Principles of Economics - Hassen

HASSEN A.
LECTURE NOTES ON PRINCIPLES OF ECONOMICS
CHAPTER ONE
INTRODUCTION
1.1 FOUNDATION, DEFINITION, SCOPE AND METHODS OF
ECONOMICS
Foundation
Two fundamental facts, which constitute the economizing problem, provide the
foundation for the field of economics. These are:
1) unlimited human wants and
2) limited resources
Material wants - the desires of consumers to obtain and use various goods and services
that provide utility (satisfaction or pleasure) - cannot be completely satisfied. This is
because:
a) wants are recurring in nature - even if some wants are satisfied for a while, they will
reappear at some intervals.
b) wants multiply endlessly over time - as soon as one want is satisfied, another want
begins to be felt.
On the other hand, resources - the means of producing goods and services - are limited.
These resources can be categorized under four headings:
A) Land: all gifts (bounty) of nature usable in the production process. This includes
arable land, non-arable land, forests, minerals, air, soil, oceans, fisheries, oil
deposits, etc.
B) Capital (Investment Goods): all manufactured aids to production. It includes,
tools, machineries, equipment, factory, storage, transportation and distribution
facilities used in producing goods and services.
C) Labor: all the physical and mental talents of human beings available and usable
in producing goods and services in the production process.
D) Entrepreneurial Ability (Entrepreneurship): a human resource but with a
special set of talents that enable him to organize and manage the other resources
to produce a product.
These two facts (unlimited wants and limited resources) imply scarcity, which is the
imbalance between human desires and the means of satisfying those desires. Because all
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HASSEN A. LECTURE NOTES ON PRINCIPLES OF ECONOMICS
wants cannot be satisfied simultaneously, scarcity forces us to choose. Choice refers to

selecting of alternative uses of scarce resources or giving priority. Thus economics
focuses on “getting the most from what we have”, on making the best use of our scarce
resources.
Definition
Economics is a social science concerned with the efficient allocation of limited

resources in the production & distribution of goods & services to satisfy the unlimited
human wants.
Scope
The most fundamental fact of economics is that people must make choices. This fact
applies to societies (or nations) as well as individuals. In other words, the core issues
of scarcity, choice, allocation, economic systems, and growth can be studied from
either a micro or a macro perspective.
Microeconomics: the study of specific economic units (such as households & business
firms) and a detailed consideration of the behavior of these individual units. Here we
concentrate upon such magnitudes as the output or price of a specific product, the
revenue or income of a particular firm or household, etc. It examines the trees not the
forest.
Macroeconomics: is the study of the overall (aggregate) performance of the economy. It
is concerned with the structure of the economy and the relationships among the major
aggregates, which include total production, consumption, employment, general price
level, investment, etc. No attention is given to the specific units that make up the various
aggregates. In short it examines the forest not the trees.
Economics is concerned both with the analysis of facts (or statements) - “what is”
and with value judgments - “ what should be”.
Positive economics: is that part of economic science which deals with specific statements
that are capable of verification, by reference to the facts about economic behavior. That
is, it is concerned with describing and analyzing the economy as it is.
Example: - increasing the money supply will lead to higher prices.
- 20% of the labor force in Ethiopia is unemployed.
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Normative economics: is that part of economic science which involves someone’s value
judgments about what the economy should be like or what particular policy action should
be recommended to solve economic problems based on a given economic generalization
or relationship.
Example: the government should reduce the tax rate in order to initiate private
investment.
Methods
In deriving economic principles, which are useful in the formulation of policies designed
to solve economic problems, one may move from descriptive or empirical economics to
theoretical economics - inductive method or the other way round - deductive method.
Inductive (empirical) method: is the process of deriving principles or theory (a general
explanation applicable to a wide range of particular circumstances) from facts. It moves
from facts to theories, from particular to general.
Deductive (hypothetical) method: is the process of beginning at the level of theory and
proceeding to the verification or rejection of this theory (rather a hypothesis) by an appeal
to facts. It moves from general to particular.
N
O 3. POLICIES
R Policy economics is concerned with controlling or influencing economic behaviour
M or its consequences.
A
T
I
V
E
2.PRINCIPLES OR THEORIES
Theoretical economics involves generalizing about economic behavior.
P
O
Deduction
S
Induction
I
T
I
V
E
1. FACTS
Descriptive (empirical) economics is concerned with gathering the facts
relevant to a specific problem or aspect of the economy.
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1.2 BASIC ECONOMIC PROBLEMS & ALTERNATIVE

ECONOMIC SYSTEMS
Basic Problems of an Economy
The basic problems of the economy are closely related/associated/ with the central
problem of endless wants and virtually limited resources. That is, whatever the nature of
the economic system, all types of economies have been faced with certain common
economic problems which arises due to shortage of available means to satisfy endless
human wants & aspirations.
These basic problems are:
i) what to produce & how much to produce,
ii) how to produce,
iii) for whom to produce.
The problem of 'what to produce' is the problem of choice between commodities. This
problem arises mainly for two reasons:
a) scarcity of resources does not permit production of all the goods & services that
people would like to consume.
b) all the goods & services are not equally valued in terms of their utility by the
consumers. The objective is to satisfy maximum needs of maximum number of
people.
The question of "how much to produce" is the problem of determining the quantities of
each commodity & service to be produced.
The problem 'how to produce' is the problem of choice of technology. Here the problem
is how to determine an optimum combination of inputs (say labour & capital) that is used
in the production of goods or services. By whom & with what resources and in what
technological manner are goods & services to be produced is the how to produce
problem.
The problem of "for whom" goods shall be produced is the problem of how is the
national product to be divided among different individuals and families-i.e, who is to
enjoy & get the benefit of the nation's goods & services?
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Alternative Economic Systems
The basic economic problems (what, how & for whom to produce) faced by every society
are universal. However, the solutions vary from place to place, because of differences in
the economic system of the world. Here economic system (economy) implies the set of
organizational arrangements & institutions that are established to solve the economic
problem
In general, economies of the world differ essentially on two grounds:
* ownership of means of production, &
* the method by which economic activities are organized.
Based on the above two factors, we can identify 4 types of economic systems. They are:
1.Free enterprise (market) economy or capitalist economy
2.The command (government controlled) economy or socialism.
3. Mixed (Hybrid) economy, and
4. Traditional (customary) economy.
How could the basic economic problems be solved under different alternative economic
systems?
1. Pure Capitalism (Market Economy). It is characterized by:
- Private ownership of means of production.
- Private gains are the main motivating forces.
- Both consumers & firms enjoy the freedom of choice.
- Free competition that probably leads to increased efficiency.
- Least government interference.
In such a system, the three fundamental problems are answered as follows. Business
enterprises produce those commodities 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 factors of production (the for whom).
In a market, every thing has a price. Prices perform two functions: one, prices serve as
signals for the producers to decide 'what to produce' & for the consumers to decide 'what
to consume'. Second, prices force the demand & supply conditions to adjust themselves
to the prevailing prices. Thus, in a market economy "what things will be produced" is
determined by the dollar votes of consumers - every day decisions of consumers to
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purchase one good instead of another, i.e., the demand. Firms are lured (attracted) into
production of goods in high demand by the high profits there.
"How things produced" is determined by the competition among different producers.
The best way for firms to meet price competition & maximize profit is to keep costs at a
minimum by adopting the most efficient methods of production.
“For whom” to produce is also solved by market mechanism. The simple market rule is
produce for those who have ability & willingness to pay. The problem is determined by
supply &demand in the markets for factors of production (labor, capital, land, etc.).
Factor markets determine factor prices (wages rates, rents, profits, etc). The sum of all
the revenues from factors yields people's incomes. The distribution of this income
among the population is thus determined by the amounts of factors (person hours, acres
of land, etc) owned and the prices of factors.
2. Command Economy
Features: means of production are owned by the society or by the state in the name of
the community; social welfare is the guiding factor; freedom of choice for the consumer
is curbed to what society can afford for all; and the role of market forces & competition is
eliminated by law.
In this case, the dictator (or more likely a planning committee appointed by the dictator or
the party) makes all decisions about production & distribution.
3. Mixed Economy.
Both private and public sectors co-exist in this economy. In a mixed economy, the
government (through taxes, subsidies, etc.) modifies and in some instances (through
direct controls) replaces the operation of the market (price) mechanism in its function of
what to produce. The operation of the price mechanism in solving the 'how to produce'
problem is also modified & sometimes replaced by a government action. Both private &
public sectors exist simultaneously. In the name of equity & fairness, governments
usually modify the workings of the price mechanism by taking from the rich (through
taxation) & redistributing to the poor (through subsidies & welfare payments). They also
raise taxes in order to provide 'public goods', such as education, law & order, and
defense.
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4. Traditional Economy
Features: production method, exchange & distribution are all sanctioned by customs;
technological changes & innovations are constrained by tradition; economic activities are
secondary to religious & cultural values. The basic questions are answered by
tradition/long staining rules of behaviors.
1.3 PRODUCTION POSSIBILITIES FRONTIER (PPF),

EFFICIENCY, AND OPPORTUNITY COST
Production Possibility Frontier
Economists use the concept of production possibilities frontier (PPF) to illustrate the
concepts of scarcity, choice, opportunity costs and the law of increasing costs.
Definition: The production possibilities frontier (PPF) represents the combinations of
goods that can be produced when the factors of production are used to their full potential.
Alternatively, it shows the maximum possible output of a pair of goods or services that can
be produced with available resources and technology over a given period of time.
Simplifying assumptions in using PPC for our Illustrations:
1) Fixed Resources: The quantity & quality of economic resources available for use
are constant for a short period of time; but they can be shifted or reallocated
among different uses in the long run.
2) Fixed Technology: Technology doesn't change over the course of our analysis
(over a very short period of time)
3) Only two products in the economy: i.e., suppose that our economy is producing
just two products: Food & clothing.
4) Efficiency: The economy is operating at full employment & achieving productive
efficiency.
Full-employment means full utilization of resources, or no waste or mismanagement
of resources.
Productive efficiency occurs when society cannot produce more of one good without
cutting back on another good.
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Now given the above assumptions, we can begin our study of food and clothing with the
numerical example of the table below.
Production Possibilities of Food & Clothing
Combination Food Clothing
(In Ton) (In Meter)
A 18 0
B 17 1
C 15 2
D 12 3
E 7 4
F 0 5
Here the economy has limited resources that can be used for food or clothing, food-
clothing trade-off.
Suppose that our economy threw all its resources in to producing the food item, and then
it will produce no clothing and the maximum of 18 tons of food with the existing
technology & resources (point A in the table).
At the other extreme (point F) all the society's resources had instead been devoted to the
production of clothing. In this case, only five units of clothing could be produced if we
are willing to produce no food. At point C, 2 units of clothing are produced; the
maximum number of tons of food that can be produced is therefore 15. Each
intermediate point between A & F represents a different combination of food & clothing
that are produced using the given resources & technology.
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A
B
18
17 C
15
D
12 G=unattainable
Food 7 H=attainable E
0 1 2 3 4 5 Clothing
Production Possibilities Frontier (Graphical Depiction of PPF)
-The Frontier (curve) shows the menu of choice along which society can choose to
substitute clothing for food or vice versa, assuming a given state of technology & a given
total amount of resources.
-Points outside the frontier (such as point G) are impossible or unattainable (under the
given assumptions)
-Any point inside the curve, such as H, indicates that resources are unemployed, or not
used in the best possible way, hence though attainable not efficient.
-Each point on the PPF represents some maximum output. That is, all points on the PPF
are efficient.
Efficiency
An economy operates on its PPF only when it uses its resources with maximum
efficiency. If the economy produces output combinations that lie on the PPF, the
economy is efficient.
Definition: Efficiency occurs when the economy is using its resources so well that
producing more of one good results in less of other goods, i.e. no resources are being
wasted.
Note that the employment of all available resources is insufficient to achieve efficiency.
Full production must also be realized. Full production implies two kinds of efficiency:
allocative efficiency & productive efficiency. Allocative efficiency means that resources
are being devoted to those combinations of goods & services most wanted by society. In
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addition, productive efficiency is realized when the desired goods & services are
produced in the least costly ways. Thus, full production means producing the "right
goods" (allocative efficiency) in the "right way" (productive efficiency).
Being on the PPF means that producing more of one good inevitably implies sacrificing
other goods, i.e., substitution is the law of life in a full-employment economy & PPF
depicts the menu of society's choice.
The PPF can help to introduce many of the most basic concepts of economics:
- It shows the outer limit of combination of producible goods & services in a given time
period with the available resources. Scarcity is a fact.
- Scarcity of resources is implicit in that all combinations of output lying outside PPC are
unattainable.
- It illustrates the combinations of goods that can be produced when resources are fully
utilized. Thus, it shows economic choices open to society.
- It is also used in illustrating the three basic economic problems (what, how & for
whom).
- Opportunity costs are always there - we obtain additional quantities of any desired good
by reducing the potential production of another good.
- Its concavity reveals the law of increasing costs.
Economic Growth and the PPF
Economic growth occurs when the economy expands its outputs of goods and services.
Economic growth is an expansion of the PPF outward and to the right.
The PPF can expand for two reasons:
a) When capital, labor or any resource(s) of the economy expand(s). This type of growth
is extensive growth. It is the result of the expansion of the economy's resources.
b) When the efficiency of the use of productive resources improve. This type of growth
is intensive growth. Intensive economic growth is the result of the more efficient use
of available resources. The sources of intensive economic growth are improvement
in technology, better management techniques, & the creation of better legal &
economic institutions.
a) The effect of increasing the stock of capital on the PPF:
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y
Consumption goods
x
y
z
O z y x
Capital goods
The initial PPF is curve XX. If the economy chooses point h, allocating all resources to
the production of consumption goods, the PPF in the future will not change. It remains
the same, xx. However, if the economy chooses point a, allocating most resources to the
production of consumption goods & few to the production of new capital goods, then the
PPF in the future will shift out to curve YY. If, however, the economy chooses point b,
with comparatively little consumption & comparatively high production of new capital
goods, the future PPF shift out further to ZZ. The economy will be able to satisfy more
wants at ZZ than at YY.
Increase in labor or land or discoveries of natural resources also shift the PPF outward.
b) Intensive growth occurs when society learns how to get more output from the
same inputs: Technological progress also shifts the PPF outward.
Technical progress & increase in productive factors (land, labor, and capital) have
different effects on the PPF. Technical progress may affect only one industry where as
labor, capital & land can be used across all industries. The figure below shows a technical
advance in wheat production without a corresponding change is the productivity of car
production.
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*Technical progress in wheat production:

Wheat
B
A
O F Car
If a higher yielding strain of wheat is discovered, a larger quantity can be produced with
the same resources. Since this wheat production will not influence car production, the
PPF will rotate from AF to BF. Here the PPF shifts upward but not to the right
Opportunity Costs
We know that resources are scarce which forced us to make choices among competing
ends. However, whenever we make choices among competing ends, we must sacrifice
valuable alternatives. The value of such a sacrifice is an opportunity cost.
Definition: The opportunity cost of any decision is the foregone (sacrificed) values of
the next best alternative that is not chosen.
Economic decisions are based on opportunity costs. Before signing a contract to work
for commercial banks, workers must consider the other employment opportunities that
they are passing up. People with saving must weigh the various alternatives before they
commit their funds to a particular investment, such as certificate of deposit, stocks or
bonds.
Every choice involved in the allocation of scarce resources has a positive opportunity
cost. Free goods have an opportunity cost of zero.
The concept of opportunity cost can be illustrated using the alternative PPF.
Consider food-clothing trade-off in the tables below.
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Combination Clothing Opp. Cost of

(possibilities) Food (in (Units)=C clothing (in tons
tons)=F ΔF ΔC of food)=ΔF/ΔC
(-)
A 18 -- O -- --
B 17 1 1 1 1
C 15 2 2 1 2
D 12 3 3 1 3
E 7 5 4 1 5
F 0 7 5 1 7
Combination Clothing ΔC Food (in ΔF Opp. Cost of

(possibilities (Units)=C tons)=F food (in units of
clothing)
= ΔC/ ΔF
F 5 - 0 - -
E 4 1 7 7 1/7
D 3 1 12 5 1/5
C 2 1 15 3 1/3
B 1 1 17 2 1/2
A 0 1 18 1 1
Graphically:
18 A
B
17
C
15 G=unattainable
12 D
Food 7 H=attainable E
F
0 1 2 3 4 5 Clothing
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Suppose the country has decided to step up its purchase of clothing from 3 units (at point
D) to 4 units (at B). What is the opportunity cost of this decision? The cost is the
alternative food that must be given up to produce the extra unit of clothing. It is
computed as:
Opportunity cost Amount of food decline
= = 5/1 =5
Of clothing (D to E) Amount of clothing generated
Opportunity cost) Clothing given up
= = 1/5 = 0.2
Of food (E to D) Food Gained
The Law of Increasing Costs
As can be seen from the tables & figures so far, the opportunity cost of increasing the
production of clothing from zero to one unit is the 1 ton of food that must be scarified in
the move from A to B. The opportunity cost of one more clothing (movement from B to
C) is 2 tons of food. The opportunity cost of the move from E to F is much higher, 7 tons
of food. In other words, the opportunity cost of clothing rises with the production of
more clothes (move from A to E). This tendency for opportunity costs to rise is known as
the law of increasing costs.
Definition: The law of increasing costs states that as more of a particular commodity is
produced, its opportunity cost per unit increases.
The bowed-out (concave from the origin) shape of the PPF shows the law of increasing
costs. The economic rational for the law of increasing opportunity costs is that economic
resources are not completely adaptable to alternative uses. Less productive resources are
taken away from one use at the first instant and the more productive ones (those with
higher opportunity costs) will follow.
In general, the PPF displays:
® Scarcity of productive resources - which limits the production of goods &
services.
® Efficiency - the need to reduce output of certain products in order to increase the
quantity produced of other products (negative slope and being on PPF).
® A concave curvature due to the less adaptability of some resources to the
production of certain products – the law of increasing costs.
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Exercise:
The exact relationship between the two exam scores can be more easily seen with a
production possibilities schedule. This is a table showing alternative combinations of two
goods (exam scores) that can be produced from a given amount of resources (ten hours of
study time.)
Statistics
Possibility Economic Points points
A 100 (A) 0 (F)
B 90 (B) 40(D)
C 70 (C) 60(C)
D 40 (D) 85(B)
E 0 (F) 100 (A)
® What is the opportunity cost of additional statistics point when its score is
increased from 60 to 85 points?
® What is the opportunity cost of each additional economics point when its score is
increased from 70 to 90 points?
® If the students were scoring 65 points in economics & 50 points in statistics, are
they using all the given hours of study time efficiently? Why?
® Suppose the amount of hours of study time increases near the exam period. Then
what would happen to the exam scores?
1.4 DECISION MAKING UNITS AND THE CIRCULAR FLOW
OF ECONOMIC ACTIVITIES
Decision Making Units
There are three decision-making units in an economy:

1) Households,
2) Firms/Business organizations, and
3) Government.
Household is defined as all the people who live in one roof & make financial decisions
jointly. The members of a household are often referred to as consumers because they buy
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and consume most of the consumption goods & services. Principal ownership of
resources is what characterizes the household. Households make consistent decisions as
though they were composed of a single individual i.e., economists avoid internal conflicts
among household members in the case of resource usage.
Firm is the economic unit that employs resources to produce goods & services. They sell
their product to households, other firms & government. Firms also make a consistent
decision as though they were composed of a single individual i.e., informal conflict is
avoided.
Government: includes all Ministries, Government Agencies and other government
organizations. It also comprises government at different levels like Federal, State &
Local Government. It is an important unit that corrects the market mechanism when
there is a failure.
The Circular Flow Model
Definition: The Circular flow model implies a complex interrelated web of decision-
making and economic activity. The interaction between consumers & producers takes
place in two different markets called:
1. Factor market – in which services of resources are sold, or
2. Goods market – in which goods & services produced by firms are sold.
In general, in the circular flow of output and income in the capitalist economy, we have
two markets-resource & product markets, and two economic participants - households
and firms (businesses).
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Costs Money income (wages, r, i, π)
Resources Resource L, Land, K, Entrepreneurial Ability

Market
Business
Enterprises
Households
Goods & Services Goods & Services
Product Consumption expenditure

Receipt Markets
Note: 1) The prices paid for the uses of inputs (L, K, etc) are determined in the resource
market (shown in the upper loop). Business enterprises are on the demand side &
households are on the supply side of this market.
2) The prices of finished goods & services are determined in the goods market
represented in the lower loop of the diagram. Households are on the demand side &
business enterprises are on the supply side of this market.
In the nutshell, households (as resource owners) sell their resources to firms and (as
consumers) spend the income received in buying goods & services. Business enterprises
must buy resources in order to produce goods and services. Firms also sell their finished
products to households in exchange for consumption expenditures, which businesses
view it as receipts (revenue). Thus, the net effect is a counterclockwise real flow of
economic resources & finished goods & services, and a clockwise money flow of income
and consumption expenditures. These flows are simultaneous and repetitive.
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Drawbacks:
¾ It does not show transactions within the household and the firm sector.
¾ Economic role of government is not mentioned.
¾ It assumes that households spend all their income and, hence the flows of income
& expenditure are equal in volume.
Costs Money income (wages, r, i,π)
Resource
Resources Market L, land, K, entrepreneurial Ability
Cash payment
Resources
Subsidy Income support
Business Government
Tax payments Tax payment
Enterprises Household
Gov't services Gov't services
Pay’t (cash)
services
Goods &
Goods & Services Goods & Services
Product
Receipt Consumption expenditure
Markets
The Circular Flow Model with Government Intervention
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1.5 Forms of Business Organization & the Stock Market
Forms of Business Organization
There are three major forms of business organization in the private sector:
® The single /sole/ proprietorship
® The partnership, and
® The corporation
Definition:
*In the single proprietorship, one owner makes all the decisions and is personally
responsible for all of the firm’s actions and debts.
* In the partnership, there are two or more joint owners, each of whom may make
binding decisions and may be personally responsible for all of the firm’s actions and
debts.
* In corporation, the firm has a legal existence separate from that of the owners. The
owners are the firm’s shareholders, and they risk only the amount they put up to
purchase their shares. The owners elect a board of directors, which hires managers to
run the firm under the board’s supervision.
Advantages and Disadvantages
Sole proprietorship
Advantages
The major advantages of the sole proprietorship are:
® The owner is the boss who maintains full control over the firm/business
® Personal motivation (since loss or profit is to the owner himself/herself).
® The business is too simple to form.
® The firm requires lower amount of financial capital to establish.
® No double taxation.
Disadvantages
® The size of the firm is limited by the amount of capital that the owner can personally
raise.
® Too small to withstand competition.
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® The owner is personally responsible by law for all debts of the firm, i.e. unlimited
liability (if the firm fails, owner’s personal asset is at risk).
® Firm’s existence is limited to the life of the owner or even less.
Partnership
Advantages
® Partners may be able to finance a much bigger enterprise than sole proprietorship.
® It is also easy to form and manager.
® No double taxation.
® Has the capacity to withstand competition.
® Greater specialization in management
Disadvantages
® Unlimited liability.
® Shortage of capital compared with corporation.
® Short-lived, i.e., its existence is limited to the existence of partners or less.
Corporation
Advantages
® Large financial capital
® Limited liability (the personal liability of any one stockholder is limited to what
he/she actually invested in the firm).
® Long life, i.e. unaffected by frequent changes in investors. It continues independent of
its owners.
® Shareholders are free to sell or retain their holdings.
Disadvantage
® Lack of coordination between management & shareholders - conflict of interest.
® Double taxation as corporate profit and as individual income (from individual)
The stock market
Stock market is an organized market in which shares (equities) are traded (bought &
sold). A share (stock) is a marketable document of a specified face value that certifies
whoever is holding it has contributed to the magnitude of the face value into the capital of
the firm that has issued and entitles the holder the payment of dividends out of the net
profits of the firm.
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CHAPTER TWO
THE THEORY OF DEMAND AND SUPPLY
2.1 The Concept of Market
Definition: Market is a place, condition, or mechanism, which brings together both

buyers (demanders) and sellers (suppliers) in order to exchange their goods and services.
Thus, the market means the system in which sellers and buyers of a commodity interact
to settle its price and the quantity to be bought and sold.
In a market economy, economic activities are coordinated through price system;
resources are allocated through price mechanism. In other words, price has a primary
influence in determining allocation of resources in market economic system.
When we think of price we often think of value, when we think of value, we may think of
utility. The above three terms i.e. price, valve and utility, are not exactly the same rather
they are closely related. The buyer will give value to the product in the market by giving
a certain amount of price. But utility is related to satisfaction that the buyer get from the
commodity he purchases. Price is the money measure of
2.2 Perfectly Competitive Markets
Economists distinguish market on the basis of:

a) Nature of goods & services e.g. factor market and product market
b) Number of firms, type of product, control over price, entry to the market and
degree of competition. E.g. pure competition, pure monopoly, monopolistic
competition and oligopoly.
The last three markets are termed as imperfectly competitive markets where as the first
one is termed as perfectly competitive market.
In the price mechanism, the market should be perfect or purely competitive. A purely
competitive market has several distinct characteristics that set it off from other market
structures.
1.Large number of sellers and buyers: There are many small firms, each producing
an identical product and each too small to affect the market price.
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2.Standardized (Homogenous) Product: Competitive firms are producing identical

products. Given price, the consumer is indifferent as to the seller from which the
product is purchased.
3." Price taker”: In a purely competitive market individual firms exert no significant
control over product price. This character follows from the preceding two. That
means firms faces with infinitely elastic or horizontal demand.
4.No non-price competition: no distinguishing feature. Because purely competitive
firms produce homogeneous product, there is virtually no room for non-price
competition, that is, competition on the basis of product differentiation, advertising
or sales promotion.
5.There is perfect knowledge of market information: price, cost, etc…
6.No government intervention: no subsidy, quota, etc…
7.Free entry and exit: New firms are free to enter and existing firms are free to leave.
Under these conditions, there will be competition among sellers and this competition will
lead to the efficient production and use of resources. All markets that will not fulfill the
above conditions are said to be imperfect markets or non-competitive markets. In reality
in many countries very few markets have met the above conditions, and thus, only a few
markets are really competitive.
There are different forms of imperfect market structure. These are:
1.Pure monopoly: It is a type of market where there is only one seller of goods and
services. No close substitute for the product of pure monopoly firms, it is a price
maker and entry to the market is blocked.
2 Monopolistic competition: It lies between the two extremes of pure competition and
pure monopoly. There is relatively large number of firms with heterogeneous
products and it has some limited power in controlling price. Entry to the market is
relatively easy and non-price competition is common.
3. Oligopoly: Few firms dominate the market for the product. The products can be
both homogeneous & heterogeneous, mostly pricing will be done in collusion and
there is some difficulty in entering the market. Advertising and quality competition is
stronger when the products are heterogeneous.
22
2.3 Demand and Supply Functions, Schedules and Curves
Meaning of Demand
Demand is defined as an individual’s willingness and ability to buy or purchase goods

and services at different levels of price during a particular time, ceteris paribus. Ceteris
paribus is a Latin term meaning “other things being equal”. Otherwise it becomes
difficult to establish the effect of one factor on anther (if other things change).
Individual Demand Functions, Schedules and Curves
The quantity of a commodity that an individual is willing and able to purchase over a
specific time period is a function of (or depends on) the price of the commodity, given
the person’s money income (M), the price of other commodities (Po) and individual
tastes (T). That is,
_ _ _
Quantity demanded = f (P, M, Po, T…), where a bar implies constant
By varying the price of the commodity under consideration while keeping M, Po and T
constant (assumption of ceteris paribus), we get the individual’s demand schedule for
the commodity. A demand schedule is a tabular representation of a series of prices of a
commodity and the corresponding quantity demanded. The graphic representation of the
individual’s demand schedule gives us his/her demand curve. The demand schedule or
function shows the relationship between various possible prices of a product and the
quantities, which consumers will purchase at each of these prices.
Suppose that an individual’s demand function for a commodity, X, is linear and given as:
Qdx = 5 – Px, ceteris paribus
Now by substituting various prices of X into this demand function, we get the
individual’s demand schedule show below
px (Price of X) 0 1 2 3 4 5
Qx(quantity 5 4 3 2 1 0
of x)
23
Demand curve is a graphical depiction of a demand schedule. It can be obtained by

plotting the demand schedule on a graph.
Px
5
4
3
2
1
0 1 2 3 4 5 Qx
The demand curve shows that, at a particular point in time, the individual is willing to
buy a certain unit of X over the period of time specified.
The Law of Demand
Note that quantity and price are inversely related: quantity demanded of X going up when
prices go down. That is, the function has a negative slope, or the curve slopes downward.
This important properly is given a name the law of downward sloping demand. The law
of demand can be stated as, all other things remaining constant, the quantity demanded of
a commodity increases when its price decreases and it decreases when its price increases.
The law implies that the quantity demanded and price changes are inversely (negatively)
related, ceteris paribus.
What is the rational behind the downward-sloping demand? There are two
reasons:
1.Substitution effect: when price of goods rise, consumers naturally substitute other
similar goods for it .For example, chicken for beef, or tea for coffee
2.Income effect: Which come in to play because when price goes up, a consumer
finds him/her self poorer than before (and hence reduce consumption of that good).
Real income decreases with price rise. i.e. purchasing power falls. The inverse is
true for price fall.
24
3.The law of diminishing marginal utility because the extra satisfaction from
successive units of a commodity declines as more of it is consumed, a consumer
buys more units only at reduced prices.
Individual and Market Demands
Individual demand may be defined as the quantity of a commodity that a person is willing
and able to buy at given prices over a specified period of time. Market demand refers to
the total quantity that all the users of a commodity are willing and able to buy at given
prices over a specific period of time.
The Market Demand for a Commodity
Gives the alternative amounts of the commodity demanded per time period, at various
alternative prices, by all the individuals in the market. Geometrically, the market demand
curve for a commodity is obtained by the horizontal summation of all the individual’s
demand curves for the commodity. For instance, If there are three identical individuals in
the market, each with a demand for a commodity X given by Qdx = 5 – Px, then the
market demand (QDx) is obtained as follows:
QDx = Qd1+Qd2+Qd3 = 3(Qdx) = 15- 3Px.
Px Px Px Px
5 5 5 5 Market Demand
2---------------- 2 ---------------------- 2------------------ 2-----------
3 5 3 5 3 5 9 15
Determinants of Demand
The demand curve shows what would happen to the quantity demanded if only the good’s
own price were to change. But good’s own price is not the only determinant of demand;
other factors can play an important role. These factors include:
a) The prices of related goods (Po)
25
b) Consumer income (I)

c) Consumer preferences (tastes) (T),
d) The number of potential buyers,
e) Expectations,
Prices of Related Goods: goods can be related to each other as either substitutes or
complements. Substitute goods are goods that serve the same purpose implying that the
demand for one and the price of the other move in the same direction. Two goods are
substitutes if the demand for one rises/falls when the price of the other rises/falls. E.g.
Tea and Coffee. Complement goods are goods used together. These goods are “go
together” goods. e.g. car and gasoline, Tea and Lemon, etc. Thus, two goods are
complements if the demand for one falls when the price of the other increases.
Income: as our income rises, we spend more on normal goods and services. But as
income increases, we spend less on inferior goods. Thus, as income changes, demand
also changes. A normal/superior good is one for which demand increases when income
increases, holding all prices constant. An inferior good is one, for which demand falls as
income increases, holding all prices constant.
Preferences: is what people like and dislike without regard to budgetary considerations.
Preferences and budgetary considerations determine demand. Thus, as preferences
change, demand changes.
The Number of Potential Buyers: If more buyers enter the market, the market demand
will rise, and vice versa.
Expectations: The mere expectation of an increase in a good’s price can induce us to buy
more of it (today). Similarly, we can postpone the purchase of things that are expected to
get cheaper. It is also true for income expectation, which results in change in demand.
Movements along and Shifts in the Demand Curve
Movement along the demand curve: is indicated by a change in the quantity demanded,
which represents the amount of a good buyer is willing and able to buy in response to a
change in its own price. In other words, a change in quantity demanded is the movement
along a given demand curve by an increase or a decrease in the price of the good itself,
other things remaining the same.
26
Px
P 1--------- ---A
P2 -------------------------- ------B
O X1 X2 QX
Shift in the Demand Curve (Change in Demand): Occurs when one or more of the
non-price determinant (s) like income, taste, prices of other goods, etc are changed while
the good’s own price held constant. Change in demand is a change in the relationship
between the price of a good and quantity demanded caused by a change in demand
determinants other than the price of the good. Thus, a change in demand implies a move
of an entire demand curve. I.e. the entire demand curve shifts. Therefore, the ceteris
paribus conditions (demand determinants other than own price) are called shift factors.
To be specific, if individuals are willing and able to buy more of a good at each possible
price (say due to rise in income), we call it an increase in demand. But if consumers buy
less of the product at each possible price (say due to fall in income), we call it a decrease
in demand.
a) Increase in Demand b) Decrease in Demand

Px Px
D’
D
D D’
Figure: Shifts in the demand curve (change in demand)

In summary, an increase in the demand for product X – the decision of consumers to buy
more of it at each possible price [see panel (a)] – can be caused by:
• A favorable change in consumer tastes
• An increase in the number of potential buyers in the market,
27
• A rise (or fall) in income if X is a normal (or inferior) good

• An increase in the price of related good, say Y, if Y is a substitute for X,
• A decrease in the price of related good, say Y, if Y is complement to X, and
• Expectations of future increases in prices and incomes
Conversely, a decrease in the demand for X [see panel (b)] can be associated with:
• An unfavorable change is tastes,
• A decrease in the number of buyers in the market
• A rise (or fall) in income if X is an inferior (or normal) good,
• An increase in the price of related good, Y, if Y is complementary to X,
• A decrease in the price of related good, Y, if Y is substitute for X, and
• Expectations of future price and income declines.
Supply Side of the Market
The quantity of a commodity that a single producer is willing to sell over a specific time
period is a function of or depends on the price of a commodity and the producer’s costs
of production (technology, prices of inputs). In a market economy, while buyers of a
product constitute the demand side of the market, sellers of that product make supply side
of the market.
• Supply may be defined as a schedule, an equation or a curve which shows the
various amounts of a product which a producer (firm) is willing and able to produce
and make available for sale in the market over specific time period, at given prices,
ceteris paribus.
• The quantity supplied of a good or service is the amount offered for sale at a given
price, holding other factors constant
The Law of Supply
The law of supply can be stated as ‘the quantity supplied of a product increases with the
increase in its price and decreases with decrease in its price, other things remaining
constant”. It implies that the quantity supplied of a commodity and its price are positively
related, which holds under the assumption that “other things remaining constant”(costs of
28
production, technology, price of related goods, and weather and climate for agricultural
products, etc. held constant).
Supply function: Is a statement that states the relationship between the quantity supplied
(as dependent variable) and its determinants (say price, as independent variable). Suppose
that a single producer’s supply function for commodity X is given as: Qsx= 10Px, ceteris
paribus.
Supply schedule: is a tabular presentation of the (law of) supply. By substituting various
“relevant” prices of X into the above supply equation, we get the producer’s supply
schedule shown below:
Px (in Br) 0 1 2 3 4 5
Qsx 0 10 20 30 40 50
Supply curve; is a graphical depiction of the supply schedule plotting each pair of values
from the supply schedule in table above on a graph and joining the resulting points we get
the producer’s supply curve, as below
Px
Sx
5
4
`
3
2
1
0 10 20 30 40 50 Qx
It will be immediately noted that the supply schedule the supply curve above show a
direct relationship between price and quantity supplied. This particular relationship is
called the law of supply. It simply tells us that producers are willing to produce and offer
for sale more of their products at a higher price.
29
The Market Supply of a Commodity
Gives the alternative amounts of the commodity supplied per time period at various
alternative prices by all the producers of this commodity in the marker. It is horizontal
summation of individual supplies in the market. Thus the market supply of a commodity
depends on all the factors that determine the individual producer’s and in addition, on the
number of producers of the commodity in the market.
If there are two identical producers in the market, each with a supply of commodity X
given by: Qsx = 10Px -20, ceteris paribus, t he market supply (Qsx) is obtained as
follows:
Px qs1 qs2 Qs (qs1+qs2)

2 0 0 0
3 10 10 20
4 20 20 40
5 30 30 60
Mathematically:
Qsx = qs1 + qs2 = 2(qsx) ---since both have the same supply function,
qs1=qs2=qsx
Qsx = 2(10Px -20)
Qsx = 20Px - 40 Qsx =20Px -40
Px Px Px
5 5 5
4 4 4
3 3 3
2 2 2
1 1 1
0 10 20 30 Qx 0 10 20 30 Qx 0 20 40 60 Qx
30
Determinants of Supply
In constructing a supply curve, the economist’s assumption is that price is the most
significant determinant of the quantity supplied of any product. But factors other than the
good’s own price can change the relationship between price and quantity supplied. These
other factors include:
¾ The prices of other goods
¾ The prices of relevant factors
¾ The techniques of production (technology)
¾ The number of sellers in the market
¾ Taxes and subsidies, and
¾ Price expectations
Change (Shift) in Supply
A change in any one or more of the basic non-price determinants of supply will cause the
supply curve for product to shift to either the right or the left.
• An increase in supply of commodity X; the decision of producers to sell more of X at
each possible price can be caused by:
Technological improvement
A decrease in resource prices
Subsidies
A decrease in the price of other goods, say Y-a good which competes for resources,
and
Expectations: expected price increases may induce firms to expand production
immediately, causing supply to increase
Conversely, a decrease in the supply of commodity X can be caused by changes in non-
price factors (listed above) in the opposite direction.
In general, an increase and a decrease in the supply of goods, X, can be illustrated by an
upward and downward shift in the supply curve respectively.
31
Px S2 S0
S1
B
A
O Qx
A shift to the left, S0 to S2 , indicates, a decrease in supply: suppliers are offering less at
each price. A shift to the right from S0 to S1, designates an increase in supply: producers
are now offering more of X at each possible price.
Change in Quantity Supplied
A change in quantity supplied refers to the movement from one point to another point on
a given stable supply curve. The cause of such a movement is a change in the price of the
specific product under consideration. The movement from A to B on S0 of figure above
represents “change in quantity supplied”.
Market Equilibrium
In general sense, the term equilibrium means the “state of rest”. In the context of the
market analysis, equilibrium refers to the marker condition, which once achieved, tends
to persist. This condition occurs when the quantity demanded of the commodity equals
the quantity supplied of the commodity. This equality produces an equilibrium price
(market- clearing price)
The equilibrium price in a free market is determined by the market force of demand and
supply. Suppose that the market demand and supply schedules are given as shown in
table below:
32
Monthly demand and supply schedules for shirts:

Price per Demand Supply market
Shirt ( br) (‘000 shirts) (‘000 shirts) position
10(rise) 80 20 shortage (-)
20(rise) 70 40 shortage (-)
30(stable) 60 60 equilibrium
40(fall) 50 80 surplus (+)
50(fall) 40 100 Surplus (+)
60(fall) 30 120 Surplus (+)
The above table shows how market equilibrium is reached. When price of shirt is, say
Birr 20, the quantity demanded is 70 units of shirts, but the quantity supplied is only
40units of shirts. The result is a shortage of 30units shirts. Thus, unsatisfied buyers will
bid the price up. Raising the price will reduce the shortage. If, however, the price of shirts
rose to, say Birr 40 per shirt, the quantity supplied is 80units of shirts while the amount
demanded is only 50 units of shirts. The result is a surplus of 30 units of shirts. This
surplus will cause the price of shirts to fall as unsatisfied sellers bid the price down. As
the price falls, the surplus will diminish. Thus as the table shows, there is only one price
of shirts (Br.30) at which the market is in equilibrium, i.e. the quantity demanded and
quantity supplied are equal at 60 units of shirts. At all other prices, the shirt market is in
disequilibrium.
We have already seen that a surplus causes price to decline & a shortage causes price to
rise. With neither shortage nor surplus (at Br.30), there is no reason for the actual price of
shirts to move away from this price. The economists call this the equilibrium price:
equilibrium meaning “in balance” or “at rest” Graphically: this is the price at which the
quantity demanded and the quantity supplied are equal.
SS
DD
Px SS
Pe
Qe 33 Qx
The intersection of the down sloping demand curve & the up sloping supply curve
indicates the equilibrium price and quantity (Birr 30 & 60 thousand shirts). The shortage
of shirts that would exist at below equilibrium price, for example 30 thousand shirts at
Br. 20, derives price up and in so doing increases the quantity supplied & reduces the
quantity demanded until equilibrium is achieved. The surplus, which occurs above the
equilibrium price, for e.g. 30 thousand of shirts at Br.40, would push prices down &
thereby increase the Qd & reduce the Qs until equilibrium is achieved. In a free market,
disequilibrium itself creates the condition for equilibrium.
Algebra of Demand-Supply Equilibrium
Let the demand function for commodity X be given as Px= 30-0.2 Qx, and the supply
function as Px= 0.10QX. We know that the equilibrium of demand &supply takes place
where the quantity supplied equals the quantity demanded, i.e. Qd=Qs.
From Px=30-0.2Qx,Qx=(30-Px)/0.2
Qx=150-5Px
From Px=0.10Qx,Qx=10Px
At equilibrium, Qs=Qd
10Px=150-5Px
15Px=150
Px=10 & Qx=10(10)=100.
What Is the Effect of Changes in Demand and Supply on the Market Equilibrium?
t Change in Demand (Supply Constant):
Case 1: Demand increases Case 2: Decrease in demand

Px S Px S
P’ P D↓⇒↓P&Q↓
D↑⇒↑ P&↑Q
P P’
D1 D2 D2 D1
0 q1 q2 Q 0 q2 q1
34
In general, assuming supply is constant, a change in demand is directly related with

change in equilibrium price and quantity.
t Change in Supply (Demand Constant):
Case 1: Supply increase Case 2: Decrease in supply S2

Px S1 Px S1
P1 S2 P2
P2 P1
D
0 q1 q2 0 q2 q1 Qx
S↑⇒ ↓P&↑Q S↓⇒↑P&Q↓
When demand is constant, there is an inverse relationship between change in supply and
the resulting change in equilibrium price. But, changes in supply and the resulting changes in
equilibrium quantity are directly related.
tChange in Demand and Supply at the Same Time:
Case 1: when both change by the same magnitude and in the same direction:
A. Increase in both dd & ss: B. Decrease in both dd & ss:
S2
D1 D2 S1 D2 D1 S1
S2 p
q1 q2 q2 q1 Qx
Case 2: when both change by the same magnitude but in opposite directions:
A. Demand increase and supply decrease: B. Demand decrease and supply increase:
P S2 P S1
p S1 p S2
p’ p’ D1
D1 D2 D2
0 q Q 0 q Q
35
Summary of the Above Diagrams:

Case 1: Assuming demand & supply change by the same magnitude, a change in demand
& supply in the same direction has a direct relationship with equilibrium quantity but it
has no effect on equilibrium price.
Case 2: Assuming demand & supply change by the same magnitude, if demand and
supply change in opposite directions, equilibrium price changes following the direction of
change in demand, i.e. change in demand & the resulting change in price are direct when
supply changes by the same amount but in the opposite direction with demand, & vice
versa. In this case, the equilibrium quantity is unchanged.
Changes of demand & supply by different magnitudes:
Case 1: in the same direction
(a) Increase in demand & supply:
Separate effect: Increase in demand leads to a rise in both equilibrium P & Q; but rise in
supply causes fall in P but rise in Q.
Combined effect: change in equilibrium price is indeterminate, but equilibrium quantity
rises.
(b) Decrease in demand & supply
Separate effect: Fall in demand causes fall in both P and Q. Fall in supply makes
equilibrium P increase & equilibrium Q fall.
Combined effect: change in equilibrium price is indeterminate but equilibrium quantity
falls.
Case 2: in different directions
(a) Increase in demand &decrease in supply:
Separate effect: Increase in demand leads to rise both in equilibrium P & Q; but fall in
supply causes equilibrium P to rise & equilibrium Q to fall.
Combined effect: change in equilibrium quantity is indeterminate, but equilibrium price
rises
(b) Decrease in demand &increase in supply
Separate effect: Fall in demand, causes fall in both P & Q. Rise in supply leads to rise in
Q but fall in P.
Combined effect: change in equilibrium Q is indeterminate but equilibrium P falls.
36
Elasticity of Demand and Elasticity of supply
Elasticity of demand is the measure of responsiveness of demand for a commodity to the

changes in any of its determinants, such as price of the commodity, price of related
goods, and consumers’ income. Accordingly, there ate three basic elasticities:
1.Price elasticity of demand,
2.Cross-price elasticity of demand &
3.Income elasticity of demand
Price elasticity of demand is a measure of the degree of responsiveness (or
sensitiveness) of consumers to a change in price of the commodity itself. More exactly, it
may be defined as the ratio of the percentage change in quantity demanded to the
percentage change in price. In other words, the price elasticity of demand (ep) is the
percentage change in the quantity demanded divided by the percentage change in price.
Economists measure the degree of elasticity or inelasticity by the elasticity coefficient
(ep), which is given as follows:
⎡ ΔQ ⎤
percentage change in quantity demanded ⎢Q ⎥ ΔQ P
ep = = ⎣ ⎦ =
percentage change in price Δ
⎡ ⎤ ΔP Q
P
⎢⎣ P ⎥⎦
Price elasticity of demand is of two types: point elasticity and arc elasticity of demand.
Point elasticity of demand: measures elasticity at a (given) point or for a very small
change in price. Symbolically,
percentage change in quantity demanded ΔQ P
ep = = , Where P & Q represent price
percentage change in price ΔP Q
and quantity at the given point.
Arc elasticity of demand measures elasticity of demand between two points on the
demand curve/ for a substantial change in price/. Here we use the average price and
average quantity to calculate the price elasticity. Thus, it is a mid-point elasticity formula.
This formula yields the same elasticity coefficient for an increase (from the lower price to
a higher price) as well as for the decrease (from a higher price to the lower price).
37
ΔQ P1 + P2
Arc elasticity of demand ep =
ΔP Q1 + Q2
Illustration
Demand schedule
Points price quantity
($) (Q)
A 0 800
B 2 600
C 4 400
D 6 200
E 8 0
Find elasticity of demand between two points (B &C).
Case 1. Price increase (B to C).
ep= [(400-600)/(4-2)] (2/600) = - 1/3
Case 2. Price decrease (C to B)
Ep= [(600-400)/(2-4)] (4/400)= - 1
Here we get different values for point elasticity of demand for the same price change but
in opposite directions. We can avoid these different results by using average prices &
quantities i.e. using a modified formula for price elasticity – arc elasticity of demand.
ep= [(600-400)/(2-4)] [(2+4)/(600+400)] = 0.6. Price elasticity varies along a given
linear demand curve. The above demand schedule can also be expressed in the form of a
demand equation or demand curve:
Demand equation: Qx=800-100Px
P
8 A
6
M
4
2
E
0 200 400 600 800 Q
Demand Curve
38
If point M is the mid point of the demand curve, then:

1.ep at that point is unity – a one percent change in price leads to the same
percentage change in quantity demanded if demand is unitary elastic (/ep /=1).
2.ep to the left of point M is greater than one – a one percent change in price leads
to a more than one percent change in quantity demanded if demand is
relatively elastic (/ep />1).
3.ep to the right of point M is less than unity (since slope is constant and P/Q is
decreasing as we move down the demand curve, ep is also decreasing) - a
certain percentage change in price leads to a change in quantity demanded by
a lesser than percentage if demand is relatively inelastic (/ep /<1).
4. ep at point A is infinitely (perfectly) elastic- a very small change in price leads
to an infinite (very large) change in quantity demanded.
5.ep at point E is zero. Demand is said to be perfectly inelastic if ep =0; the
situation where a price change results in no change in quantity demanded –
(demand is perfectly inelastic).
Price Elasticity and Total Expenditure /Revenue/
Total Revenue/ TR/of producers or Total Expenditure/TE/ of consumers on a particular

commodity in a market is the price of the commodity times the quantity sold (bought).
i.e.=Px Q. Regardless of the shape of the demand curve, as the price of the commodity
falls, the TE (=PQ) of consumers on the commodity:
1. rises when / ep />1,
2. remains unchanged when / ep /=1 and
3. falls when / ep /<1.
That is:
1. Price & TE move in different directions if / ep />1 (demand is elastic).
2 Price & TE move in the same direction if / ep /<1 (demand is inelastic).
3.TR/TE doesn’t change when price changes if / ep / =1 (demand is unitary elastic).
39
Numerical Example
Points Px($) Qx TE Ep= (ΔQ/ ΔP)/(P /Q)
A 8 0 0 ∞ perfectly elastic
B 7 1000 1000 7
C 6 2000 12,000 3 Elastic
D 5 3000 15,000 5/3
E 4 4000 16,000 1 Unitary Elastic
F 3 5000 15,000 3/5
G 2 6000 12,000 1/3 Inelastic
H 1 7000 7,000 1/7
I 0 8000 0 0 perfectly inelastic
Income Elasticity of Demand (eM): measures the percentage change in the amount of a
commodity purchased per unit time resulting from a given percentage change in a
consumer’s income. That is,
⎡ ΔQ ⎤
percentage change in quantity demanded ⎢Q ⎥ ΔQ M
eM = = ⎣ ⎦ =
percentage change in income ⎡ ΔM ⎤ ΔM Q
⎢⎣ M ⎥⎦
eM can be positive, zero or negative depending up on the nature of the good.

⇒If eM is negative (eM <0), the good is inferior, implying consumption varies inversely
with income.
⇒If eM is zero (eM =0), the good is income independent
⇒If eM is positive (eM >0), the good is normal (either a necessity or a luxury good).
If eM >1, the normal good is usually a luxury and if 0< eM <1, the normal good is a
necessity.
Based on the level of income, the coefficient of income elastically for a commodity is
likely to vary considerably. Hence, a good may be a luxury at ‘low’ level of income, a
necessity at ‘intermediate’ level of income & an inferior good at ‘high’ level of
income.
40
Illustration
Based on the table below, answer the following question.
Income elasticity of demand:
Income (M) Quantity (Q)
($ per year) (Units per year)
12,000 10
16,000 15
20,000 18
24,000 20
28,000 19
i Determine eM between the various successive levels of available income.

ii Indicate the range of income over which commodity X is a luxury, a necessary or an
inferior good.
Cross Price Elasticity of Demand: measures the responsiveness or sensitivity of
consumer demand of one good to changes in the price of another good. More precisely,
the cross-price elasticity of demand (exy) is the percentage change in demand of the first
product (X) divided by the percentage change in the price of the related product (Y).
Symbolically:
⎡ ΔQX ⎤
percentage change in quantity demanded of X ⎢ QX ⎥ ΔQX PY
exy = = ⎣ ⎦ =
percentage change in price of Y ⎡ ΔPY ⎤ ΔPY QX
⎢⎣ PY ⎥⎦
The coefficient of exy can be positive, zero or negative depending on the relationship that
may exit between commodities X and Y.
• If exy is positive, the two products are substitutes.
• If exy is zero, the products are unrelated.
• If exy is negative, the two products are complements.
41
Price Elasticity of Supply

Price elasticity of supply measures the responsiveness of producers to price changes.
More formally, price elasticity of supply (eS) is the percentage change in quantity
supplied divided by the percentage change in price of the commodity. That is,
⎡ ΔQ ⎤
percentage change in quantity supplied ⎢Q ⎥ ΔQ P
eS = = ⎣ ⎦ =
percentage change in price ⎡ ΔP ⎤ ΔP Q
⎢⎣ P ⎥⎦
This is point elasticity of supply.
ΔQ P1 + P2
eS = - Arc elasticity of supply.
ΔP Q1 + Q2
42
CHAPTER THREE
THEORY OF CONSUMER BEHAVIOR
UTILITY AND CONSUMPTION
Utility of a commodity is the basis of demand for it. Economists like to make a
distinction between preferences and demand. A consumer's preferences are what he or
she likes or dislikes; a consumer's demands are what she or he buys. Yet what we
demand depends on our preferences.
* Preferences indicate how we as consumers would rank

different commodity bundles in all conceivable situations. A
simple criterion for evaluating consumer preferences is to use
the utility of various commodity bundles.
Definition: Utility is a numerical ranking of a consumer's preferences among different

commodity bundles. It measures the rank order of different satisfactions rather than the
magnitude of those satisfactions (modern economic theory). In the 19th c, however,
economists expressed utility in cardinal numbers, which indicate both ranking &
magnitude. Some times the utility of a commodity depends on the availability of other
complimentary goods, like the utility from TV depends on the availability of electricity.
Utility is “ethically neutral”.
In abstract sense, the term 'utility' refers to the power or property of a commodity to
satisfy human needs. For example bread has the power to satisfy hunger, water quenches
our thirst. Utility is synonymous to 'pleasure' because consumer can derive a pleasure out
of the consumption of commodities.
Consumption: is the act of using goods & services to satisfy human wants. Some goods
satisfy final wants directly (for immediate uses). Such goods are known as consumer
goods (food, cloth, watch, etc). Some goods are produced in order to produce other
goods & services in the future. Such goods are known as producer (capital) goods.
The basic assumptions in analyzing consumer behavior are
• The consumer has limited income.
• The consumer is a rational being.
• A consumer is a utility maximizing entity.
• A consumer has full information relevant to his decision.
Two Approaches In Studying Consumer Behavior

1. Cardinal Approach: In this case utility is quantitatively or cardinally measurable
feeling like height and weight. Their method of measuring utility is as follows:
i. They used the term “util” meaning units of utility.
ii. They used money as the measure of utility and assumed that one unit of money
equals one util.
iii. They assume marginal utility of money remains constant.
43
Total utility and marginal utility

• Total utility (TU) is the amount of satisfaction or pleasures a person derives from
consumption of some specific quantities of a commodity at a particular time.
• Marginal Utility (MU): is the extra satisfaction a consumer realizes from an
additional unit of consuming that good. Alternatively, MU is the change in TU
resulting from the consumption of one more unit of a product. That is,
MU = ΔTU , where Q = quantity of a product
ΔQ
Thus, MU represents the slop of TU.
Numerical example: The utility of Bread

Quantity TU of Bread MU of Bread
of Bread (QB) (TUB) (MUB)
1 10 10
2 23 13
3 30 7
4 35 5
5 38 3
6 38 0
7 35 -3
* The law of diminishing marginal utility: is central to the cardinal utility analysis of
the consumer behavior. This law states that as the quantity consumed of a commodity
increases, over a unit of time, the utility derived by the consumer from the successive
units goes on decreasing, provided the consumption of all other goods remains constant.
The above table shows a numerical illustration of the law of diminishing MU. Here TU
increases with increase in consumption of bread, but at a decreasing rate. It means that
MU decreases with increase in consumption. This is shown in the last column of the
table.
TU
45
38
35 TU MU
30
15
23 12
9
10 6
3
0 Q 0
1 2 3 4 5 6 7 -3 1 2 3 4 5 6 7
MU
Graphically, the law of diminishing marginal utility is represented by a downward
sloping MU curve. The relationship between TU & MU can be stated as:
1. When TU increases at an increasing rate MU will increase;
44
2. When TU increase at a decreasing rate, MU will fall;

3. When TU is constant, MU is zero; and
4. When TU decreases MU will be negative.
Equilibrium (Optimum) of the Consumer

The objective of a rational consumer is to maximize the TU, or satisfaction derived from
spending his/her income. This objective is reached (or said to be in equilibrium), when
the consumer spends his/her income in such a way that the utility or satisfaction of the
dollar spent on the various goods is the same.i.e. the MU per unit of price for each
commodity must be equal. Mathematically,
Mux = MUy = … = Mun , subject to the constraint
Px Py Pn
PxQx + PyQy + …+QnPn = M ( M = individual's money income).
Example: Suppose bread (B) & Butter (T) are the only two commodities available, & PB
= 2 & PT = 1, the individual income is 18 per time period & is all spent. Given the above
information & based on table bellows, compute equilibrium quantities of B & T and TU
obtained at equilibrium.
Q 2 4 6 8 10 12 14 16
MUB 18 16 14 12 10 8 6 4
MUT 12 11 10 9 8 7 6 5
Solution:
Q 2 4 6 8 10 12 14 16
MUB/PB 9 8 7 6 5 4 3 2
MUT/PT 12 11 10 9 8 7 6 5
MUB/PB = MUT/PT = 8 , at QB=4 and QT = 10

(Thus, equilibrium quantities are:QB = 4 & QT = 10).
TU at equilibrium=(18+16)B + (12+11+10+9+8)T = 84
NB: TU=Summation of MUs, i.e. TUi=MU1+MU2+---+MUn ; (i=1,2,---,n)
Indifference Curve (ordinal) Approach
For Ordinalists what we bother about is whether a consumer prefers certain bundles of
goods and services to others, but not how much utility is derived from the consumption.
The basic assumptions under the ordinal utility theory are:
• A consumer is a rational being
• Utility is only measurable ordinally.
• Transitivity and consistency of choice.
Transitivity: If A>B, and B>C, then A>C
Consistency: If A>B, in one period, then B is not greater than/equal to A
in another period.
• Consumers always prefer a large quantity of all the goods.
45
• Diminishing marginal rate of substitution.
Indifference schedule & curve: (Assumes ordinal measurement)
Indifference schedule: is a tabular list showing various combinations of the

commodities among which the consumer is indifferent (since all combinations are
equally desirable).
Points A B C D E
Qx 2 4 6 8 10
Qy 18 12 8 6 5
An indifference curve: is the locus of points, each representing a different combinations

of a pair of goods, which yield the same utility or level of satisfaction to the consumer so
that he/she is indifferent between any two combinations of goods when it comes to
making a choice between them. We can also call these curves as Iso-utility (or equal
utility) curves. The set of indifference curves are called indifference map.
Y Y
18
12
8 IC3
6 IC1 IC2
5 IC1
0 2 4 6 8 10 X 0 X
Indifference curve Indifference map
Characteristics (Features) of (Well – Behaved) Indifference Curves:

1. ICs are downward sloping. Because of scarcity of resources, if the consumer
wants more of X, he/she must consume less of Y to maintain the same level of
satisfaction.
2. ICs are convex to the origin - the two goods are substitute to one another (but not
perfect substitute).
3. ICs do not intersect (cross one another). If they do, their point of intersection
exhibits the same level of utility, which is impossible.
4. As an indifference curve becomes far from the origin, it represents a higher
utility.
MRSxy (marginal rate of substitution of X for Y): refers to the amount of Y that a
consumer is willing to sacrifices in order to gain an extra unit of X, if he/she wants to
maintain the same level of satisfaction.
46
MRSxy = - ΔY, ----(slope of IC)

ΔX
Or MRsyx = - ΔX
ΔY
MRSyx refers to the amount of X that a consumer is willing to sacrifices in order to gain
an extra unit of Y, if he/she wants to maintain the same level of satisfaction.
Suppose utility function of a consumer is given as U = f(x,y) = K let us suppose that the
consumer substitute X for Y. When the consumer foregoes some units of Y, the stock of
Y decreases by ΔY. His loss of utility may be expressed as : - ΔY* MUY. As a result of
substitution, his stock of X increases by ΔX. His gain of utility from ΔX equals:
+ΔX*MUx.
Therefore, for TU to remain the same, -ΔYMUy must be equal to +ΔXMUx. i.e.
-ΔYMUy = + ΔXMUx => - ΔY = Mux = MRSxy or
Δx MUy
MRSyx = - Δx = MUy
ΔY MUx
The budget line: shows all the various combinations of any two products, which can be
purchased, given the prices of the products & the consumer's money income.
Assuming a two-commodity model, the income constraint may be expressed as:
PxQx +PyQy = I ---- Budget constraint
Solving for Qy from the above equation we get a budget equation:
Qy = I/ Py – (Px/ Py )Qx Æ Budget equation
An easier method of deriving the budget line is to find the point on Y-axis (assuming Qx
= 0) & the point on X-axis (assuming Qy = 0). This is indicated by point I/Py on the Y
axis and I/Px on the x-axis.
Qy Any point above the price line

I/Py like point B is non-feasible (area)
because they are unattainable.
*C *B Any point on or below the line
like point A and C is feasible
*A Budget line region.
0 I/Px Qx
The slope of the budget line is the ratio of the two prices: Px/Py.
Whenever there is change in income and price the budget line will be affected.
When income increases the budget line will shift to upward; and decrease in
income will shift the budget line to the left but remains parallel to the original
one. And the effect of change in price is to rotate the budget line to the left or the
right.
47
Y
Y Y
0 X 0 X 0 X
a)Change in income b)Change in price of X c)Change in price of Y
Consumer Equilibrium
The consumer is in equilibrium (maximizes utility) when, given his/her budget

line, the person reaches the highest possible indifference curve. This optimal
consumption combination occurs at the point where the budget line is tangent to
the highest attainable IC. Thus, at this point (tangency point), the slope of an IC
(MRSxy) is equal to the slope of the budget line ( Px/Py)
Y
A
I3
I2
I1
0 B X
Therefore, equilibrium position occurs at point E where:
MRSxy = MUx = Px , subject to

MUy Py
Px Qx + Py Qy = I
Effect of Change in Prices on Consumer Equilibrium
Ceteris paribus, when there is a decrease or increase in the price of one commodity the
budget line rotates outward or inward. That means, the slope of the budget line depends
on the relative prices. When the price of the commodity changes, the slope of the budget
line changes, which changes the conditions of consumer's equilibrium. A rational
consumer adjusts his consumption basket to the change in relative prices with a view to
maximizing his satisfaction under the new price conditions. The change in consumption
basket is called price-effect. The total price effect may be stated as the change in
consumption basket resulting from the change in price.
Let us illustrate effect of change in prices:
48
Suppose the price of X falls, while consumer's taste & income and price of Y remains
constant. To represent this, one foot of the budget line is moved to the right by a distance
proportionate to the fall in price.
Y Suppose that the consumer is

A initially in equilibrium at point
PCC E1. Now, let the price of x fall,
ceteris paribus, so that
E1E2 E3 consumer's budget line shifts
from AB to AB'. The new
equilibrium occurs at
E2 to the right of E1. With

B B’ B’’ X successive fall in the price of x,
Consumer's equilibrium shifts
from E2 to E3. By joining the
P1 points of equilibrium E1, E2, &
P2 E3 we get a curve called price
P3 consumption curve (PCC)
D
X
O X1 X2 X3
PCC is a locus of points of consumer’s equilibrium resulting when only price of a

commodity is varied. The lower part of the figure shows the demand curve; as price
decreases the consumer will buy more of the commodity.
Effect of Change in Income
Given the prices of the commodity and preference of the consumer, when there is an
increase/ decrease in income, the budget line shifts to the right/left. That means, the
position of the budget line depends on the consumer income.
Figure below illustrates the parallel upward shift in the budget line & their effect on the
quantity consumed of two normal goods, X & Y, due to rise in income. By definition.,
when consumption of a commodity increases with increase in income, it is a norml
good.
With his given money income M1 & prices Px & Py, the consumer is initially in
equilibrium at E1 on I1. Let the consumer's income now increases to M2. Owing to this
increase in purchasing power budget line shifts from position AB to CD, & the consumer
reaches a new equilibrium point, E2, on I2. Similarly, if his income increases
successively from m2 to m3, etc, his budget line will shift from CD to JK, etc and
consumer will move from equilibrium E2 to E3. The successive equilibrium combination
49
of goods (X& Y) at different levels of income are indicated by E1 , E2 & E3. By joining
these points we get income consumption curve (ICC). It gives the path of increase in
consumption resulting from the increase in income.
Y
J
C ICC
A E2 E3
E1
I3
0 I1 I2
x1 x2 x3
Y
Engel curve
M3
M2
M1
0 X
x1 x2 x3
Definition: ICC is the locus of points representing various combinations of two

commodities purchased by the consumer at different level of his income; all other things
remain the same. ICC is the locus of points of consumer equilibrium (representing
optimum bundles) resulting when only consumer's income is changed.
The ICC may be used to derive Engel curves. An Engel curve is a function (or schedule)
showing the relationship between equilibrium quantity purchased of a commodity & the
levels of income. In other words, Engel curve shows the amount of a commodity the
consumer would purchase (demand) per unit of time at various levels of total income.
This is given in the lower part of the above figure.
50
CHAPTER FOUR
THEORIES OF PRODUCTION AND COSTS
THEORY OF PRODUCTION
Production is the process of converting economic resources (inputs) into consumable
forms (goods and services). Production function describes the relationship between the
amount of economic resources (inputs) and the amount of output that can be obtained.
In general production function can be expressed in a schedule or a graph or a
mathematical equation showing the maximum amount of output that can be produced for
a specified set of inputs, given the existing technology. It can be given as
Q = f (labor, capital, natural resource, etc.)
4.1 The Long Run & Short Run
Before we define long run and short run, we have to distinguish between fixed and
variable inputs.
Fixed inputs are inputs whose quantity cannot be easily varied over a short period of
time to change the level of output. E.g. Land, building, heavy machines, etc.
Variable inputs are inputs that can be varied easily according to the desired level of
output. E.g. Labor, raw material, etc…
Now we are in a position to define what long run and short run mean.
The short run is a period of time during which firms or producers can adjust production
by changing only variable factors but cannot change fixed factors. It is a period of
production in which at least one input is fixed.
The long run refers to a period of time, which is long enough to allow changes in the
level of all inputs. In the long run all inputs are variable and there is no fixed input.
4.2 Short Run Production Functions
A short run production function refers to a production function where, at least, one input
is fixed. So now let us take a farmer producing corn. To the farmer, the only variable
input is assumed to be labor and all other inputs like land, capital and technology are
fixed inputs.
That is: _ _ _
Qc = f (L, La, K, T)
Where, L = Labor, La = Land, K = Capital, T = Technology, and the bar implies
constant.
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So the short run production function tells us only the effect of change in the farmer’s
labor on the production of corn, keeping the size of land, capital and technology constant.
The following are the three basic concepts of the production function:
- Total physical product (total product) (TP)
- Average physical product (Average product) (AP)
- Marginal physical product (marginal product) (MP)
Total product (TP): refers to the total output produced by a given amount of a variable
input, keeping the quantity of other (fixed) inputs constant.
Average Product (AP) of an in put is the total product divided by the number of units of
that input used. That is:
⎛ total product ⎞ ⎛ TP ⎞
APL = ⎜⎜ ⎟⎟ = ⎜ ⎟
⎝ number of wor ker s ⎠ ⎝ L ⎠
Average product measures the output per worker, which is an indication of the
productivity of the input. Graphically AP is the slope of the ray drawn from the origin to
the point on the TP curve.
Marginal Product (MP) is the extra or additional output obtained, with one extra unit of
the variable input while other factors remain fixed.
⎛ change in total product ⎞ ⎛ ΔTP ⎞
MPL = ⎜⎜ ⎟⎟ = ⎜ ⎟
⎝ change in number of wor ker s ⎠ ⎝ ΔL ⎠
Graphically, marginal product of an input at any point is determined by, the slope of the
line tangent to the TP at that point. Simply MP is nothing but the slope of the TP.
Now let us take a hypothetical example that explains a farmer producing corn on a fixed
land (say 10 acres of land) by changing only the amount of labor.
52
Labor TP APL MPL Stage of

(L) production
1 10 10 ---
2 24 12 14
3 39 13 15 Stage I
4 52 13 13
5 61 12.2 9
6 66 11 5 Stage II
7 66 9.42 0
8 64 8 -2
9 54 6 -10 Stage III
TP
Stage I Stage II Stage III
TP
Labor
APL&MPL
APL
L
MPL
As you can see from the above graph, as we add more units of labor on the fixed inputs,
our total product first increases, then reach maximum and starts to fall. The same is truth
for MPL and APL. TP & MPL are related as:
o MPL increases when TP increases at an increasing rate
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o It starts to fall but positive when TP increases at a decreasing rate

o MPL reaches zero when TP is maximum and
o MPL becomes negative when TP is falling.
APL also increases first, reach maximum and starts to fall but it remains positive
whenever TP is positive.
The Relationship between MPL and APL
As you have seen from the above figure, the MPL curve reaches its maximum before the
APL curve. Also, as long as the APL is rising, the MPL is above it; when APL is falling,
the MPL is below it. When APL is at its maximum, the MPL is equal to the APL. Thus,
o for the APL to rise the addition to TP (or MPL) must be greater than the previous
APL, i.e. APL rises when MPL>APL.
o for the APL to fall, the addition to TP (or MPL) must be less than the previous
average, i.e. APL falls when MPL<APL.
o for the APL to remain unchanged, the addition to total product (or MPL) must be
equal to the previous Average. i.e. APL is at its maximum if APL=MPL.
Why TP, APL & MPL Behave like this?
The answer for the above question is very short; it is because of the Law of Diminishing
Returns. This law states that the extra production obtained from a unit increase in a
variable input will eventually decline as more of the variable input is used together with
fixed amount of other input(s). In other words, the law of diminishing returns states that
as successive units of the variable resource (say labor) are added to a fixed resource,
beyond some point the extra (or marginal) product attributable to each additional unit of
the variable resource will decline.
The rationale behind this law is that, suppose the farmer has a fixed amount of land in
which corn has been planted. At the first level of usage of variable input (labor) the land
would be understaffed, and production therefore would be inefficient because there is too
much land relative to labor, i.e. there will be idle land. Thus, as more workers added to
the previously understaffed land, the extra or marginal product of each will tend to rise as
a result of more efficient production. But this is not for ever. As still more workers are
added, problem of over-crowding will occur. As a result total product starts to increase at
a decreasing rate, because given the fixed land workers will have less and less land to
54
work with. Lastly, when the over-crowding become the worst, total product starts to fall
i.e. MPL will be negative
Stages of Production
We can divide the production stages into three:
Stage I (stage of increasing returns): this stage includes the range of variable inputs at
which the APL continues rising up i.e. up to the point of equality of APL and MPL.
Stage II (stage of Diminishing returns): this stage includes the value over which MPL is
positive but less than APL. In this stage both APL & MPL are decreasing but positive.
Stage III (stage of Negative returns): is defined as the range of negative MPL or
decreasing TP. In this stage of production, since MPL is negative, additional units of
variable inputs (L) actually cause a decrease in TP.
Hence, the question is that which stages of production is efficient, i.e. where dose a
rational producer needs to produce? Let us start from stage III; it implies that an increase
in the variable input (labor) results in a decrease in total product. As a result a rational
producer will never choose to produce at this stage. Even if the producer gets labor for
free he cannot increase total output by hiring more labor, rather he can increase total
output only by using less labor. Stage I, on the other hand, implies that an increase in the
variable input results in an increase both in the total product and productivity of the
variable input. So at this stage, a rational producer will not stop production rather he will
expand his output further and make use of the fixed input effectively & efficiently. As a
result a rational producer will always produce in stage II, and it is sometimes called the
stage of operation or rational stage of production. The other two stages, stages I and III,
are irrational stages of production.
THEORY OF COST
Cost is the value of inputs or factors of production that are utilized in the production
process. Therefore, cost is the payment made for inputs like land, labor and capital. Cost
of production can be classified in to two: as explicit costs and implicit costs.
i. Explicit (accounting) cost: it refers to the actual expenditure (monetary payment) by
the firm to outsiders for those who supply factors of production.
ii. Implicit cost: it refers to the value of inputs owned by the firm and used by the firm in
its own production process. For example, the cost involved in using the firms’ own
55
building and self-managing represent implicit costs. Implicit costs can be determined by
the monetary payment, which these resources could have earned in their best alternative
employment i.e. the opportunity cost of the input. The summation of explicit and implicit
costs is the economic cost.
The term profit is conceived differently by accountants and economists. Since profit is
always total revenue minus total cost the difference lies upon how they perceive cost.
Accounting profit is total revenue minus explicit costs. But economic profit is total
revenue minus economic cost (= explicit + implicit cost).
Economic Profit = Total Revenue –Economic costs
E ∏ =TR – (EC + IC), where E∏ = economic Profit
TR = total revenue.
EC = explicit cost
IC = Implicit cost
Normal profit is the minimum payment required to retain an entrepreneur in the business.
i.e. a firm is said to be earning normal profit, when its economic profit is zero. That
means,
E∏ = TR – (EC+IC), since E∏ =0
0 = TR – EC – IC, since TR – EC = A∏=accounting profit
0 = A∏ - IC
A∏ = IC
Thus, when the firm earns normal profit, accounting profit (A∏) = implicit cost (IC).
We can also classify costs as long run and short run costs. Long-run costs are costs
incurred over a long period where all inputs are variable but short-run costs are costs
incurred over a short period during which some inputs are fixed while others are variable.
Cost function tells us the functional relationship between output and cost of production.
That is, Costs=f (Output,...).
Short-Run Cost Functions
In the short-run we have two types of inputs: fixed & variable inputs. So our costs can
also be classified as fixed and variable costs.
Total Fixed Cost (TFC) refers to the sum total of the value of all fixed factors of
production used in the production process. It is independent of the level of output
produced.
56
Total Variable Cost (TVC) refers to the sum total of the value of all Variable inputs used
in the production process. It represents those costs that vary with the level of output.
Total Cost (TC) represents the lowest total (dollar) expense needed to produce each level
of output i.e. the summation of TVC and TFC.
TC=TFC+TVC
Hypothetical Example
Q TFC TVC TC
0 60 0 60
1 60 30 90
2 60 40 100
3 60 45 105
4 60 55 115
5 60 75 135
6 60 120 180
Costs
TC
150
120 TVC
90
60 TFC
30
Q
0 1 2 3 4 5 6
57
Average and Marginal Costs in the Short Run
⎛ TFC ⎞
i. Average Fixed Cost (AFC) equals total fixed cost dived by output, i.e. AFC = ⎜⎜ ⎟⎟
⎝ Q ⎠
ii. Average Variable Cost (AVC) equals total Variable cost divided by output, i.e.
⎛ TVC ⎞
AVC = ⎜⎜ ⎟⎟
⎝ Q ⎠
iii. Average Total Cost or Average cost (ATC or AC) equals total cost divided by output,
i.e.
⎛ TC ⎞
ATC or AC = ⎜⎜ ⎟⎟ , but TC =TVC+TFC
⎝ Q ⎠
⎛ TFC + TVC ⎞
= ⎜⎜ ⎟⎟
⎝ Q ⎠
Q
⎛ TFC ⎞ ⎛ TVC ⎞
= ⎜⎜ ⎟⎟ + ⎜⎜ ⎟⎟
⎝ Q ⎠ ⎝ Q ⎠
AC = AVC + AFC
iv. Marginal Cost (MC) refers to the addition to total cost as a result of the production of
one more unit of output. Or, MC equals the change in total cost per unit change in
output, i.e.
⎛ ΔTC ⎞
MC = ⎜⎜ ⎟⎟
⎝ ΔQ ⎠
⎛ Δ(TFC + TVC ) ⎞
MC= ⎜⎜ ⎟⎟
⎝ ΔQ ⎠
ΔTFC + ΔTVC
MC =
ΔQ
⎛ ΔTVC ⎞
MC = ⎜⎜ ⎟⎟
⎝ ΔQ ⎠
Now we can calculate the average and marginal costs for the above total cost Schedule.
58
Q TFC TVC TC AFC AVC AC MC

0 60 0 60 -- -- -- --
1 60 30 90 60 30 90 30
2 60 40 100 30 20 50 10
3 60 45 105 20 15 35 5
4 60 55 115 15 13.75 28.75 10
5 60 75 135 12 15 27 20
6 60 120 180 10 20 30 45
Unit costs are graphically illustrated as follows.
Costs
MC
TC
AVC
AFC
Q
On the above figure AFC falls continuously because a constant total fixed cost is divided
by increasing outputs. But the AC, AVC and MC curves are U- shaped and it is mainly
because of the law of diminishing marginal returns (LDMR). The MC curve reaches it
lowest point at a lower level of output than both the AVC curve and the AC curve and the
rising portion pf the MC curve intersects the AVC and AC curves at their minimum
points.
Relationship between MC and AC:
o when MC is below AC, AC will decline,
o when MC is above AC, the latter (AC) is rising, and
o when MC is equal to AC, the latter will reach its minimum point.
The above relationship holds true for MC and AVC, i.e.
o when MC is below AVC, AVC will decline,
59
o when MC is above AVC, the latter (AVC) is rising, and when MC is equal to
AVC, the latter (AVC) will reach its minimum point.
Relationship between Product Curves and Cost Curves
Unit products and unit cost curves are mirror images of each other, i.e.
NB: The relation ship between AP and AC is also the same. That is,
o when AP is ring AC is falling;
o when AP is falling AC is rising; and
o when AP is maximum AC is minimum
See below for illustration of these relations.
Q Let TVC =wL, where w= given wage rate &
L =labor input
Thus, AVC= TVC
Q
=(wL) /Q = w (L /Q) = w /(Q/L)
APL But Q/L=APL, so
0 MPL AVC= w/ APL
C MC
AVC
Similarly, MC=ΔTVC/ΔQ, since TVC=wL
0 Q =ΔwL/ΔQ = w (ΔL/ΔQ)
=w/(ΔQ/ΔL), but ΔQ/ΔL =MPL
Thus, MC=w/MPL
Profit Maximization Under Perfectly Comparative Market

Since profit is the function of revenue and cost, it is better to see first what revenue
functions look like.
Total revenue is defined as total quantity of a product times price of the product. I.e.
TR= QP
Average revenue is revenue per unit of output sold, i.e.
AR= TR/Q = (QP)/Q
Thus, AR = P in any market.
60
Marginal revenue is the change in total revenue resulting from a charge in output of one
unit of the product, i.e.
MR = ΔTR/ΔQ = Δ (QP)/ ΔQ, since price is constant
MR = P(ΔQ/ΔQ)
MR = P in a perfectly competitive market only.
Previously we have said perfectly competitive firms face horizontal or perfectly elastic
demand curve that indicates the firm is capable of selling any amount at the prevailing
market price. So the demand curve, AR curve & MR curve will be the same for a
perfectly competitive firm.
Hypothetical Example
Q P TR MR AR
0 10 0
1 10 10 10 10
2 10 20 10 10
3 10 30 10 10
4 10 40 10 10
5 10 50 10 10
TR
50
40
30
20
10 AR=MR =P =DD
0 1 2 3 4 5 Q
Now you have enough knowledge to talk about profit because we are equipped with both
revenue and cost concepts. The objective of every producer in the market economy is to
maximize profit. So the question is that how much should a firm produce in order to
maximize his profit?
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There are two approaches to answer this question:

i. Total Approach, and
ii. ii. Marginal Approach
i. Total Approach
Total profit is maximized when the positive difference between TR & TC is greatest. The
output at which total profits are maximized is called equilibrium of the firm.
Q P TR TC Profit MR MC
0 10 0 50,000 -50,000 -- --
2000 10 20,000 65,000 -45,000 10 8
9000 10 90,000 89,000 10,000 10 2
14,000 10 140,000 95,000 45,000 10 3
16,500 10 165,000 112,000 53,000 10 6
18,000 10 180,000 125,000 55,000 10 10
18,750 10 187,500 140,000 47,000 10 20
So for this producer profit is maximized when it produces 18,000 units of the output,
because at this level of output the difference between TR and TC is greatest, i.e.
Profit = TR – TC = 180,000 - 125,000
= 55,000
ii. The marginal approach: the marginal cost- marginal revenue approach is generally
more useful and applicable for decision making. This approach tells us that the perfectly
competitive firm maximizes its short run profit at the output level where MR or price
equals MC and MC is rising. The above firm maximizes its profit when it produces
18,000 units of output.
Unit profit is obtained by subtracting each value of AC from the corresponding value of
price (or MR or AR) .i.e Profit per unit = total profit/ output
= (TR-TC)/Q = (PQ-TC)/Q
= (PQ)/Q – (TC)/Q
Unit Profit = P-ATC
Now let us see the two approaches graphically.
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TR/C
TC
TR
0 Qe Q
MC/MR/P MC
Pe MR=AR
0 Qe Q
In the total approach, whenever TC is greater than TR, our firm is getting negative profit.
The point of intersection between TR & TC represents break-even point, i.e. the firm is
earning zero profit. Between the two break-even points, TR>TC and the firm is earning
excess profit and it is the area of positive profit.
Now the question is which level of output is giving the firm the maximum profit? This
point is determined by considering the vertical gap between TR and TC, and when the
gap is greatest, the firm is maximizing profit, i.e. it is at 180,000 units of output and the
profit is 55,000.
In the second approach, profit is maximized when MC equals MR and MC is rising. If
MR is greater than MC, it implies that each additional output is adding more to the total
revenue than it adds to the total cost. Thus, it is adding to the profit of the firm and the
firm should not stop production when MR>MC. When MC is grater than MR, it implies
that the extra output produced is adding more to the cost than the revenue so it is
decreasing the total profit. As a result a firm should decrease its level of output. Hence,
profit will be maximized when MR=MC and the slope of MC is greater than the slope of
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MR. The above firm maximizes its profit when it produces an output level between of
18,000 (i.e. Qe).
In the marginal approach we can calculate total profit in two ways:
i. Profit= TR-TC, since TR= PQ and TC= AC x Q
= PQ - AC*Q
=(10) (18,000)- (6.94) (18,000)
= 55,000
ii. Total Profit = profit per unit x Q, profit per unit = P-AC
=(10-6.94) (18,0000
= 55,000
The fact that the firm is in short-run equilibrium does not necessarily mean that it
maximizes excess profit; rather sometimes there are cases of loss minimization. Whether
the firm makes excess profits or losses depends on the level of the ATC (relative to P) in
the short-run equilibrium.
P/MC/AC/AV
Break-even
AC
Point
MC
AVC
P1
AR=MR Shut - down

P2 point
P3 AR=MR
If price is at P1, i.e. AR>ATC, the firm is earning positive profit. If price is at P2, i.e.
AR=ATC, the firm earns zero profit and the firm is said to be at break-even point. The
corresponding price is called break-even price. If price is less than P2, the firm will get
negative profit (loss). Even if the firm is earning negative profit, it will continue
64
production until it reaches the shut-down price. The shut-down price for the firm is P3,
i.e. when MR or price = AVC. At the shut down price, the firm always covers its TVC
and the loss is equal to TFC. The firm continues production up to the shut - down point,
even if it is in loss because it is covering the whole variable cost and part of its fixed cost
between the break – even and the shut – down point. At the shut – down point, if the firm
quits production, it will incur loss equals to TFC because in the short run, it cannot adjust
its fixed inputs. So, as long as the loss is less than TFC, the firm should continue
production.
The MC curve above the shutdown point is the firm’s short-run supply curve. Below
shut-down price (P3) output is zero. At each price above this point, the firm will produce
and supply an amount that corresponds to a point on the MC curve. Thus, the firm’s MC
curve above the minimum point of AVC curve is identical to its supply curve.
65
CHAPTER FIVE
NATIONAL INCOME ACCOUNTING
National income accounting concepts have been designed to measure the overall
production performance of the economy. By comparing the national income accounts
over a period of time, we can plot the long-run course that the economy has been
following; the growth or stagnation of the economy will show up in the national income
accounts. It also provides a basis for the formulation & application of public policies
designed to improve the performance of the economy.
It is generally agreed that the best available indicator of an economy’s health (well being)
is its total annual output of goods & services, or the economy’s aggregate output. The
basic social accounting measures of the total output of goods & services are Gross
Domestic Product (GDP) and Gross National Product (GNP).
Definition: GDP is defined as the total market value of all final goods and services
produced in the territories (within the boundary) of the economy in a given year.
GNP is defined as the total monetary value of final goods & services produced by
citizens of the country in a given year. Thus, GDP and GNP are related as follows:
GNP = GDP + Net Factor Income (NFI)
But NFI = Factor income generated from citizens living abroad
- factor income flowing out by foreigners living in host country.
GDP is a monetary measure that includes only the market value of final goods & services
and ignores transactions involving intermediate goods (in order to avoid double
counting). To avoid double counting national income accountants are careful to calculate
only the value added by each firm.
Value added is the market value of a firm’s output less the value of the inputs, which it
has purchased from others.
GDP also excludes two non-productive transactions i.e.,
1) Purely financial transactions, which include:
- Public transfer payments because recipients make
- Private transfer payments no contribution to current
- Buying & selling of securities production in return for them.
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2) Second hand sales because such sales either reflect no current production, or they
involve double counting.
How Can GDP Be Measured? Three approaches:
1. Product (Output) Approach or Value Added Approach:
In this method, GDP can be obtained either by taking the market value of final goods &
services or by taking the value added at each stage of production. Consider the
hypothetical data below:
Sales Value Added
Stages of Production value of
product
Firm A, sheep ranch $ 60 $ 60
Firm B, Wool processor 100 40
Firm C, suit manufacturer 125 25
Firm D, clothing wholesaler 175 50
Firm E, clothing retailer 250 75
Total sales value $ 710
Value added (total income) $250
Thus, by calculating and summing the values added by all firms (sectors) in the economy,
we can determine the GDP, that is, market value of total output.
GDP can also be determined either by adding up all that is spent on this year’s total
output or by summing up all the incomes derived from the production of this year’s
output. That is,
The amount spent on this The money income derived from the
year’s total output production of this year’s output.
(Expenditure-side) (Income-side)
2. The Expenditure Approach to GDP
All final goods produced in an economy are purchased either by the three domestic
sectors: households, government and business enterprises or by foreign nations. Thus, to
determine GDP through this approach, one must add up all types of spending on finished
goods & services by these sectors. That is;
GDP
GNP = Personal consumption expenditure (C) by households
+ Gross private domestic investment (I) by businesses
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+Government purchases of goods & services (G) by Government

+ Net exports (export - import) (Xn) by foreign sector
Thus, GDP = C + I + G + Xn
Personal consumption expenditure (C) entails expenditures by households on durable

consumer goods, non-durable consumer goods & consumer expenditures for services.
Gross investment (I) (purchase of machinery & equipment, all construction, and
changes in inventories) includes replacement & added investment i.e., replacement
investment implies depreciation (capital used up), D, and added investment that is
known as net investment (In). Thus, I=D+ In. The relationship between gross
investment & depreciation provides a good indicator of whether our economy is
expanding, static or declining.
*When gross investment (I) exceeds depreciation (D) i.e., positive net investment (In>0),
the economy is expanding (since its productive capacity or stock of capital goods is
growing.)
* A stationary or static economy reflects the situation in which I and D are equal (or In =
0).
*The unhappy case of declining economy arises whenever I is less than D, i.e., when the
economy uses up more capital in a year than it manages to produce.
Gov’t expenditures (G) include all government (federal state, and local) spending on
the finished products of businesses & all direct purchases of resources by government.
Net exports (Xn): is the amount by which foreign spending on domestic goods and
services (Exports =X) exceeds domestic spending on foreign goods & services (import =
M). It can be positive or negative.
GDP = C + I + G +Xn
3. Income Approach
This year’s GDP can also be determined (other than by adding up all that is spent to buy
this year’s total output) by summing up all the incomes derived from the production of
this year’s total output.
68
It measures GDP in terms of income earned. It is the sum of all incomes received from
all factors of production that contribute to the production process. The main income
categories are:
a) Compensation of employees: This comprises wages & salaries paid by governments
and businesses = W + S
b) Rents (r): Consists of income payments received by households& businesses, which
supply property resources.
c) Interests (i): comprise items such as the interest payments households receive on
saving deposits, certificate of deposits (CDs) and corporate bonds.
d) Proprietor’s Income or profit (ΠP) - is net income of sole proprietorships and
partnerships (or income of unincorporated businesses).
e) Corporate Profits (ΠC) - may be divided into three:
- They may be collected as corporate income taxes
- They may be distributed as dividends (to stockholders)
- They may be retained as undistributed corporate profits.
(i.e. corporate II = corporate income tax + dividend + undistributed corporate profits).
Note: Total Profits (Π) =Πp +Πc
Adding employee compensation, rents, interests, Πp & Πc, we get a country’s
National Income (NI) less NFI.
f) Indirect Business Taxes (IBT): Which firms treat as costs of production & therefore
add to the prices of the products they sell. E.g. Sales tax, excise tax, business property
tax, license fee.
g) Consumption of fixed capital (depreciation-D): the annual charge, which estimates
the amount of capital equipment used up in each year’s production is called
Depreciation.
Therefore, GDP = (W+S)+r+i+ + D+ IBT
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Other Social Accounts

1) GNP=GDP+NFI
2) Net National Product (NNP): Is GNP adjusted for depreciation changes. It is derived
by subtracting the capital consumption allowance, which measures replacement
investment, from GNP. That is,
NNP=GNP-D
3) National Income (NI): Measures the income earned by resource suppliers for their
contributions of land, labor, capital, and entrepreneurial ability, which go into the year’s
net production. The only component of NNP that does not reflect the current productive
contributions of economic resources is IBT. Thus,
NI = NNP - IBT
4) Personal Income (PI): it is income received by households.
PI = NI (income earned)
-Social security contribution are not actually
- Corporate income taxes received by hhs &
- Undisturbed corporate profits should be deducted.
+ Transfer payments --- is received but not currently earned.
5) Disposable income (DI): Is simply personal income less personal taxes (PT).
DI = PI - PT
Example: Below is a list of domestic output and national income figures for a given
year. All figures are in billions.
S.N. Income/Expenditure components Value (In millions)
1 Personal Consumption expands $245
2 Net foreign factor income earned 4
3 Transfer payments 12
4 Rents 18
5 Consumption of fixed capital (D) 27
6 Social Security contributions 20
7 Interest 13
8 Proprietor’s income 33
70
Continued
9 Net exports 11
10 Dividends 16
11 Compensation of employees 223
12 Indirect Business Taxes 18
13 Undistributed Corporate Profits 21
14 Personal Taxes 26
15 Corporate income taxes 19
16 Corporate profits 56
17 Government purchases 72
18 Net private domestic investment 33
19 Personal saving 20
a) Using the above data, determine GDP by both the expenditures & income methods.
Then determine GNP &NNP.
b) Determine NI in two ways:
i) By adding up the types of income which make up NI, &
ii) By making the required additions or subtractions from NNP.
c) Obtain PI, &
d) Obtain DI
Nominal versus Real GDP
Nominal GDP: Represents the market value of all final goods at current prices. But the
value of different years’ GDPs can be usefully compared only if the value of money
(price) itself doesn’t change. Thus, to compare GDPs of different periods (or to see
differences in production activity) Nominal GDP must be adjusted for price level
changes.
Definition: Nominal (Current Birr) GDP measures each year’s output valued in terms
of the prices prevailing in that year. Real (constant-Birr) GDP measures each year’s
output in terms of the prices, which prevailed in a selected base year. Inflation (or
deflation) complicates GDP because GDP is a price times quantity figure. The change in
either the quantity of output or the level of prices will affect the size of GDP since GDP
equals the sum of PiQi. But it is the quantity of goods & services produced & distributed
to households which affects their standard of living, not the price. E.g. the bread selling
71
for Br. 2 in 1998 yields the same satisfaction, as an identical bread of 1960 that is sold for
50 cents, not four times as much satisfaction, as the nominal value might imply.
Therefore, Nominal GDP can be adjusted by using a price index.
Price Index: Measures the combined price of a particular collection of goods & services
in a specific period relative to the combined price of an identical group of goods &
services in a reference period. That is:
Price Price of a market basket

GDP = Index = in specific year x 100
Deflator In a given year prices of the same market
basket in base year
Thus,
Real GDP = Nominal GDP = NGDP
Price Index (in hundredths) PI
Year Units of output Price of output Price index Unadjusted or Adjusted, or Real GDP
per unit (Year 1 =100) Nominal GDP
1 500 $10 (10÷10) 100 = 100 $ 5,000 $5000÷1.00= $5000

2 700 20 (20/10) 100 = 200 14,000 14,000÷2.00 =
$ 7000
3 800 25 (25/10) 100 = 250 20,000 $8,000
4 1000 30 (30/10) 100 = 300 30,000 $ 10,000
5 1100 28 (28/10) 100 =280 30,800 $11,000
The following table shows ‘market-basket’ (or collection) of output & the corresponding
price for a group of selected years. Compute Nominal GDP, price index, and real GDP.
Indicate in each calculation whether you are inflating or deflating the Nominal GDP data.
(Use 1990 as a base year). PI = (current price/base year price)(100).
72
Year Collection Unit PI = (Pi/P90) NGDP RGDP

of output price (PiQ) (NGDP÷PI)
1960 50 $10 (10/20) 100 =50 $500 $1000
1965 60 11 55 660 1200

1968 70 12 60 840 1400
1975 85 16 80 1360 1700
1990 150 20 100 3000 3000
1995 190 25 125 4750 3800
GDP AND WELFARE

GDP has some limitations in gauging the social well being of the people in a nation. This
is mainly because:
A) Non- market transactions are not included: non –monetary economies will be under
estimated.
B) It doesn’t include the under ground economy
C) It ignores the quality aspect of goods & services.
D) It does not consider the cost of environmental damage, among others.
UNEMPLOYMENT
Whenever we are talking about unemployment, we are talking about the idleness of
economic resources. But most of the time unemployment is mainly related to labor.
Unemployment is defined as a state of affairs where there is a large number of able-
bodied persons of working age who are willing to work but cannot find job at the current
wage rate. People who are working under their full capacity are called underemployed.
There are three main types of unemployment:
I. Frictional Unemployment: this type of unemployment is very common even if the
economy is at full employment. It occurs when there is a continual mount of workers
between jobs, i.e. workers that have voluntarily dropped their previous jobs and are
searching for new and better jobs or looking for employment for the first time. The
unique feature of this type of unemployment is that the economy is capable of absorbing
the unemployed persons.
73
II. Structural Unemployment: this is because of the mismatch between the workers
skills & experience and the skills required by the employers who are hiring the workers.
It also occurs because of the mismatch between the location of job vacancies of the
expanding industries and location of job vacation of the unemployed workers.
III. Cyclical Unemployment: occurs when there are fewer vacancies than the
unemployed. This mainly occurs in the recession phase of the business cycle. The main
cause is low level of aggregate demand, i.e. the community is not capable of absorbing
goods &services produced by all workers
Hence the first two types of unemployment consist of what we call it the natural rate of
unemployment which is unavoidable from the economy. So, full employment is achieved
despite the existence of natural rate of unemployment when cyclical unemployment is
zero. So it doesn’t mean zero lever of unemployment.
Hence, unemployment rate can be calculated as:
Number of unemployed people X 100%

Unemployment rate =
Total number of labor force
where the labor force usually includes those people aged between 15 and 64 and are
willing to and capable of work.
INFLATION
Inflation is a situation in which the general price lever is rising. Inflation does not mean
that the price of all goods/services have increased rather some specific prices may be
relatively constant, but in general there is a percentage change in a price index such as
consumer price index (CPI).
That is,
Rate of = CPI in current year –CPI of previous year X100

Inflation CPI of previous year
It the rate of inflation is positive, that will be inflation and if it is negative, it will be
deflation.
74
POLICY INSTRUMENTS
The major macro- economic objective of every country is to achieve high economic
growth, full employment and stability in price levels. So in order to stabilize the business
cycle we need policy instruments. The major stabilization policy instruments are:
i. Fiscal Policy
ii. Monetary policy
I. Fiscal policy: this is related to government expenditure and tax. There are two types of
fiscal policies:
a) Expansionary fiscal policy: it is a tax-cut and/or rise in government expenditure
aimed at increasing aggregate demand.
b) Contractionary fiscal policy: this is a policy aimed at decreasing aggregate demand by
increasing tax and/or reducing government expenditure.
II. Monetary: it is the control of money supply and interest rate by the central bank. This
policy is mainly used to stabilize the rate of inflation and unemployment. Monetary
policy can be tight (contrationary) or expansionary. An expansionary monetary policy is
policy to increase money supply and /or to reduce the interest rate. Contractionary
monetary policy involves a reduction in the growth of money supply and /or increase in
interest rate.
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Principles of Economics - Hassen

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Principles of Economics - Hassen

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HASSEN A.

LECTURE NOTES ON PRINCIPLES OF ECONOMICS

wants cannot be satisfied simultaneously, scarcity forces us to choose. Choice refers to

Economics is a social science concerned with the efficient allocation of limited

1.2 BASIC ECONOMIC PROBLEMS & ALTERNATIVE

Basic Problems of an Economy

Alternative Economic Systems

1.3 PRODUCTION POSSIBILITIES FRONTIER (PPF),

Production Possibility Frontier

Economic Growth and the PPF

*Technical progress in wheat production:

Combination Clothing Opp. Cost of

Combination Clothing ΔC Food (in ΔF Opp. Cost of

The Law of Increasing Costs

Decision Making Units

There are three decision-making units in an economy:

Costs Money income (wages, r, i, π)

Resources Resource L, Land, K, Entrepreneurial Ability

Goods & Services Goods & Services

Product Consumption expenditure

Costs Money income (wages, r, i,π)

Subsidy Income support

Goods & Services Goods & Services

The Circular Flow Model with Government Intervention

1.5 Forms of Business Organization & the Stock Market

Forms of Business Organization

2.1 The Concept of Market

Definition: Market is a place, condition, or mechanism, which brings together both

Economists distinguish market on the basis of:

2.Standardized (Homogenous) Product: Competitive firms are producing identical

2.3 Demand and Supply Functions, Schedules and Curves

Demand is defined as an individual’s willingness and ability to buy or purchase goods

Individual Demand Functions, Schedules and Curves

Demand curve is a graphical depiction of a demand schedule. It can be obtained by

b) Consumer income (I)

a) Increase in Demand b) Decrease in Demand

Figure: Shifts in the demand curve (change in demand)

• A rise (or fall) in income if X is a normal (or inferior) good

The Market Supply of a Commodity

Px qs1 qs2 Qs (qs1+qs2)

Monthly demand and supply schedules for shirts:

Algebra of Demand-Supply Equilibrium

t Change in Demand (Supply Constant):

Case 1: Demand increases Case 2: Decrease in demand

In general, assuming supply is constant, a change in demand is directly related with

t Change in Supply (Demand Constant):

Case 1: Supply increase Case 2: Decrease in supply S2

S↑⇒ ↓P&↑Q S↓⇒↑P&Q↓

Summary of the Above Diagrams:

Elasticity of Demand and Elasticity of supply

Elasticity of demand is the measure of responsiveness of demand for a commodity to the

0 200 400 600 800 Q

If point M is the mid point of the demand curve, then:

Total Revenue/ TR/of producers or Total Expenditure/TE/ of consumers on a particular

eM can be positive, zero or negative depending up on the nature of the good.

i Determine eM between the various successive levels of available income.

Price Elasticity of Supply

This is point elasticity of supply.

* Preferences indicate how we as consumers would rank

Definition: Utility is a numerical ranking of a consumer's preferences among different

Two Approaches In Studying Consumer Behavior

Total utility and marginal utility

Numerical example: The utility of Bread

Personal consumption expenditure (C) entails expenditures by households on durable