Table of content

Contents Page

Chapter 1: Fundamentals to Economics ………………..........1

Chapter 2: Theory of Demand and Supply…… ..................... .24

Chapter 3: The Theory of Consumer Behavior.......................53

Chapter 4: Theory of production .............................................64

Chapter 5: Theory of Cost .........................................................83

Chapter 6: Analysis of Market Structure.................................90

Chapter 7: An Introduction to Macroeconomics ............. 106

i
 CHAPTER ONE
FUNDAMENTALS TO ECONOMICS

1.1 Chapter Objectives

1.2 Introduction
1.3 The Subject Matter of Economics
1.4 Economics and Society
1.5 Scarcity and Choice
1.6 Elements of Economic System
1.6.1 Households (or Individuals)
1.6.2 Business Firms
1.6.3 Government
1.6.4 Foreigners
1.7 The Circular Flow of Economic Activities
1.8 Method, Types and Levels of Economic Analysis
1.9 Fundamental (Basic) Economic Problems and Alternative Systems
1.10 The Production Possibility Frontier
1.11 Summary
1.12 Review Questions

1.1. Chapter Objectives

This chapter is designed to enlighten the students with the subject matter of economics,
which is the basic for further economic considerations. By the time you complete this chapter
you would be able to exhaustively understand and able to explain the related concepts
including:
o the concept of human needs;
o scarcity and choice;
o elements of economic system;
o the circular flow of economic activities;
o method, types and levels of economic analysis;
o the production possibility frontier;
o fundamental (basic) economic problems and alternative systems.
Introduction to Economics –Econ-1011 19
1.2. Introduction
Dear students! Economics is one of the most exciting disciplines in social sciences. It is
concerned with the problem of how to use the scarce resources available to satisfy society's
material wants. It is doing the best with what we have.

Lastly, you will be introduced to your curve in this course. This is the production possibility
from their (PPF). Economics uses verbal explanation mathematical equations and graphs.
The PPF is the first curve that you will encounter in this chapter.

1.3. The Subject Matter of Economics

There are two fundamental facts that provide the foundation for the field of economics.
1. Human or society's material wants are unlimited.
2. Economic resources are scarce or limited in supply
But what do we mean by society's material wants? And what do we mean that these wants
are unlimited?
By society's material wants we mean:
i. Consumer's desire to get goods and services to satisfy their wants. Goods are tangible
things that can help a consumer to satisfy his/her wants. Automobile, chairs,
pencils, house, etc are some of the examples of goods. On the other hand, services
are intangible things from which the consumer can derive satisfaction. They have
no physical characteristics. The medical service you get from clinics, the legal
service we get from a lawyer or court, counseling service you get from guidance
and counseling officer in your' school, the defense service we get from our
defense forces, etc., are all considered as services. We can think of services as
intangible goods
ii. Businesses also want to have things that can assist them to produce goods or services.
To produce goods and services they need Inputs like labor, land, machinery,
equipment, etc.
iii. The government of a country also wants to have different types of goods and services
that assist it satisfy the collective wants of its citizens. For example, it needs public
schools, public health stations, armaments, etc to educate, treat and defend it citizens.

Introduction to Economics –Econ-1011 20

In short by society's material wants, we refer to the desires of consumers, businesses, and
governments to get those things that help them realize their respective goals. Note that the
goal of the consumers is to get maximum satisfaction, the goal of the businesses is to produce
goods and services and get profit, and the goal of the government is to satisfy the collective
wants of its citizens.

All of these wants are not only numerous but also multiply through time. Consider the
following example. An average Ethiopian wants to have a beautiful house, automobile;
clothes, good vacation, television set, etc. Let us take one of these goods only: television set
Twenty years ago, an Ethiopian wants to have a black and white television set. Now he/she
does not want to have a black and white TV set but a colored TV; not a colored TV as such
but a multi system stereo TV with many channels, etc. From this we can see that human
wants are not only numerous but also expand and diversify through time. Therefore, human
wants are unlimited.

What do we mean by economic resources?

By resources, we refer to any thing-natural or man made that can be used in production of
goods and services. By economic resources, we refer to the various types of labor, oil
deposits, minerals, buildings, trucks, communication facilities, etc. that can be used in the
production of goods and services. And all these resources are scarce or limited in supply

So, on the one hand, society's material wants are unlimited; on the other hand, economic
resources are limited. These two' contradictory facts lay the foundation for the field of
economics.

Economics is, thus, defined as a social science, which studies resources in the production and
distribution of goods and services so as to attain the maximum fulfillment of society's
material wants.

From the definition we understand the following points.

Introduction to Economics –Econ-1011 21

 i. Economics is a science because it is a systematized body of knowledge about
human behavior in production, exchange and consumption of goods and services
through time. And it is constituted based on systematically collected and analyzed
facts. But it is also an art. As Begg Fisher and Dornbusch clearly stated it,
economics does not "ignore people as individuals... Good economics retain an
element of art, for it is only by having a' feel for how people actually behave the
economist can focus their analysis on the right issue.
ii. Any society faces a problem of scarcity. If economic resources are scarce, then
outputs are also limited. A society, therefore, tries to allocate its scarce resources so
as to satisfy as much society's material wants as possible. Satisfying human material
wants are the goal of production.
iii. To satisfy its competing ends, a society is forced to make choice as to what outputs
to produce, in what quantities, how to use the available resources, etc. Hence, there
is a problem of choice

1.4. Economics and Society

Economics helps us understand the human behavior in production, consumption and

exchange of goods and services. Principles can be applied in resolving a number of real
world economic problems.

Knowledge of economics is very important in private lives, in business decisions and in

government activities. Economic (actors play important role in one's decision to leave his/her
job and take different training or join the universities, to buy a house, to take vacation, etc. In
business world, the motive behind each decision is to- get the maximum possible profit. To
achieve this objective, economics is very useful. For instance, economics can help
businesses.

Make reasonable predictions about the effect of external changes on the businesses objective.
If there happen an increase in petroleum price, what would be its impact on a certain
business? If the government increases the minimum wage rate payable to' workers, what
would be its impact on production and supply of goods and services?

Introduction to Economics –Econ-1011 22

It is also useful in deciding whether a business should be expanded or not, whether another
branch should be opened or not, etc

Economics is also very useful in various government decisions. In allocating resources to

various activities such as education, health or defense, in predicting the effects of certain
events on the economy, in bringing about rapid economic growth and economic stability in a
country, etc. government experts use economic theories and principles. To control
undesirable consequences of certain events such as high level of unemployment or inflation
in an economy, and to bring about growth and stability, governments design various types of
economic polices. Understanding of economics also makes people of a country well-
informed citizens and voters. For example, in the 1992E.C national election in our country, a
number of individual candidates and parties, if elected, promised to reduce or even" avoid';
taxes, eliminate unemployment problem from the country, to do this, to do that....
Understanding basic economic theories will help the voters to identify at least credible
promises from incredible promises. It also helps them analyze the impact of different parties’
proposals on their own private lives as well as on the economy of the country. You can think
of the issue of land as an example. Should it be in the hands of the people or in the hands of
the private sector?

1.5. Scarcity and Choice

In any human society, people want to have a variety of goods and services. Food, clothing,
automobile, electronic products, education, health care services are only a few of what people
desire to have. To produce these goods and services, they need economic resources. But
economic resources are scarce. Hence, the amount of goods and services that a society can
produce would be limited.

The fundamental economic problem that any human society faces is, therefore, the problem
of scarcity. Scarcity refers to the fact that all economic resources that a society needs to
produce goods and services, are finite or limited in supply. But their being limited should be
expressed .in relation to human wants. Thus, the term scarcity reflects the imbalance between
our wants and the means to satisfy these wants.

Introduction to Economics –Econ-1011 23

Resources can be classified as free resources and scarce (economic) resources. A resource is
said to be free if the amount available to a society is greater than the amount people desire at
zero price (if it would be supplied freely).

Choice
Scarcity is not also the same as poverty Scarcity is the problem of any human society.
Whether an individual is rich or poor or whether a country is advanced or least developed, it
does not matter. Each person or country faces the problem of scarcity.

If resources are scarce, then output would be limited. If output is limited, then we can not
satisfy all of our wants. Thus, choice must be made. The society must make choices as to
what output to produce, in what quantities, and what output not to produce. In other words,
due to the problem of scarcity, individuals, firms and government are forced to choose as to
how to use their scarce resources and for what purpose. In short, scarcity implies choice.

Choice, in turn, implies cost, i.e., choice involves sacrifice. That means whenever choice is
made, an alternative opportunity is sacrificed. Consider that you have Birr one. You can use
your money to buy loaves of bread or one ticket for a foot ball game. The price of the ticket
is one Birr and 3 loaves of bread are also worth one Birr. If you choose to buy loaves of
bread, then you would forgo the ticket. It means that when you decide to have loaves of
bread, at the same time, you decide not to have the ticket. The cost of having 3 loaves of
bread is, therefore, sacrificing one foot ball game ticket. In short, cost is the forgone
opportunity. This leads us to a new concept known as opportunity cost.

Opportunity Cost
In a world of scarcity, a decision to have more of one thing, at the same time, means a
decision to have less of another thing. The value of the next-best alternative that must be
sacrificed is, therefore, the opportunity cost of the decision.

Opportunity cost is the amount or value or the next-best alternative that must be sacrificed or
foregone in order to obtain one more unit of a product.

Introduction to Economics –Econ-1011 24

Note that the opportunity cost of getting one more unit of a product is the amount or value of
the next- best alternative that is sacrificed, not the value of all alternatives. The value of the
next-best alternative is determined by the decision maker himself/herself. In the above
example, the opportunity cost of getting one more ticket is 3 loaves of bread.

1.6. Elements of Economic Systems

The modern economic system is affected by several factors. The common ones are:
1. Households: - is important supplier of resources. When we say resources it could
be human resources (labor) natural resources like land, financial capital resources
through savings, and the supplier of entrepreneur resources.
a. Households are also major consumer of final goods and services
produced by domestic business firms
b. Households consumes some imported final goods and services
produced by foreign business firms
c. household is a tax payer; i.e., it finances government expenditure
2. Business Firms: - goods and resources are produced by business firms, and they
are also the major creators of jobs.
a. On the other side they are also consumers of inputs like raw materials,
energy, telephone service, and many other things
b. They have roles in international trade
c. They import goods and services produced by foreign business firms
and export their own products to foreigners
d. In addition to contributing in financing the government expenditures,
they pay taxes alike households.
3. Governments: - produces peace and political stability, which is a primary pre
requisite for economic and social development.
a. Coordinates various economically and socially relevant activities
better than the market. One obvious example of such a social
coordination is the monetary system.
b. protects property rights and enforces contracts. In the absence of
government, property rights are not secured and contracts are not

Introduction to Economics –Econ-1011 25

 binding; thus, there will be less interest accumulating capital and
contractual transactions. Market economy demands for high degree of
protection of property rights and enforcement of contracts
c. Finances or directly produces various types of public and worthy
(merit) goods. Public goods are goods and services whose
consumption is joint; and excluding those who do not want to pay is
difficult or totally impossible.
d. Corrects market failures. Market may fail for several reasons; for
example, due to monopoly, negative externalizes business cycles,
inflation and unemployment. In each case, the government can take
some measures to correct the failures.
e. Redistributes wealth in a such a way as to achieve more equitable (not
necessarily equal but equitable) distribution of wealth. Good
governments carry out this task by taxing the rich and providing direct
and indirect assistance to the poor
4. Foreigners :- includes both foreign business firms and households which
participate in economic activities in several ways, including:
a. may purchase commodities produced by domestic firms (export)
b. may purchase commodities produced by foreign business firms
import)may invest their capital in our economy and run business in a
country
c. may save money in our banks; and we can save our money in their
banks
Capital entering into an economy from other countries is called capital inflow; and capital
leaving our country is called capital outflow.

1.7. The Circular Flow of Economic Activities

The economic agents explained in the previous secretion interact in two markets:
i. Resource Markets: where resources are bought and sold, and
ii. Product Markets: where final products are bought and sold.

Introduction to Economics –Econ-1011 26

Now, to understand the economic interaction among households, firms and the government
we will use two models:
A. Two-Sector Circular Flow Model: where there are only firms and households, and
B. A Three-Sector Circular Flow Model: where firms households and the government
interact
A. The Two - Sector Circular Flow Model:
The circular flow of economic activities in a pure market system, where there is no
government

Resource
markets

Costs
Resources
Resources( Labor, Land, capital
and entrepreneurship)
Firms

In this model, there are only two decision-making units: households and firms. Households
are owners of the means of production and hence suppliers of resources while firms are
buyers of economic resources.
In order to produce goods and services, firms require resources. To acquire the resources they
need, they go to the resource markets and buy the required resources. Firms I pay money to
the resource suppliers - households. What firms pay is considered as cost of production.
Households receive income in the form of wages, rent, interest and profits. In short, what is
cost/or firms is income/or households.

Introduction to Economics –Econ-1011 27

Once firms buy those resources, they combine them and produce goods and services and
supply to the market. Households, on the other hand, require those goods and services in
order to satisfy their material wants. Now, firms as suppliers of goods and. services, and
households as demanders of those goods and services interact in the product markets.
Households pay money to acquire and consume those products, and their expenditures are
known as consumption expenditure. What is considered as expenditures by households is
received by the firms as revenues.
In this model, there are two flows
a. Real Flow: the flow of resources, goods and services - the flow of real- things. In the
diagram, see the arrows, which flow in the anti-- clockwise directions in the above
diagram.
b. Financial Flows: the flow of income and expenditures. See the arrows, which flow in
clockwise directions
Note:
i. In this model there are two decision making units only: households and firms.
Government and foreigners are not included.
ii. The households spend all of their income - they do not save
iii. Since all of what is produced is consumed in the same period, the model economy is a
stagnant [no economic growth].
B. The tree- sector Circular Flow Model
In the above discussion, we. have seen the economic interactions that exist between
households and firms. Now let us include the government and see the economic interaction
among households, firms and government.
As stated earlier, a government produces and supplies some goods and services such as
public education, public health services, defense services, highways, street light, etc. To
produce those goods and services, it needs resources, goods and services. It can get resources
from the resource markets where households supply them. It can buy necessary goods and is
from firms through the product markets. But, to obtain the required resources, goods and
services, it has to pay money to firms and households. That will be its expenditure but it will
be income of households and revenue of firms.

Introduction to Economics –Econ-1011 28

1.8. Scope of Economics
By scope of economics, we refer to the coverage of economics. Generally, economics can be
divided into two main branches: Microeconomics and macroeconomics.
A. Microeconomics: is concerned with the economic behavior [or action] of individual
economic units, well-defined groups of individual economic units, and how markets of
individual commodities function. These individual economic units can be a household or a
,firm. It is concerned with individual economic units in an economy and their interaction. For
example, questions like how does a particular person or household maximize satisfaction,
how does a particular business enterprise strive to get maximum possible profit by producing
and selling a product, etc are studied in "microeconomics”:. Therefore, in microeconomics,
our analysis is in terms of individual firm, industry, or household.

Some of the issues that are- studied in microeconomics are:

i. The behavior of consumers in maximizing satisfaction. Here economists assume that a
consumer acts rationally. By this we mean that every individual acts in a way that can
give him or her maximum possible satisfaction. She or he tries to use his or her limited
income in a way that can give him/her, the maximum possible satisfaction .or pleasure.
Economists believe that no person makes a deliberate decision that makes him or her
worse of.

ii. How businesses make decisions as to what, how and for whom to produce outputs so as
to obtain the maximum possible profits.
iii. How prices of products and factors of production are determined in product and resource
markets. For example, we can study how the price of "teff' is actually determined in the
"teff' market. We can also study how the price of labor is determined the labor market.
iv. The different types of markets and how each type of market affects the efficiency of the
producers and the welfare of consumers; etc.
B. Macroeconomics: is a branch of economic analysis which deals with the economy as a
whole and sub aggregates of the economy. It does not deal with individual household, firm,
or industry. That means, it does not deal with individual quantities such as output level of a
firm or industry, income level of a household or family, employment level in an industry,

Introduction to Economics –Econ-1011 29

price of a product, etc. Rather it deals with magnitudes such as the total output level in an
economy, national income of a country, total employment level in an economy, the general
price level of goods and services in the economy, etc. For example, in microeconomics we
can study why the price of "teff' increases or decreases in Addis Ababa. But this increase or
decrease in the price of level of "teff' is not the concern of macroeconomics.
Macroeconomics is rather concerned with whether the average level of prices of goods and -
Services in the economy as a whole is increasing or decreasing.

Thus, as professor McConnell says it, in macroeconomics we focus on obtaining a general

outline or overview about the economy. In short, in microeconomics we study a tree in a
forest; but in macroeconomics, we study the forest, not a tree. Remember that, like
macroeconomics, microeconomics also uses aggregates. For example, we talk of the total
market demand for wheat, total market demand for maize; total market supply of wheat, total
market supply of automobile, etc. In microeconomics, we aggregate over homogeneous or
identical product, but in macroeconomics, the aggregation is at the economy level. For
example, in microeconomics, we cannot aggregate the total market demand for wheat and'
maize together. But in macroeconomics, we can aggregate the total of several products and
talk about the total level of outputs currently produced in a country this year. The main
differences between microeconomics and macroeconomics can be summarized as follows.

NO MICROECONOMICS MACROECONOMICS

Deals with detail consideration of the

1. Deals with the economy as a whole
behavior of individual economic units

Emphasizes on the interaction in the

Emphasizes on the behavior of individual
economy as a whole; tries to obtain a
2.
decision makers and their interaction general outline or overview about the
economy.

3. Deals with magnitudes such as Deals with magnitudes such as total

Introduction to Economics –Econ-1011 30

 output of a firm, income of a
household, number of workers of outputs, total income, total level of
an industry, consumption pattern employment in an economy, general
of a household, expenditure price level, etc.
pattern of a firm, etc

Deals, with aggregates, which do Deals with aggregate at economic

4. not relate to the entire economy, level, and investigates their
and their interactions. interactions at economic level.

Studies the relationship ,between Studies the relationship among major

5. individual participants, such as aggregates such as inflation, outputs,
producers and consumers and unemployment, etc

Has the following broad objective:

Determining the national income and
Efficient allocation of resources, and
output level, aggregate resource
6. to do that understanding price
employment, economic growth and
determination [how prices are
inflation
determined ] is vital

1.9. Fundamental (Basic) Economic Problems and Alternative Economic

Systems
Basic Economic Questions
As is repeatedly stated, scarcity is the fundamental economic problem that any human society
faces. In connection with this fundamental problem, any human society should confront and
answer the following three basic questions. They are:
1. WHAT to produce and in what quantities. Given the problem of scarcity, any human
society should decide on what outputs to produce and what not to produce.

Introduction to Economics –Econ-1011 31

2. HOW to produce them. Once we decide on what outputs to produce, the next task is to
decide on how to combine resources to produce the desired outputs. This is a question of
technological choice. Given the limited resources and technology, consider that Ethiopia
decides to produce more beer. Should the country use more of capital goods and less of
labor [we call it capital intensive technology] or vice versa- a labor intensive technology?
The question of technological choice has a far-reaching implication on the economic
performance of a country.

Alternative Economic Systems

The above mentioned questions are universal in nature that every human society should
answer. But the solutions vary from society to society. The way a society tries to answer
those fundamental questions is summarized by a concept known as economic system.
An economic system is a set of organizational and institutional arrangements established to
answer the basic economic questions. Customarily, we can identify 3 types of economic
systems.
A. Pure capitalism
B. Command economy C. Mixed economy

A. Pure Capitalism
In pure capitalism, the three basic economic questions are answered as follows.
o Firms address the 'what to produce' question by producing those goods and services
that give them the maximum possible profit.
o The how to produce' question is answered by choosing the techniques of production
which are least costly. That means the technology that firms choose to produce goods
and services are least costly methods of production.
o The 'for whom to produce and distribute quotation is addressed depending on people's
decision as to how to spend their income.
In pure capitalism, there is private ownership of the means of production. Economic
activities are also coordinated and directed through market mechanism. One of the
advantages of such a system is that it is good for economic efficiency. The existence of

Introduction to Economics –Econ-1011 32

market system to coordinate and direct economic activities and the private ownership of the
means of production create .conducive [favorable] environment for economic efficiency.

People argue that, in such a system, there should be little or no need of government
intervention in the market, because such intervention disturbs the smooth functioning of the
markets. But there are some disadvantages [demerits] of pure capitalism associated with
market failures. There are areas where market fails.

i. Provision "of Public Goods: public goods are those goods that can be jointly consumed
by many individuals simultaneously, whether they payer not, with no additional cost or
decline of quality and quantity of the good. Streetlight and national defense are good
example of public goods because they benefit all of us whether we payer not. The
government cannot prohibit a person from using the streetlight just because he does not pay
taxes to the government.

ii. Regulating Externalities: Externality refers to costs or benefits that arise from production
or consumption of goods and services to other parties or economic units
These benefits or costs are not reflected in market prices and falls on a third party [other than
the buyers and sellers of the good or service]. When a producer brings additional benefit to a
third party because of his production of that good or service, this is known as positive
externality. Example, a beehive keeper is benefited from a nearby flower grower. The former
gets benefits from the activities of the latter. And for that benefit, the beekeeper may not pay
to the flower grower. But a producer of a particular product may also have a negative impact
on other households or producers
This is known as negative externality. Example, pollution created by a firm. Because of the
pollution created by the producer of the product, the society is forced to incur additional
costs. The market cannot take care of these negative externalities. In this case the government
must tax additional money from the producer of such product in order to cover the additional
cost that the government or the society incurs because of the producers actions.

iii. Income and Wealth Inequalities: unregulated market eventually leads to income and
wealth inequalities among the population of a country. When ownership of resources is

Introduction to Economics –Econ-1011 33

concentrated" in the hands of the few, the majority would become poor while small fraction
of the society become very rich. In fact, this is undesirable.

The government should intervene and take actions in order to create fair distribution of
income in the society. For example, the government can tax the riches higher taxes and use
the money it collects to construct public schools, public health stations, an<;i other facilities
to the poor

IV. Promoting Efficiency: competition among producers is good for economic efficiency.
Competition; which is regarded as the very basis for progress, contains within itself' the
tendency to destroy itself. This leads to the emergence of monopoly. In unregulated markets,
producers create a sort of association and agree to set common prices. Restrict output or set
quota in order to prevent competition; and this is not. 900d for the efficiency of the economy.
To remote competition and thereby et1iciency in the economy a government should intervene
in the economy. Example, nowadays, there is such a tendency in the gold market in Ethiopia.
Around 1991 E.C. the price of gold was declining continuously in Addis Ababa. To control
the decline in price of gold goldsmiths took one measure. Rather than allowing the gold
market to function freely, they set common prices for gold. If you go to piazza, you would
see identical price lists of gold posted on the wall of each shop.

v. Stabilizing the Economy: fluctuation of prices and employment levels are inherent
problems of market economies. A sustainable (continues) increase in the price level of goods
and services, we call it inflation, may not be good to an economy. An increase in
unemployment level in an economy also costs the society too much. To control these
undesirable consequences of free markets, a government should take necessary measures.

B. Command Economy
Socialism is the term used to describe the general doctrine that people should own and
administer property resources (land and capital) for the interest of the whole.
Unlike pure capitalism, command economy is characterized by:
a. Public ownership of property/ resources, and

Introduction to Economics –Econ-1011 34

b. Economic activities are coordinated and directed by the government through central
planning.
In such a system, almost all decisions regarding what, how and for whom to produce are
determined by the government. In short, while, in pure capitalism, production and
distribution of goods and services are decided by the private sector through market
mechanism, in command economy, they are decided by the government. ,Example:- between
1974- .1991 G.C., Ethiopia was more ore less under the command economic system even
though to some extent, there was still private ownership of the means of production, and
market had some role in coordinating economic activities in the economy. During that
period, virtually all property/ resources were in the hands of the government. Even workers,
especially graduates of higher institutions, were allocated through the then central planning
office of the country.
Resources were allocated depending on the priorities set by the government.

C. Mixed Economy
Pure capitalism and command economy are the two extreme types of economic systems.
Both systems have their own advantages and disadvantages. Pure capitalism has one strong
merit: it is good for efficiency! Since resources are allocated through market mechanism and
everybody is acting in order to get the maximum possible benefits out of what it has, it
enables a country to achieve economic efficiency and growth. But the disadvantages are that
there are areas where market fails. The command economy, on the other hand, takes care of
the undesirable consequences of unregulated markets on an economy. We have already seen
that unregulated markets create income and wealth inequalities, fluctuation in prices, output
and employment level, etc. In short, the advantages of command economy are:
o fair distribution of income
o absence of business fluctuation
o absence of private monopolistic practices.
However, economic inefficiency is the main problem of countries which were more or less
under such economic system.

Introduction to Economics –Econ-1011 35

The mixed economic system takes the strong elements of the above two systems. Here, it is
believed that market is good! But it is not enough. Government can also play very important
role. It can play important role:
o in promoting economic growth and stability
o providing public goods
o bringing about equitable distribution of income
o controlling factors that can disturb the free functioning of the market system, etc.
In such a system, both the government and the market decide on the questions of what, how
and for whom to produce and distribute. It is a system that combines competitive private
enterprises with some degree of government control. While the allocation of resources
among alternative uses is largely determined by individual actions through the price
mechanism, the government plays a role in determining the level of aggregate output level,
employment level, distribution of income, etc by using various policies.

In some cases, government controls some sectors by owning certain industries. In fact,
neither the U.S.A. nor any other country in the world has pure capitalist type of society. In
strict sense of the word, there is no country under pure capitalist type of economic system in
the world. Real world economies are between pure capitalism and the command economic
system. The shortcomings of pure capitalism and command economy have led to the
evolution of modern mixed economies.

1.10. The Production Possibility Frontier

Once we understand the concept of scarcity, choice and opportunity cost, the next task
possible combination of goods and services that the society can produce given its resources
and technology. To draw the PPF we have the following assumptions.
The Underlining Assumptions of the PPF:

i. Efficiency: "the economy is operating at full employment and is achieving full production.
By full employment we mean all the available resources are used in production of goods and

Introduction to Economics –Econ-1011 36

services. That means, there is no idle resource. All labor, capital, land and entrepreneurial
abilities available in the economy will be used in the production of goods and services. By
full production we mean that those resources should be used in a way that can give us the
maximum possible output level.

ii. Fixed Resources: the quantity or amount of resources of a given quality is fixed in supply.
That means both the quantity and quality of labor, land, capital and entrepreneurship
available in the economy remain fixed or constant. But this does not mean that we cannot
reallocate resources for different uses. For example, a farmer who is working on a farm to
produce agricultural products can be used as a soldier to give defense service [for defense].
Or, a building used as a restaurant can be used as an office.

iii. Fixed Technology: technology does not change for a given period of time, say for a year.
The society uses its current state of technology, i.e., the best technology it has, to produce
goods and services. And technological advancement helps a society replace the problem of
scarcity by making its economic resources more productive. In our case, we assume that
there is no technological advancement, for the time being.

iv. Two Products: for simplicity purpose, let us assume that the society is producing two
goods: say "teff' and tractor.
Given the above assumption, a hypothetical PPF is constructed in a table and a graph below.

Possibility Output Output A A

Y B
X Y 20 B
2
0
A 0 20 16 C
14 D 1 H
B 1 16 E 6
C 2 14 1
4
D 3 10 F
E 4 6
X
F 5 4 G
Gk 6 0 12 X

Introduction to Economics –Econ-1011 37

According to the definition given above, PPF connects all possible maximum combinations
of outputs that can be produced by using the given amount of total inputs and technology.
Therefore, an economy, which performs on its PPF, is said to technically efficient because
that economy fully utilizes all its inputs and technology. Thus, points A, B, C, D, E, F, G,
and any other points on the PPF in the above diagram represent full employment output
combinations. In other word, if any economy is technically efficient, (i.e. if it performs on its
PPF) there is no unemployment of resources (labor and other resources). Such an economy
cannot increase one of its outputs without sacrificing some of the other outputs. For example,
in moving from possibility B to D the economy increase 2 units of output X but sacrifices 6
units if output Y. This discussion leads us to an important economic concept known as
Opportunity Cost.
On the PPF, opportunity cost equals to the value of all outputs that should be given-up in
Value given - up
Opportunity Costs 
Value gained
order to increase one of the outputs by one unit.
Example:
1. Given the PPF discussed above, calculate the opportunity cost of shifting production
from opportunity D to F.

Answer:
Value given - up
Opportunit y Costs 
Value gained

10 - 4
OC of shifting D to F   3 Y per X
5-3

This means that in shifting production from D to F, 3 Ys should be sacrificed to increase X

by one unit. An economy that performs inside its PPF is said to be technically inefficient. For
example, an economy that produces combination H in the above diagram is inefficient
because it underutilized the available resources and technology. Therefore there

Introduction to Economics –Econ-1011 38

unemployment of resources and under utilization of the available technology if an economy
performs below its PPF.

The PPF is constant only in the short-run. In the long-run new resources or better technology
may be discovered and the PPF may shift to the right. A right-ward shift of the PPF represent
economic growth; while a left-ward shift of the PPF represent Economic recession.

 


Economic Growth Economic RecessionE

c
1.8 1.9 o
n
o
m
i
c

R
1.11. Summary e
c
Economics is one of the most exciting disciplines in social sciences. It is concerned with the
e
s wants. It is
problem of how to use the scarce resources available to satisfy society's material
s
doing the best with what we have.
i
o
There are two fundamental facts that provide the foundation for the field of economics.
n
1. Human or society's material wants are unlimited.
2. Economic resources are scarce or limited in supply
Economics helps us understand the human behavior in production, consumption and
exchange of goods and services. The fundamental economic problem that any human society

Introduction to Economics –Econ-1011 39

faces is, therefore, the problem of scarcity. To understand the economic interaction among
households, firms and the government we will use two models:
A. two-Sector Circular Flow Model: where there are only firms and households, and
B. three-Sector Circular Flow Model: where firm’s households and the government interact

1.12. Review Questions

1. Explain the concept of resources. List and explain the major types of resources using
your own statements and give examples of each type of resource.

2. Explain why economics deals with allocation and efficient utilization of scarce resources
only?

Introduction to Economics –Econ-1011 40

3. Explain the relationship between scarcity of resources and the necessity of making
choice?

4. Why human needs are believed to be unlimited?

5. In what ways you participate in Ethiopian economy: as a consumer, producer, supplier,

exporter, policy maker, or what? Note that you can play all or most of the above roles
simultaneously.

6. List the major economic agents and their economic roles.

7. Ethiopians residing and working abroad often send money to their relatives at home. Is
the money received this way an injection or a leakage?

8. Give other examples of injections and leakage.

9. What are the differences between fundamental, definitional and procedural assumptions?

10. Describe how to verify your conclusions.

Introduction to Economics –Econ-1011 41

 CHAPTER TWO
THEORY OF DEMAND AND SUPPLY

2.1. Chapter Objectives

2.2. Introduction
2.3. Theory of Demand
2.4. Theory of Supply
2.4.1. Supply schedule, Curve and Function
2.4.2. Individual and Market supply
2.4.3. Determinants of supply
2.5. Market Equilibrium
2.5.1. Definition of Market Equilibrium
2.5.2. Effects of Change in Demand or Supply on the Market Equilibrium
2.6. Elasticity
2.6.1. Elasticity of Demand
2.6.1.1.Price Elasticity of Demand
2.6.1.2.Income Elasticity of Demand
2.6.1.3.Cross-Price Elasticity of Demand
2.6.2. Elasticity of Supply
2.6.2.1.Price Elasticity of Supply
2.6.2.2.Application of Elasticity
2.7. Summary
2.8. Review Questions

2.1. Chapter Objectives

Demand and Supply are the main building block of Economics. This chapter focuses on the
theories of demand and supply. After completing this chapter, you will be able to:
o define concepts like demand, and supply,
o explain the law of demand, law of supply, etc.
o construct demand and supply schedules, curves and. functions,

Introduction to Economics –Econ-1011 42

 o explain determinants of demand and supply
o analyze how price changes affect quantity demanded and quantity supplied.
o show how market price of a product' is determined, and the market becomes in
equilibrium,
o show how changes in the determinants of demand and supply of a product affect
equilibrium price and quantity of a product

2.2. Introduction
Dear students! Having seen the very nature of economics in the first chapter, we will now
resort to simple but very important concepts in economics- demand and supply- which will
help us to understand how a market economy functions. We will start our study by examining
the demand side of the market, i.e., by studying the theory of demand. Next, we will consider
the, supply side of the market by studying the theory of supply. The theory of demand deals
with the behavior of buyers- individuals, households; groups and/or organizations while .in
theory of supply, we deal with the behavior of sellers who offer goods and/or services to
buyers. Once we understand the two sides of the market independently, we will then discuss
how the price of a product is actually determined in the market through the interaction of
demand and supply.

2.3.Theory of Demand
What desires do you have as students? Do you satisfy .your desire for the things you have
mentioned simply because you desired them? If your answer is No, what other conditions are
required to realize your desires?

Individuals or households may desire or wish to have goods and services that they think will
satisfy their needs. For example, a person may desire to have an umbrella, or a particular
family may want to have a table with three chairs. However, having desire does not
necessarily mean that the person or the family may actually possess the items. This means
that desire to have umbrella or tables and chairs alone is not enough to own them because
they are not free goods.

Introduction to Economics –Econ-1011 43

In order to have the desired goods and services, an individual or a household, not only should
have desires, but should also have the ability, i.e., the means by which the goods and/or
services can be obtained.

In economics, a desire for goods and services backed by the ability and willingness to buy
those goods and services in a given period of time is generally referred to as demand.
Hence, when economists talk about demand they are not referring to the wish desire want or
need of an individual or a household to have a good or service.

Desire: is a wish to attain some object from which pleasure and satisfaction are derived.
Desire is basic human attributes, which induces him (her) to work or make an effort to fulfill
it.

Want: is desire for anything as a necessity to life or happiness but which is not satisfied due
to lack of resources (e.g. Income). Man desires house but if he has no money to constuct or
buy it, his desire remains unsatisfied. Here house is a necessity but remains as want due to
lack of money.

Demand is a willingness and ability of a consumer to purchase goods and services at specific
price within a set of possible prices at a given period of time.

Law of demand: This is the principle of demand, which states that, other things being
constant, price of a commodity and it quantity demanded are inversely related i.e., as price of
a commodity increases (decreases) quantity demanded for that commodity decreases
(increases), ceteris paribus.

Quantity demanded of a commodity is the amounts of the commodity purchased at a given

price level. The inverse relationship between the quantity demand and price of a commodity
can be shown by a demand schedule and a demand curve.

Demand Schedule is a table which shows how much of a good individuals are willing and
able to buy at different price levels during a given period of time (week, month etc)

Introduction to Economics –Econ-1011 44

 Hypothetical Demand Schedule for Teff.
Price of teff (in Birr) Quantity Demanded for
teff (in quintals)
100 40
150 35
200 25
250 15
300 10
At each price level consumers buy definite quantity of teff. As price of teff increases from
100 Birr to 300 Birr, quantity demanded for the teff decreases from 40 quintals to 10
quintals. This demand schedule can also be depicted graphically as a demand curve for teff as
follows.

Price of teff
teffteff 300
250
200
150
100

0 10 15 25 35 40
Quantity of teff
. Demand curve for teff

Demand curve of a commodity is a curve, which shows the relationship between the
quantities demanded of the commodity at different price levels. In drawing the demand curve
we singled out price of a commodity as the most important factor affecting the quantity
demanded of the commodity and ignored the influences of other factors. However in addition
to own price, quantity demanded of a commodity depends on a number of other factors. A
fundamental analytical method used in economics is to hold all other influences constant &
focus on one important variable.

Economists do not say price is the only variable which influences purchases but they say that
price generally has very important effect on quantity purchased. It is to identify the influence
of price of a commodity on its quantity demanded that economists hold other variables

Introduction to Economics –Econ-1011 45

constant and concentrate on the relation between quantity demanded and price, that is, the
relation shown by the demand curve. In this way attention can be focused on the effect of
price. However, in using the demand curve students should be aware of the other factors,
which actually can influence quantity demanded, but which were held constant in deriving
the demand curve.

Factors Affecting Demand

The demand curve shows how a change in commodities own price will affect the quantity
demanded, but what determine the shape and the position of the curve itself?

The shape and position of the demand curve depends on the following major determinants.
That is to say, the following variables are also important determinants of quantity demanded
of a commodity. However, we treat them separately from own price of a commodity because
unlike change in own price level, change in these variables has quite different effect on the
position of the demand curve itself. All the following variables cause demand curve to
change its position and we call them shift variables of demand curve. As one of the following
determinants changes assuming other things being constant demand curve shifts either to the
right or to the left. A right ward (left ward) shift of the demand curve indicates an increase (a
decrease) in demand.

A. Tastes and Preferences of the Consumers

Individuals' preferences and tastes for particular commodity differ according to the
satisfaction they get from the commodity.

When people change their mind about taste and preference for a commodity demand for the
commodity also changes. For example if consumers have favorable (unfavorable) taste and
preference for a commodity the demand for commodity increases (decreases), other things
being constant.

Tastes and preferences of the individuals to wards the consumption of egg increases if it is
announced that consumption of egg is helpful in curing lung Cancer. For example,

Introduction to Economics –Econ-1011 46

advertisement on different goods and services changes tastes and preferences of consumers
and accordingly the demand for these goods and services changes.

For example, other things being constant, during rainy season demand for raincoat increases.
The following demand curve depicts the effect of a favorable tastes and preferences of a
consumer on raincoat during rainy season.

An increase in Demand
A decrease in demand (a left ward shift)

Price of
Raincoat
A decrease in demand ( a left ward shift)

Quantity of raincoat

An individual demand for raincoat

B. The Income of Consumers

Other things being constant, as income of the consumers' increases (decreases) demand for
normal goods increases (decreases), but demand for inferior goods decreases (increases).

C. Prices of Related Goods

If two goods are related, then the change in price of one good affects demand for the other. .
If two goods are related they can be either" substitute or "complementary" each other in
consumption. When price of its substitute good (Injera) increases (decreases) demand for the
commodity (Bread) increases (decreases), ceteris paribus. As price of its complementary
good (Fuel) increases (decreases) demand for that commodity (Car) decreases (increases),
ceteris paribus.

Introduction to Economics –Econ-1011 47

Price of Price of
Substitute Complementary
good (injera) (fuel)

0 0
Quantity of Commodity (bread)
Quantity of Commodity (car)

Effects of change in other prices on demand of a commodity

D. Number of Consumers
An increase in a number of consumers causes an increase in demand for commodities given
that consumers have ability to pay for. For example, Addis Ababa with the total population
of 3 million people buys commodities 3 times than the population of Nazareth with 1 million
people.

E. Expectation of Consumers
Just as current income and price affect demand for a commodity so can expected price and
income. If consumers expect their income to increase in the future, they may buy more since
they would be able to pay for this later on. If consumers expect higher (lower) prices in the
future, they may buy more (less) of the goods today. In discussing the effect of each of the
above variables on quantity demanded of a commodity we assumed other things remain
constant.

Change in Quantity Demanded and Change in Demand

The law of demand states that other things being constant, price and quantity demanded of a
commodity are inversely related.

The demand curve is derived under the assumption of Ceteris Paribus (other things remain
constant) i.e., other determinants of demand except own price are held constant. Thus, the
demand curve shows how quantity demanded of a commodity varies when the price of the
commodity changes. In this case we observe change in quantity demanded simply because of
change in the price of a commodity, and the dd curve remained unchanged (not shifted).

Introduction to Economics –Econ-1011 48

Thus, if we vary only price of a commodity and hold other determinants of demand (income,
taste and preference, prices of related goods, expectation, no of consumers) constant, the
demand curve does not shift In this case as price varies we are moving along the same dd
curve and we call this movement change in quantity demanded. The following graph shows
change in quantity demanded from Q1 to Q2 or from Q2 to Q1 due to change in price of the
commodity from p1 to p2 or from p2 to p1 respectively, ceteris paribus.

Price A
P1
Fig. 2.4: Change in quantity demanded (movement along
B
the same demand)
P2

P3 C
0
Q1 Q2 Q3
Quantity
If the price of a commodity (own price) remains constant and one or more of those other
factors affecting demand (e.g., income, taste and preference, prices of other goods,
expectation and number of consumers) change, then the demand curve shifts from its position
either to the right or to the left.

Thus, when the demand curve changes its position we call it change in demand (shift in
demand)
Price D1 D0 D2

P0

D1 D0 D2
0 Quantity

. Change in demand (shift in demand curve)

Introduction to Economics –Econ-1011 49
When demand curve shifts from D0 D0 to D2 D2 we say increase in demand, i.e., shift of the
demand curve to the right

When demand curve shifts from D0 D0 to D1 D1 (shift of demand curve to the left) we say
decrease in demand.

Increase in demand (shift from D0 D0 to D2 D2) is caused due to: increase in consumers'
income for normal goods, favorable taste and preference for a commodity, expectation of
higher price in the future, increase in the price of substitute goods, decrease in price of
complementary goods and others, ceteris paribus the reverse is also true.

Therefore, when we say increase (decrease) in demand we mean shift of the demand curve to
the right (left). When we say increase (decrease) in quantity demanded we mean downward
(upward) movement along the same demand curve.

NB. An increase (decrease) in demand also implies purchasing of more (less) of goods at
each price level. Thus, change in demand necessarily implies change in quantity
demanded, but change in quantity demanded does not necessarily imply change in
demand. Change in own price causes movement along the same demand curve without
causing shift of the demand curve while change in other factors affecting demand cause
shift in the demand curve.

Individual and Market Demand Curve

Individual demand curve is defined as amount of goods that a single consumer is willing
and able to buy at different price levels over certain time period.

Market Demand Curve is the total amount of goods that all consumers are willing and able
to buy at each price level over certain time period.

Introduction to Economics –Econ-1011 50

 Demand for wheat by three individual consumers over the last five months
Price per Abebe's demand Bekele's Almaz's demand for Total (market)
quintal for wheat demand for wheat demand for wheat
of wheat wheat
(1) (2) (3) (4) 5 = 2+3+4
300 0 3 5 8
260 2 6 10 18
220 4 9 15 28
180 6 12 20 38
140 8 15 25 48
100 10 18 30 58
60 12 21 35 68

From this table we can see that market demand is the horizontal summation of the demand
of those three consumers, which can be shown as individuals and market demand curve as
follows.
300
260 + + =
220
180
140
100
60
0 2 4 6 8 10 12 3 6 9 12 15 18 21 5 10 15 20 25 30 35 8 18 28 38 48 58 68

Quantity of wheat
Individual and Market Demand Curves.

2.4. Theory of Supply

Supply indicates the various quantities of a product that sellers (producers) are willing and
able to provide at various prices in a given period of time, other things remain unchanged.
Like demand, supply refers not only to the willingness of sellers to provide goods/services
but also the ability to do so. It should also be time specific because supply of a product per
day is different from that of per month or per year.

Introduction to Economics –Econ-1011 51

Note that quantity supplied and supply are two different concepts. Quantity supplied refers to
a specific quantity that a supplier is willing and able to provide at a specific price. But supply
refers to the whole relationship between possible prices of a product and the corresponding
quantities supplied. If supply refers to the relationship between price of a product and the
quantities supplied, then it can be presented in the form of a table, graph or equation.

2.4.1. Supply schedule, curve and function

It is a tabular representation of the relationship between the various prices of a product and
the corresponding quantities supplied, other things remain unchanged

An individual Producer's Supply of Orange per week

Price per Quantities supplied per
kg. kg
A 6. 9
B 5 7.5

C 4 6
D 3 4.5

E. 2 3

F 1 1.5
Form the above table we notice that as price rises, the respective quantizes supplied rises, and
as price decreases, quantity supplied also decreases. This direct relationship between price of
a product and quantity supplied, holding other things constant, is called the law of Supply.
From the law of supply, we understand that sellers are motivated to sell more at higher prices
than at lower prices.

Supply of a product can also be represented graphically. A Supply curve is, therefore, a
graphical representation of supply schedule. It shows how the quantity supplied of a product
varies as price varies, ceteris paribus. To draw the supply curve, put price on the vertical axis
(Y-axis), and quantity supplied on the horizontal axis (X-axis) and plot the price –quantity
supplied combinatioris listed in the supply schedule.

Introduction to Economics –Econ-1011 52

Each point on the supply curve indicates a specific price-quantity supplied combination. It
can be seen that the supply curve slopes upward from left to right. The positive slope of the
supply curve reflects the law of supply.

The supply schedule/supply curve of a product can also be expressed in the form of
mathematical equation- the supply junction. Assuming that all factors, except the price of the
product, remain uncqa.t:}ged, the above-mentioned individual producer's supply of orange
can be expressed mathema.tically. as,
.I
Qso== 1.5 Po
Where: Qso= quantity supplied of orange
Po = Price of orange per kg.

2.4.2. Individual and market supply

We can derive the market supply schedule or curve of a product from individual supply
schedule or curves. The'market supply schedule or curve indicates the total market supply of
a product that all sellers in the market are willing and able to provide in a given period of
time. It is derived by horizontally adding the quantity supplied of the product by all sellers at
each.
Example: consider that there are only three sellers of good x in the market. The supply
schedule of the 3 sellers is presented as follows.
The supply Schedule of Good x by 3 sellers

Price Quantity supplied per week Market

(per unit) Seller 1 Seller 2 Seller 3 supply/week

6 9+ 7+ 8= 24
5 7.5 + 6+ 6= 19.5
4 6- + 5+ 5= 16
3 4.5 + 4 +. 4.5 = 13
2 3+ 3+ 3= 9
1 1.5+ 2+ 2.5 = 6
We can also derive the market supply schedule in the same manner

Introduction to Economics –Econ-1011 53

 2.4.3. Determinants of supply
The supply of a particular product is determined by:
i. price of the product
ii. prices of input(cost of inputs)
iii. technology
iv. price of related goods
v. sellers' expectation of price of the product
vi. taxes and subsidies
vii. number of sellers in the market
viii. wemher
The determinants from (ii) to (viii) are collectively known as non-own price determinants of
supply or supply-shifters.
To explain the effec'ts of each of the determinants of supply of a product, it is essential
to understand the difference between change in quantity supplied and change in supply.

Change in Quantity Supplied and Change in Supply

When the price of a product changes, the quantity supplied also changes, other factors
remaining constant. For instance, an increase in price of orange causes a corresponding
increase in quantity supplied, and a decrease in price leads to a dec'rease in quantity supplied,
that is, a movement from one price-quantity combination to another price-quantity
combination is on a fixed supply curve. Hence, a change in quantity supplied resulting from
change of price of the product is represented as a movement along the same supply curve.

Price S0
P1

P0

Quantity
Q0 Q1

Introduction to Economics –Econ-1011 54

2.5. Market Equilibrium

2.5.1 Definition of market equilibrium

Through the theory of demand you have learnt about the behavior of buyers of a product. The
theory of supply has enabled you to see the behavior of sellers of a product. Now, let's bring
demand and supply of a product together so as to see how a price of a product is determined
in a market. To start with, let's assume that there are a large number of buyers and sellers of a
product in a particular market where a single buyer or seller has no control over the price of
the product. For example, let us take the maize market in a certain Woreda where there are
many farmers selling maize .and many households buying the same. The market demand and
supply schedule of maize is presep.ted below

The Market Demand and Supply of Maize Per Week

Market Demand Price (Per quintal) Market supply (in Surplus (+), Shortage( -)
(in quintal) (1) (2) quintal) (3) (3) - (1)
400 120 1200 ( +) 800
600 100 1000 ( +) 400
.800 80 800 0
1000 60 600 ( - )400
1200 40 400 ( -) 800

Consider that the price of maize is Birr 120 per quintal. At this price, sellers are willing and
able to supply 1,200 quintal per week, but buyers are willing to purchase 400 quintals. There
would be surplus of 800 quintals. The excess of supply over demand is called surplus. This
surplus or .unsold output in the hands of the sellers increases the competition among sellers,
and this pushes the price down. Let's say that the price goes down to Birr 100. The decrease
in. price encourages buyers to buy more. As a result market quantity demanded increases to
600 quintals. The decrease in price, however, reduces market quantity supplied to 1000
quintals but there is still a surplus of 400 quintals. This further reduces the price down to,
say, Birr 8Q.

Introduction to Economics –Econ-1011 55

A perfectly competitive market is a market, which fulfills the following criteria, i.e., the
followings are assumptions of perfectly competitive market:

1. Large number of buyers and sellers (so that the influence of individuals seller or buyer is
insignificant.
2. Firms produce a homogeneous product (so that an attempt to increase price by the
producer brings loss of market share)
3. Perfect information (knowledge) of the market (so that each market participant can act
according to the market operation)
4. Absence of government control of economic activities (no government price control, no
taxation, no subsidy, etc)
5.Free entry and exist of firm (no business license, no patent right, etc)
6.Free mobility of resources

At that equilibrium, price and quantity remain unchanged as long as we have the assumption
of other things being equal, i.e., until something operates to change supply or demand. If
some changes occur to shift either the supply curve or the demand curve, then the market
equilibrium point also changes.

In order to understand the market equilibrium let us consider our market demand schedule
and supply schedule of wheat we showed in the table 2.2 and table 2.4 respectively.

2.5.2 Effects of Change in Demand or Supply on The Market

Equilibrium
When we calculate the equilibrium price and quantity, the other determinants of demand and
supply were kept constant, when one or more determinants of demand changes, the demand
curve shifts. The same is true for supply. So, when the curve or supply curve or both shifts,
the equilibrium position also changes. Now let's see the effect of change in demand, supply
or both on equilibrium price and equilibrium quantity for the following conditions when:
o demand changes while supply remains unchanged,
o supply changes while demand remains constant,
o both demand and supply change.
Introduction to Economics –Econ-1011 56
When one of the factors varies and others held constant, then the market equilibrium point
also changes. This situation can be shown by the following graph.

D0 D1 S
Price

P1 e1

P0 e

S
D0 D1
Quantity
Q1 Q0
Effects of an increase in Demand when Supply Remains Unchanged

An increase in demand (shift of the demand curve from D0 D0 to D1D1) supply being
unchanged causes equilibrium point to change from e to e1. In this case the new equilibrium
point (point e1) is attained both at a higher price and quantity than the initial equilibrium
(point e).
A decrease in demand (shift of the demand curve from D1D1 to D0D0) and supply remains
constant causes attainment of the equilibrium at a lower point. i.e., equilibrium point
decrease from point e1 to e and therefore equilibrium quantity decreases from Q1 to !0 and
equilibrium price decreases from P1 to P0.
D0 S0 S1
Price
P0 e

P1 e1
S0
S1 D0
0 Q0 Q1 Quantity
Effects of an increase in supply when demand remains unchanged

Introduction to Economics –Econ-1011 57

An increase in supply (shift of supply curve from S0S0 to S1 S1) assuming demand not to
change causes equilibrium point to change from point e to e1. As a result equilibrium price
decreases from P0 to P1 and equilibrium quantity sold or bought increases from Q0 to Q1,
i.e., the new equilibrium is attained at a lower price but higher quantity than before.

Decrease in supply (shift of the curve from S1 S1 to S0S0) assuming demand being
unchanged causes equilibrium point to change from e1 to e. That is to say the new
equilibrium point e is attained at higher price but lower quantity level than before.
D0 S0 S1
Price
P0 e

P1 e1
S0
S1 D0
Q0 Q1 Quantity
Effects of a decrease in supply when demand remains unchanged

Effect of simultaneous change in demand and supply on equilibrium price and quantity. If
both demand and supply increase simultaneously, then the equilibrium quantity increases but
equilibrium price may increase, decrease or remain unchanged depending on the relative
magnitude of the percentage change in demand and supply. There are three cases.

(1) If demand increases by more proportion than the supply, the new equilibrium (e1) is
attained at both higher equilibrium price and quantity than before. Thus, the new
equilibrium quantity (Q1) is greater than the previous equilibrium quantity (Q0) and the
new equilibrium price (P1) is also greater than the previous equilibrium price (P0).

Introduction to Economics –Econ-1011 58

 D1 S0 S1
D0
Price P1 e1

P0 eo D1
S0
S1 Do
Q0 Q1 Quantity
Effects of increase in demand by more proportion than supply increase.

(2) If supply increases by more proportion than demand, then the new equilibrium (e1) is
attained at a higher equilibrium quantity (Q1) than previous quantity (Q0) but at a lower
equilibrium price (P1) than the previous price (P0).
S0
D0 D1
S1
Price P0 e0

P1 S0 e1
S1 D0 D1 Quantity
Q0 Q1
Effects of increase in supply by more proportion than demand increase.

3) If both demand and supply increases by an equal proportion the new equilibrium quantity
is attained at a higher level then the initial equilibrium quantity. But equilibrium price
remains unchanged.

Introduction to Economics –Econ-1011 59

 Price D0 D1 S0 S1

P0 e0 E1

S0
S1 D0 D1
Q0 Q1 Quantity

Effects of increase in supply and demand by equal proportion.

2.6. Elasticities
In the previous section, we have studied useful concepts like demand and supply and
investigated how price of a product is determined in a market. For instance, from the law of
demand, we can predict the direction of change in quantity demanded for a product whenever
there is change in the price of the same. We know that as price of a product increases, the
quantity demanded decreases, and as price decreases, quantity .demanded increases. But, by
how much? This depends on the reaction of the consumers to changes in price. Hence,
knowing the direction of the change is not enough. We have to measure the responsiveness of
buyers to changes in price or other determinants of demand. The same is true to the supply
side. Measuring the responsiveness of buyers or sellers of a product to changes in price or
other variables takes us to the concept of elasticity.

Generally, elasticity is a measure of responsiveness of a dependent variable to changes in an

independent variable. In economics, we use the concept of elasticity of demand or supply to
measure the responsiveness or sensitivity of consumers or sellers to changes in price or other
variables: We will discuss 4 types of elasticity.
i. Price elasticity of demand
ii. Income elasticity of demand
iii. Cross price elasticity of demand
iv. Price elasticity of supply

Introduction to Economics –Econ-1011 60

 2.6.1. Elasticity of demand
Elasticity of demand is defined as a measure of the degree of responsiveness of quantity
demanded (consumers) to the change of determinants of demand including price of a product.

There are three major types of elasticity of demand:

 Price elasticity of demand
 Income elasticity of demand
 Cross-price elasticity of demand

2.6.2. Price elasticity of demand

What is price elasticity of demand? How can we measure it? Price elasticity of demand is a
measure of the responsiveness of buyers of a product to changes in price of the same product.
It. is measured as a percentage change in quantity demanded of a product divided by
percentage change in price of the same product, other factors remain unchanged.

Price elasticity of Demand [E d]= Ep

percentage change in price of the same product

i.e.,
Ep =
percentage change in quantity demanded = (Q/Q) x 100
Percentage change in price (P/P) x 100
Where Ep = Price elasticity of demand
Q = Quantity demanded of a commodity

p = Price of a commodity
P = Change in price
Q = Change in quantity demanded
but Q = Q2 - Q1 and
P = P2 - P1
Where Q2 and Q1 are quantity demanded of a commodity at price level P2 and P1
respectively. Therefore,
Ep = [(Q2 - Q1)/Q1] x 100
[(P2 - P1)/P1] x 100
Ep = (Q2 - Q1) x P1 = (Q2 - Q1) x P1
Q1 P2-P1 (P2- P1) Q1

Introduction to Economics –Econ-1011 61

This type of elasticity is called point price elasticity of demand. Even though calculation of
price - elasticity of demand yields negative value because of the inverse relationship between
quantity demanded and price, for convenience we consider a positive value in terms of its
"absolute value".

From this example we can calculate 'point" price elasticity of demand in two ways:
1. Considering movement from point A to B, i.e.,
Ep = Q2 - Q1 x P1 = (30 - 20) x 15 = / -1.5 / = 1.5
P2 - P1 Q1 (10 - 15) 20
2. Considering the same points but movement in opposite direction, i.e., from B to A we
get:
Ep = Q2 - Q1 x P1 = 20 - 30 x 10 = / -0.67/ = 0.67
P2 - P1 Q1 15-10 30
Although price decreased from P1 to P2 quantity demanded remained unchanged.
2. Inelastic Demand: in this case percentage change in quantity demanded is less than
percentage change in price. eg . a change of price by 10%, which caused quantity,
demanded to change only by 5%. Here the value of demand elasticity lies between 0 and
1, i.e. 0 < ep < 1. Graphically it can be shown as follows.
D
P P1 0 < ep < 1

P2

D Q
Q1 Q2
Inelastic Demand curve

Introduction to Economics –Econ-1011 62

3. Elastic Demand: When percentage change in quantity demand is greater than percentage
change in price, it is said to be elastic demand. eg change in quantity demand by 10%
which was caused by 5% change in price.

P D
P1 ep > 1

P2

D
Q
Q1 Q2
Elastic Demand
4. Unitary Price Elasticity: here percentage change in price is equal to percentage in
quantity demanded. e.g. As demand changes by 10% price also changes by 10%.
P D
P1 ep = 1

P2
D
Q
Q1 Q
Unit Price Elastic demand curve

5. Perfectly Elastic demand: The percentage change in price is zero but percentage change in
quantity demanded is high. Here elasticity of demand is infinite, ep = 

P
P0 D ep = 

Q1 Q2 Quantity

Introduction to Economics –Econ-1011 63

Perfectly Elastic demand:
Linear demand curve and price elasticity of demand
Graphically, elasticity of demand for a straight-line demand curve can be shown as follows:

Price 4 D
ep > 1
3 B

2 M ep = 1

1 E ep < 1
D1
o 1 2 3 4 Quantity
Elasticity of demand and price elasticity of demand

Determinants of Price Elasticity of Demand

What makes price elasticity of demand elastic, inelastic or unitary elastic other than change
in the price of a product? Factors that determined price elasticity of demand are:
i. The Availability of Substitutes: - Other factors remain constant, the more substitutes
available for a product, the more elastic will the price elasticity of demand be. For
example, a rise in the price of Coca-Cola would force consumers to shift to consumption
of Pepsi; the demand for Coca-Cola tends to be price elastic.
ii. Time: - The demand for a particular product tends to be more elastic with time. Because,
with time, a. more substitute goods will be produced, & people tend to adjust their
consumption pattern as the price of a product continuously increases.
iii. The Proportion of Income Consumers Spends for a Product: - The smaller the proportion
of income spent for a good, the fewer prices elastic its demand would be.
iv. Luxury versus Necessity:

Introduction to Economics –Econ-1011 64

The demand for luxury good tends to be more elastic. The demand for necessity good tends
to be less elastic
Income Elasticity of Demand
It is a measure of a percentage change in quantity demanded that comes due to a percentage
change in consumer's income, other things remain unchanged. Income elasticity of demand
[E I] = percentage change in quantity demanded of a product percentage change in income

% Qd
EI= % I

Like price elasticity of demand, we use two formula to calculate E I

Cross Price Elasticity of Demand

One of the determinants of demand is the price of another good. To measure how much the
demand for a product is affected by a change in price of another good, we use cross price
elasticity of demand. Cross price elasticity is used to measure the percentage change in
quantity demanded of a commodity, (say X) due to percentage change in price of the other
commodity:
exy = (Qdx) / Qdx = Qdx , Py
 py/py py Qx

Where Qdx is changed in quantity demand of x.

py is changed in price of commodity y
Qxd is quantity demanded of x at particular price
 Q x 2  Q x1 
   P 
P  P   y1

 y2 
 Q 
y1

exy = x  x1  this is point cross price elasticity

If goods are related in consumption they are either a substitute or a complementary to each
other. Cross price elasticity can be positive, negative or zero. For substitute goods cross price
elasticity is positive. For complementary goods cross price elasticity is negative. If goods
have no relation their cross price elasticity of demand is zero.

Introduction to Economics –Econ-1011 65

Demand Schedule For Good X And Y
Points Px Py Qx Qy
A 2 3 18 13
B 4 5 12 9
C 5 6 10 4

Cross - elasticity of demand for commodity X i.e. exy as we move from A to B is given by
 Qx 2  Qx1  PY1
 
 PY  PY 
exy =  2 1
- QX 1

12  18  3 6 3
e xy   
(5  3  x 18 = 2 x 18 = -½ for the movement from A to B

18  12 5
 
For the movement from B to A, exy = (3  5)  x 12
exy = 6/-2 x 5/12 = -5/4
(Q x2  Q d x1 ) ( Py 2  Py1 )
( Py 2  Py1 ) d
 Q d x1 )
Arc cross - price elasticity (exy) = . (Q x2

2.6.3. Elasticity of supply

Price Elasticity of Supply
It measures the percentage change in quantity supplied of a product due to a % change in the
price of the same product, ceteris paribus. The change in quantity supplied due to certain
percentage change in the price of a commodity is given by:

Q s p  Q2 s  Q1 s  P1
 
P  P  Q s
 2  x 1 - Point elasticity it supply
s
es = P - Q = 1

Where es = price elasticity of supply

Qs = Change in quantity supply
P1 = price of a commodity
Qs = quantity supplied at a particular price.

Introduction to Economics –Econ-1011 66

Price elasticity of supply is positive. It may vary from 0 to 
Arc cross - price elasticity (exy) = (Qx2d - Qdx1) . (Py2+Py1)
(Py2 - Py1) (Qdx2 + Qx1d)
If es = 0 it is called perfectly inelastic supply. Graphically it is:
S
P1
Price P2 es = 0

Q Quantity
perfectly inelastic supply curve
If es =  i.e p = 0 then it is called a perfectly elastic supply

P es = 
P0 S

Q1 Q2 Q
Perfectly elastic supply curve

2.6.4. Application of elasticity

Elasticity has a meticulous application in business. The concept of demand elasticity is useful
for business people. If a producer wants to sell more of his commodity by reducing price then
the demand curve for his product must have elastic demand.

If demand for the product is elastic, an increase in price results decrease in revenue as small
percentage change in price causes large decrease in quantity sold. If a producer faces an
inelastic demand curve for his product he can increase his revenue by increasing price
because under this case large percentage increase in price causes little percentage decrease in
quantity demanded. If a producer faces inelastic demand curve, then it cannot increase its
revenue by decreasing price.
If demand is unitary, change in price does not affect total revenue. In this case there is no
need of decreasing or increasing price, as it does not affect total revenue of the producer.

Introduction to Economics –Econ-1011 67

2.7. Summary
Individuals or households may desire or wish to have goods and services that they think will
satisfy their needs. In economics, a desire for goods and services backed by the ability and
willingness to buy those goods and services in a given period of time is generally referred to
as demand.

Demand is a willingness and ability of a consumer to purchase goods and services at specific
price within a set of possible prices at a given period of time.

Demand curve of a commodity is a curve, which shows the relationship between the quantity
demanded of the commodity at different price levels. In drawing the demand curve we
singled out price of a commodity as the most important factor affecting the quantity
demanded of the commodity and ignored the influences of other factors.

The supply schedule/supply curve of a product can also be expressed in the form of
mathematical equation- the supply junction.

Introduction to Economics –Econ-1011 68

2.8. Review Questions
1) State and explain why the demand curve is negatively sloped?

2) State factors that affect quantity demanded and quantity supplied and explains how they
affect the position of the demand curve or supply curve.

3) Why the supply curve is up - ward sloped (ie why price of a commodity and its quantity
supplied are positively related)?

4) What is market equilibrium? How it is arrived at? Under a perfect competitive market
assuming other things being constant, explain why any deviation from the equilibrium is
a self - adjusting, i.e., it finally returns to the initial equilibrium level?

5) Define price elasticity of demand. How it is computed, what are its determinant and what
is its use in business world?

6) Based on the following table answer questions a and b.

Introduction to Economics –Econ-1011 69

 Demand Schedule for two commodities

Points Price of Price of Quantity Quantity

Teff Wheat demanded of teff demanded of
In Birr In Birr In quintals Wheat
In quintals
A 100 160 18 15
B 150 120 12 19
C 200 80 6 23

a) Calculate cross - price elasticity of teff?

b) Calculate cross - price elasticity of wheat. Are the two goods substitutes or
complementary? Why?
7) What are the factors held constant while deriving the demand and supply curve? State
their significance.
8) Use supply and demand curve to show the effect of increase in consumer income on
market equilibrium? Compare the resulted equilibrium quantity and price with the
original quantity and price.

9) Suppose the demand and supply functions for Coca are given by
Qd = 200 - 30p and
Qs = 20p, respectively.
a. Find the equilibrium quantity of coca demanded?
b. Find equilibrium price of Coca
c. Do you have excess demand or excess supply when price of Coca is 20 Birr?
When price of Coca is 50 Birr?
10) Suppose unseasonable flood attacked wheat production of maize in the upper Awash
Valley, assuming other things being constant. What effect will this have on:
a. the market supply curve for maize?
b. The market demand curve for maize?
c. The market equilibrium of maize?

Introduction to Economics –Econ-1011 70

 CHAPTER THREE
THE THEORY OF CONSUMER BEHAVIOR

3.1 Chapter Objectives

3.2 Introduction
3.3 Consumer Choice and the Concept of Utility
3.3.1 Cardinal Utility
3.3.1.1 Total and Marginal Utility
3.3.1.2 Consumer’s Equilibrium
3.3.2 The Budget Line
3.3.2.1 Shift and Rotation of the Budget Line
3.3.3 Ordinal Utility
3.3.3.1 The Indifference Curve
3.3.3.2 Marginal Rate of Substitution
3.3.3.3 Consumer’s Equilibrium Using Ordinal Approach
3.4 Review Questions

3.1. Chapter Objectives

This chapter is designed to enlighten the students about the theory of consumer behavior. By
the time you complete this chapter you will be able to understand and discuss the following
related concepts of the consumer behavior.
o Consumer Choice and the Concept of Utility
o Cardinal Utility
o How the consumer maximizes satisfaction from different consumption possibilities
o The Budget Line
o Ordinal Utility

Introduction to Economics –Econ-1011 71

3.2. Introduction
Dear students! This chapter analyzes several questions such as: what is the relationship
between the price we pay for a good and the overall benefit, worth of the good to us? Do
low-priced goods cost less because they are not worth much to us?

The demand side of the market is about how changes in price, taste, income, etc influence the
consumption pattern of consumers. Hence, the demand side of the market, in essence, is
about the behavior of buyers. In this sense, this chapter is a continuation of the previous
chapter

In our day-to-day life, we buy different goods and services for consumption. As consumers,
we act to derive satisfaction by using goods and services. But, have you ever thought of how
your mother or any other person whom you know decides to buy those consumption goods
and services? This is what we intend to discuss in this chapter; we want to understand their
behavior in detail

3.3.Consumer Choice and the Concept of Utility

Before discussing the concept of utility, let us first point out some of the assumptions that
economists make about the average consumer. First, economists assume that an average
consumer is rational. That means, among other things, a consumer has a clear-cut preference.
By this we mean that consumer is able to compare any two bundles 'a' and 'b' and decide
which one he/she prefers.

Economists have called this benefit or satisfaction utility, and have assumed that, in choosing
among goods, the consumer will attempt to gain the greatest possible utility, subject to
his/her budget constraints. Utility is thus the satisfaction obtained from consuming good or
service. In short, utility is a want satisfying power of a product to satisfy human needs. The
two approaches to consumer's behavior analysis:

Introduction to Economics –Econ-1011 72

 3.3.1. Cardinal Utility
As stated above utility is the satisfaction or pleasure that a consumer obtains from consuming
a product. Total utility is the total satisfaction or pleasure a consumer drives from consuming
a specific quantity of a commodity at a particular time. These economists have become
known as cardinality, because they believed that cardinal numbers could be used to express
the utility derived from the consumption of a commodity. Some economists suggested that
utility could be measured in monetary units while others (in the same school) suggested the
measurement of utility in subjective units, called units.

However, utility is an abstract, subjective concept and there are two major problems involved
in trying to measure it: It is difficult to find an appropriate unit of measurement. If we call the
unit a util, what is a util? Are 5 utils enjoyed by one individual equivalent to 5 utils enjoyed
by another? Stated differently, can we make interpersonal comparison of utility?

Total and marginal utility

The total utility is the total satisfaction obtained from the consumption of a good or bundle of
goods in a given time period.
The total utility (U) of the consumer depends on the quantities of the commodities
consumed:
TU = f (q1, q2, ... qn)
The marginal (or incremental) utility is the satisfaction added by the consumption of the last
unit or in other words, it is the change in total utility caused by changing consumption of a
good by on unit, holding consumption of all other goods fixed. Geometrically, the marginal
utility of X is the slope of the total utility curve.
Mathematically this can be written as:
Mux = ΔTu/Δx

The following table shows the relationship between total and marginal utility of a particular
commodity.

Introduction to Economics –Econ-1011 73

Total and marginal utility hypothetical data.
Units of a commodity A Total utility of commodity A Marginal utility of commodity A
(TUa) (MUa)
0 0 _
1 40 40
2 75 35
3 105 30
4 130 25
5 150 20
6 165 15
7 175 10
8 180 5
9 180 0
10 175 -5

The total utility increases, but at decreasing rate, up to quantity 9, reaches its maximum and
then starts to decline there after. Accordingly the marginal utility of X declines continuously
and becomes zero when total utility reaches maximum or saturation point and then negative
beyond quantity 9.

The fact that marginal utility will decline as the consumer acquires additional units of a
specific product is known as the law of diminishing marginal utility.

MU1 ------- ------------------------------------------------------P1---------

demand curve
MU2 -------------------------------------------------------------- P2 ---------------

MU3 ---------------------------------------------------------------------------------------------------
- P3 ----------------------------

MU4 ------------------------------------------------------------------------------------------P4- ---

-----------------------------------------

0 1 2 3 4
0 1 2 3
D
4
Quantity MU
Quantity
Derivation of demand curve from marginal utility curve

Introduction to Economics –Econ-1011 74

Consumer's equilibrium
A consumer is said to have reached his/her equilibrium position when he/she has maximized
the level of his/her satisfaction, given budget constraints and other conditions. At
equilibrium, the consumer is supposed to have spent his/her entire income on the goods and
services he/she consumes. If we assume that the consumer consumes only two products, say,
X and Y, then the following condition should fulfill in equilibrium:
MU x Px MU x MU y
MU y Py
= or Px = Py
The utility derived from spending an additional unit of money must be the same for all
commodities. If the consumer derives greater utility from any one commodity, he can
increase his welfare by spending more on that commodity and less on the others, until the
above equilibrium condition is fulfilled.

We will illustrate this using a three - commodity model.

Marginal utility and units of a good
Unit Marginal Utility
Good A Good B Good C
1 60 36 16

2 50 30 14

3 40 18 10

4 30 12 8

Given:
1) The price of commodity A(PA) = birr 5, commodity B(PB) = birr 3, and commodity
C(PC) = birr 1.
2) The total income of the consumer is birr 19, Now, would the consumer purchase the first
unit of A, B or C? The answer is the consumer would purchase the first unit of commodity
C. Why? Because, the highest level of marginal utility per birr is obtained from the first
unit of C

Introduction to Economics –Econ-1011 75

That is:
Commodity A will have 60/5 = birr 12
Commodity B will have 36/3 = birr 12
Commodity C will have 16/ 1= birr 16
Now that consumer is left with birr 18. Which unit of commodity will he buy next? Again by
the same logic, he will purchase the 2nd unit of C. This time is having 17 birr.

3.3.2. The budget line

A budget line is a graph that shows the various combinations of two goods that a consumer
can buy given his/her limited income and the prices of the goods.

Consider that Tolosa has a money income (M) of Birr 100, and the consumes two goods X
and Y. The price of good X (Px) is Birr 10 and the price of good Y(Py) is Birr 5 per unit. If
he spends his income to buy goods X only he would buy 10 units of X (i.e. 100/10 = 10). If
he spends the whole Birr 100 to buy good Y, he would buy 20 units (i.e. 100/5 = 20 units). If
you join these points you get the budget line.

The Budget Line

M
Py
Budget set (Market opportunity set)

M Px
P P
Y= y - y X
B

Introduction to Economics –Econ-1011 76

 0 X
M
Px
M
P
(-) y , Mathematically speaking, is the Y - intercept.
Py

(-) In the above equation, - Px (the negative of the price - ratio), is the slope of the budget
line. That is,
M / Py Py
OA
Slope = OB = M / Px = Px
 Px 
 
P 
The negative sign in the price ratio  y  indicates that the budget line slopes downward from
left to the right.
Shift and Rotation of the Budget Line

If a consumer has an increase in money income at the original set of commodity prices, the
amount of the commodities (in our case, X and Y), which the consumer can purchase, must
increase. And since the increase in money income allows the consumer to buy more goods
(of X and Y) the budget line is pushed out ward (shifts outward). Since prices are not
changed, the slope of the budget line does not change. Therefore, an increase in money
income (prices of commodities remaining constant) caused an outward parallel shift in the
budget line, as indicated below.

Introduction to Economics –Econ-1011 77

 Y
M
Py

M
Py
Where M > M

0
M M
Px Px X
Rightward Shift of the budget line

3.3.3. Ordinal utility

Earlier many economists were coming to the view that utility could not be measured
cardinally and that cardinally measurement was not essential for a theory of consumer
behavior. These economists have become known as ordinalists. This is because they claimed
that an individual can only rank bundles of goods in order of his/her preference. And the
consumer can say that he/she obtains more utility from one bundle than from another, or the
consumer derives equal utility from two or more bundles. It is impossible, though to measure
by how much one bundle is preferred to another. Only ordinal numbers (first, second, … so
on) can be used to "measure" utility, and these say nothing about the absolute difference of
any other relationship between utilities.

The Indifference Curve (iso-utility curve)

Before we get out to discuss indifference curve and consumer equilibrium, let us first of all
state the basic assumptions of indifference curves:
1) The consumer is assumed to be rational: the consumer aims at the maximization of
his utility, given his/her income and market prices.
2) The consumer can rank his/her preferences according to the satisfaction of each
basket of goods. He/She need know precisely the amount of satisfaction derived from
the consumption of the commodities. The ranking of goods according to his/her
preference is all that is needed.

Introduction to Economics –Econ-1011 78

 3) Diminishing marginal rate of substitution: the slope of the indifference curve, which
depicts the rate at which the consumer is willing to substitute one good for another,
declines. The indifference curve analysis is, thus, based on the axiom of diminishing
marginal rate of substitution.
4) The total utility (U) of the consumer depends on the quantities of the commodities
consumed: U = f (q1, q2, ... qn)
5) Consistency and transitivity of choice. It is assumed that the consumer is consistent in
his choice, that is, if in one period he chooses bundle A over B he will not choose B
over A in another period if both bundles are available to him. The consistency
assumption may be symbolically written as: If A > B then B < A
6) Similarly, it is assumed that consumer's choice are characterized by transitivity: if
bundle A is preferred to B, and B is preferred to C, then bundle A is preferred to C.
Symbolically, If A > B, and B > C, then A > C
7) The non- satiety assumption. This assumption implies that the consumer always
prefers the bundle with at least one more commodity in it.
Example: The first bundle consists of 8 units of X and 6 units of Y while the second
bundle consists 10 units of X and 6 of Y. According to the above assumption, the
consumer prefers the second bundle to the first one.
8) The consumer is assumed to have all relevant information.

Introduction to Economics –Econ-1011 79

3.4.Review Questions
1) What are normal goods?

2) What are inferior goods?

3) What are substitutes goods?

4) What are complementary goods?

5) What is an effect of a decrease in income of the consumer on demand for inferior good
ceteris paribus? Show your answer graphically.

6) What is Market Equilibrium?

7) Given:
If the Demand and supply equations of a commodity are:
Qd = 30 - 5P (demand equation)
and
Qs = 25P (supply equation), respectively, where Qd, Qs and P arequantity
demanded, quantity supplied and price respectively.
Based on the above demand and supply equations, what will be:

a) equilibrium price ?

b) equilibrium quantity ?

8) In the figure below if price of commodity Y is 6 Birr and the budget line of the consumer
is given by AB, then

Introduction to Economics –Econ-1011 80

 Y A
Y(0, 36)

0 B0)
(54.
X
a) What is the consumer's budget (income)?
b) What is the price of commodity X?

9) Assume a consumer consumes only two products (X, Y); show graphically effect of
decrease in price of commodity Y on budget line, ceteris paribus. Use vertical axis for
commodity Y and horizontal axis for commodity X.

10) Why people act according to the law of demand or in other words why price of a
commodity and its quantity demanded are inversely related or why demand curve is
downward sloping?

11) When teff prices rise other things being constant, an individual purchases more wheat
but fewer teff. How you explain substitution and income effects of the price change on
these two goods?

12) Explain the law of demand in terms of diminishing marginal utility.

13) What information is contained in an indifference curve?

14) Why are indifference curves downward sloping?

15) Why does total utility increases as a consumer moves to indifference curves further from
the origin?

16) Explain why the point of tangency of the budget line with an indifference curve is the
consumer's equilibrium position.

Introduction to Economics –Econ-1011 81

 CHAPTER FOUR
THEORY OF PRODUCTION

4.1 Chapter Objectives

4.2 Introduction
4.3 Concepts of Production and Production Functions
4.3.1. Production with One Variable Input
4.3.2. Capital intensity, Labor Intensity and the Concept of Returns to Scale
4.3.3. Production With Two Variable Inputs
4.3.4. Momentary Run, Short Run and Long Run
4.3.5. Production Efficiency
4.4 Production in the Short-Run and the Stages of Production
4.5 Production in the Long-run concepts of Iso-quant, Iso-Cost and Producer’s
Equilibrium
4.5.1. Substitution Possibilities
4.5.2. The Concept of Iso - cost
4.6 Review Questions

4.1.Chapter Objectives
This chapter explores the theory of production in detail. At the end of this chapter you would
be able to understand and be able to explain:
o Concepts of Production and Production Functions
o Production in the Long-run concepts of Iso-quant, Iso-Cost and Producer’s
o Capital intensity, Labor Intensity and the Concept of Returns to Scale
o Momentary Run, Short Run and Long Run

4.2. Introduction
Dear students! This chapter discusses issues and concepts of production theories and
production functions in detail. After going through the chapter the students are expected to
differentiate production and production and production functions. In the previous chapter, we

Introduction to Economics –Econ-1011 82

have studied how a consumer attempt to maximize utility given the prices of commodities
and his/ her income. In this chapter, on the other hand, we will study how a firm combines
economic resources so as to maximize output, given the technology. This chapter, therefore,
emphasizes in understanding of the behavior of firms in the production of goods and services

4.3. Concepts of Production and Production Functions

All inputs can be divided into two categories: fixed inputs and variable inputs. Fixed inputs
are those inputs whose quantity remains fixed for a given period of time. On the other hand,
variable inputs are those inputs whose quantity can be increased or decreased during a given
period of time. For example, a farmer requires land surface, water, capital goods, labor etc.
Labor can be considered as variable input while land and capital goods are fixed inputs
assuming that the size of the plot and the capital goods available for production remain fixed.

In economics, production period is classified as short run or long run. Short run refers to a
period of time ip. which the quantity of at least one input remains fixed. On the other hand,
the term long run refers to period of time in which all inputs are variable. Here, you should
note that short run doesn't refer to relatively short period of time like a year or less than a
year, and long run doesn't refer to period of time greater than a year or 5 year. They rather
refer to the nature of economic adjustment in the firm to changing economic environment.
Once we define the most important concepts as output, input and production periods, and
classified inputs as fixed and variable inputs, we can now see the relationship between
various combinations of inputs and the maximum output a firm can produce. This
relationship is depicted by a concept known as production function.

Business firms function in sole proprietorships, in partnerships or in giant corporations

(modern corporations) i.e., they many be owned by a single person, a small group of persons
or by large number of persons and organizations. Their size may be small, medium or large.
The majority of small-scale firms are owned by single persons - the sole proprietor. The
bigger ones tend to be corporations.

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There are some common questions to be forwarded before the theory of firm or production
theory is discussed: Why do we need large organizations to produce our daily bread rather
than producing everything ourselves? Why does business activity generally take place in
firms? Why do people need to gather into small or large organizations to produce goods?

Firms exist for many reasons, but the most important are to:
1. exploit economies of scale in production
2. raise funds
3. organize the production process
The most compelling factor leading to organization of production firms arises from
economies of scale. In production analysis, economies of scale occur when the cost of
production declines with larger and larger volumes of output. If there were no economies of
scale and specialization, then we could each produce our own goods (own food, cloth, car
etc.) It is obvious that we gain enormously because production is organized in large firms.

The second reason is related to the necessity of raising resources for large - scale production.
Often, large amount of money is needed to run large-scale production. Where are the funds to
come from? In a private - enterprise economy, most funds for production must come from
company profits or when firms borrow from large number of individual savers.

A third reason for firms is the necessity of management. The manager is the person who
organizes production, introduces new ideas or products or processes, makes the business
decisions, and is held accountable for success or failure. Production cannot organize itself.
Managerial decisions are made by firms, or more precisely by people on behalf of firms.

Production Function
Production function shows the relationship between various combinations of inputs and the
maximum outputs obtainable from those combinations. It represents the maximum output
that can be produced from given combination of inputs. It describes technological
relationship between inputs arid output.
Mathematically, it can be represented as
Q = f(XJ,X2,X3 ,Xn)

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Where, Q represents the maximum quantity of output
XI,X2,X3 ,Xn are different types of inputs
If the quantity of at least one input remains fixed, the above mentioned production function is
called short run production function. But, if all of the inputs are variable, the production
function is called long run production function.

Most production utilizes several inputs at the same time or in some time sequence. In fact, it
is difficult to think of an example where production occurs with just one input. Inputs can be
grouped or classified in several ways. One common classification is that of land, labor and
capital. Land can be seen as the resource provided by nature, including the minerals,
petroleum, and water therein.

Inputs can be grouped into two main categories:

1) fixed inputs,
2) variable inputs.

4.3.1. Production with one variable input

Consider that a farmer wants to produce maize on 2 hectare of land. To produce maize, he
needs land, fertilizer, water, some equipment and labor. Assume that all of the inputs except
labor are fixed at certain quantity. Given this, the farmer can increase maize production by
increasing the unit of labor only. But, the farmer cannot increase maize production
indefinitely since he is combining increasing unit of labor with fixed inputs land and capital.
Eventually, total output will decline. Assume there is one variable input-labor-and everything
else such as machines, tools, and the building is fixed, except the raw materials and energy to
manufacture the cookies, which are assumed to be available in unlimited quantities. The
relationship we are interested in is between the input of labor and the output of cookies.

As stated above the production function is the technical name given to the relationship
between the maximum amount of output that can be produced and the inputs required to
make that output. It is defined for a given state of technical knowledge.

Production function describes the relationship between any combination of inputs and the
maximum attainable output from that combination.
Introduction to Economics –Econ-1011 85
Production Function

1 2 3 4
Labor Input Total Physical Marginal Physical Average physical
(days) Product (TPP) Product (MPP) product (APP)
0 0 - -
10 100 10 10
20 800 70 40
30 2000 120 67
40 2900 90 73
50 300 70 72
60 4200 60 70
70 4600 40 66
80 4800 20 60
90 4800 0 53
100 4500 -30 45

This general relationship between labor and output is typical for most production activities.
When a small amount of labor is available, it has to do a variety of jobs. Therefore, no person
becomes proficient at any one job. Or, people may have to do tasks they are not trained to do.
As more labor is added, in this example, up to 30 days per week, greater specialization is
possible, and perhaps all the machines are working at least eight hours per day. Thus, output
increases more rapidly than labor increases.

4.3.2. Capital intensity, labor intensity and the concept of returns to

scale
Capital Intensive Industries:- are those industries that comparatively require abundance of
capital and advanced techniques as compared to the labor. Basic key and heavy industries are
capital extensive while usually the consumer's goods industries do not require that much of
capital. An economy cannot progress with its basic and heavy industries like steel and paver.
These are all capital extensive industries.

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Labor Intensive Methods: are the inverse of the capital intensive methods of production.
When the producer comparatively puts labor more as compared to the capital in making a
given product, such a technique of production is known as labor intensive. Cottage industry
products are labor intensive Pavers and Steel project require capital intensive methods.

Diminishing marginal product of labor, diminishing marginal product of other inputs is so

prevalent that the phrase "the law of diminishing returns is often used to describe it. The law
of diminishing returns is to production while diminishing marginal utility is to consumption.
These two propositions are the bed rock of all micro economics - diminishing marginal utility
on the consumer and demand side, and diminishing returns on the production and supply
side.

Returns to Scale
What if all factors of production change? For example, what would happen if all the inputs
that the farmer uses in the production of maize increase? Diminishing returns and marginal
products refer to the response of output to an increase of a single input when all other inputs
are held constant. For example, increasing labor while holding land constant would increase
food output by ever smaller increments.

But sometimes we are interested in the impact on output when all inputs are increased. What
would happen to production of automobiles if the quantity of labor, computers, robots, steel
and factory space were all doubled? These questions refer to the returns to scale, or the
effects of scale increases of inputs on the quantity produced. Put differently the returns to
scale reflect the responsiveness of total product when all the inputs are increased
proportionately. It is important to distinguish 3 main cases.

Constant returns to scale denote a case where a change in all inputs leads to an equally large
increase in output. For example, if inputs of labor, land, capital, and other inputs are doubled,
then under constant returns to scale output would also double. Many handicraft industries
(such as handlooms) tend to show constant returns.

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A situation of decreasing returns to scale occurs when a balanced increase of all inputs leads
to a less than proportional increases in total output. For examples say that a farmer's corn
land, seed, labor, machinery, etc., were increased by 50%. If as a result total output increased
by only 40%, then this situation is one of the decreasing returns to scale. Many productive
activities involving natural resources, such as grunting wine grapes or forestry, show
decreasing returns to scale.

i. Constant Returns to Scale: if a certain percentage change in all inputs results in the same'
percentage change in output, a production function is said to exhibit constant returns to
scale.[ i.e., % 1:1 in all inputs =, % 1:1 in output]. It is a situation in which a percentage
change in all inputs" leads to the same percentage change in output. For example, if the
farmer manages to increase all the inputs he uses in production of maize by 5%, and as a
result total maize production increases by 5 %, the return is said to be constant returns to
scale.
ii. Increasing Returns to Scale: is a situation in which a percentage change in all inputs
causes a more than proportionate change in output. [i.e., % 1:1 in all inputs> % 1:1 in
output]. For Example, if a 5% change in all inputs leads to a more than 5% change in maize
production, this relationship is called increasing returns to scale.

Increasing returns to scale may occur because of :

a. an increase in the scale of operation of firm: it may permit the use of a more productive,
specialized machinery which was not feasible at lower scale of production.
b. greater division of labor
c. greater degree of specialization: each worker can specialize in specific piece of work
rather than doing many different tasks. This increases the productivity of worker~, thereby,
increases total product.
iii. Decreasing Returns to Scale: is a situation in which a percentage change in all inputs
causes a less than proportionate change in output.[ i.e., % 1:1 in all inputs < % 1:1 in
output]. For Example, if a 5% change in all inputs leads to a less than 5% change in maize
production, this relationship is called decreasing returns to scale. For example, as the scale

Introduction to Economics –Econ-1011 88

 of production increases, if communication difficulties arise, it may lead to a decrease in
total product per period.
If increasing returns prevailed, then the larger scale of inputs and production would lead to
greater productivity where productivity is a concept measuring the ratio of total output to a
weighted average of inputs. If, for example, the typical firm's inputs increased by 100 percent
and output consequently increased by 120 percent, then productivity (output per unit of
input) would rise by 20 percent. This example shows that increases in a nation's per capita
output and living standards may result in part from exploiting economies of scale in
production as the nation grows.

While the potential scale economies are great in many sectors, at some point decreasing
returns to scale may take hold. As firms become larger and larger, the problems of
management and coordination become increasingly difficult. The number of geographic
markets or product lines with less time to be studied each by the management will be harden.
While technology might ideally allow constant or increasing returns to scale, the needs for
management and supervision may eventually lead to decreasing returns to scale from giant
firms.

4.3.3. Production with two variable inputs

The firms production technology in the long-run setting will enable it to use two inputs
(instead of one) i.e., where two inputs are variable. One can examine the alternative ways of
producing by looking at the shape of a series of iso-quants. More of either input increases
output: so if output is to be kept constant as more of one input is used, less of the other input
must be used.

Diminishing Returns
There are diminishing returns to both labor and capital in this example as well. To see why
there are diminishing returns to labor, for example, draw a horizontal line at a particular level
of capital, say 3. Reading the levels of output from each isoquant as labor is increased by an
additional unit (from B to C); output increases by only 15 (from 75 to 90). Thus, there are
diminishing returns to labor both in the long and short - run. Because adding other factor

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while holding the other factor constant eventually leads to lower and lower increments to
output, the isoquant must become both steeper and steeper, as more capital is added in place
of labor, and flatter and flatter when labor is added in place of capital.

4.3.4. Momentary run, short run and long run

The period of Productions Functions
Pipelines cannot be built over-night, and once built they last for decades. Farmers cannot
change crops in mid-season, nor can new land be cleared quickly. Nuclear power plants take
a decade or more to plan, constructs test and commission.

The period of production can be used to understand the dynamics of production response. It
can be grouped into 3 periods: momentary run, short run and long run production periods.
o The Momentary run is a period so short that production is fixed and that no change in
production can take place.
o The short run - is a period of production during which some inputs cannot be varied. (A
variable input is one whose quantity can be changed). It is a period in which firms can
adjust production by changing variable factors such as materials and labor but cannot
change fixed factors such as capital. In this period, fixed factors, such as plant and
equipment cannot be fully modified or adjusted.
o The long run - is a period of production enough that managers have time to vary all the
inputs used to produce a good. In this period there are no fixed inputs. This period is
sufficiently long so that all factors (fixed and variable) including capital can be changed.
Producers have more flexibility here than in short run. Managers can in this period
contemplate future changes in the use of currently fixed inputs.
To understand these concepts more clearly, let's consider the way the production of steel
might respond to changes in demand. Say it is operating its furnaces at 70 percent of capacity
when a sudden and an expected increase in the demand for steel occurs because of a break
down in a competitor's plant. In the momentary run of a day or so, the steel firm cannot
adjust its production at all. It takes time to check and recheck the order books, to call
customers to confirm their needs, to recalculate the optional production level, to stock up the
furnace, to reschedule worker - hours, and to order the necessary materials.

Introduction to Economics –Econ-1011 90

The firm can increase production by asking its workers to work overtime, by hiring more
workers, and by operating its plants and machinery more intensively.

Suppose that the increase in steel demand persisted for an extended period of time, for 2 or 3
years or even for a decade. The plant might then examine its plant and equipment and decide
that it should increase its productive capacity. More generally, it might examine all its fixed
factors, those being ones that cannot be changed in the short run because of physical
conditions or legal contracts.

The factors, which are increased in the short run, are called variable factors, for they can
easily be changed in a short period of time. Hence, the level of production can be increased
within the limits of existing plant capacity during the short run.

The period of time over which all inputs fixed and variable can be adjusted is called the long
run. In this period the steel plant might add new and more efficient production processes,
introduce robots to perform new tasks, computerize additional steps, or build a plant would
allow a greater increase in production than simply adding more workers, and they would also
allow more efficient use of the existing labor force.

4.3.5. Production efficiency

Efficiency means absence of waste or using the economy's resources as effectively as
possible to satisfy people's needs and desires. The economy is said to be producing
efficiently when it cannot produce more of one good without producing less of another -
when it is on the production possibility frontier. Production efficiency is one of the central
concepts of economics.

Being on the production possibility frontier (PPF) means producing more of one good
inevitably implies sacrificing other goods. When we produce more of one good we are
substituting another good. Substitution is the law of life in a full - employment economy,
and the production possibility frontier depicts the menu of society's choices.

Introduction to Economics –Econ-1011 91

Mismanagement of economic resources also causes the economy to operate within its PPC.
Sloppy management therefore, also prevents an economy from attaining production
possibility for which it has the capability.

Attainment of productive efficiency means we can't reallocate economic resources so as to

increase the output of any single good or service without decreasing the output of some other
good or service. Points on PPC represent efficient use of production resources, because once
the curve it's impossible to increase the output of one good without reducing the output of the
other.

Other things being equal, the more workers willing and able to work, the more capital, and
the more land, the greater the production possibilities. This means the production possibilities
curve will shift outward in response to an increase in available economic resources. Increases
in economic resources available for production will therefore result in a new production
possibility curve.

The division of labor (specialization) of workers in particular tasks that are part of a larger
undertaking to accomplish a given objective. By specializing, workers become more
proficient at their jobs. It lets factories and other producing (plants) enterprises use mass
production techniques that allow workers to produce more.
Technological Improvements and Improved quality of inputs - shift the PPC/ Outward. This
expands the economy's opportunities.

Food per year (tons)

New PPC
Initial
PPC

0 Clothing per year (no of garments)

Economic growth

Introduction to Economics –Econ-1011 92

Improved quality of inputs - improvement in skill, education, or training of the labor force
can also increase the output obtainable from any given combination of inputs. Devoting more
economic resources to education and job training in the current year pays off in the future in
terms of greater production possibilities. Investment to improve production machinery and
equipment - to provide better goods for future consumption also improve production
efficiency. Education, new structures and equipment to be used in production, and research
for and development of new technologies are investments, which improve the efficiency of
future production possibilities. Similarly, the quality of capital also improves as new
machines are introduced that can accomplish tasks more quickly or more accurately.
Improvements in the quality of capital require advances in technology, which is the next
source of economic growth. Technological advances in one sector of the economy cause
gains in production possibilities in other sectors as well.

The gain from these investments is the expansion in production possibilities they allow in the
future.

In addition to deciding what to produce, how to produce it and who will receive it, each
economy is supposed to decide what and how much it will sacrifice today to make
investments to improve the efficiency of future production possibilities.

4.4.Production in the Short - Run And the Stages of Production

In this section we are going to explore production in the short run and the stages of
production and its impact in economic growth and related factors. The short-run production
pertains to a period of time in which one or more factors of production cannot be changed. In
the short - run, firms vary intensity with which they utilize a given plant and machinery.
Factors that cannot be varied over this period are called fixed inputs. A firm's capital, for
example, usually requires time to change - a new factory must be planned and built, and
machinery and other equipment must be ordered and delivered, which can take a year or
more.

Introduction to Economics –Econ-1011 93

The levels of input use are classified into three stages:-
o Stage 1 includes the area of increasing returns and extends to the point where the
MPP curve intersects the APP curve. At this point, APP is at a maximum. Stage 1
includes a portion of the MPP curve that is declining. The distinguishing
characteristic of stage 1 is that MPP is greater than APP. As long as the marginal unit
is greater than the overall average, the average will always increase.
o The specific characteristic of stage II is that MPP is every where less than APP. This
results in the continual decline of APP. Stage II ends at the point where MPP
becomes zero.
o Stage III begins where the MPP curve crosses the horizontal axis and extends to the
right indefinitely as the negative MPP continues to pull APP down, approaching Zero
but never reaching it.
It is established that a rational, profit maximizing producer would add enough of the variable
input to go past the region of increasing returns but would stop adding before entering stage
III, the region of negative marginal physical product. Thus, a producer will always produce
in the region of diminishing returns. Note that production always occurs in stage II.

4.5. Production In The Long - Run: Concepts Of Isoquant, Isocost And

Producers Equilibrium
Long - run period is a period in which full adjustments in supply response to a change in
demand for the product can be made. How much time would make the period long depends
upon the nature of the product under question. It may be of a few months or a few years
depending on the type of the activity.

Firms continually make production decisions in the short run, while simultaneously planning
how to alter their inputs in the long run. Thus, the long - run is the amount of the time
sufficient to make all inputs variable. In the short run, firms vary the intensity with which
they utilize a given plant and machinery; In the long-run, they vary the size of the plant. All
fixed inputs in the short run represent the outcomes of previous long-run decisions based on
the firms' estimates of what they could profitably produce and sell. The long run can be as
brief as a day or two for a child's lemonade stand or as long as ten years for a petrochemical
producer or an automobile manufacturer.

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The Concept of Isoquant
An isoquant is a line showing the possible combinations of two inputs that can be used to
produce a given level of output since is means equal, a more literal translation of the term is
equal quantity. It is referred as the equal product curve or isoquant curve, which is also
product indifference curve. It shows the various combinations of two goods that yield the
same amount of input (say labor and capital) yield, the same output of goods. So the producer
is indifferent as to order in which these inputs may be used for they result in an equal
quantity of output.

Consider, for example, the possible ways of producing a given level of output, say 500 dozen
cookies. At one extreme, you might utilize a lot of labor and a small amount of labor, as
indicated by the ten labors, seven machine combination. The first situation would be
described as a labor - intensive method of production while the second would be called
capital - intensive. There may be other combinations too to make the output more. Whatever
the level of output, each isoquant tells us the possible combinations of the two inputs that can
be used to produce that output.

4.5.1. Substitution possibilities

A. Imperfect substitution - the particular shape of the isoquant is of intersect at this point. In
the next figure each isoquant is drawn convex to the origin. This implies that the two
inputs are imperfect substitutes for one another in the production of cookies. They are
called imperfect substitutes because it takes more of the abundant input to compensate for
the loss of each successive unit reduction of the scarce input. As you move down along
the labor axis, more machine days are required to compensate for the loss of each unit of
labor. Moving from 60 to 50 days of labor required only about one-half extra-machine
day to compensate for the loss of 10 days of labor. But moving from 20 to 10 days of
labor requires about two and one-half extra machine days. The same relationship is true
for increasing labor and decreasing machine time. The distinguishing characteristics of
inputs that are imperfect substitutes are the progressively increasing amount of the
abundant input required to substitute for the loss of each unit of the scarce input.

Introduction to Economics –Econ-1011 95

 80
Labor (days) 70
60
50
40
30
20 1,000 dozen
10
500 dozen
0 1 2 3 4 5 6 7 8
Machine (days)
Isoquant of labor and Machine inputs (cookies) production example
B. Perfect Substitutes - exist when the amount of input required compensating for a unit
reduction of the other remains constant at all possible combinations. The ratio does not
have to be one for one - just constant. It is difficult to think of realistic examples of inputs
that are perfect substitutes; in practice they would be the same input. If such inputs could
be found, the isoquants would be straight, down ward-sloping lines such as in the next
figure. In this example, natural gas and fuel oil are perfect substitutes as sources of
energy for heat in baking cookies, as long as the equipment for using either or both fuels
is in place.
Gas 300,000 BTUs

200,000 BTUs

100,000 BTUs

Oil
Isoquants illustrating perfect substitutes

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C. Fixed proportion - In this case inputs cannot be substituted for each other. The input must
be used together in a fixed ratio or proportion. Probably the most common examples of
fixed proportions occur in manufacturing, where products require certain materials or
ingredients. This means that when more of one input is added, the other input cannot be
decreased if the same level of output is to be maintained. Unless the other input is also
increased, the input that is added is simply not used in the production process. Sugar and
salt are examples of two inputs that are used in fixed proportions in cookie production as
shown in the graph below.
Perfect substitutes and fixed proportions are the extreme or limiting cases of general
imperfect substitutes. In more general case, isoquants can vary in shape from a gentle
curvature to a sharp curve. The less curvature of the isoquant, the closer it comes to limiting
case of perfect substitutes. Thus, an isoquant that exhibits a small amount of curvature
represents the case of two inputs that can be readily substituted for each other. On the other
hand, a sharply curved isoquant comes close to the case of fixed proportions, meaning that
the possibility for substitution is limited.

Sugar

300 dozen

200 dozen

100 dozen

Salt
Isoquant curves in the case of fixed proportion

4.5.2. The concept of isocost

An isocost line shows various combinations of two inputs that can be purchased for a given
amount of money. It is a line showing equal total costs. It is a straight down ward - sloping

Introduction to Economics –Econ-1011 97

line that shows various combinations of two inputs that can be purchased with a given sum of
money.
To construct an isocost line, two pieces of information are required the:
(i) price of each input and
(ii) total amount of money to be spent on the inputs. If the total amount of money to be
spent and the prices the two inputs are known, the point of intersection between the
isocost line and the two axes is easily determined.

4.5.3. The concept of producers equilibrium

Let us consider the process of attaining equilibrium condition by a firm under a market in the
long - run since it will tell us how zero profit market equilibrium will be eventually
established in the industry in which the firms operate.

P P P MC P
D
MC
S MC
P1 P1 G P1
C AC
S D
q1
Q
0 Q1 0 q1
For Industry For a Firm
Short run Market Equilibrium

(a) an industry (b) firm

The above figure shows short - run Equilibrium for an industry and a firm under perfect
competition.

Introduction to Economics –Econ-1011 98

 Since price is the exogenous factor for a firm in the
This shows the short - run market industry so it (i.e., the firm) will adjust its level of
equilibrium for an industry. The output in such a way as to maximize total profit and thus
price P1 for the industry is attains short-run equilibrium. Such equilibrium for a
determined through intersection of representative firm is given above the conditions for the
its demand and supply curves at E equilibrium of the firm for profit maximization are as
point which gives Us Q1 as the we have seen earlier, P = MC and the MC are intersects
total quantity of the commodity the price line from below. The profit maximization level
demanded or sold in the market. of output or what is called as the equilibrium output
corresponding to G point is q1. What the firm is doing
here is just to adjust its output in order to get maximum
profit for a given price of its product
The maximum profit that the firm gets is shown by the dotted area which is equal to (P - AC)
q1. All other firms in the industry may also be getting this much profit since all of them are
assumed to be similar. Even if they are not similar, there is a positive profit in the short - run
in the industry.

The short-run equilibrium of a firm under monopolistic competition prevails when the plant
size for each firm is fixed and the total number of firms in the market is also fixed. The
output of each firm varies with changing variable inputs. Apart from prices, the demand for
the product of a firm under monopolistic competition is affected by the factors like quality
changes, advertisement, and other types of non-price competition. For a short - run
equilibrium of the firm in the market under study all such factors are assumed to be constant
and so prices are the only relevant variables for that.
In the short - run, a firm acts as a monopoly for its product since it is different from the
products of all other firms. The firm follows the conditions of a monopoly market to decide
its equilibrium price and quantity combination. It operates on its anticipated demand curve
with the assumption that its actions will not be followed by the other firms. The equilibrium
situation of the firm under the assumption that rival firms do not change their prices and
quantities. The proportional demand curve is not playing any role in determining the
equilibrium of the firm. If the firm is quite a small, almost insignificant as compared to the

Introduction to Economics –Econ-1011 99

market as a whole, then this kind of equilibrium may be stable in the short - run as rival firms
will not be affected much by this. However, as per the concept of the monopolistic
competition itself, there is competition in the market along with the monopoly. Therefore, it
is too restricted assumption that rival firms are not reacting when an individual firm reduces
its price or increases its quantity. By assumption all firms are identical under monopolistic
competition. All of them react almost in the same way.

4.6. Review Questions

1. What is a production function? How does long - run production function differ from a
short-run production function?

2. What is an isoquant? What determines the shape of an isoquant? How is it possible to

substitute capital for labor, and vice versa, if each machine has an operator?

3. What is an isocost line? Draw a $100 Birr isocost line for two inputs assuming the price
of input 1 is 10 Birr and the price of input 2 is 25 Birr.

4. Give an example of a production process in which the short run involves a day or week,
and the long run any period longer than a week.

5. Can a firm have a production function that exhibits increasing returns to scale, constant
returns to scale, and decreasing returns to scale as output increases? Discuss.

6. If a firm has several divisions, what condition should the firm satisfy when allocating a
fixed input toward the production of each of the divisions' products?

Introduction to Economics –Econ-1011 100

 CHAPTER FIVE
THEORY OF COST

5.1 Chapter objectives

5.2 Introduction
5.3 Costs in the Short-Run and Long-Run
5.3.1. Short-Run Costs and Short-Run Cost Curves
5.3.2. The Conventional Short-Run Cost Curves
5.3.3. Long-Run Costs and Long-Run Cost Curves
5.3.4. Accounting Costs and Economic Costs
5.4 Review Questions

5.1. Chapter Objectives

By the time this chapter is completed, you will be able to:
o costs in the short-run and long-run
o short-run costs and short-run cost curves
o accounting costs and economic costs
o long-run costs and long-run cost curves
o the conventional Short-Run Cost Curves

5.2. Introduction
Dear students! To produce goods and services, producers need factors of production. To
acquire most of these factors of production, or simply inputs, they have to buy them from the
resource suppliers. Cost is, therefore, the monetary value of inputs used in production of an
item. We can identify two types of cost of a product: social cost and private cost. Costs are
important in economics for a deeper reason; firms will decide how much of a good to
produce and sell depending on the price and cost of the good. More precisely, supply
depends upon incremental or marginal cost. And the dependence of supply decisions on cost
is true not only for perfect competitors but also for firms in the vast terrain of imperfect

Introduction to Economics –Econ-1011 101

competition. Whatever the market structure, whether perfectly or imperfectly competitive,
marginal cost is a key concept for understanding a firm's behavior.

The production function relates inputs to outputs. These inputs have prices and represent
costs to the firm. These prices are determined in factor markets and may or way not be
affected by the firm it self. Given the prices of inputs and the production function, we can
derive cost data for the firm.

5.3. Costs In The Short Run And Long Run

In the short run, some inputs are fixed in amount, while others are variable. A firm can
expand or contract its output only by varying the amounts of the variable inputs. Output can
rang from zero, if the firm shuts down altogether to some maximum amount permitted by the
fixed factors. In the long run, all inputs are variable in amount, a firm's out put can rang from
zero to an indefinitely large quantity.

5.3.1. Short run costs and cost curves

In the short run, inputs are divided in to two: fixed inputs and variable input:
Likewise, short run costs are divided in to two: fixed costs and variable costs.
i. Fixed Costs: are those costs that do not vary as the firm changes its 'output level.
These are costs that must be incurred even if the firm does not produce any thing.
Examples for fixed inputs are rents on leased properties, interest on borrowed fund
,the wear and tear of machinery, etc. The fixed costs are mainly those of the fixed
plant and equipment of the firm. The clearest way to define fixed costs is to say that
they are the costs that continue even if the firm is temporarily shut down, producing
nothing at all. Fixed costs include such items as interest on the investment in plant
and equipment, insurance, property taxes, depreciation and maintenance, salaries and
wages of those people who would continue to be employed even in a temporary shut
down like guards, cleaners and so on.
ii. Variable Costs: are those costs of production that change directly with the output
level of the firm. When out put is zero, variable costs are also zero. But as the firm
expands its output level the variable costs also rise. In short, variable costs of a firm

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 are dependent on the output level of the firm. Some of the examples of variable costs
are wages of workers (excluding the administrative staff), cost of raw materials, etc.
These costs include wages, payments for raw materials, payments for fuel, excise
taxes (if any), and interest on short - term loans and so on.
Q TFC TVC TC
0 100 0 100
1 100 50 150
2 100 90 190
3 100 120 220

4 100 140 240

5 100 150 250
6 100 170 270
7 100 200 300
8 100 240 340
9 100 290 390
10 100 360 460

The sum of all the costs of production is simply the total cost of producing different levels of
output. The total cost (TC), is made up of two components: total fixed cost, (TFC), and total
variable cost (TVC).As explained above, total fixed cost is the cost of the fixed factors and
hence, does not vary or change in the short - run. These total fixed costs will be the same in
the short run regardless of how many units of output the firm produces. While on the other
hand, total variable costs vary directly with output, increasing as more output is produced or
vice versa. This happens because more variable factors have to be purchased if more output
is to be produced.

Total Cost = Total Fixed Cost + Total Variable Cost

TC = TFC + TVC
The total of costs that vary directly with out put, increasing as more out put is produced is the
total variable cost, (TVC).

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The total cost of producing an out put, divided by that amount of output produced gives us
the average total cost, (AC).
TC
That is AC = Q , Q being the amount produced
The total fixed cost, (TFC) divided by the number of units of output produced gives us the
average fixed cost (AFC) and is the same for average variable cost (AVC), that is total
variable cost divided by the number of units of out put the addition to the total cost (TC) of
producing one more unit of out put is the Marginal Cost, (MC).
TC TVC
MC = Q = Q
This indicates that marginal costs are really marginal variable costs, because there are no
marginal fixed costs.
Important notations (Mathematical)
TC = TFC + TVC
TC
AC = Q
AC = AVC + AFC
TFC
AFC = Q
TVC
AVC = Q
TC TVC
MC = Q = Q

5.3.2. The conventional short-run cost curves

It is necessary to look into conventional short-run cost curves. The following table represents
a hypothetical firm’s cost function is the short-run.

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Quantity Total Total Total Average Average Average Marginal
of output fixed variable Cost fixed variable Total Cost
costs costs (2 + 3) Cost Cost Cost TC/Q
(1) (2) (3) 4 (2  1) (3  1) (4  1) 8
5 6 7
0 100 0 100.00 __ __ __ __
1 100 10.00 110.00 100.00 10.00 110.00 10.00
2 100 16.00 116.00 50.00 8.00 58.00 6.00
3 100 21.00 121.00 33.30 7.00 40.33 5.00
4 100 26.00 126.00 25.0 6.50 31.50 5.00
5 100 30.00 130.00 20.00 6.00 26.00 4.00
6 100 36.00 136.00 16.67 6.00 22.67 6.00
7 100 45.50 145.00 14.29 6.50 20.78 9.50
8 100 56.00 156.00 12.50 7.00 19.50 10.50
9 100 72.00 172.00 11.11 8.00 19.10 16.00
10 100 90.00 190.00 10.00 9.00 19.00 18.00
11 100 109.00 209.00 9.09 9.91 19.00 19.00
12 100 130.00 230.00 8.33 10.87 19.20 21.40
13 100 160.00 260.00 7.69 12.31 20.00 29.60
14 100 198.00 298.00 7.14 14.16 212.30 38.20
15 100 249.00 349.00 6.67 16.63 23.30 51.30
16 100 324.00 424.00 6.25 20.25 26.50 74.50
17 100 418.00 518.00 5.88 24.62 30.50 94.50
18 100 539.00 639.00 5.56 29.94 35.50 120.50
19 100 698.00 798.00 5.26 36.74 42.00 159.00
20 100 900.00 1,000.00 5.00 45.00 50.00 202.00
relationship between short-run costs.
All small outputs average fixed cost per unit is high and for large out puts it is low. The AFC
curve is a rectangular hyperbola, because average fixed cost multiplied by output is always
exactly the same amount. The other curves are U-shaped. Please, note also that the MC curve

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interests the AC curve at its minimum point. The explanation is parallel to that for the
intersection of MC curve with the minimum point AVC.

Marginal cost is independent of the fixed cost. Note that marginal cost is the addition to total
cost when one extra unit of output is produced. One more unit of output causes nothing to be
added to the fixed cost. Hence, Marginal cost is associated only with the variable cost.

5.3.3. Long run costs and long run cost curves

In the long-run there are no fixed factors of production. Consequently there are no fixed
costs; hence, all costs are variable. The long run is defined as that period which is long
enough to vary all inputs.

Long run Cost Curves:

When a fixed factor such as capital or land limits the firm's production capacity the firms
short-run costs look U-shape. But what will happen when firms can replace their worn out
capital, adjust the size of their plants, or even build new firms? What is the relation between
the short - run cost curves and those holding for the long run?

Suppose that a petroleum refinery located in the Gulf coast has a plant of so much capacity
perhaps 100,000 barrels per day of refining capacity. For this size plant, it has a short - run
U-shaped AC curve, call it SAC in order to emphasize its short - run nature. If the firm builds
a larger refinery, its cost minimizing output will be larger, so the new SAC curve must be
drawn farther to the right. Now, suppose the firm is still in the planning stage, with no
obligations not having decided exactly what size plant to build. The firm's engineers can
estimate different U-shaped SAC curves. For each design capacity, or planned out put level,
the firm would choose a different plant size and a different SAC curve.

5.3.4. Accounting cost and economic costs

There are three basic cost components. These include: opportunity cost, accounting cost and
economic cost. For economists the most important of these is social or opportunity cost.

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The first type of cost is the Accounting costs which are monetary costs only they do not
include costs like pollution damage that are social costs and do not enter into firm's accounts.
Economists include all costs whether they reflect monetary transactions or not, business
accountants generally exclude non-monetary transaction. An economist would insist that the
wages of management to an owner's effort or the return on contributed capital are real
economic costs; they use real live managers and tangible capital. The concept that can help
us understand this distinction between monetary costs and true economic costs is opportunity
cost. The opportunity cost of a decision consists of the things that are given up by making
that particular decision rather than the best alternative decision. Hence, the major difference
between the view points of the economist and the accountant is that the accountant generally
prefers actual historical cost as a technique for measuring the value of goods while the
economist prefers to use the market value of a good in measuring its value. The market value
as indicated above, measures the value of a good in its highest and best use or the opportunity
cost. If we take a practical example, the owner of a small business is also its manager; but
takes himself no salary, but takes out his share of the profits at the end of each year. If he
were to be employed he could have earned say 20,000 birr a year. That is his market value as
a manager. Thus the income statement understates the "true" economic cost of management
by 20,000 birr. To point out that accountants do not use the same concept as economists do,
does not imply any criticism of the accounting profession, for there are good reasons why
accountants might be reluctant to use the economists' approach.

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5.4. Review Questions
1. Explain the following terms by using examples
i. Short-run fixed costs
_______________________________________________________________
_______________________________________________________________

ii. Short-run variable costs

_______________________________________________________________
_______________________________________________________________

iii. Short-run average costs

_______________________________________________________________
_______________________________________________________________
iv. Short-run marginal costs
_______________________________________________________________
______________________________________________________________

2. Classify and mention a list of fixed cost elements and variable cost elements.
________________________________________________________________________
________________________________________________________________________

3. What do you understand by the following terms

v. Total physical product
______________________________________________________________
______________________________________________________________
vi. Average physical product
_______________________________________________________________
______________________________________________________________
vii. Marginal physical product.
_______________________________________________________________
______________________________________________________________
4. Explain briefly the short-run and long run costs of a firm.
________________________________________________________________________
________________________________________________________________________

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5. Explain why the average cost curves are drawn in a "U" shaped pattern.
________________________________________________________________________
_______________________________________________________________________
6. Distinguish between accounting cost, economic cost, opportunity cost.
________________________________________________________________________
_______________________________________________________________________
7. Complete the missing values in the following figure
________________________________________________________________________
_______________________________________________________________________

Quantity Fixed Variable Total Average Marginal Average Average

or output Cost FC Cost VC Cost TC Cost AC Cost MC Fixed Variable
Cost Cost AVC
AFC
0 30 0
1 30 10
2 30 20
3 30 30
4 30 40
5 30 70

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 CHAPTER SIX
ANALYSIS OF MARKET STRUCTURE

6.1. Chapter objectives

6.2. Introduction
6.3. Meaning of the Market
6.4. Elements of Market
6.5. Classification of Market
6.5.1. On the Basis of Area
6.5.2. On the Basis of Time
6.5.3. On the Basis of Nature of competition
6.6. Conditions for the Existence of Perfect Market
6.7. Short Run Equilibrium of the Firm
6.7.1. Total Approach
6.7.2. Marginal Approach
6.8. Short Run Profit or Loss?
6.9. Short run Supply Curve
6.10. Long Run Equilibrium of the Firm
6.11. Imperfect Competition
6.11.1. Monopoly Defined
6.11.2. Price and Output Determination Under Monopoly
6.12. Summary
6.13. Review Questions

6.1. Chapter Objectives

The purpose of the chapter is to explain the meaning, elements and different forms of
markets and the determination of price of a product under different periods, such as short run
and long run.

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After completing this chapter, you will be able to:
o define a market
o identify the elements of market
o distinguish the classification of market
o identify the conditions for the existence of perfect market
o understand short run equilibrium of the firm
o understand the Long Run Equilibrium of the Firm

6.2. Introduction
Dear students! In this chapter, you will see how a particular firm makes a decision as to how
to maximize profit. From the outset you should bear in mind that the goal of a firm is to
maximize profit. Maximizing profit means getting the maximum possible profit or
minimizing the loss. But a firm's decision to achieve this goal is dependent on the type of
market in which it operates.
Market is a mechanism that brings buyers and sellers of a product together. It consists of
those firms that provide a product for the market, and those individuals that buy the product.
We can identify four major types of market structures. They are:
1. perfectly competitive market
2. monopolistically competitive market
3. oligopoly market, and
4. pure monopoly
Except the first type, the remaining types of markets are known as imperfect markets. In the
subsequent sections, you will study each of the above mentioned market structures

6.3. Meaning of the Market

The word market is generally used to describe the process of exchange. The process of
exchange always involves certain elements such as goods or service, buyers, place and time.

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6.4. Element of Market
There are several elements of a market. The most common elements are there must be:
1. a place, be it a certain province, a country or the entire world, where the process of
exchange takes place
2. buyer and sellers,
3. a commodity which is to be dealt with
4. intercourse between buyers and sellers.

6.5. Classification of Market

We may classify markets into three categories according to factors such as area, time and
nature of competition

6.5.1. On the basis of time

Markets may be classified on the basis to time. We further classify these markets into:
i. very short period market
ii. short period market
iii. long period of secular markets which cover a generation

6.5.2. On the basis of area

Markets may be categorized on the basis of area they may be further classified into:
i. Local markets: certain commodities, which are perishable and which are cheap have local
markets. For example, milk, fish and vegetables usually have local markets.
ii. National markets: there are some goods which have national market. For example certain
varieties of cloth, say “ Yager Lebes” (i,e, locally made national cloth), have national
market. There may not be a market for “Yager Lebes” in other nations for their mode of
dress is different. They may not wear “Yager lebes”.Similarly “Tella “ and “Tej”, a
national drink of Ethiopia, has national market.
iii. International markets: there are certain commodities the transactions of which are
carried on through the world. For example, gold, steel, wool and tea etc.

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 6.5.3. On the basis of nature of competition
Markets are classified into two as those with perfect and imperfect competition based on the
nature of competition. These are elaborated as follows:
i. Perfect competition: Buyers and sellers are aware of the prices at which
transactions take place. There are huge numbers of buyers and sellers in the market.
For a commodity the same price prevails uniformly throughout the market. In other
words a perfect market is a market in which a firm is a “price taker”. The same
price of a commodity rules throughout the market. No individual seller or buyer can
influence the price in the market.
ii. Imperfect competition: different prices come to prevail for the same commodity at
the same time in an imperfect market. Imperfect market is a market in which a firm
is a ”price maker”. A market is said to be imperfect when the buyer or seller or both
are not aware of the offers being made by others. In the real world, however, we
cannot find a perfect market. Especially, in this dynamic world imperfect market is
widely practiced.

6.6. Conditions for the Existence of Perfect Market

Perfect market (or perfectly competitive market) is one type of market classified on the basis
of nature of competition. Perfect competition in economic theory has a meaning
diametrically opposite to the everyday use of this term. It is a market structure characterized
by a complete absence of rivalry among the individual firms.

There are various assumptions behind the existence of a perfect market. The following
discusses the reasons why perfect market exists.

a) Large number of sellers and buyers.

As stated above the number of buyers and sellers under perfect market are very large. In this
case, each contributing only an insignificant portion to the total volume of goods sold and
bought, it is difficult for any one seller or buyer or even a group of sellers or buyers to affect
the price. I.e. , the price of the product in the market is the result of the combined influence

Introduction to Economics –Econ-1011 113

of all the firms in the industry and once a price is determined, each one of the firms takes it
for granted and adjusts its own output to that price. Therefore, each seller is a “price taker”.

In a perfectly competitive market the demand for output of each seller is perfectly elastic,
indicating that the firm can sell any amount of out put at the prevailing market price. The
demand curve of the individual firm is also its average revenue (AR) and its marginal
revenue (MR) curve.

Price (p)
Where:
p: market price
p p= AR=MR AR: Average revenue
MR: Marginal revenue

0 out put

b) Product homogeneity:
The goods offered for sale are perfect substitutes for one another from buyers’ point of view.
Therefore, no advertising to differentiate between the products of various sellers. The product
offered for sale by all sellers must be homogenous. A lower his price from the ruling price,
since he can sell all his output at the prevailing price. This condition also points out to the
same conclusion that every seller under perfect competition will be content to accept the
prevailing price in the market.

c) Free entry and exit of firms

This type of competition implied in the first condition itself, is that there should be absolute
freedom for firms to get in (enter) or get out (exit) of the industry. In this case, each firm is
small in size, and produces only a small portion of the total out put. New firms will be
attracted to the industry if high profits are earned, and some of the existing firms might leave
the industry if they continue to incur losses.

Introduction to Economics –Econ-1011 114

d ) Profit Maximization
The fourth reason is in which case each seller is aimed at maximizing profits. The ultimate
goal is possible profit. No other goals are pursued.

e) No government regulation
The next reason for perfect competition is that there is no government intervention in the
market. The government can not manage the activities (operations) of the firm.

f) No collusion among buyers and sellers

The sixth assumption of perfect competition is that buyers do not gang up on sellers to force
them to sell at a lower price. The sellers do not gang up on buyer to force them to buy at
highest price.

g) Perfect mobility or free movement of resources

h) Perfect knowledge

6.7. Short Run Equilibrium of the Firm

The firm is in equilibrium when it maximizes its profits, defined as the difference between
total cost (TC) and total revenue (TR). That is total profit = TR-TC. The equilibrium of the
firm may be shown graphically in two ways. Either by using the TR and TC curves (called
total approach), or the marginal revenue (MR) and marginal cost (MC) curves (called
marginal approach). Here MR is the change in TR for a one-unit change in the quality sold.

6.7.1. Total approach

Total profits equal total revenue (TR) minus total cost (TC). Thus, total profits are
maximized when the positive difference between TR and TC is greatest. The equilibrium out
put of the firm is the output at which total profits are maximized. This can be explained with
the help of the following table.

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 1 2 3 4 5
Output Price Total revenue Total cost Total Profits
(Q) (In Birr) (In Birr) (In birrr) (In Birr)
0 8 0 800 -800
100 8 800 2000 -1200
200 8 1600 2300 -700
300 8 2400 2400 0
400 8 3200 2524 +676
500 8 4000 2775 +1225
600 8 4800 3200 +1600
650 8 5200 3510 1690
700 8 5600 4000 1600
800 8 6400 6400 0

In the above table 6.1 out put (column 1) times price (column2) gives us TR (column3). TR
minus TC (column 4) gives us total profits (column 5).

So the table reveals to us the fact that total profit are maximized ( at birr 1690) when the firm
produces and sells 60 units of the commodity per time period.

The profit maximizing level of out put for this firm can also be viewed from the figure 6.2
below (obtained by plotting the values of columns 1,3,4, and 5 of the above taste). In this
figure the arrows indicate parallels lines and the TR curve is a positively sloped straight line
through the origin because price remains constant at birr 8. At 100 units of output, this firm
maximizes total losses or negative profits (point A).At 300 units of output, TR equals TC
(point B) and the firms breaks even. The firm maximizes its total profits (point D) when it
produces and sells 650 units of output. At this output level, the TR curve and the TC curve
have the same slope and so the vertical distance between them is greatest.

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 6.7.2. Marginal approach
In general, it is more useful to analyze the short run equilibrium of the firm with the marginal
revenue – marginal cost approach. Marginal revenue (MR) is the change in TR for a one unit
change in the quantity sold. Thus, MR equals the slope of the TR curve. Since in perfect
competition, p is constant for the firm, MR equals p. The marginal approach tells us that the
perfectly competitive firm maximizes its short-run totals profits at the out put level, when
MR or p equals marginal cost (MC) and MC is rising. The firm is in short run equilibrium at
this best or optimum, level of output.
(1) (2) (3) (4) (5) (6)
Output (Q) Price=MR marginal Average cost Profit/Unit Total Profits
(in Birr) cost (in Birr) (in Birr) (in Birr) (in Birr)
100 8 12.00 20.00 -12.00 -1200
200 8 3.00 11.50 -3.50 -700
300 8 1.00 8.00 0 0
400 8 1.25 6.31 +1.69 +676
500 8 2.50 5.55 +2.45 +1225
600 8 4.25 5.33 +2.67 +1602
650 8 (8.00) 5.40 +2.60 +1690
700 8 8.00 5.71 +2.29 +1603
800 8 24.00 8.00 0 0

In the above table 6.2 above, column (1) and (2) are the same as in Table 6.1. Column (3)
and (4) of table 6.2 are calculated directly from column (4) and column (1) of table 6.1 (since
the MC values refer to the mid points between successive levels of output, the MC at 650
units of out put is birr 8 and is the same as the MC recorded along side 700 units of out put) .
The values in column (5) are obtained by subtracting each value of column (4) from the
corresponding value in column (2). The values of column (6) are then obtained by
multiplying each value of column (5) by the values in column (1). Note that the values of
total profits are the same as those in table 6.1 (except for two very small rounding errors).

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The firm maximizes total profits when it produces 650 units of output. At that level of out
put, MR= MC and MC is rising.

The profit maximizing, or best level of out put for this firm can also be viewed from figure
6.3 below (obtained by plotting the values of the first four columns of table 6.2). As long as
MR exceeds MC (from A’ to D’), it pays for the firm to expand output. The firm would be
adding more to its TR than to its TC and so its total profits would rise. It does not pay for the
firm to produce past points D’ since MC exceeds MR. The firm would be adding more to its
TC than to its TR and so its total profits would fall. Thus, the firm maximizes its total profits
at the output level of 650 units ( given by point D’, where P or MR equals MC and MC is
rising ). The profit per unit at this level of output is given by D’D” or birr 2.60, while total
profit is given by the area of rectangle D’D”FG, which equals birr 1690.

6.8. Short Run Profit or Loss?

If, at the best, or optimum, level of output, price (p) exceeds average cost (AC) the firm is
maximizing total profits; if p is less than AC but greater that AVC, the firm is minimizing
total losses; if p is less that AVC, the firm minimizes its total losses by shutting down.

Hypothetical MC, AC and AVC curves for a “Representative” firm; d1 to d4 (and MR1 to
MR4) are alternative demand (and marginal revenue) curves that might face the perfectly
competitive firm. The results with each alternative demand curve are summarized in table6.3.
Equilibrium Output Price (P) AC Profit/ Total Result
point (q) ( in (intirr) unit (in Profits
Birr) Birrr) (in birr)
Total
With d4 A 600 19 15.00 4.00 2,400 profits
maximized
Break
With d3 B 500 14 14.00 0 0 even point
Total
With d2 C 400 10 15.00 -5.00 -2,000 losses
minimized
Shut down
With d1 F 300 7 16.33 -9.33 -2,800 point

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With d2, if the firm stopped producing, it would incur a total loss equal to its total fixed cost
(TFC) of birr 2800 (obtained from the average fixed cost (AFC) of DE, or birr 7 per unit,
times 400). With d1 , P= average variable cost(AVC) and so TR = TVC (Total variale cost).
Therefore, the firm is indifferent to whether it produces or not ( in either case it would incur
total losses equal to its TFC). At prices below birr 7 per unit, AVC exceeds P and so TVC
exceeds TR. Therefore, the firm minimizes its total losses ( at the level of its TFC of birr
2800) by shutting down altogether.

6.9. Short Run Supply Curve

In perfectly competitive market we can read from the MC curve how much the firm will
produce and sell at various prices, the firm’s short-run supply curve is given by the rising
portion of its MC curve (over and above its AVC curve). If factor prices remain constant, the
competitive industry short run supply curve is obtained by summing horizontally the short
run MC SMC curves (over and above their respective AVC curves) of all the firms in the
industry.

The industry or market short run supply curve shown in panel B above is obtained on the
assumption that there are 100 identical firms in the industry and factor prices remain constant
to this industry regardless of the amounts of inputs it uses (The ““ sign refers to the “
summation of “.) Note that no output of the commodity is produced at prices below birr 7 per
unit.

6.10. Long Run Equilibrium of the Firm

In the long run, all factors of production and all costs are variable. Therefore, a firm will
remain in business in the long run only if (by constructing the most appropriate plant to
produce the best level of out put) its TR equals or is greater than its TC. The best, or
optimum, level of out put for a perfectly competitive firm in the long run is given by the
point where P or MR equals long run MC (LMC) and LMC is rising . If, at this level of out
put, the firm is making a profit, more firms will enter the perfectly competitive industry until
all profits are squeezed out.

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In the figure 6.6 below, at the market price of birr 16, the perfectly competitive firm is in
long run equilibrium at point A, where P or MR = SMC=LMC = SAC=LAC. The firm
produces and sells 700 units of out put per time period, utilizing the most appropriate scale of
plant (represented by SAC 2) at point B. The firm makes a profit of birr 5 per unit (AB) and a
total profit of birr 3500.

Since the firm in fig. 6.6 is making profits, in the long run more firms will enter the industry,
attracted by those profits. The market supply of the commodity will increase, causing the
market equilibrium price to fall. This will continue until all firms just break even. In figure
6.6 this occurs at point E, where P=MR=SMC=LMC=SAC=LAC=8 birr. The firm will
operate the optimum scale of plant (represented by SAC1,) at the optimum rate of output
(400units) and will make zero profits. All firms in the industry find themselves in the same
situation (if all firms have identical cost curves) and so there is no incentive for any of them
to leave the industry or for new firms to enter it.

6.11. Imperfect Competition

In real life, neither pure competition nor perfect competition exists. Rather there are different
varieties of imperfect competition. An imperfectly competitive firm is one that can exercise
some control over the price it receives for its product. There are two main reasons a firm
might have some control over the price it charge (1) each firm produces a sizable share of the
market and (2) each firm sells a product that is distinguishable fro competitors’ products.
These two reasons are the opposite for a perfectly competitive firm. It is sufficient for a firm
to fulfill either of these requirements to be imperfectly competitive.

6.11.1. Monopoly defined

Monopoly refers to a market structure where there is only one seller having some kind of
control over the supply of a commodity and , therefore , is in a position to influence the price.
There are no close substitutes for the products produced by the monopolist. Thus the firm is
the industry and faces the negatively sloped industry demand curve for the commodity. As a
result, if the monopolist wants to sell more of the commodity, he or she must lower its price.
Thus for a monopolist, MR<P and the MR curve lies below the demand (D) curve.

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 6.11.2. Price and output determination under monopoly
As in the case of perfect competition, it is more useful to analyze the short run equilibrium of
the pure monopolist with the marginal approach. This tells us that the short run equilibrium
level of output for the monopolist is the output at which MR= SMC and the slope of the MR
curve is smaller than the slope of the SMC curve (provided that at this output P AVC).

6.12. Summary
There are four major types of market structures. They are:
o Perfectly competitive market
o Monopolistically competitive market
o Oligopoly market, and
o Pure monopoly
The word market is generally used to describe the process of exchange.
The common elements of a market include:
o There must be a place, be it a certain province, a country or the entire world, where
the process of exchange takes place
o There must be buyer and sellers,
o There must be a commodity which is to be dealt with
o There must be intercourse between buyers and sellers.
Markets can be classified into three categories according to factors such as area, time and
nature of competition.
The firm is in equilibrium when it maximizes its profits, defined as the difference between
total cost (TC) and total revenue (TR). Total profits equal total revenue (TR) minus total cost
(TC).
perfectly competitive market we can read from the MC curve how much the firm will
produce and sell at various prices, the firm’s short-run supply curve is given by the rising
portion of its MC curve (over and above its AVC curve).

Monopoly is one example of imperfect market. It refers to a market structure where there is
only one seller having some kind of control over the supply of a commodity

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6.13. Review Questions
1. What is market in economics?
_____________________________________________________________________
____________________________________________________________________

2. What are the elements of market?

3. Classify the markets on the basis of area?

4. Classify the markets on the basis of nature of competition.

5. What is the shape of the demand curve facing a perfectly competitive firm? What is
implied by such a demand curve?

6. What is perfect competition?

7. What is marginal revenue and why is price always equal to marginal revenue under
perfect competition?

8. What are the two conditions that should be fulfilled by the firm to maximize its total
profits using marginal approach?

9. What does shut down point refers to?

Introduction to Economics –Econ-1011 122

 10. Examine the equilibrium of firm under perfect competition in the long run.

11. Explain the adjustment process through which long-run equilibrium of a firm is
achieved under perfect competition.

______

12. Define an imperfect market.

13. Describe the process of price and output determination under monopoly and compare
it with under perfect competition.

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 CHAPTER SEVEN
AN INTRODUCTION TO MACROECONOMICS

7.1 Chapter objectives

7.2 Introduction
7.3 An Introduction to Macroeconomics
7.4 Objectives and Instruments in Macroeconomics
7.4.1. Objectives
7.4.2. Instruments
7.5 National Income: Concept and Measurement
7.5.1 Basic Concepts of Gross Domestic Product (GDP), Gross National
Product (GNP) and Others
7.5.2 Measurement of GNP
7.5.3 Shortcomings of National Income Accounting System
7.6 Major Macroeconomic Problems
7.6.1. Unemployment
7.6.2. Inflation
7.7 Summary
7.8 Review Questions

7.1. Chapter Objectives

Macroeconomics deals with important aggregate economic variables such as national output,
unemployment, inflation etc. After completing this chapter you would be able to understand
and explain:
o objectives and instruments in macroeconomics
o national income: concept and measurement
o major macroeconomic problems
o basic concepts of gross domestic product (gdp), gross national product
o measurement of GNP

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7.2. Introduction
Dear students! This Chapter explores about the branches of economics, macroeconomics,
which studies the general performance of an economy. Every nation has some common
macro economic objectives and instruments to achieve these objectives. You will deal with
these objectives and instruments. Basic concepts used in macroeconomics can also be learnt
in this unit. This unit also deals with some important macroeconomic concepts their
measurements, and major macro economic problems.

7.3. An Introduction to Macroeconomics

As stated in chapter one, macroeconomics is a branch of economics,. which deals with the
economy as a whole. It studies the structure and performance of national economies and the
various policies governments take to bring about better economic performance in their
countries. [To refresh your memory about macroeconomics and its distinction with
microeconomics, please read chapter one under sub title' scope of economics:]
 What are the determinants of the economic growth of a country? Why is Ethiopia so
poor while some countries enjoy higher economic growth rate and prosperity?
 Why does a country's economic performance fluctuate through time?
 What is unemployment? How can we measure it? Why is it so high some time- and
low at another time? What is the cost of unemployment?
 What is inflation? What are its causes? Is inflation harmful to every individual
household and business in a country? What is its impact on the economy?
How do government policies affect the economic performance of a country? Etc.
All these and related questions are the concerns of macroeconomics. In short, the
macroeconomic concerns are those issues related with: economic growth, employment,
inflation [average price level of goods and services], economic fluctuations, and distribution
of income, macroeconomic policies, and international trade resource flows.

Connection to this, therefore, the objectives of macroeconomics are:

1. Full employment: by this we mean not only providing jobs for all that are willing and able
to work, but also full utilization of other economic resources [land, capital and
entrepreneurship].

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2. Price stability: though it is difficult to have stable price level of goods and services all the
time, economists try to avoid a high increase and decrease in the average price level of
goods and services.
3. Economic growth and raising standard of living of citizens
4. Fair distribution of income among all the citizens of a country, and
Business cycle refers to the recurrent ups and downs [fluctuations] in the level of
economic activity. Countries usually experience ups, and downs in the level of total output
and employment through time. For some period of time, the total output level may increase,
after a while total outputs may decline. With this fluctuation in the overall economic
activity unemployment level, also moves up and down.

7.4. Objectives and Instruments in Macroeconomics

7.4.1. Objective (Issues) in macroeconomics
Macroeconomics primarily concerned with four major areas. These areas include output,
employment, prices, and the foreign sector.
Output:- The ultimate yardstick of a country’s economic success is its ability to generate a
high level of production of economic goods and services for its population. What could be
more important for an economy than to produce and consume large quantities of housing,
shelter, food, education?
High Employment:- The next major objective of macro economic policy is high
employment, which also requires low unemployment. People want to be able to find good,
high-paying jobs and to find them easily.

Stable Prices:- This objective contains two parts. Prices stability denotes that the overall
price level does not rise or fall rapidly. Why stable prices are preferable? The reason is that
prices are a yardstick where by economic values are measured. The second issue is
maintenance of free markets, means that prices and quantities should be determined by
market forces, by supply and demand, to the maximum possible extent.

All economics are open. They import and export goods and services, they borrow or lend
money to foreigners; they imitate foreign technologies or sell their inventions abroad.

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Decrease in the costs of transportation and communication have made these international
linkages even tighter than they were a generation ago. Some economies today trade over half
their national output.

Nations also keep a close eye on their foreign exchange rates, which represent the price of
their own currency in terms of the currencies of other nations. When a nation’s exchange rate
rises, its exports become more expensive and therefore less competitive in world markets,
causing exports to shrink relative to imports. By contrast, when a nation’s exchange rate
falls, import prices rise and the inflation rate therefore tends to increase. These and other
impacts on the economy make the exchange rate increasingly important for all nations.

7.4.2. Instruments or policies in macroeconomics

The goal of a nation is to attain high output and employment level accompanied
by stable price level. To achieve theses objectives, a government uses different types of
policies. Here will see three types of policies: fiscal policy, monetary policy and income
policy.

I. Fiscal Policy: refers to a deliberate change in government expenditure and

taxation so as to achieve a certain government objective. Here, we can identify
two types of fiscal policies:
A. Expansionary fiscal policy: it is used when the government wants to raise total
output and employment. This increase AD thereby total output and employment
level increases.
B. Contraction Fiscal Policy: it is used when the government wants to control high inflation.
It is usually taken when the economy faces high inflationary pressure. To achieve this
objective the government decreases its expenditure or/and raises taxes. This decreases
AD thereby the general price level of goods and services decreases.
II. Monetary Policy: is a deliberate manipulation of money supply and interest rate to bring
about desirable changes in the economy. This measure is usually taken by the national bank
of the country. In our case, it is taken by the National Bank of Ethiopia. The national bank
uses the following instruments to achieve its objectives.

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a. Open Market Operations: it is the selling and buying of bonds and treasury bills by the
national bank to increase and decrease the money supply in the economy. When the Bank
buys bonds and bills, it injects money in to the economy, hence, money supply increases.
When it sells bonds or bills, on the other hand, money supply decreases.
b. Changes in the Discount Rate: discount rate refers to the interest rate commercial banks
pay to borrow money from the national bank. When the national bank wants to increase
money supply in the economy or reduce interest rate, it will reduce the discount rate to
commercial banks. They, in turn, increase their lending ability and reduce the interest rate to their
customers. This action encourages the business community to borrow and invest in various
economic activities. The opposite happens when the national bank increases the discount
rate.
c. Change in the Required Reserve Ratio: require reserve ratio is the portion of commercial banks'
total deposit that they are required to put in the national bank. When the government wants to
increase money supply, it will reduce the required reserve ratio. This creates higher lending
ability for the banks.
Like Fiscal policy, we have also two types of monetary policy: expansionary and
contradictory monetary policy.

7.5. National Income : Concept(S) And Measurement

7.5.1. Basic concepts of gross domestic product (GDP), gross
national product (GNP) and others
As stated earlier, macroeconomics is a study of the economy as a whole. Studying the
economy as a whole requires the measure of economic activity of an economy is obtained
from the national income accounts of the country. National income account is an accounting
record of the level of economic activities of an economy. It is a measure of aggregate output,
income and expenditure in an economy.

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The national income accounts are important for the following reasons it:
i. enables a country to measure the level of total output in the economy in a given period
of time, and to explain the causes for such level of performance in the economy.
ii. enables us to observe the long run trend of the economy, i.e., the growth and decline of
the economy through time.
iii. provides information to formulate policies that can help improve the economic
performance of the country.

In the next section we will discuss about the two most important measures of economic
performance of a country: Gross Domestic Product [GDP] and Gross National Product
A. Gross Domestic Product [GDP): is the total value of curreI,1tly produced final goods and
services that are produced within a country's borders during a given period of time, usually
one year. From this definition we can understand that: It measures current production only:
we take newly produced final goods and services only. That means, any output produced last
year will not be counted. For example, a chair produced last year and resold this year will not
be counted, as part 0 f this year's total output of Ethiopia.

It takes final goods and services only: we take end products of production processes. We do
not take intermediate goods in to the GDP calculation. Intermediate goods are goods that are
completely used up in production of another goods in the same period that they themselves
are produced National income accounting system is a systematic recording of the economic
performance of a nation with in a given period of time. It can be done (compiled) at different
levels depending on the administrative structure of the country.

The most comprehensive available measure of the size of an economy is the gross domestic
product (GDP). GDP is the total market (money) value of all final goods and services made
in the country during a specified period of time usually a year. It is a monetary measure.
GDP include the production of both factories of the country and foreign-owned factories in
the country. It includes only newly produced goods and services with in the borders of a
country. Goods produced by Ethiopians working in other countries are not part of GDP of the

Introduction to Economics –Econ-1011 129

country. They are part of the other countries’ GDP. Goods and services produced by
foreigners working in Ethiopia are part of GDP of Ethiopia.

By final goods we mean goods and services which are being purchased for final use and not
for resale or further processing or manufacturing. Transactions involving intermediate goods,
on the other hand, refer to purchases of goods and services for further processing and
manufacturing or for resale.

GNP attempts to measure the annual production of the economy. In so doing, the many non-
productive transactions, which occur each year must be carefully excluded. Non-productive
transactions are of two types:
1) purely financial transactions, and
2) second hand sales.

7.5.2.Measurement (Estimation) of GNP.

There are three ways of measuring GNP of a country. They are: product method, the income
method and the expenditure method.
a) Product (value added) Method
In this approach GDP is calculated by adding the market value of goods and services
currently produced by each sector of the economy. As stated before, to avoid double counting
we take the value added by each sector of the economy.
Example:
GDP at Factor cost
Sector Amount
Agriculture 2000.00
Industry 500.00
Service 1000.00
GDP 3500.00
Firm E, retail clothier 340
Total sales values 1160
Value added (total income)

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(b) Income (allocation) method
All output produced automatically generates income for the factors that take part in the
production process. The sum total of all these is the total value of this output. i.e. We can add
up all the wage, rent, interest, and profits income created in the process of production of
goods and services. Labor income is the sum of wages, salaries, and fringe benefits paid to
workers.

Capital income is the sum of profits, rental payments and interest payments. Profits include
the profit of large corporations and also the income of small business firms. Rental payments
are income to persons who own land, machine and buildings and rent them out. The rents
they receive from their tenants are rental payments. Interest payments are income received
from borrowing money to business firms. Interest payments are included in capital income
because they represent part of the income generated by the firm's production.
GNP= Non-income charges + wage + Rent + Interest + Profits.
The two non-income charges are:
- capital consumption allowance (depreciation) and,
- indirect taxes
C. Expenditure Approach
It is a total expenditure approach. When we use this method we arrive at the nation's total
output by adding up the expenditures or outlays needed to purchase all of the final output of
the economy. That is to determine GNP through the expenditure approach, one must add up
all types of spending on finished or final goods and services

GNP = C + Ig + G + Xn

Where:
C: Personal consumption expenditures
Ig: Gross private domestic investment
Xn: Net exports which is defined as value of export minus value of import
G: Government expenditures on goods and services. i.e. it excludes spending on
transfer payments (TPs).

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 7.5.3.Shortcomings of national income accounting system
Gross national product (GNP) measures the values of all goods and services at market value
resulting from current production during a year in a country. However, GNP figures which
countries are using for economic indicators do not accurately measure the value of national
output because estimation of GNP is a complicated problem. The major problems are:

1. Omission of some transactions:

National income is measured in terms of money. There are some goods and services which
are difficult to assess in terms of money. e.g. items produced, with in households such as
cooking, washing, entertaining, teaching, directing children at home, etc which do not enter
market transaction. Obviously, these activities and others are not included in the estimation
of national income which causes GDP to be understated.

2. The under ground economy

Income earned from illegal activities such as smuggling, production of mariwana, hashish,
cannabis, etc are not included in GDP because of difficulty of access to such performance.
But Omission of such transactions actually understates the GDP figure.

3. Public goods
Public goods are generally difficult to assign values because they are not sold in the market.
eg. Defense, street light, road etc. Probably, these goods are included in the GDP at their cost
of production rather than at their market value, which again causes GDP to be understated.

4. Transfer payments
Transfer payments such as pension, unemployment allowance, interest on public loans,
rehabilitation fund for disasters, etc . are part of individuals income. At the same time they
are part of government expenditure. These transactions are deducted from national income in
the estimation of GDP.

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7.6. Major Macro Economic Problems
7.6.1. Unemployment
Unemployment is the main problem in modern societies. Unemployment refers to group of
people who are in a specified age, who are without a job but are actively searching for a job.
In the Ethiopian context, the specified age is between 14 and 55.

But,
o What are the causes of unemployment?
o What are the types of an employment?
o How can we measure it?
o What is the economic cost of an employment?
All these questions are addressed below.

When unemployment is high, resources are wasted and people's incomes are depressed;
during such periods, economic distress also spills over to affect people's emotions and family
lives. High unemployment is a symptom of waste for during recessions.

How to measure unemployment (U)? The unemployed are often measured as a percentage of
the labor force. The following standard formula is used to measure it.
U = Number of persons unemployed X 100
Labor force

Different types of unemployment

Some of the unemployment causes are:
a) Structural Unemployment. It involves a mismatch between worker qualifications and job
requirements. If often arises when changes take place in the methods of production and in
the types of goods and services produced. If also arises from changes in the conditions of
demand and supply for the products of particular industries. It persists over long periods
of time and can not be cured easily. Eg. New automatic banking machines may mean
unemployment for bookkeepers.

Introduction to Economics –Econ-1011 133

b) Seasonal unemployment. It arises from the effects of seasons on either the process, as in
agriculture and construction industry, or the demand for the product, as in the service
trades comprising the tourist industry.
c) Disguised (concealed) unemployment This refers to a form of unemployment in which
people who are able and willing to work do not register their names as unemployed and
seeking work. As a result their names and numbers are absent from the official
unemployment figures. This is a typical problem of LDCS where the problem is found in
agriculture.
d) Cyclical unemployment: it is also known as business cycle unemployment. It results from
a deficiency of aggregate demand in periods of depression or low economic activity. In
other words, it exists when the over all demand for labor is low as a result of insufficient
aggregate demand. This type of unemployment affects the whole economy rather than
particular industries. There are simply not enough jobs available for the people qualified
to fill them. In practice it becomes very difficult to measure cyclical unemployment
accurately.
e) Frictional unemployment. It arises because of the continual movement of people between
regions and jobs or through different stages of the life cycle. Even if an economy were at
full employment, there would always be some turnover as people search for jobs when
they graduate from school or move to a new city. Women may reenter the labor force
after having children. Because frictionally unemployed workers are often moving
between jobs, or looking for better jobs, it is often thought that they are” voluntarily”
unemployed.

Unemployment is one of the social evils. The following is some of the economic effects of
unemployment. The worst possible consequences of unemployment are lost output. If there is
the problem of involuntary unemployment (a kind of unemployment which involves people
who are able to work but do not search for job) society’s actual out put or GNP will be less
than its potential output. Stated differently, unemployment keeps the economy inside the
production possibilities curve. This sacrificed output is called the GNP gap or production
gap. This is the amount by which the actual GNP falls short of potential GNP . It is, no
doubt wasteful.

Introduction to Economics –Econ-1011 134

Non economic Cost
Cyclical unemployment is likely to have some non-economic consequence as well. History
amply demonstrates that sever unemployment is conducive to rapid and often violent social
and political change.

7.6.2. Inflation: definition and costs

Inflation refers to a situation of continuously rising prices of commodities and factors of
production. It is a significant and sustained increase in the general price level. It does not
refer to changes in relative prices of commodities, but to a rise in the general price level. You
should not, however, infer that all prices rise by the same amount during inflationary periods.

How inflation is measured?

Inflation is measured by changes in the wholesale and retail prices. The retail price index
records changes in the general price level the general level of prices paid by consumers for
all the goods and services they buy.

The annual rate of inflation is normally calculated for any given year by subtracting last
year’s price index from this year’s index, dividing that difference by last year’s index. Then
we multiply the figure by 100 to express the rate of inflation as a percentage.

Rate of inflation = price level Price level

(Year t) (year t) - (Year t-1) x 100
Price level (year t-1)
Using 1994 as the base year, we set the price of each commodity at 100, so the CPI is also
100 CPI (1994) (= ( 0.20 x 100) +(0.50 x 100) +(0.30 x 100). Next, calculate the consumer
price index and the rate of inflation for 1995. In 1995, food price rise 2 percent to 102,
shelter prices rise 6 percent to 106, and medical care prices are up 10 percent to 110. We
calculate the CPI for 1993 as follows:
CPI (1995) = (0.20 x 102) +(0.50 x 106) + (0.30 x 110)
= 106.4

Introduction to Economics –Econ-1011 135

The Rate of inflation in 1995 = CPI - CPI
(1995) (1994) x100
CPI (1994)
= 106.4 – 100 x 100
100
= 6.4 Percent per year
This example captures the essence of how inflation is measured. The only difference between
this simplified calculation and the real one is that the CPI in fact contains many more
commodities. Other wise, the arithmetic and the concepts are exactly the same

Causes of Inflation:
What are the causes of inflation? They are discussed here in this section. In order to analyze
the causes we have to discuss the theories of inflation. Economists often disagree over what
they feel is the main causes of inflation.

The term “monetarism” has become associated with a range of beliefs held by some
economists strictly speaking a monetarist economist believes that It is large increase in the
money supply that cause inflation. That is, any increase in the supply of money will cause
inflation if there is no growth in out put. Only if the out put of goods and services rises
should the money supply rise so that people have enough money to buy up these extra
products.

Economists normally distinguish between the following two types of inflation, namely
demand-pull and cost –push
i. Demand- pull inflation
A rise in aggregate demand, whatever its source, can force up the prices of goods and
services and cause inflation. As aggregate demand rise for good and services firms will
be tempted to increase production of them. To do this they will need more workers, more
machines and more raw materials. If these resources are not available, because they are
already fully employed, they will not be able to increase output. In this case, rising
demand causes the price of the existing output to rise. An increase in demand when the

Introduction to Economics –Econ-1011 136

 economy is at full employment will cause inflation. This type of inflation has been
termed as demand-shock inflation or demand-side inflation.
ii. Cost push inflation
Some Keynesian economists also argue that inflation can be caused by rising costs, If
firms face rising production costs they may try to pass these costs on to consumers as
higher prices on the goods and services they sell, so that they do not have to take a cut in
their profits. Again if cost per unit rises due to rise in prices of raw materials and rise in
wages profits will be squeezed. Consequently, business firm will lose incentive to
produce more. So they will reduce the amount of output that they are willing to supply at
the existing price level. As a result, the aggregate supply of goods and services will fall
in the economy. This fall in supply will , in turn, push up-the price level, rather than
demand pulling it upward, as in the case of demand-pull inflation. Thus, cost-push
inflation is defined as any rise in the price level originating from increase in cost that
was not brought about by excess demands in the market for factors of production. When
inflation is caused by supply side shocks, it is called a supply-shock inflation, a supply-
side inflation or, most commonly, a cost-push inflation.

What are the Effects of inflation?

o Rising prices reduce the purchasing power of people’s incomes. That is, their real
income, in terms of what it can buy, falls. For example, if a person’s income in
terms of money, or their money income (also called nominal income), was birr
100 it could buy ten goods at birr 10 each. If each one of those goods goes up in
price to birr 20 their money income of birr 100 will now only buy five of those
goods. That is, real income has fallen. Clearly, if that person could increase their
money income to birr 200 they will be no worse off. However, many people will
face hardship if they are unable to increase their money incomes.

Introduction to Economics –Econ-1011 137

 o People like pensioners are on fixed incomes decided by the government. If the
prices of the goods and services they buy rise they may not be able to afford as
much goods as before. Their real incomes and therefore their living standards will
fall.
o Some economists argue that inflation causes unemployment. As prices rise,
people cannot afford to buy so many goods and services and so demand falls. In
addition, some people save more in times of high inflation to protect the real
value of their savings. This again means less spending on goods and services. As
a result firms may cut their output and make resources, including labor,
unemployed.

Inflation and Deflation

The words ‘inflation’ and ‘deflation’ are very frequently used even by lay people let us
clearly understand what we precisely means by them

By inflation, we mean a situation in which there is a persistent, continuous and abnormal rise
in prices.
Deflation is the opposite of inflation and indicates a situation of persistently falling prices
and a fall in the money incomes of the factors of production.

When we contrast both of them, an increase in the average level of prices is inflation; where
as falling prices are deflation. In these terms, inflation tends to benefit debtors and people
whose incomes respond quickly to rising prices at the expense of creditors and those whose
incomes are slow to change

Deflation, on the other hand, tends to benefit creditors and people whose incomes respond
only slowly to falling prices at the expense of debtors and those whose incomes are more
flexible.

Introduction to Economics –Econ-1011 138

7.7. Summary
Macroeconomics primarily concerned with four major areas. These areas include output,
employment, prices, and the foreign sector.
When a nation’s exchange rate rises, its exports become more expensive and therefore less
competitive in world markets, causing exports to shrink relative to imports.

The goal of a nation is to attain high output and employment level accompanied
by stable price level. To achieve theses objectives, a government uses different types of
policies. Here will see three types of policies: fiscal policy, monetary policy and income
policy.
GNP attempts to measure the annual production of the economy. In so doing, the many non-
productive transactions, which occur each year must be carefully excluded. Non-productive
transactions are of two types:
3) purely financial transactions, and
4) second hand sales.
There are three ways of measuring GNP of a country. They are: product method, the income
method and the expenditure method.
Unemployment is the main problem in modern societies. Unemployment refers to group of
people who are in a specified age, who are without a job but are actively searching for a job.

Inflation refers to a situation of continuously rising prices of commodities and factors of

production. It is a significant and sustained increase in the general price level.
Deflation is the opposite of inflation and indicates a situation of persistently falling prices
and a fall in the money incomes of the factors of production.

Introduction to Economics –Econ-1011 139

7.8. Review Questions
1. What are the four major macroeconomic objectives of nations?
________________________________________________________________________
________________________________________________________________________

2. Why stable prices considered as macro economic objective?

________________________________________________________________________
________________________________________________________________________

3. What are the major macro policy instruments of nations?

________________________________________________________________________
________________________________________________________________________

4. What is a policy instrument?

________________________________________________________________________
________________________________________________________________________

5. What are the three approach to measuring GNP of a nation?

________________________________________________________________________
_______________________________________________________________________
6. What are the components of GNP when measured using expenditure approach?
________________________________________________________________________
________________________________________________________________________
7. Can we totally rely upon GNP figures to measure the value of national output (called
national incomes)?
________________________________________________________________________
________________________________________________________________________

8. What are the shortcomings of national income accounting system?

________________________________________________________________________
________________________________________________________________________

9. What is Unemployment?
________________________________________________________________________
________________________________________________________________________

10. Outline some of the economic and non-economic effects of unemployment?

________________________________________________________________________
________________________________________________________________________

Introduction to Economics –Econ-1011 140

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P.O.Box______________________
Region /Zone_________________
Centre _______________________

This work sheet is prepared for you to do by your own. It carries 30 points. The worksheet
should be completed and mailed to the Office of Distance and Continuing Education, Adama
Head Office

Do not try to complete the worksheet until you have covered all the lessons and exercises in
the course material.

If you have any questions in the module that you have not been able to understand, please
state on a separate sheet of paper and attach it to this worksheet, otherwise, your tutor will
clarify them for you.

After completing this worksheet, be sure that you write your Name, ID. No, Address on the
first page and Your Name and ID. No only on the other pages.
Part I. Multiple choice. (13Pts)
______1. A mechanism by which economic resources are organized in order to satisfy
materials wants of a society is called
A. Firm B. government C. economy or economic system D. none
______2. Scarcity
A. Implies that choice is unnecessary
B. Means shortage
C. Is not the problem of rich countries
D. Is a universal problem
______3. Microeconomics is the study of the decision making behavior of :-
A. The society as a whole C. An individual economic entity
B. A large group of individuals D. None of the above
______4. An efficient economy
A. Can produce more of one goods without reducing any other output level
B. Produces on the PPF
C. May have some level of idle resources
D. A and B
______5. A decrease in the demand for good will ____ price and _____ quantity.
A. Decrease/increase C. Increase/decrease
B. Increase/increase D. Decrease/decrease
______6. When the price of a commodity changes from Birr 4 to 5, quantity supplied
changes from 80 to 100. Calculate the price elasticity of supply and interpret the
result.
______7. A price above the market equilibrium price results in
A. Shortage C. Excess demand
B. Inflation E. A surplus
______8. Households
A. Have utility maximization top in their agenda
B. Are the major consumers of final goods and services
C. Own and supply resources to Business firm
D. Can be involved in international trade E. All of the above

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______9. One of the following is different from the others
A. PCME
B. Command Economic System
C. Market Economic System
D. Traditional Economic System
E. None of the above
______10 Market is
A. A place where goods and services are exchanged for money
B. A system through which transaction is activated
C. A place where you can see the curves of demand and supply
D. A and C
E. C and B
______11 . Elasticity
A. Quantities the relationship between a dependent and an independent variables
B. Show the type relationship between a dependent and an independent variables
C. Equates the dependent variable to the independent variables
D. A and B
E. None of the above
______12. Which of the following is wrong about scarce resources
A. All scarce resources are nature given
B. All scarce resources are human made
C. Labor is a homogenous scarce resource
D. Labor is not a scarce resource in developing countries
E. All of the above
______13. Which of the following determinants affects both price elasticity of demand
and price elasticity of supply?
A. Unit cost of production
B. Time
C. The availability of substitutes
D. None

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Part II. Explanations (17Pts)
1. Define the subject matter of economics in your own words.

2. What are the components of GNP when measured using expenditure approach?

3. State the law of Demand.

4. Can we totally rely upon GNP figures to measure the value of national output (called
national incomes)?

5. What do you understand by the following terms

a. Total physical product

b. Average physical product

c. Marginal physical product

3. Classify the markets on the basis of nature of competition.

4. Consider that the price of “Teff” in Adama increases from Birr 500 per quintal to Birr
650. As a result total quantity demanded for Teff decreases from 50,000 quintals
per day to 30,000.
a. Calculate price elasticity of demand.

b. It is elastic or inelastic?
c. Interpret the result

5. What is an isoquant? What determines the shape of an isoquant? How is it possible to

substitute capital for labor, and vice versa, if each machine has an operator?
6. Describe the process of price and output determination under monopoly and compare
it with under perfect competition.

7. Outline some of the economic and non-economic effects of unemployment?