The effect of government economic polices can be brought out hereunder:
A) Price floors: A price floor is a legal minimum price, which is set up above the equilibrium price leading to
surplus of a commodity. Price floors fixed above the equilibrium price would have the following
consequences:
a. Price floors bring about excess supply (surplus) because sellers cannot easily find enough buyers to
clear the market.
b. The surplus, because of minimum price fixation by law, will create storage and income problems to the
producers.
B) Price ceilings: A price ceiling is a legal maximum price, which is established below the equilibrium price
resulting in the shortage of a commodity. If government imposes price ceilings, price is
not legally permissible to increase above the fixed price. Price ceilings would have the
following consequences:

(i) There are usually persistent shortage of goods and services whose prices are controlled as
a result of price ceilings. Moreover, prices do not perform the market system since
shortage causes a problem of allocating the limited goods and services among buyers.
(ii) Price ceilings would bring about illegal or black market operations in the supply of goods
and services. Since there would be some individuals who are willing and able to pay
prices above the controlled price and in response to such a potential market, illegal
(black) markets will develop. Definitely, the prices charged on black markets are higher
than those found in a free market.

21
 (iii) Investment in industries generally dries up because price ceiling rescues the potential
returns that investors earn from their economic activities. This means that less capital will
be invested in industries due to the price control.
In summary, price ceilings have three predictable effects; they
 Increase the quantity demanded.
 Decrease the quantity supplied.
 Create a market shortage.
C) Subsidy: A subsidy is a direct or an indirect payment by a government to its country's firms to make selling
or investment cheaper and more profitable for them. If a government grants a per unit cash subsidy to
producers of goods and services, the outcome would be:
(i) supply will increase over and above the market equilibrium quantity (i.e the supply curve shifts
outwards to the right);
(ii) price will fall below the equilibrium price.
D) Taxation: tax is a compulsory levy imposed by government on the people inhabiting a country for the
support of government services. By collecting taxes, the government raises income to finance its budget. If
the government collects taxes per unit of output, the supply curve shifts inwards to the left triggering
(i) an increase in the price above the equilibrium price (a leftward shift of the supply curve)
(ii) a decline in supply below the market equilibrium quantity (a leftward shift of the supply curve).

3.5. ELASTICITY – MEASURE OF RESONSIVENESS

Generally speaking, whenever the price of a certain commodity goes up, the quantity demanded of the
commodity goes down, keeping all other determinants of demand intact. This is what we call the law of demand.
But, the law of demand does not tell the extent or degree to which the increase in the price of a commodity would
cause the quantity demanded of the commodity to decline.

The degree of responsiveness or sensitiveness of quantities exchanged (quantities bought and sold) to the
change in various variables is called elasticity. In general, elasticity measures the responsiveness or sensitiveness
of consumers and sellers to changes in various variables such as price and income and time. The greater the
degree of responsiveness, the larger the size of elasticity; and the smaller the degree of sensitiveness; the smaller
the size of elasticity.
There are four (4) different elasticities:
1) Price elasticity of demand (Ed)
The price elasticity of demand (Ed) measures the responsiveness of quantity demanded of a commodity to
changes in its price, other things being equal. The price elasticity of demand (E d) at any point on the demand
curve is defined as the percentage change in quantity demanded as a result of the percentage change in own price.
Mathematically,
Price elasticity of = Percentage change in quantity demanded of X
Demand (Ed) Percentage change in price of X
Ed = % change in Qx
% change in Px
= Q2 – Q1 X 100
Q1
P2 – P1 X 100
P1
= rQ ÷ rP
Q1 P1
= rQ X P1
Q1 rP

Where:
Ed = -rQ x P1
rQ = Change in quantity demanded
rP Q1
22
 rP = Change in Price
Q1 = Original quantity demanded
P1 = Original price
The above formula is known as the point elasticity of demand. This is because it measures the price elasticity of
demand at a given point on the demand curve.
Elasticity can also be measured between two points on the demand curve. The measure of elasticity of demand
between any two finite points on the demand curve is known as arc elasticity of demand (average elasticity of
demand).
Arc elasticity of demand can be mathematically expressed as:
Arc = -rQ x (P1 + P2)
Ed rP 2

(Q1 + Q2)
2
Arc Ed = rQ x P1+ P2
rP Q1 +Q2

Where:
P1 and Q1 represent the original price and quantity respectively and P 2 and Q2 represent the new price and quantity
respectively.
The coefficients of elasticity (numerical value) of demand which refer to the proportionate change in the
dependent variable divided by the proportionate change in the independent variable can range from zero to
infinity which can be categorized and illustrated as follows:
(i) When the price elasticity of demand is greater than unity, demand is elastic (E d > 1). To state it
differently, demand is said to be elastic if a given percentage change in price results in a larger
percentage change in quantity demanded.
Example:- a) If a two percent change in price causes a three percent change in quantity demanded of a
3%
commodity, demand is elastic (Ed = = 1.5)
2%
b) If a 5% decline in price results in (is accompanied by) a 6% increase in quantity demanded, demand
is elastic (Ed = 6% = 1.2)
5%
The demand curve for elastic demand is flatter.
P

d
0 Q

Note that most luxury goods are demand elastic because a change in the price of luxury goods would cause the
demand to respond more highly to the change in the price of these goods.
ii) When the price elasticity of demand is less than one, demand is inelastic (E d< 1). This means a given percent
change in price is accompanied by a relatively smaller percentage change in quantity demanded.
Example a) If a 3% change in price brings about a 2% change in quantity demanded, demand is inelastic (Ed =
2%
= 0.67)
3%

23
 b) If a 4 increase in price causes a 2% decrease in quantity demanded, demand is inelastic (E d = 2% =
0.50).
4%
Most essential commodities or necessities are demand inelastic and their demand curve is usually steeper because
the quantity demanded of necessities doesn’t respond significantly to the change in the prices of same. Hence, the
coefficient of elasticity for necessities can be expressed as o< E d <1.

Price

d
0 Q Quantity
iii) When the price elasticity of demand is equal to unity, demand is unitary elastic (E d = 1). This means quantity
demanded changes by exactly the same percent as price does.
Example: a) If a 4% change in price leads to a 4% change in quantity demanded, demand is unitary elastic ( i.e.
Ed = 4% = 1).
4%
b) When a 10% drop in price leads to a 10% increase in quantity demanded, demand is said to be
10%
unitary elastic (Ed = = 1).
10%
The rectangular hyperbola reflects the shape of the unitary elastic demand curve and its price elasticity of demand
is equal to one. That is,
Px
d

0 Q Qx
iii) When the price elasticity of demand is equal to zero, demand is perfectly inelastic ( E d = 0).
This is a situation in which the quantity demanded of a certain product is invariable relative
to a change in price. The demand curve for perfectly inelastic demand is a vertical line drawn
parallel to the price axis. This shows that quantity demanded does not respond to price
change.

Px

24

d(Ed = 0)
 0 rQ = 0 Qx

Typical examples of a perfectly inelastic demand are an acute diabetic patient’s demand for insulin or an addicted
person’s demand for heroin.
V) When the price elasticity of demand is equal to infinity, demand is perfectly elastic (E d =  ). This
indicates that a one-percentage change in price results in infinite change in quantity demanded. A demand
curve of infinite elasticity means that a small price reduction would embolden consumers to buy any
desired quantities of the commodity at this price, while at an even slightly higher prices they would buy
none. The demand curve for a perfectly elastic demand is a horizontal line drawn parallel to the quantity
axis.
Px

d(Ed= )

0
Qx
2) Price Elasticity of Supply (Es)
The price elasticity of supply measures the responsiveness of quantity supplied of a commodity to
changes in the price of the commodity, other things being constant. More specifically, the price elasticity of
supply (Es) at any given point on the supply curve can be expressed as a given percentage change in the quantity
supplied of a commodity as a result of a given percentage change in the price of the commodity, ceteris paribus.
Mathematically,
Price elasticity of = Percentage change in quantity supplied of X
Supply (Es) Percentage change in price of x
= %change in Qx
%change in Px
Q2  Q1
100
Es  Q 1
P2  P1
X 100
P1
Es = rQ ¸ rP
Q1 P1
Es = rQ X P1
rP Q1

25
The coefficient of the price elasticity of supply may vary from zero to infinity, which can be categorized and
interpreted as follows:
i) If the price elasticity of supply is greater than one, supply is price elastic (E s>1). This means that for any price
change, there will be a more than proportionate change in quantity supplied of a commodity.
Example: a) If a 3% change in the price of a commodity brings about a 4% change in quantity supplied of the
commodity, supply is price elastic
4%
(Es = = 1.33).
3%

b) If a 2% increase in the price of a certain product triggers a 3% increase in the quantity supplied of the
commodity, ceteris paribus, supply is price elastic (Es = 3%/2% = 1.2).
ii) If the price elasticity of supply is less than unity, supply is price inelastic (E s<1). This implies that for any
price change, there will be a less than proportionate change in the quantity supplied of the commodity,
everything being equal.
Example: a) If a 4% change in the price of a commodity causes a 3% change in the quantity supplied of the
commodity, supply is price inelastic
3%
(Es = = 0.75).
4%

b) If a 5% decline in the price of a commodity is accompanied by a 4% decrease in the quantity

4%
supplied of the commodity, supply is price inelastic (Es = = 0.80)
5%

iii) If the price elasticity of supply is exactly unity, supply is unitary elastic (E s = 1). This means a given
percentage change in the price of a commodity would cause a proportionate change in the quantity supplied
of the commodity. Any straight-line supply curve passing through the origin has unitary elasticity
throughout its length, regardless of its slope. Thus, for a unitary elastic supply curve, Es = 1.

Px
S

S Qx
0
Example:
a) If a 3% change in the price of a commodity is accompanied by a 3% change in the quantity supplied
of the commodity, supply is unitary elastic.
b) If a 6% drop in the price of a commodity causes a 6% decline in the quantity supplied of the
commodity, supply is unitary elastic.

iV) If the price elasticity of supply is exactly zero, supply is perfectly inelastic (E s = 0). This means quantity
supplied does not respond to price change and the supply curve will be vertical drawn parallel to the price
axis.

26
Px

Es = 

0 rQx = 0 Qx

v) If the price elasticity of supply is infinity, supply is perfectly elastic (E s =  ). This means an infinite quantity
of a commodity is supplied at the prevailing price and nothing will be supplied at an even slightly lower
prices than the ruling price. For a perfectly elastic supply, the supply curve is a horizontal line drawn
parallel to the quantity axis.

Px

S (Es = )

0 Qx

3) Cross (price) elasticity of demand (Exy)

The cross elasticity of demand (Exy) measures the responsiveness of quantity demanded of commodity X as a
result of change in the price of commodity Y. Mathematically,

Cross elasticity of = Percentage change in quantity demanded of X

Demand (Exy) Percentage change in price of Y
= % change in Qx
% change in Py
Q x2  Q x1
Q x1

PY2  PY1
PY1
Q x PY1
E xY  
PY Q x1
The numerical value of the cross elasticity of demand (E xy) can be negative, positive or zero depending on
the degree of substitutability or complementarity between two goods which can be categorized and interpreted as
follows:

a) Substitute Commodities: If the cross elasticity of demand (E xy) is positive –that is, if the quantity demanded
of commodity X varies directly with the change in the price of commodity Y, then X and Y are substitute
commodities. The larger the positive coefficient, the greater the degree of substitutability between X and Y.

27
 For instance, an increase in the price of butter (Y) would encourage consumers to purchase more of oil
(X). Likewise, a rise in the price of white teff (Y) would embolden consumers to raise their purchases of red teff
(X). Thus, Exy = +ve.
b) Complementary Commodities: Because complementary goods go together – that is, the consumption of one
good necessitates the consumption of the other good, the cross elasticity of demand for these goods turns out to be
negative. The larger the negative coefficient, the greater the degree of complementarity between X and Y.

For example, an increase in the price of camera (Y) would reduce the quantity of film purchased (X). Thus, E xy =
-ve.
c) Independent (unrelated) Commodities:
If the cross elasticity of demand for two commodities X and Y (E xy) is zero, the commodities are independent or
unrelated. For example, a change in the price of sugar (Y) would have no impact on the quantity demanded of
coca-cola (X). Thus, Exy = 0
In summary, substitute commodities have positive cross elasticities (E xy>0) and complementary
commodities have negative cross elacticities (E xy<0). But, independent (unrelated) commodities have zero cross
elasticity (Exy = 0 ).
4) Income Elasticity of Demand (E1)
Income elasticity of demand measures the responsiveness of quantity demanded of a commodity for an individual
consumer to the change in the income of the consumer. The income elasticity of demand (E 1) is expressed as a
percentage change in quantity demanded of a commodity divided by a percentage change in income, ceteris
paribus.
Mathematically,
Income elasticity = Percentage change in quantity demanded
Of demand (EI) Percentage change in income
EI = % change in Q
% change in I
For most goods a rise in income leads to increase in demand and the income elasticity of demand for
these goods will be positive. These types of goods are said to be normal goods. For inferior goods, demand
(consumption) decreases in response to an increase in income. Thus, the income elasticity of demand for inferior
goods is negative. This is so because when the income of the consumer increases, he/she substitutes the superior
goods for the inferior ones.
On the whole, the income elasticity of demand for most commodities varies as income changes depending on the
nature of the commodity. If the income elasticity of demand (E I) is negative, the commodity is inferior. If the
income elasticity of demand (EI) is positive, the commodity is normal (either luxury or necessity). A normal good
is usually a luxury if EI > 1, and a necessity if 0<EI<1.
Depending on the level of income, the income elasticity of demand (E I) for a commodity is likely to vary
considerably. Thus, a commodity may be a luxury at low level of income; a necessity at intermediate level of
income; and inferior at high level of income.

4. THEORY OF PRODUCTION AND COSTS

4.1 Theory of production

28
Technically defined, production is the process of transforming factors of production (inputs) into output.
Inputs are the physical, human, material, financial, and information resources that enter the transformation
process. Transformation process comprises the technologies used to convert inputs into output.
If we take a university as a production process, transformation process includes technologies such as lectures,
reading assignments, laboratory experiments, term papers and tests/ examinations. Inputs at the university
comprise students, faculty, building, etc. Graduating students from universities are regarded as output.
Inputs are classified into fixed inputs, the supply (quantity) of which cannot be changed over a short period of
time and variable inputs, the quantity of which can be varied in the short-run. The most important fixed
inputs in the short-run are land and capital whereas labour and raw materials are instances of variable inputs
in the short-run. Output is defined as any final good or service that comes out of the production process.
Thus, the description of the technical relationship between inputs and output is called production function.
Stated differently, production function describes the combination of inputs and the maximum attainable
output that can be produced using that combination of inputs. Production function is defined for a given
technology because as technology improves the maximum attainable output for a given cost increases and a
new production function is formed.
The distinction between the momentary-run, short-run and the long-run period is based on the difference
between fixed inputs and variable inputs. The momentary - run is the period of time so short that no change
in production an take place. The short-run is the period of time in which the quantity of some factors of
production cannot be varied. The long run is the period of time in which it would be possible to increase the
quantity of all factors. Consequently, therefore, all inputs are variable in the long-run.
The time period varies from firm to firm and from industry to industry. The short-run may be a matter of eight
or ten months for some firms while for others it may extend to years.
Production in the short-run
The short-run is the period of time in which variable inputs such as labour and raw materials can be adjusted
while fixed factors such as plant and equipment cannot be fully modified or adjusted.
At any point in time, for instance, the production of teff requires inputs of labour, land, fertilizer and available
technical knowledge, which can be portrayed in the form of the production function as follows:
Qt = f (L, Ld, F, T,) Where:
QT = Quantity of teff produced
L = labour input
Ld = land input
F = fertilizer
T = technical knowledge
The above production function states that the output of teff depends on the inputs listed in the parenthesis. A
real production function is very complex. However, economists have simplified it by reducing the number of
variable inputs used in the production function to a manageable number.
Thus, given land input, fertilizer and available technical knowledge, the output of teff in the above production
function depends on the labour input (L) in the short-run. Hence, the production function boils down to:
QT = f (L, Ld*, F*, T)
QT = f (L)
Note that all other inputs in the bracket with the asterisk are assumed to be constant in the short-run.
Production function can be portrayed with the help of mathematical equations, tables and graphs. Mathematically,
QT = f(L, Ld* K*,M*)

It can be stated as
Q = f(L1, L2 - - - Ln, Ld1 Ld2 - - - Ldn, K1, K2, - - - Kn, m1, m2 - - - mn)
Where: Q = Maximum attainable output
L = Labour service
Ld = Land input
K = Capital services
M = Materials

29
 Table 4.1. Relations between Total , Average and marginal products of labour
Labour Total Product of Average Product of Marginal Product of Stages of
(No. Of workers) Labour (TPP) Labour (APL) Labour (MPL) Production

0 0 - - First stage of
1 10 10 10 Production
(increasing
2 30 15 20 Returns to labour
3 66 22 36
4 88 22 22 Second stage of
5 105 21 17 Production
(diminishing
6 114 19 9 Returns to labour)
7 119 17 5
8 119 15 0
Third stage of
9 110 72 -9 production
(Negative returns
10 70 7 -40 to labour)
Table 4.1 displays the various levels of teff output associated with different number of workers. Here, the
following important production concepts need to be defined:
i. Total physical product (TPP) refers to the total quantity of teff output produced and measured in
physical units by the labour input, during a given period of time, holding other inputs constant.
ii. Average physical product (APL) is total physical product divided by the unit of the variable input.

TPP
That is, APL =
L
iii. Marginal physical product (MPL) is the change in total physical product as a result of a unit change in
the usage of the variable input. That is, MPL = ΔTPL .
ΔL
Where: ΔTPL = change in total product
ΔL = change in labour input
The relations between total, average and marginal products of labour in Table 4.1 help define three stages
of production, which can be depicted graphically hereunder:

120

30
 110
100
TPP, APL and MPL

90
TPP
80
70

Stage III
Stage II
60

50
40
Stage I

30

20
10 APL
0 1 2 3 4 5 6 7 8 9 10
-5

-15

-20

-25 MPL
As shown in Fig. 4.2, a business firm encounters three stages of production in the course of producing different
levels of teff output using labour input, keeping all other inputs constant.
Stage I: It goes from the origin where TP L is zero to the point where AP L is maximum and AP L=MPL. In this
stage of production when additional units of labour are employed, total product (TPP) increases at an increasing
rate. This is the stage of increasing returns to the variable input (labour)
Stage II. It originates from the point where the AP L is maximum (APL=MPL) to the point where MPL= zero. In
this stage of production, total product (TPL) increases at a diminishing rate. This means that the rate of increase of
TPL (which is the MPL) falls. This is the stage of diminishing returns to the variable input.
Stage III. It covers the range over which the marginal product of labour (MP L) is negative. In stage III of
production, total product (TPL) declines and this makes MP L negative. This is the stage of negative returns to the
variable input.
A rational producer would not produce in stage I of production because there is very limited variable input
(labour) for the fixed inputs (land and capital). In this stage, labour is underemployed in relation to the fixed
inputs, which are underutilized. Thus, by increasing the usage of the variable input (labour), total product (TPP)
can be increased.

31
In stage III, there is excess labour when compared to the given fixed inputs. Hence, labour is over-employed in
relation to the fixed inputs, which are over-utilized. Therefore, a rational producer would not produce in this
stage, either.
Thus, from the firm's point of view, setting an output target in stage I and III is irrational. This leaves stage II the
only stage of production for the rational producer, whose objective is to produce the maximum attainable output.
In Summary, if increasing units of labour are added to fixed quantities of land and capital, the rate of total product
increase rises in the first stage of production. In the second stage of production, the rate of increase in total
product declines. Finally, there is an actual decline in the volume of production as more and more units of labour
are added to the fixed factor of production in the third stage.
Relations between TPL and MPL
The following relations can be developed between TPP and MPL from table 4.1 and Fig.4.2 above:
I. When TPP is increasing at an increasing rate, MPL is rising.
II. When TPP is increasing at a decreasing rate, MPL is falling.
III. When TPP is maximum and constant, MPL becomes zero.
IV. When TPP itself is declining, MPL becomes negative (MPL < 0).
Relations between APL and MPL
i. When MPL is above APL (MPL> APL), the latter is rising.
ii. When MPL =APL, the latter is at maximum level.
iii. When MPL is below APL (MPL < APL), both MPL and APL are falling.
Law of Diminishing Marginal Returns
The law of diminishing returns can be classified into the law of diminishing average returns and the law
of diminishing marginal returns. The points at which average product (AP L) and marginal product (MPL) attain
their maximum points are respectively called the points of average returns and marginal returns.
Theory of Costs
Production and costs are highly interrelated concepts. Production is hardly possible without costs. When goods
and services are produced, various expenses are incurred. These expenses are generally called costs. Costs of
production embody the sum of all payments made to the suppliers of inputs. Inputs can be supplied either by the
owners of inputs or owner of the business. Thus, the payment for inputs can be made either explicitly or
implicitly.
The money payments which a business firm makes to the outside suppliers of inputs in the course of
producing a variety of goods and services are called explicit (accounting) costs. Explicit costs include payments
made for labour services, raw materials, transport service, fuel, power, etc---. By contrast, implicit costs are costs
of self-owned and self-employed inputs, which do not involve out of pocket payments. The value of these owned
inputs can be inputted or estimated from what they could earn in their best alternative use-opportunity cost.
Implicit costs may include salary of the owner of the plant, the estimated rent of building belonging to the owner,
etc.
Economic cost is the sum total of implicit cost and explicit cost. (EC = IC + EC)
32
 Accounting Profit versus Economic Profit
Accountants and economists define profit in quite different ways. Accounting profit is equal to total revenue less
explicit costs whereas economic (pure) profit is the difference between total revenue and total costs (explicit +
implicit). Normal profit = Accounting profit- Economic Profit.
When economic profits are negative, firms leave an industry in the long run but when long run economic profits
are positive, firms enter the industry and when economic profits are zero, firms stay in the industry with
expectation of making profits.
Short-Run Costs
Corresponding to the fixed and variable inputs, short-run costs can be divided into fixed costs and variable
costs. Fixed costs are those unavoidable “overhead” costs which the firm must incur before production can get
under way-fixed costs are the same whether the output is large or small. Fixed costs are sometimes called indirect
costs or sunk costs. These costs include such things as rents on leased property, interest on borrowed funds,
insurance and administrative expenses maintenance and equipment costs, and the like.
Those costs which vary with the level of output are said to be variable costs. Variable costs are the costs of
those inputs for which supply could be altered in the short- run. Examples of variable costs are cash outlays on
intermediate goods, raw materials, wages, advertising, power and transport.
Short-Run Total Costs
Three short-run total costs can be identified:
1) Total fixed Cost (TFC): is part of total cost that does not vary with the level of the firm’s output. It is
unaffected by any variation in the quantity of output.
2) Total variable cost (TVC): is a component of total cost which varies directly with the level of output
produced. By the virtue of the fact that total variable cost depends on the level of output when output is
zero, total variable cost is zero and as output expands the total variable cost increases.
3) Total cost (TC): is the sum of total fixed cost (TFC) and total variable cost (TVC). That is,
TC=TFC+TVC.
Short-Run Per unit costs
The other important concept in cost analysis is per unit (average cost) analysis.
1) Average Fixed Cost (AFC): is the total fixed cost divided by the units of output. That is, AFC=TFC/Q.
Even if total fixed cost (TFC) is independent of output, the average fixed cost (AFC) depends on output
level.
2) Average variable cost (AVC): is the total variable cost divided by the units of output. That is,
AVC=TVC/Q. As TVC depends on level of output, so does the AVC.
3) Average total cost (AC): is total cost divided by the units of output. That is,

AC = TC
Q
= TFC+ TVC
Q
= TFC + TVC
Q Q

AC= AFC+AVC
Average cost is often called per unit cost.
Short-Run Marginal Cost (SMC)
Short-run marginal cost (SMC) is the extra or additional cost of producing one extra unit of output. That is,
SMC = ∆TC
∆Q
33
 = ∆ (TFC + TVC)
∆Q
= ∆TFC + ∆TVC
∆Q ∆Q
= ∆TVC (since ∆TFC =0)
∆Q
TVC
SMC =
Q
Hence, marginal cost (MC) is not influenced by fixed costs.
Table 4.9 Cost-output relations
Units of Total Fixed Total TotalAverage Average Average Short-run
Output (Q) Cost variable cost fixed costvariable total cost marginal cost
cost

Q (TFC) TVC) (TC) (AFC) (AVC) (AC) (SMC)

0 10 0 10 -  - -
1 10 4 14 10 4 14
4
2 10 6 16 5 3 8 2
3 10 10 20 3.3 3.3 6.6 5
4 10 17 27 2.5 4.2 6.7 7
5 10 26 36 2 5.2 7.2 9
6 10 37 47 1.7 6.1 7.8 11
7 10 51 61 1.4 7.3 8.7 14
8 10 68 78 1.28.4 9.6 17
9 10 87 97 1.1 9.6 10.8 19
Cost in dollar
90
TC
80
TVC
70
60
50
40
30
20
10 TFC

0 1 2 3 4 5 6 7 8 9 Units of Output

Fig. 4.10 Short-run Total Costs

34
 ATC
16
SMC
14 AVC

12

10
Cost Per Unit output

4
AFC
2

0 1 2 3 4 5 6 7 8 9 Units of output

Fig. 4.11 Short-Run Marginal and per unit Cost

From Table 4.9 and Fig. 4.10, the following important points need to be noticed:
1) Total fixed cost (TFC) is $ 10 regardless of the level of output. This implies that TFC is not affected by
the level of output produced.
2) Total variable cost (TVC) is zero when output is zero and rises as output rises. Initially, TVC increases at
a decreasing rate and then increases at an increasing rate.
3) Total cost (TC) equals TFC plus TVC at each and every level of output. Since TFC does not change with
the level of production, the TC curve has similar shape as the TVC curve.
From Fig. 4.11, the following crucial points need to be borne in mind:
1) Since total fixed cost is a constant amount, dividing it by the increasing total output gives a steadily falling
AFC. In other words, the AFC curve falls continuously as output expands, imparting it a shape of rectangular
hyperbola. Nevertheless, AFC can never be zero or negative.
2) As total variable cost rises with expansion of output, the average variable cost (AVC) also rises.
3) Since average cost (AC) equals average fixed cost (AFC) plus average variable cost (AVC), the vertical
distance between the AVC and AC curves gives AFC. As output expands, the vertical distance between AVC
and AC (AFC) falls.
4) When AFC falls but AVC increases, AC changes as follows:
i) If the fall in AFC is greater than the increase in AVC, then AC decreases.
ii) If the fall in AFC is less than the increase in AVC, then AC increases.
35
 iii) If the fall in AFC equals the increase in AVC, AC remains unchanged.
5) The MC curve intersects both AVC and AC at their respective lowest points. Stated differently, both AVC and
AC curves are always pierced at their minimum points by the rising MC curve. But, the minimum point of
AVC curve comes before the minimum point of the AC curve.
6) When the MC curve is below the AVC and AC curves, both AVC and AC are falling because so long as MC is
below AVC and AC curves, it pulls both AVC and AC down through the effects of TVC and TC.
7) When the MC curve is above the AVC and AC curves, both AVC and AC are rising because when MC is above
AVC and AC curves, it pulls AVC and AC up.
8) Cost curves and product curves are the inverted (mirror) images of each other. This means that marginal
product and average product curves initially rise, reach maximum and begin to fall. As a result, MC, AVC and AC
curves fall at first, subsequently reach their respective minimum points and ultimately commence to rise. This
implies that so long as the MP and AP curves are ∩- shaped, the MC, AVC and AC curves are U-shaped because
of the operation of the law of diminishing returns (the law of variable proportions) resulting from the existence of
fixed inputs in the short-run.
Market Structures
Perfect Competition
A. Basic Characteristics of a Competitive Firm
 Very large numbers: With many sellers no one market participant, or small group of participants, can influence
the market in a significant way. All buyers and sellers have the option of trading with several others, often in a
highly organized or structural market. Farm commodity markets and foreign exchange markets are examples.
 each firm has very small market share
 Standardized product: Competing firms in a market offer a standardized good or service for sale. Grain and
livestock, for example, are traded in specific classes or grades, as are diamonds and crude oil. Within a specific
class or grade, buyers do not discriminate among sellers. Often neither the buyer nor the seller physically
examines the commodity exchanged
 products in each group are perfect substitutes
 Price Taker: In a purely competitive market, individual firms exert no significant control over product price.
 price is given
 Freedom of entry and exit: New firms can enter and existing firms are free to leave the industry. There are no
restrictions such as licenses. Existing firms are free to exit without getting approval from a government
commission or other body. Farming usually meets this condition

B. Demand function
An individual has no control over the market price (it is a price taker) so that the demand curve he faces is given
by a perfectly elastic (flat) horizontal line at the market price. In other words, marginal revenue and average

36
revenue for a competitive firm are identical to the firm’s demand curve. For each unit of product being sold in the
market, total revenue increases by the product price.
PQ
Average revenue( AR)  Total Re venue
Output  P
Q
is the same as
C. Revenue Functions  ( P Q )
M arg inal revenue( MR )  TR
Q  Q P
Thus for the pure competitive market only
 AR  MR  P
Types of Revenue
 Total revenue:
 The total amount of money received by a firm(s) from the sale of a product.
 The quantity sold (demanded) multiplied by the price at which it is sold
 The total expenditures for the product produced by the firm(s)
 Marginal revenue:
 The change in total revenue that results from the sale of one additional unit of a firm’s product
 The change in total revenue divided by the change in the quantity of the product sold
 Average revenue:
 Total revenue from the sale of a product divided by the quantity of the product sold (demanded)
 The price at which the product is sold when all units of the product are sold at the same price
D. Profit Maximization Approaches
Approaches to profit-maximization level of output are
The daily output for corn production
Fixed Total Total
Q Price Total Rev Cost Var’bl Cost Cost MC AC AVC P-AC Profit
0 100 0 100 0 100 -100
1 100 100 100 39 139 39 139 39 -39 -39 -39
2 100 200 100 68 168 29 84 34 16 32
3 100 300 100 107 207 39 69 35.67 31 93
4 100 400 100 156 256 49 64 39 36 144
5 100 500 100 235 335 79 67 47 33 165
6 100 600 100 334 434 99 72.33 55.67 27.67 166
7 100 700 100 483 583 149 83.29 69 16.71 117
8 100 800 100 682 782 199 97.75 85.25 2.25 18
9 100 900 100 981 1081 299 120.11 109 -20.11 -181
10 100 1000 100 1380 1480 399 148 138 -48 -480
1. The total revenue-total-cost: - under this approach the profit-maximizing level of output is obtained at a point
where the difference between total revenue and total cost is the greatest. In the above table, it is given by the
sixth level of output, i.e. 166Birr.
profit ( )  Total Re venue  Total Cost
It is also possible to indicate the maximum level of output by using curves for the total values. In the diagram
below both the total revenue (TR), total cost (TC) and total profit (Profit) curves are drawn. The diagram indicates

37
that the vertical distance between the TR and the TC is the largest at the 6 th level of output. At the same level of
output the vertical distance between the horizontal axis and the Profit function is the largest too.
2. The marginal-revenue-marginal-cost approach: under perfect or pure competition case, marginal revenue
(MR), which is the additional amount of money someone receives for each additional unit of product sold, is
assumed to be identical to the price. Observe that the price is not affected by the amount of product a firm or
some group of firms sell. As a result the following relation is concluded from this situation
MR  AR  P
This implies that the demand curve that the firm faces is given by the flat or perfectly elastic curve (from the
above table it is given at Birr 100).
How is then profit maximized?
Any producer keeps on producing a given product as long as the marginal return or price or the average revenue
obtained from the employment of the variable input is larger than the marginal cost (MR>MC). Even if we know
from the production theory that the rational firm produces at Stage II, where the marginal product of a variable
input is decreasing, we do not exactly know the level of output the firm should produce.
The decision on how much to produce is determined by the maximum level of profit that could potentially
obtained from the production process. The amount of total profit is at its maximum when the marginal profit is
zero. Put differently, when the marginal cost (the slope of the cost curve) equals to the marginal revenue (the slope
of the total revenue curve), total profit will be at its maximum.[NB. when a certain function reaches a
maximum/minimum point, its marginal value (slope) is zero at this extreme point]

38
 Marginal Marginal Marginal
   0
P rofit  Revnue  Cost 

MR C PM
Example: the corn production of firm A and firm B is given as follows

No of Price of Total Variable Total fixed Total Price of

Firms input used input cost cost cost Corn output output Total revenue
A 200 0.2 40 150 190 116.3 2 232.6
B 260 0.2 52 150 202 124.3 2 248.6
A* 240 0.2 48 150 198 122.2 2 244.4
B* 280 0.2 56 150 206 125.6 2 251.2

If A wants to increase his output from its current level to, say 122.2 units, for the additional 5.9 units he needs to
spend an additional cost of 8.00 Birr (Total cost of A - Total cost of A* = 198-190) or 1.36 Birr /unit (8/5.9) of
marginal cost. This value of 1.36 Birr is still less than the marginal revenue of birr 2.00. Similarly, the increase in
total revenue (244.4-232.6=11.8) is higher than the increase in total cost (198-190=8.00). Thus at this level of
production profit increases by Birr 3.80 and the decision will be to produce the amount given by A*
What should be the decision about firm B? Why? Compare your answer with MC=3.08 and MR=2.00.
The Break-even Point
At some specific output price the firm doesn’t make any profit at the profit maximizing level of output where
MR=MC=AC. The corresponding level of output is then referred to as the break-even point. For example if the
price falls to Birr 63 in the above case then at that level of output there will be zero economic profit or normal
profit (the firm earns exactly its implicit cost). The firm, despite making zero profit, prefers to operate rather than
closing down since this way of production covers its fixed costs fully.
39
The Shutdown Case
If the price falls further down to Birr 30 at this price MR is just equal to AVC, i.e., the firm is losing money that
amounts to the fixed costs. At this price the firm is indifferent between operating and ending operations. If the
price falls below this level, then the firm will incur a loss and it is preferable shutting down to operating at a loss.
But for the price above this closedown price the firm minimizes its loss by operating rather than closing down.
Thus, when MR=MC= AVC, the level of output is referred to as the shutdown point.
Pure Monopoly
The Basics of Monopoly
 A pure monopolist is the sole supplier of a product or service for which there are no close substitutes
 Monopolies exist because of entry barriers such as economies of scale, patents and licenses, and the
ownership of essential resources
 The monopolist’s demand curve is downward sloping, and its marginal-revenue curve lies below its
demand curve
 The downward sloping demand curve means that the monopolist is a price maker
 The monopolist will operate in the elastic region of demand since in the inelastic region it can increase
total revenue and reduced total cost by reducing output
The production behavior of a firm has no competitors and has complete control of its product price.
Characteristics of Pure Monopoly
1. Single seller: - a pure, or absolute, monopolist is a one-firm industry. A single firm is the only producer of
a specific product or the sole supplier of a service; the firm and the industry are synonymous
2. No close substitutes: - the monopolist’s product is unique in that there are no good, or close, substitutes.
From the buyer’s viewpoint, there are no reasonable alternatives. The buyer who does not buy the product
frown the monopolist has no alternative but to do without
3. Price maker: - the pure monopolist is a price maker; the firm exercises considerable control over the price
because it controls the total quantity supplied. Because it faces a downward sloping demand curve, the
monopolist can change the product price by manipulating the quantity of the product supplied
4. Blocked entry: - a pure monopolist has no immediate competitors because there are barriers to entry.
Economic, technological, legal, or other obstacles exist to keep new competitors from coming into the
industry. Entry under conditions of pure monopoly is totally blocked. A monopolist firm can block entry
in several ways
 Economies of scale- the production cost is lower as very large numbers are produced. Many
public utilities- electric and gas companies, bus firms, local water and sewerage companies are
considered as natural monopolies that enjoy such advantage
 Legal ownership: patents and licenses
i. Patents aim to protect an inventor from rivals who would use the invention without
having shared in the cost of developing it. It is also used to encourage creation and the
production of new products.
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 ii. Licenses that generate monopolies are often put in place to promote welfare or generate
public revenue. Examples are EELPA, TELE, Postal, Water Sewerage authority, National
Lottery.
 Ownership of essential resources:- a firm owning a resource essential to a production process can
prohibit the creation of rival firms
 Strategic barriers:- it is a way of blocking entry by setting some mechanism against potential
entrants; for example, a monopolist might create an entry barrier by cutting its price or greatly
increasing advertising
Demand Function
Having the controlling power over the price of its product, a monopolist decides the market price at which it
needs to sell. If the monopolist wants to increase its sales it can do so by reducing the price. This implies that it
faces a downward sloping demand curve, which is also the market demand curve. This means that the marginal
revenue is less than the price for every level of output, i.e., the marginal revenue curve lies to the left of the
demand curve.
TR
MR  P
Q

In short,
 The monopolist maximizes profit or minimizes loss at the output where MR=MC and charges the price which
corresponds to this output on its demand curve.
 The monopolist has no supply curve since any of several prices can be associated with a specific quantity of
output supplied
 Assuming identical costs, a monopolist will be less efficient than a purely competitive industry because the
monopolist produces less output and charges a higher price.
Price Discrimination
The monopolist enhances its revenue by practicing price discrimination power. This refers to the case when the
firm charges different prices to different buyers.
 Price discrimination occurs when a firm sells a product at different prices which are not based on cost
differences
 The conditions necessary for price discrimination are
o monopoly power,
o the ability to segregate buyers on the basis of demand elasticities, and
o the inability of buyers to resell the product
 Compared with single pricing by a monopolist, perfect price discrimination results in greater profit and
greater output. Many consumers pay higher prices, but other buyers pay prices below the single price
 Monopoly price can be reduced and output increased through government regulation

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 The socially optimal price (P=MC) achieves allocative efficiency but may result in losses; the fair-return price
(P=ATC) yields a normal profit but falls short of allocative efficiency.
o socially optimal price is the price of a product that results in the most efficient allocation of an
economy’s resources and that is equal to the marginal cost of the product
o fair-return price refers to the price of a product that enables its producer to obtain a normal profit
and that is equal to the average total cost of producing it
Monopolistic Competition
Monopolistic competition characterizes many industries in the real world. Like the pure monopolist, firms in these
industries face downward- sloping demand curves. Like the pure competition case, entry and exit are easy.
Characteristics of monopolistic competition
1) Relatively large numbers: - the number may range, say from 25 to 100, but the hundreds or thousands needed
for perfect competition. Because of the fairly large number of firms such characteristics emerge:
i) Small market share: - each firm has a small percentage of the total market1, so each has limited
control over market price.
ii) No collusion: - the relatively large number of firms ensures that collusion to restrict output and raise
prices is all but impossible
iii) Independent actions: - with numerous firms, there is no feeling of mutual interdependence. Each firm
determines its policies without considering possible reactions of rival firms
2) Product differentiation: - as a fundamental feature of monopolistic competition, purely competitive firms turn
out a homogeneous product, and monopolistically competitive firms produce variations of a particular
product. The non-price competition takes such forms
i) Product quality: - the basic product is the same but features of the product differ somewhat, for
example, different terms on a credit card.
ii) Services: - some may provide carry out service while another grocery store lets you carry your own
purchases.
iii) Location: - some gas stations locate near interstate highways and sell at a higher price than firms
located in a city some distance from the highway. The location of some firms may be convenient and
they stay open the whole night.
iv) Advertising and packaging: - to differentiate their products many firms apply perceived differences
created through advertising or packaging. For example, toothpaste in a pump container may be
preferable to toothpaste in a tube for some consumers
3) Easy entry: - entry in a monopolistically competitive industry is relatively easy. Economies of scale and
capital requirements are few
Demand function
The monopolistically competitive firm faces a demand curve that is downward sloping, but much more elastic that
the demand curve facing a pure monopolist. The latter faces a fairly inelastic or steeper demand curve, and hence

42
marginal revenue curve. But a monopolistically competitive firm, which sells a product that has many close
substitutes, faces a more elastic or flatter demand curve, of which slope is much closer to zero, and marginal
revenue curve.
Short run and Long run
1) Short run
 the firm can make excess profits or lose money, as the demand and marginal revenue curve shift
 The firm produces the level of output at which MR=MC and the price that corresponds to this level of
output is obtained using the demand curve.
 The vertical distance between the ATC and the demand curve provides the excess profit per unit sold
 The excess profit attracts entry in the industry and the production of more close substitutes, which leads
to a downward shift in the demand curve that faces individual firms
 Finally, as the demand curve continues to shift down until the excess profit is exhausted and the
individual firm loses money
2) Long run
 If a firm loses money as a result then it goes out of business and the demand curve that faces for the
firms that still remain in the industry will shift upward
 Easy entry and exit of firms cause monopolistic competitors to earn only normal profit
 The equilibrium output is such that price exceeds the minimum average total cost and price exceeds
marginal cost

Oligopoly
Oligopoly is a market dominated by a few large producers of a homogeneous or differentiated product. “Few” is
crucial here. Oligopolists have considerable control over prices but each must consider the possible reaction of
rivals to its own pricing, output, and advertising decisions.
Differentiated product
 a product that differs physically or in some other way from the similar products produced by other
firms,
 a product such that buyers are not indifferent to the seller when the price charged by all sellers is the
same
Main Characteristics of Oligopoly
An oligopolistic industry is made up of relatively few firms producing either homogeneous or
differentiated products; these firms are mutually interdependent in their pricing policies. An oligopoly
with just two firms constitutes a duopoly.

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 Barriers to entry such as scale economies, control of patents or strategic resources, or the ability to
engage in retaliatory pricing characterize oligopolies. Oligopolies can result from internal growth of
firms, mergers, or both
the four-firm concentration ratio shows the percentage of an industry’s sales accounted for by its four
largest firms (concentration ratio refers to the percentage of the total sales of an industry made by the
four or some other number largest sellers in the industry)
firms enhance their profits through collusion (= a situation in which firms act together and in
agreement (collude) to fix prices, divide a market, or otherwise restrict competition)
In general unpredictable action and reaction will make it difficult to analyze oligopoly market. Firms may come ‘in
collusion with each other’ or ‘may try to fight each other on the death.’ So accordingly we can classify oligopoly
market structure as:
 Non-collusive Oligopoly and
 Collusive Oligopoly
 Non- Collusive Oligopoly
Oligopoly firms may cooperate (collude) or may not cooperate (no- collusion) in some activities with respect to their
businesses depending on their interest and agreement. If firms do not cooperate, their decision-making process is
analyzed using the non- collusive model. Under this model we have the Cournot's duopoly model, the 'kinked-
demand' model, Bertrand Duopoly model and Stackleberg Duopoly model. We will look how firms arrive at
equilibrium points in each model one by one.
 Collusive Oligopoly
Sometimes firms form collusion each other in many actions to avoid uncertainty or competition among
themselves. This collusion helps the oligopolist firms to act like a monopoly. The two main types of collusion,
cartels and price leadership

PART THREE: MACROECONOMICS

1. Major Problems of the Macro Economy
Any macro economy could have confront in either one or all of the following problems
 How to increase production capacity of the economy?
o In most developing countries population size has grown much faster than production. This
situation gives rise the problem of poverty
o As some countries grows faster some other may stagnate. This gives rise to the problem of
growth
⇒ Such problems entails the development of the Theory Of Growth

 How to stabilize the economy?

o many market economies have experienced fluctuations in their macroeconomic performance
 high inflation and/or

44
  high unemployment
o leads to the wastage of resources

⇒ Such problems causes the emergence of Business Cycle Theories

 Other problems
o Poor performance on the international trade causes a balance of trade deficit and shortage of
foreign currency to import even very important items like medicine and oil.
⇒ As a result of this the Theory Of International Trade has got its foundation

National Income Accounting

Basic Concepts
 Gross Domestic Product(GDP)
GDP is the value of the total final goods and services produced within the boundaries of a country for a given
period of time and measured by the value-added principle. It is the single most widely used measure of the
output of an economy. It includes those goods and services produced in the current time period only. GDP is
evaluated at market prices (factor cost + indirect taxes).
 Gross National Product (GNP)
GNP is the value of output produced by land, labor, capital and entrepreneurial talent supplied by citizens
whether the resources are located at home or abroad.
 GNP=GDP + foreign earnings of domestic residents and firms - earnings in the
domestic economy by foreign residents and firms
 Net National Product (NNP)
NNP is the market value of annual output less depreciation (capital consumption).Depreciation refers to
estimates of the amount of capital worn out or used up (consumed) in producing the gross domestic product.
 National Income(NI)
It is all income earned by citizens of a particular nation for their current contributions to production within the
nation or abroad
 Personal Income
It is all income received by households whether earned or not
 Disposable Income
It is all income received by households less personal taxes
Limitations of GDP
Even if the most comprehensive measure of the economic performance of a nation, GDP has the following
limitations
1. Non-market productive Activities are Left Out
Because goods and services are evaluated at market prices in GDP, non market production is left out. This
includes such examples as homemakers' services and agrarian non market production.

45
2. The Informal Economy is Left Out
Also left out of GDP are illegal forms of economic activity and legal activities that are not reported to avoid
paying taxes - the informal economy. Gambling and the drug trade are examples of illegal activities.
Repairmen may underreport or fail to report about the income receipt from the service they provide to avoid
tax payment.
3. GDP is not a Welfare Measure
GDP measures production of goods and services; it is not a measure of welfare or even of material well-being.
For one thing GDP do not reckon the welfare that can be realized from leisure. If we all began to work 24-
hour a day, GDP would increase, but we would not be better off for leisure also contributes to maximize
welfare.
GDP also fails to subtract for some welfare costs of production. If, for example, production of chemical
fertilizer cause environmental pollution, we only give weight to the amount of fertilizer produced in GDP but
may ignore the economic cost of pollution. Thus GDP is a useful measure of the overall economic activity
rather than welfare. In spite of these shortcomings, GDP still serves to monitor the short run economic
fluctuations and to analyze the long run growth trends and take a corrective policy measures.

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 Foreignsource  Income arned 
  
GNPGDP incomeof  by foreigners 
households  insidethecountry
  

Capitalconsumption
 
N PGNP alowances 
 Depreciatons 
 

National  Indirect 
 GNPDepreciaton 
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Approaches to Measuring GDP
The total goods and services produced in a given period of time of a national economy can be measured by three
different methods
1. Production Method (Value-added Method)
This method consists of three stages
 estimating the gross value of domestic output (GDP) in the various production units or sectors
 determining the costs of materials and services used and depreciation of capital goods
 deducting these costs and depreciation from gross value to obtain net domestic output
⇒ the measurement takes place by the value- added principle

2. (Factor ) Income Method

According to this method the national economy performance is measured on the basis of the income received by
the factors of production that are used in the production of the final goods and services. Even though the factors of
production are usually categorized into labor, capital, natural resource and entrepreneurship skills, under this
consideration they are broadly grouped into labor and capital. As a result the income of the economy is going to
be divided between the owners of factors of production.
o Labor income, which is obtained by selling the labor service, includes wages and salaries together with
different kinds of benefits
o Capital income includes
 dividend
 profits of both private (corporations, partnership and sole business organizations) and public
enterprises
 interest payments on lent out funds
 rent payments on land, buildings and other natural resources
3. Expenditure Method
This method measures spending made on the final goods and services on the basis of either
 The uses of income for
o private consumption expenditure(C)
o private saving (S)
o tax payments (T)
o transfer payments(Rf)
 The spending made for
o private consumer goods and services (C)
o private investment spending ( I )
o public goods and services(G)
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 o net investment abroad(NE)
Aggregate Expenditure can be given by
GDP  C  I  G  NE  C  S  T  R f

Nominal and Real GDP

 Nominal GDP measures the value of the economy's total output evaluated at current market prices, or
in dollars. It changes when the overall price level changes as well as when the actual volume of
production changes
 Real GDP measures the total output produced in any one period in terns of constant price of some
base year. It changes only when quantities change. For most purposes, such as to compare the
physical change in production/output or to analyze the relationship between the actual quantity
produced and the level of employment we want a measure of output that varies only with the quantity
of goods produced, real GDP
Fluctuations in Economic Activities: Unemployment and Inflation
Unemployment
Fluctuations in economic activities lead to a fall in real GDP. As the real GDP falls, apart from reducing the
national production and national income, it leads to an excessive unemployment. It is measured by unemployment
rate
U the number of unemployed people
u 
L Total labor force

There are three kinds of unemployment

o Frictional unemployment: - occurs when people have left jobs and are searching for a new one
o Structural Unemployment: - occurs when there exist permanent shift in the pattern of demand for goods and
services or technology in a specific industry
o Cyclical unemployment: - occur when the economy fails to operate at its potential level. In this case the real
GDP declines to its recession level

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 Frictonal  Struc al  Naturl 
   
unemployent unemployent unemployent
 when the economy operates at zero cyclical unemployment, it is referred to as full employment (in which case
the actual unemployment rate is not zero)
 if the economy operates at full employment rate the real GDP thus attained would be potential real GDP
Costs of unemployment
- reduce national output and tax revenues
- increase mental and physical illness and other social problems but the problems can be mitigated
through unemployment insurance systems that maintain the well-being to some extent

Inflation
It is the rate at which the general price level increases for goods and services and is measured by the percentage
change in consumer price index (CPI). CPI measures the retail prices of a fixed market basket of several
thousands of goods and services purchased by households.

CPI 
pq t 0

p q 0 0

where Pt and P0 are current price and base period prices respectively and q o is the quantity of weighted basket of
goods.
When inflation exists
- the purchasing power of a nation’s currency declines, i.e., the currency buys fewer and fewer goods as price
increases
- increases in nominal income will be absorbed by the increase in price

50
NominalIncomeRealIncomeCPI
OR
Growthrateof  Growthrateof  Growthrateof 
     
NominalIncome Realincome   CPI 
⇒ real income declines if the rate of inflation is higher than the growth rate of nominal income
Inflation can
- result in varying benefits for debtors and creditors: if debtors borrowed money when inflation was
low and repay when there is inflation, debtors will be better off while creditors are worse off. This is
because now the purchasing power of money is low.
- harm saving as savers are creditors
Anticipation of inflation (expectation of price increase in the future) adversely affects the performance of the
economy. This means such anticipation can distort consumer choices by causing buyers to purchase goods now
that they might otherwise prefer to purchase in the future and thereby distorting market prices.
Aggregate Demand and Aggregate Supply Equilibrium
Aggregate Demand
- the relationship between the price level and the aggregate quantity of final products demanded
- the relationship is shown by aggregate demand curve which slopes downward

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 The aggregate demand curve for a given economy
Price level
Price level

Aggregate quantity Aggregate quantity demanded

demanded
when the aggregate demand curve shifts outward because
of an increase in demand

- if factors other than price level changes, the aggregate demand changes (increase/decrease)and the AD curve
will shift (outward/downward)
- such factors as real interest rate, the money stock, the foreign exchange rate, government purchases, taxes,
transfers and factors influencing demand for exports are factors responsible for such a shift on the demand
curve

The effects of the determinants of AD

 real interest rate
⇑real interest rate ⇒⇓new investment ⇒ ⇑ price⇒ ⇓AD
 quantity of money in circulation
⇑money stock⇒⇑ money holding in the hands of the public⇒⇑ Spending ⇒⇑AD
 foreign exchange value
⇑price of Birr in terms of other countries currency ⇒⇓demand for export AND ⇑demand for
import⇒ ⇓AD
 government purchases, taxes and transfer payment
⇑government purchases⇒⇑ AD
⇑taxes⇒⇓ disposable income⇒⇓ AD
⇑transfer payments⇒⇑ AD
 expectations
deterioration⇒⇓ AD
improvement ⇒⇑AD
 foreign nations income and other economic conditions
⇑income in foreign nations OR ⇑demand for export ⇒⇑AD
Aggregate Supply
- the relationship between the price level and the aggregate quantity of final products supplied
- this relationship is given by the AS curve which slopes upward
- the AS curve becomes flat during slack periods and steep when the economy is operating at the potential real
GDP

52
 Price level Aggregate supply
curve

Potential level of Over employment

real GDP level

Excessive
unemployment
Full employment
level

Aggregate quantity
supplied

- changes in such factors as input prices, in the quality and quantity of inputs and advance in technology
changes the AS curve outward (when AS increases) or inward (when AS decreases)
The effects of the determinants of AS
 price of input
⇑nominal wage ⇒⇑cost of production ⇒⇑MC ⇒AS shift inward

 availability /productivity of resources and advance in technology

⇑size of labor OR other inputs quantity⇒⇑ AS

improvement in the quality of inputs AND advance in technology ⇒⇑ AS

Economic Policy Instruments: Monetary, Fiscal and Income policies

Macroeconomic policy instruments: refer to macroeconomic quantities that can be directly controlled by an
economic policy maker. Instruments can be divided into two subsets:
- Monetary policy instruments- policy is conducted by the national (central) bank of a country.
- Fiscal policy instruments- Fiscal policy is conducted by the executive and legislative branches of the
Government and deals with managing a nation’s budget.
Monetary Policy
Monetary policy instruments consists in managing short-term rates (interest and discount rates), and changing
reserve requirements for commercial banks. Monetary policy can be either expansive for the economy (short-term
rates low relative to inflation rate) or restrictive for the economy (short-term rates high relative to inflation rate).
Historically, the major objective of monetary policy had been to manage or curb domestic inflation. More
recently, central bankers have often focused on a second objective: managing economic growth as both inflation
and economic growth are highly interrelated.
In other words, monetary policy is the process by which the monetary authority of a country controls the supply
of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The
official goals usually include relatively stable prices and low unemployment. Monetary theory provides insight
into how to craft optimal monetary policy. It is referred to as either being expansionary or contractionary, where
an expansionary policy increases the total supply of money in the economy more rapidly than usual, and
contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is
traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy
credit will entice businesses into expanding. Contractionary policy is intended to slow inflation in hopes of
avoiding the resulting distortions and deterioration of asset values.
Monetary policy differs from fiscal policy, which refers to taxation, government spending, and associated. There
are different methods to exercise monetary policy.
i. Open Market Operations

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There are two types of open market operations: Open market purchases government buys securities to increase the
monetary base. Open market sales = government sells securities to decrease the monetary base. Thus, the
government conducts open market operations by buying and selling Ethiopian government securities–especially
treasury bills.
ii. Discount Loans
When the government or national bank can affect the volume of loans by setting the discount rate it is
discounting. A higher discount rate makes discount borrowing less attractive to banks and will therefore reduce
the volume of loans. A lower discount rate makes discount borrowing more attractive to banks and will therefore
increase the volume of loans.
iii. Changes in Reserve Requirements
By affecting the money multiplier, changes in the required reserve ratio can lead to changes in the money supply.
Changes in reserve requirements can cause problems for banks by making liquidity management more difficult.
Fiscal Policy
Fiscal policy consists in managing the national Budget and its financing so as to influence economic activity. It
operated on managing government expenditure and taxation. There are two types of fiscal policies. This entails
the expansion or contraction of government expenditures related to specific government programs. a.
Expansionary fiscal policy – it is used when the government wants to raise total output and employment. It is
usually taken during recession (low total output) period. To achieve this objective the government increases its
expenditure or/and reduce taxes. This increase AD thereby total output and employment level increases. b.
Contractionary fiscal policy - it is used when the government want to control high inflation. To achieve this
objective the government decreases its expenditure or/ and raises taxes. This decrease AD there by the general
price level of goods and services decreases.
Income Policy
Income policy is another instrument by which government achieves its predefined goals and objectives. It refers
to a set of rules and regulation designed by a government to control wage and price rise.

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