Economics

Bedele Campus
Department of Economics

2022/23
Bedele Ethiopia
Chapter One
Basics
of
Economics
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Chapter objectives

After successful completion of this

chapter, you will be able to:
Define economics by your own words
Differentiate scarcity from shortage
Explain the implication of scarcity
Describe types of economic system
Explain the circular model in
economics
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 Definition of Economics
The word "economics" is derived from a
Greek word "oikonomia" which means
" Household management"
 Political economy was the earlier name of
economics.
But economists in the late 19th century
suggested 'economics' as a shorter term for
'economic science‘.

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 Con’t…………………………………………
There is no universally accepted definition of
economics.
 Because different economists defined
economics from different perspectives:
 Growth economics
 Welfare economics
 Wealth economics
 Scarcity economics

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 Con’t…………………………………………
The definition of economics has encountered
so many controversies.
The reason behind is:
dynamic and
frequent changes

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 Con’t…………………………………………
 The most agreed up on definition of Economics
is:
Economics is a science which studies about
efficient allocation of scarce resources so
as to attain the maximum fulfillment of
unlimited human wants.
 Economics is a science of choice.

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 Who is the father of Economics?
Adam Smith( 1723-1790) is the father of modern
economics and the grandfather of economics.

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 Objective of Economics
To study how to satisfy the unlimited human
wants up to the maximum possible degree by
allocating the resources efficiently.

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 The Rationales of Economics
There are two universal facts that provide the
foundation for the field of economics.
 Human material wants are unlimited.
 Economic resources are limited (scarce)

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Nature of Economics

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 Economics is a social science
Is one of the most debatable questions
among the economists all around the world.
Economics is a social science. Because, the
basis of the theories and underlying concept
of it is to find out or determine the cause
and effect relationship.

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 Economics is an art
Unlike other fields of science in which individuals
perform tests and experiments in laboratories,
economists perform these tests and experiments by
the help of models.
 According to Marshall, Economics considered as
an art.

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Con’t……………………………………….

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 The Scope of Economics
Economics is a complex social science that
spans from mathematics and psychology.

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 Branches of Economics
Economics can be analyzed at micro and
macro level.
Microeconomics: is concerned with the
economic behavior of individual decision
making units such as households, firms,
markets and industries.
Macroeconomics: it is a branch of economics
that deals with the economy as a whole.

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Department of Economics,2022/23
Note:
Both microeconomics and macroeconomics
are complementary to each other. That is,
macroeconomics cannot be studied in
isolation from microeconomics.

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Method of Analysis in Economics
Economics can be analyzed from two
perspectives: Positive and Normative
Analysis.
a) Positive economics
It is a method of analysis of economics that
has a more objective approach, presents
more data and fact-based statement.

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 Con’t……………………………………..
Example:
The current inflation rate in Ethiopia is
37.7%.
Poverty and unemployment are the biggest
problems in Ethiopia.
The life expectancy at birth in Ethiopia is
rising.

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b) Normative economics
It is a method of analysis of economics that
has a more subjective approach and
presents statement based on personal
opinions.

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Example:
The poor should pay no taxes.
There is a need for intervention of
government in the economy.
Females ought to be given job opportunities.

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Positive Vs Normative Economics

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 Reasoning in Economics
Methods of logical reasoning:
inductive and deductive
a) Inductive Reasoning
it is the process of deriving a principle by
moving from facts to theories or from
particular to general economic analysis.

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 Con’t……………………………………………..
b)Deductive reasoning
It is the process of deriving a principle by
moving from theories to facts or from
general to particular economic analysis.

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 Scarcity, choice, opportunity cost
and production possibilities frontier
Scarcity
Scarcity refers to economic resources are
finite or limited in supply.
It is the imbalance between our wants and
resources availability

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 Kinds of Resources
A. Free resources: A resource is said to be
free if the amount available to a society is
greater than the amount of people desire
at zero price. E.g. sunshine
B. Scarce (economic) resources: A resource
is said to be scarce or economic resource
when the amount available to a society is
less than what people want to have at zero
price. E.g. Gold ,Machines

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 Examples of scarce resources
Labour: (manual, intellectual, skilled and
specialized labor).
Land: (especially, fertile land), minerals,
clean water, forests and wild – animals)
Capital (like machines, intermediate goods,
infrastructure ) and
 Entrepreneurial resources

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 Economic Resources
Economic resources are classified into
four
Labour: refers to the physical as well as
mental efforts of human beings in the
production and distribution of goods and
services.
Land: refers to the natural resources or all
the free gifts of nature usable in the
production of goods and services.

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 Con’t…………………………………………..
Capital: refers to all the manufactured
inputs that can be used to produce other
goods and services.
Entrepreneurship: refers to a special type of
human talent that helps to organize and
manage other factors of production to
produce goods and services and takes risk of
making loses.

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Con’t…………………………………………..

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 Scarcity Vs. Shortage
Note: Scarcity does not mean shortage.
a good is said to be scarce if the amount
available is less than the amount people wish
to have at zero price.
But we say that there is shortage of goods
and services when people are unable to get
the amount they want at the prevailing or
on going price.

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Scarcity Vs. Shortage

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 Con’t…………………………………………..
If resources are scarce, then output will be
limited. If output is limited, then we cannot
satisfy all of our wants. Thus, choice must be
made.
 Scarcity → limited resource → limited
output → we might not satisfy all our
wants →choice involves costs→
opportunity cost.
scarcity implies choice

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 What is Opportunity Cost?
Opportunity cost is the amount or value of
the next best alternative that must be
sacrificed (forgone) in order to obtain one
more unit of a product.
Note: It is measured in goods & services but
not in money costs.

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The Production Possibilities Frontier
or Curve (PPF/ PPC)
The production possibilities frontier (PPF)
It is a curve that shows the various possible
combinations of goods and services that the
society can produce given its resources and
technology.

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 Con’t…………………………………………..
To draw the PPF we need the following
assumptions.
The quantity as well as quality is fixed.
Two broad classes of output (Consumer &
capital).
The economy is operating at full employment
and is achieving full production (efficiency).
Technology does not change during the year.
Specialization. (focusing on one product or a
limited scope of products so as to become more
efficient )
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 PPF

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 Con’t…………………………………………..
Suppose a hypothetical economy produces food
and computer given its limited resources and
available technology
Types of Unit Production alternatives
products
A B C D E

Food metric tons 500 420 320 180 0

Computer number 0 500 1000 1500 2000

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 Shape of PPF
A PPC is a downward sloping curve. because
as we produce more of one commodity, the
amount of other commodity is decreased.
The PPC curves becomes concave to the
origin, mainly because of increasing
opportunity cost.

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Opportunity Cost Computation

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Example 1

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Example 2

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Example 3

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 Economic growth and PPF
Economic growth or an increase in the total
output level occurs when one or both of the
following conditions occur:
a) Increase in the quantity or/and quality of
economic resources.
b) Advances in technology.
•

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Effect of economics growth

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Asymmetric Growth and PPF

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 Basic Economic Questions
Economic problems due to scarcity of
resources are known as basic economic
problems.
These problems are common to all economic
systems. They are also known as central
problems of an economy.
Any human society should answer the
following three basic questions.

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 Basic Economic Questions
Any human society should answer the
following three basic questions.
WHAT TO PRODUCE?
HOW TO PRODUCE?
FOR WHOM TO PRODUCE?

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 Con’t…………………………………………..
What to Produce?
This problem is also known as the problem
of allocation of resources.
It is the decide on which goods and in what
quantities are to be produced.
 The economy must make choices such as
consumption goods versus capital goods,
civil goods versus military goods, and
necessity goods versus luxury goods.

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 Con’t…………………………………………..
How to Produce?
This problem is also known as the problem
of choice of technique.
It is the stage of choosing between
alternative methods or techniques of
production.
 Capital-intensive or labor-intensive
method

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 Con’t…………………………………………..
For Whom to Produce?
This problem is also known as the problem
of distribution
It relates to how an output is to be
distributed among the members of a society.

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 Economic systems
Economic system is a set of organizational
and institutional arrangements established
to answer the basic economic questions.
Three types of economic system
1) capitalism
2) command and
3) mixed economy

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 Capitalist Economy
free market economy or market system or
laissez faire.
it is the oldest formal economic system 19th
c
In this economic system, all means of
production are privately owned, and
production takes place at the initiative of
individual private entrepreneurs who work
mainly for private profit with a minimum
government intervention.
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Characteristics of Capital Economy
1. The right to private property
economic or productive factors such as land,
factories, machinery, mines etc. are under
private ownership.
2. Freedom of choice by consumers
Consumers can buy the goods and services that
suit their tastes and preferences.
Producers produce goods in accordance with
the wishes of the consumers. This is known as
the principle of consumer sovereignty.
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 Con’t…………………………………………..
3. Profit motive
Entrepreneurs are guided by the motive of
profit-making.
4. Competition
High competition among sellers or producers
of similar goods to attract customers, among
buyers-to obtain goods, among workers-to get
jobs, among employers-to get workers and
investment funds.

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 Con’t…………………………………………..
5. Price mechanism
All basic economic problems are solved through
the price mechanism.
6. Minor role of government
The government does not interfere in day-to-
day economic activities and confines itself to
defense and maintenance of law and order.

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 Con’t…………………………………………..
7. Self-interest
 Each individual is guided & motivated by
self-interest & the desire for economic gain.
8. Inequalities of income
There is a wide economic gap between the
rich and the poor.

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 Con’t…………………………………………..
9. Existence of negative externalities
A negative externality is the harm, cost, or
inconvenience suffered by a third party
because of actions by others.
 In capitalistic economy, decision of firms
may result in negative externalities against
another firm or society in general.

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Advantages of Capitalistic Economy
Flexibility or adaptability
Decentralization of economic power
It is a good system for an Increase in per-
capita income and standard of living
New types of consumer goods & Growth of
entrepreneurship
Optimum utilization of productive resources
High rate of capital formation

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 Disadvantages of Capitalistic Economy
Inequality of income: promotes economic
inequalities and creates social imbalance.
Unbalanced economic activity: an
unbalanced way in terms of different
geographic regions and different sections of
society.
Exploitation of labour: by paying low wages
is common.
Negative externalities

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 Command Economy
Command economy is also known as socialistic
economy
Under this economic system, the economic
institutions that are engaged in production
and distribution are owned and controlled by
the state.

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 Con’t…………………………………………..
Collective ownership: All means of
production are owned by the society as a
whole, and there is no right to private
property.
Central economic planning: Planning for
resource allocation is performed by the
controlling authority according to given
socio-economic goals.
Strong government role: Government has
complete control over all economic activities.
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 Main Features of Command Economy
Collective ownership: All means of
production are owned by the society as a
whole, and there is no right to private
property.
Central economic planning: Planning for
resource allocation is performed by the
controlling authority according to given
socio-economic goals.
Strong government role: Government has
complete control over all economic activities.
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 Con’t…………………………………………..
Maximum social welfare: it aims at
maximizing social welfare and does not allow
the exploitation of labour.
Relative equality of incomes: Private
property does not exist in a command
economy, the profit motive is absent, and
there are no opportunities for accumulation
of wealth. All these factors lead to greater
equality in income distribution, in comparison
with capitalism.
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 Advantages of Command Economy
Absence of wasteful competition
Balanced economic growth
Elimination of private monopolies and
inequalities

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Disadvantages of Command Economy
Absence of automatic price determination
Absence of incentives for hard work and
efficiency
Lack of economic freedom
Red-tapism (Disapproving)

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 Mixed Economy
A mixed economy is an attempt to combine
the advantages of both the capitalistic
economy and the command economy.
 It incorporates some of the features of
both and allows private and public sectors to
co-exist.

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 Con’t…………………………………………..
Co-existence of public and private
sectors: Public and private sectors co-exist
in this system.
Economic welfare: The public sector tries
to remove regional imbalances, provides large
employment opportunities and seeks
economic welfare through its price policy.
Government control over the private sector
leads to economic welfare of society at
large.
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 Con’t…………………………………………..
Economic planning: The government uses
instruments of economic planning to achieve
coordinated rapid economic development,
making use of both the private and the public
sector.
Price mechanism
prices are defined and regulated by the government
but not for those produced by private sector.

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 Con’t…………………………………………..
Economic equality: Private property is
allowed, but rules exist to prevent
concentration of wealth through
 Limits are fixed for owning land &
property.
 Progressive taxation
concessions and subsides are
implemented to achieve economic
equality.
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 Advantages of Mixed Economy
Private property
 profit motive and price mechanism
 Adequate freedom
 Rapid and planned economic development
Social welfare and fewer economic inequalities

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 Disadvantages of Mixed Economy
Ineffectiveness and inefficiency
Economic fluctuations
Corruption and black markets

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Decision making units &the circular
flow model
There are three decision making units
in a closed economy. These are
households
firms and
the government

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 Con’t…………………………………………..
i)Household: A household can be one person or
more who live under one roof and make joint
financial decisions. HHs make two decisions
a) Selling of their resources
b) Buying of goods and services
ii)Firm: A firm is a production unit that uses
economic resources to produce goods and
services. Firms also make two decisions
a) Buying of economic resources
b) Selling of their products
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 Con’t…………………………………………..
iii) Government: A government is an
organization that has legal and political power
to control or influence households, firms and
markets.
Government also provides some types of goods
and services known as public goods and
services for the society.

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 Con’t…………………………………………..
The three economic agents interact in
two markets
A. Product market(output market)
 It is a market where goods and services are
transacted/ exchanged.
A market where households and
governments buy goods and services from
business firms.

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 Con’t…………………………………………..
B. Factor market (input market)
It is a market where economic units
transact/exchange factors of production
(inputs).
In this market, owners of resources
(households) sell their resources to business
firms and governments.

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What is the circular flow diagram?
It is a visual model of the economy that
shows how money (Birr), economic resources
and goods & services flows through markets
among the decision making units.

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 The circular flow of two unit model
Assume that there are only two sector
Households
 Firms
Note:
Goods and services flow from firm to HH
Resources flow from HH to firm

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Con’t…………………………………………..

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 The circular flow of Three unit model
Assume that there are THREE sector
Households
Firms
Government
Note:
Goods and services flow from firm to HH
Resources flow from HH to firm
The government provide public services &
purchase goods and services from business
firms
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Con’t…………………………………………..

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End of Chapter One
 Chapter Two
Theory
of
Demand & Supply
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Con’t…………………………………………..

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Objectives
After covering this chapter, you will be
able to:
Understand the concept of demand and the
factors affecting it;
Explain the supply side of a market and the
determinants of supply;
Understand how the market reaches
equilibrium condition, and the possible
factors that could cause a change in
equilibrium and
Explain the elasticity of demand and supply
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 Definition of Demand
Demand is the desire of the consumer for a
commodity backed by purchasing power.
𝑫𝒆𝒎𝒂𝒏𝒅 = 𝑾𝒊𝒍𝒍𝒊𝒏𝒈𝒏𝒆𝒔𝒔 + 𝑨𝒃𝒊𝒍𝒊𝒕𝒚

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 Con’t…………………………..
Demand indicates various quantities of a
product that buyers (consumers) are willing
and able to buy at any prices in a given period
of time, other things remaining
unchanged(Ceteris Paribus).

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 Theory of demand
 The theory of demand is related to the
economic activities of consumers-
consumption.
The quantity demand of a particular
commodity depends on the price of that
commodity.

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 Law of demand
Law of demand is the principle of demand.
Ceteris paribus, as price of a commodity
increases (decreases), quantity demanded for
that commodity decreases (increases).
Clearly, price of a commodity and its quantity
demanded are inversely related.

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 Demand schedule
A demand schedule states the relationship
between price and quantity demanded in a
table form
Numerically,

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 Con’t…………………..
Combinations Price per Quantity demand per week
kg
A 5 5
B 4 7
C 3 9
D 2 11
E 1 13
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 Demand Curve
Demand curve is a graphical representation
of the law of demand.

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 Demand function
Demand function is a mathematical
relationship between price and quantity
demanded, all other things remaining the same.

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Demand function

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Example
Combinations Price per Quantity demand per week
kg
A 5 5
B 4 7
C 3 9
D 2 11
E 1 13
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 Demand function
From the above table suppose we are moving
from point A to B

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 Con't………………………
Therefore, 𝑸 = 𝟏𝟓 − 𝟐𝒑 is the demand function
for orange in the above numerical example.

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 Market Demand
Market Demand: The market demand
schedule, curve or function is derived by
horizontally adding the quantity demanded for
the product by all buyers at each price.

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 Market Demand
Numerically,
Price Market
individual demand demand
Consumer-1 Consumer-2 Consumer-3
8 0 0 0 0
5 3 5 1 9
3 5 7 2 14
0 7 9 4 20

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 Market Demand
Graphically,

Price Price Price Price

3 + 3 + 3 = 3

5 Q 7 Q 2 Q 14 Q
Consumer-1 Consumer - 2 Consumer - 3 Market Demand

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 Market Demand
Mathematically,
Numerical Example: Suppose the individual
demand function of a product is given by:
P=10 - Q /2 and there are about 100 identical
buyers in the market. Then find the market
demand function.
P= 10 - Q /2 ↔ Q /2 =10-P ↔ Q= 20 -
2P and Qm = (20 – 2P) 100 = 2000-200P

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Determinants of Demand
The demand for a product is influenced by many
factors. Some of these factors are:
1. Price of the product
2. Taste or preference of consumers
3. Income of the consumers
4. Price of related goods
5. Consumers expectation of income and
price
6. Number of buyers in the market

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Cont.………………………….
1}𝑄𝑑 → 𝑁𝑜𝑛 − 𝑠𝑕𝑖𝑓𝑡𝑖𝑛𝑔 𝑓𝑎𝑐𝑡𝑜𝑟 →
𝑚𝑜𝑣𝑒𝑚𝑒𝑛𝑡 𝑎𝑙𝑜𝑛𝑔 𝑡𝑕𝑒 𝑠𝑎𝑚𝑒 𝑑𝑒𝑚𝑎𝑛𝑑 𝑐𝑢𝑟𝑣𝑒.
2-6} ∆ 𝑖𝑛 𝑑𝑒𝑚𝑎𝑛𝑑 → 𝑠𝑕𝑖𝑓𝑡𝑖𝑛𝑔 𝑓𝑎𝑐𝑡𝑜𝑟 →
𝑒𝑖𝑡𝑕𝑒𝑟 𝑠𝑕𝑖𝑓𝑡 𝑡𝑜 𝑡𝑕𝑒 𝑟𝑖𝑔𝑕𝑡 𝑜𝑟 𝑡𝑜 𝑡𝑕𝑒 𝑙𝑒𝑓𝑡.

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 Changes in demand
An increase in demand, shifts the demand
curve to rightward or upward.

 A decrease in demand, shifts the demand

curve leftward or downward.

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Changes in demand
When demand in creases, demand
Price
curve shifts up ward ( D1) while a
1 decrease in demand shifts demand
curve downwards (D2).
2 D1

D0
D2
Quantity

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Changes in Quantity demand
An increase in quantity demand, moves the
demand to the right on the same demand
curve called Expansion.
A decrease in quantity demand, moves the
demand curve to the left on the same
demand curve called Contraction.

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The effect of determinants on demand curve

I. Taste or preference
When the taste of a consumer is good for
the product ,the demand curve shift to the
right.

When the test of a consumer is bad for the

product, the demand curve shift to the left.
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 Con't………………………………
II. Income of the consumer
 Normal Goods are goods whose
demand is directly related with income.
↑ 𝒀 ≫↑ 𝑫𝑫 ≫ 𝒔𝒉𝒊𝒇𝒕 𝒅𝒅 𝒕𝒐 𝒕𝒉𝒆 𝒓𝒊𝒈𝒉𝒕
↓ 𝒀 ≫↓ 𝑫𝑫 ≫ 𝒔𝒉𝒊𝒇𝒕 𝒅𝒅 𝒕𝒐 𝒕𝒉𝒆 𝒍𝒆𝒇𝒕

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 Con't………….………………….

Inferior goods are those whose

demand is inversely related with
income.
↑ 𝒀 ≫↓ 𝑫𝑫 ≫ 𝑫𝑫𝒄 𝒔𝒉𝒊𝒇𝒕 𝒕𝒐 𝒕𝒉𝒆 𝒍𝒆𝒇𝒕
↓ 𝒀 ≫↑ 𝑫𝑫 ≫ 𝑫𝑫𝒄 𝒔𝒉𝒊𝒇𝒕 𝒕𝒐 𝒕𝒉𝒆 𝒍𝒆𝒇𝒕

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 Con't………………………………..
III. Price of related goods
Substitute goods are goods which satisfy the
same desire of the consumer.
 Eg: tea and coffee or Pepsi and Coca-Cola are
substitute goods.
𝑷𝑷𝒆𝒑𝒔𝒊;𝒄𝒐𝒍𝒂 &𝑫𝑪𝒐𝒄𝒂;𝑪𝒐𝒍𝒂 ≫ +𝒗𝒆
↑ 𝑷𝑷𝒆𝒑𝒔𝒊;𝒄𝒐𝒍𝒂 & ↑ 𝑫𝑪𝒐𝒄𝒂;𝑪𝒐𝒍𝒂 ≫ 𝑫 𝒔𝒉𝒊𝒇𝒕𝒔 𝒕𝒐 𝒕𝒉𝒆 𝒓𝒊𝒈𝒉𝒕
↓ 𝑷𝑷𝒆𝒑𝒔𝒊;𝒄𝒐𝒍𝒂 & ↓ 𝑫𝑪𝒐𝒄𝒂;𝑪𝒐𝒍𝒂 ≫ 𝑫 𝒔𝒉𝒊𝒇𝒕𝒔 𝒕𝒐 𝒕𝒉𝒆 𝒍𝒆𝒇𝒕

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 Con't…………………………………….
Complementary goods: are those goods
which are jointly consumed.
 Eg: car and fuel or tea and sugar are
considered as compliments.
𝑷𝑺𝒖𝒈𝒂𝒓 &𝑫𝑻𝒆𝒂 ≫ −𝒗𝒆
↑ 𝑷𝑺𝒖𝒈𝒂𝒓 & ↓ 𝑫𝑻𝒆𝒂 ≫ 𝑫 𝒔𝒉𝒊𝒇𝒕𝒔 𝒕𝒐 𝒕𝒉𝒆 𝒍𝒆𝒇𝒕
↓ 𝑷𝑺𝒖𝒈𝒂𝒓 & ↑ 𝑫𝑻𝒆𝒂 ≫ 𝑫 𝒔𝒉𝒊𝒇𝒕𝒔 𝒕𝒐 𝒕𝒉𝒆 𝒓𝒊𝒈𝒉𝒕

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 Con't……………………………………..
IV. Consumer expectation of price

𝒉𝒊𝒈𝒉 𝑷 𝒆𝒙 ≫↑ 𝑫𝑫 ≫ 𝑫𝑫 𝒔𝒉𝒊𝒇𝒕 𝒕𝒐 𝒕𝒉𝒆 𝒓𝒊𝒈𝒉𝒕

𝑳𝒐𝒘 𝑷 𝒆𝒙 ≫↓ 𝑫𝑫 ≫ 𝑫𝑫 𝒔𝒉𝒊𝒇𝒕 𝒕𝒐 𝒕𝒉𝒆 𝒍𝒆𝒇𝒕

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 Con't………………………………….
IV. Consumer expectation of income

𝒉𝒊𝒈𝒉 𝒀 𝒆𝒙 ≫↑ 𝑫𝑫 ≫ 𝑫𝑫 𝒔𝒉𝒊𝒇𝒕 𝒕𝒐 𝒕𝒉𝒆 𝒓𝒊𝒈𝒉𝒕

𝑳𝒐𝒘 𝒀 𝒆𝒙 ≫↓ 𝑫𝑫 ≫ 𝑫𝑫 𝒔𝒉𝒊𝒇𝒕 𝒕𝒐 𝒕𝒉𝒆 𝒍𝒆𝒇𝒕

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 Con't……………………………………..
V. Number of buyer in the market

↑ #𝑩𝒖𝒚𝒆𝒓 ≫↑ 𝑫𝑫 ≫ 𝑫𝑫 𝒔𝒉𝒊𝒇𝒕 𝒕𝒐 𝒕𝒉𝒆 𝒓𝒊𝒈𝒉𝒕

↓ #𝑩𝒖𝒚𝒆𝒓 ≫↓ 𝑫𝑫 ≫ 𝑫𝑫 𝒔𝒉𝒊𝒇𝒕 𝒕𝒐 𝒕𝒉𝒆 𝒍𝒆𝒇𝒕

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 Elasticity
Elasticity is a measure of
responsiveness of a dependent
variable(Demand) to changes in an
independent variable(Price).

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 Elasticity of demand
 It refers to the degree of responsiveness
of quantity demanded of a good to a
change in
its price (price elasticity)
 income (income elasticity)
prices of related goods(cross
elasticity)

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 Price Elasticity of Demand
It is a measure of how much the
quantity demanded of a good
responds to a change in the price of
that good

𝑑
%∆𝑄
𝜀 =
%∆𝑝
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 point and arc elasticity
Price elasticity of demand can be measured in
two ways. These are point and Arc elasticity.
Point Price Elasticity of Demand
This is calculated to find elasticity at a given
point.
∆𝑄
%∆𝑄 𝑄 ∗ 100% ∆𝑄 𝑃
𝜀𝑑 = = = ∗
%∆𝑝 ∆𝑃 ∗ 100% ∆𝑃 𝑄
𝑃

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Point Price Elasticity of Demand
Y
In the diagram ‗RP‘ is the straight -line
R
demand curve, which connects both axes . In
the beginning at the price ON the quantity
N Qo demanded is OM. Then the price changes to
∆P
N1 N1 Q1 ON1 and the new quantity demanded will be

∆Q OM1. The symbol ‗ ∆P‘ represents the change

in price while the symbol ‗ ∆Q‘ shows the

change in quantity demanded.
O M M1 P Quantity

Figure 2.4: Point elasticity of demand

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 Elasticity of Demand for straight line downward
sloping
Note that:
 Elasticity of demand is unit free because it is a ratio
of percentage change.
 Elasticity of demand is usually a negative number
because of the law of demand.
i. If e > 1,demand is elastic
ii. If e < 1,demand is inelastic
iii. If e = 1, demand is unitary.
iv. If e = 0, demand is said to be perfectly inelastic.
v. If e = ∞, demand is said to be perfectly elastic.

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 Arc Price Elasticity of Demand
In arc price elasticity of demand, the
midpoints of the old and the new values of
both price and quantity demanded are
used.
𝑸𝟏 − 𝑸𝟎 𝑷𝟏 − 𝑷 𝟎
𝒆𝒅 = ÷
𝑸𝟏 + 𝑸𝟎 𝑷𝟏 + 𝑷𝟐
× 𝟏𝟎𝟎 × 𝟏𝟎𝟎
𝟐 𝟐

𝑸𝟏 ;𝑸𝟎 𝑷𝟏 :𝑷𝟎 ∆𝑸 𝑷𝟏 :𝑷𝟎

𝒆𝒅 = × = ∗
𝑷𝟏 ;𝑷𝟎 𝑸𝟏 :𝑸𝟎 ∆𝑷 𝑸𝟏 :𝑸𝟎

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Numerical example
Suppose that the price of a commodity is
Br. 5 and the quantity demanded at that
price is 100 units of a commodity. Now
assume that the price of the commodity
falls to Br. 4 and the quantity demanded
rises to 110 units.
a) Find the point elasticity of demand
b) Find the arc elasticity of demand

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Con’t…………………………………………………
110;100 5 10 1 1
a) 𝜀𝑑 = ∗ = ∗ = − = 0.5
4;5 100 ;1 20 2

110;100 4;5 10 ;1 ;9 ;3
b) 𝜀𝑑 = ÷ = ÷ = = = 0.43
110:100 4:5 210 9 21 7

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 Determinants of price Elasticity of Demand
i) The availability of substitutes: the more
substitutes available for a product, the more
elastic will be the price elasticity of demand.
ii) Time: In the long time , price elasticity of demand
tends to be elastic. Because:
 More substitute goods could be produced.
 People tend to adjust their consumption pattern.

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 Income Elasticity of Demand
It is a measure of responsiveness of
demand to change in income.

𝒅
𝑰 %∆𝑸 ∆𝑸 𝑰
𝒆𝒅 = = ∗
%∆𝑰 ∆𝑰 𝑸

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 Income Elasticity of Demand
If 𝒆𝒅 >1,the
𝑰
good is luxury good

If 𝒆𝑰𝒅 < 𝟏 ,(+ve) ,the good is necessity

good

If 𝒆𝑰𝒅 <0,(-ve),the good is inferior good

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 Cross Elasticity of Demand
Measures how much the demand for a
product is affected by a change in price
of another good.

%∆𝑸𝒙 𝑸𝒙𝟏; 𝑸𝒙𝟎 𝑷𝒚𝟎 ∆𝑸𝒙 𝑷𝒚

𝒆𝒙𝒚 = = ∗ = ∗
%∆𝑷𝒚 𝑷𝒚𝟏 − 𝑷𝒚𝟎 𝑸𝒙𝟎 ∆𝑷𝒚 𝑸𝒙

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 Con’t…………………………………..
Note:

If 𝜺𝒙𝒚 is + ve,it is substitute good

 If 𝜺𝒙𝒚 is − ve ,it is complementary good

If 𝜺𝒙𝒚 is zero,it is unrelated good

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 Numerical example
Example: Consider the following data
which shows the changes in quantity
demanded of good X in response to
changes in the price of good Y.
Unit price of Y Quantity demanded of
X
10 1500

15 1000

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 Cross Elasticity of Demand
%∆𝑄𝑥 𝑄𝑥1; 𝑄𝑥0 𝑃𝑦𝑜 1000 − 1500 10
𝑒𝑥𝑦 = = ∗ = ∗ = −0.67
%∆𝑄𝑦 𝑃𝑦1 − 𝑃𝑦0 𝑄𝑥𝑜 15 − 10 1500

Therefore, the two goods are complements.

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 Theory of supply
Supply indicates various quantities of a
product that sellers (producers) are
willing and able to provide at different
prices in a given period of time, other
things remaining unchanged.

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 The law of supply
The law states that, ceteris paribus, as
price decreases(increases), quantity
supplied decreases(increases).

It tells us there is a positive

relationship between price and quantity
supplied
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 Supply Schedule
A supply schedule is a tabular
statement of the law of supply

Price ( birr per kg) 30 25 20 15 10

Quantity supplied 100 90 80 70 60

kg/week

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 Supply Curve
A supply curve conveys the same
information as a supply schedule.

But it shows the information

graphically rather than in a tabular
form.

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Supply Curve

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 Supply Function
• A supply function conveys the same
information as a supply schedule
and curve. But it shows the law of
supply mathematically.

• 𝑸𝑺 = 𝒇 𝒑 𝑸 = 𝒄 + 𝒅𝒑
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 Market supply
It is derived by horizontally adding
the quantity supplied of the
product by all sellers at each price.

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 Market supply
Price Quantity Quantity Quantity Market
per unit supplied by supplied by supplied by supply per
seller 1 seller 2 seller 3 week

5 11 15 8 34

4 10.5 13 7 30.5

3 8 11.5 5.5 25

2 6 8.5 4 18.5

1 4 6 2 12

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 Determinants of supply
i) price of inputs ( cost of inputs)
ii) technology
iii) prices of related goods
iv) sellers‘ expectation of price of the
product
v) taxes & subsidies
vi) number of sellers in the market
vii) weather, etc.

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 Elasticity of supply
It is the degree of responsiveness of
the supply to change in price.
𝑆
%∆𝑄
𝜀𝑠 =
%∆𝑃

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What is market Equilibrium?
Market equilibrium, also known as the
market clearing price, refers to a
perfect balance in the market of supply
and demand, i.e.

when supply is equal to demand.

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Graphically
- At point ‗E‘ market
Price demand equals market
D S
supply (equilibrium point)
H J - P is the market
(P1) equilibrium (market
(P ) E clearing) price.
- M is the market
G F
(P2) equilibrium (market
clearing) quantity.
S D

Quantity
M
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 Shortage Vs Surplus
Shortage & surplus
𝑺𝒉𝒐𝒓𝒕𝒂𝒈𝒆 = 𝑫𝒆𝒎𝒂𝒏𝒅 > 𝑺𝒖𝒑𝒑𝒍𝒚
𝑺𝒖𝒑𝒍𝒖𝒔 = 𝑫𝒆𝒎𝒂𝒏𝒅 < 𝑺𝒖𝒑𝒑𝒍𝒚

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Numerical example on Market Equilibrium
Given market demand: Qd = 55 - P,
and market supply: P = Qs + 5
a) Find the market equilibrium price and
quantity?
b) Calculate and interpret price elasticity
of demand and supply at the
equilibrium point.

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Effects of shift in demand & supply on
equilibrium price & quantity demand

when demand changes but supply

remains constant
𝑺𝒉𝒊𝒇𝒕 𝒊𝒏 𝑫𝑫 𝒕𝒐 𝒕𝒉𝒆 𝒓𝒊𝒈𝒉𝒕 𝒃𝒖𝒕𝒔𝒔 ≫↑ 𝑷∗ &𝑸∗
𝑺𝒉𝒊𝒇𝒕 𝒊𝒏 𝑫𝑫 𝒕𝒐 𝒕𝒉𝒆 𝒍𝒆𝒇𝒕 𝒃𝒖𝒕𝒔𝒔 ≫↓ 𝑷∗ &𝑸∗

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 Contd……………………………………..
When supply changes but demand
remains constant
𝑺𝒉𝒊𝒇𝒕 𝒊𝒏 𝑺𝑺 𝒕𝒐 𝒕𝒉𝒆 𝒓𝒊𝒈𝒉𝒕 𝒃𝒖𝒕𝑫𝑫 ≫↓ 𝑷∗ 𝒃𝒖𝒕
↑ 𝑸∗
𝑺𝒉𝒊𝒇𝒕 𝒊𝒏 𝑺𝑺 𝒕𝒐 𝒕𝒉𝒆 𝒍𝒆𝒇𝒕 𝒃𝒖𝒕𝑫𝑫 ≫↑ 𝑷∗ 𝒃𝒖𝒕
↓ 𝑸∗

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Effects of combined changes in
demand &supply
𝑺𝒉𝒊𝒇𝒕 𝒕𝒐 𝑺𝑺 & 𝑫𝑫 𝒕𝒐 𝒕𝒉𝒆 𝒓𝒊𝒈𝒉𝒕
𝒂𝒕 𝒕𝒉𝒆 𝒔𝒂𝒎𝒆 𝒑𝒓𝒐𝒑𝒐𝒓𝒕𝒊𝒐𝒏 , 𝑷∗ 𝒃𝒖𝒕 𝑸 ↑
𝑺𝒉𝒊𝒇𝒕 𝒊𝒏 𝑺𝑺 & 𝑫𝑫 𝒕𝒐 𝒕𝒉𝒆 𝒓𝒊𝒈𝒉𝒕
𝒃𝒖𝒕 𝒕𝒉𝒆 𝒈𝒓𝒆𝒂𝒕𝒆𝒓 𝒑𝒓𝒐𝒑𝒐𝒓𝒕𝒊𝒐𝒏 𝒐𝒇 𝑫𝑫
𝒕𝒉𝒂𝒏 𝑺𝑺 , 𝑸∗ ↑>↑ 𝑷∗
𝑺𝒉𝒊𝒇𝒕 𝒊𝒏 𝑺𝑺 & 𝑫𝑫 𝒕𝒐 𝒕𝒉𝒆 𝒓𝒊𝒈𝒉
𝒃𝒖𝒕 𝒕𝒉𝒆 𝒈𝒓𝒆𝒂𝒕𝒆𝒓 𝒑𝒓𝒐𝒑𝒐𝒓𝒕𝒊𝒐𝒏 𝒐𝒇 𝑺𝑺
𝒕𝒉𝒂𝒏 𝑫𝑫 , 𝑸∗ ↑ 𝒃𝒖𝒕 ↓ 𝑷∗

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Department of Economics,2021/22
 BYE BYE CHAPTER
TWO
WELCOME CHAPTER
THREE
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 Chapter Three
Theory
of
Consumer Behaviour
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 Chapter objectives
After successful completion of this chapter, you will be able to:

 explain consumer preferences and utility

 differentiate between cardinal and ordinal utility
approach
 define indifference curve and discuss its properties
 derive and explain the budget line
 describe the equilibrium condition of a consumer

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 Consumer Preference
Strict preference
𝑖𝑓 𝑥 > 𝑦, 𝑡𝑕𝑒𝑛 𝑐𝑜𝑛𝑠𝑢𝑚𝑒𝑟 𝑠𝑡𝑟𝑖𝑐𝑡𝑙𝑦 𝑝𝑟𝑒𝑓𝑒𝑟𝑠 𝑥 𝑡𝑜 𝑦

Weak preference
𝑖𝑓 𝑥 > 𝑦 𝑎𝑛𝑑 𝑦 > 𝑥, 𝑐𝑜𝑛𝑠𝑢𝑚𝑒𝑟 𝑖𝑠 𝑝𝑟𝑒𝑓𝑒𝑟𝑖𝑛𝑔 𝑥 𝑎𝑛𝑑 𝑦 𝑤𝑒𝑎𝑘𝑙𝑦

Indifference preference
𝑖𝑓 𝑥 ≥ 𝑦 𝑎𝑛𝑑 𝑦 ≥ 𝑥, 𝑡𝑕𝑒𝑛 𝑡𝑕𝑒 𝑐𝑜𝑛𝑠𝑢𝑚𝑒𝑟 𝑖𝑛𝑑𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 𝑡𝑤𝑜 𝑏𝑢𝑛𝑑𝑙𝑒𝑠 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠

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 The concept of utility
WHAT IS UTILITY?
It is the satisfaction or pleasure derived from the
consumption of a good or service.

In other words, utility is the power of the product

to satisfy human wants.

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 Characteristics of utility
Utility’ and ‘Usefulness’ are not the same.
usefulness is product centric whereas utility is
consumer centric.
Utility is subjective
The utility of a product will vary from person to
person
Utility can be different at different places and
time.

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Approaches of measuring utility
There are two major approaches to measure or
compare consumer‘s utility:
1) Cardinal approach and
2) Ordinal approach.

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 The cardinal utility theory
According to the cardinal utility theory, utility is
measurable

The unit of measurement is called utils in the form

of 1, 2, 3 etc.

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 Total and Marginal Utility
Total Utility (TU) is the total satisfaction a
consumer gets from consuming some specific
quantities of a commodity at a particular time.
Marginal Utility (MU) is the extra satisfaction a
consumer realizes from an additional unit of the
product.
it is the slope of total utility.
∆𝑇𝑈
Mathematically,𝑀𝑈 =
∆𝑄

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Quantity Total Marginal
utility (TU) utility (MU)
0 0 -
1 10 10
2 18 8
3 24 6
4 28 4
5 30 2
6 30 0
7 28 -2
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 TU

30

TU

18

0 2 6 Quantity Consumed

MU

Quantity Consumed
0 2 6

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 Con’t………………………….
From the graph
When TU is increasing, MU is positive.
When TU is maximized, MU is zero.
When TU is decreasing, MU is negative.

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 Law of diminishing marginal utility
(LDMU)
The law states that as the quantity consumed of a
commodity increases per unit of time, the utility
derived from each successive unit decreases,
consumption of all other commodities remaining
constant.

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 Equilibrium of a Consumer
a) the case of one commodity
The equilibrium condition of a consumer that consumes a
single good X occurs when the marginal utility of X is equal
to its market price.
Mathematically. 𝑴𝑼𝒙 = 𝑷𝒙

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 proof
Given the utility function :𝑼 = 𝒇(𝒙)
Expenditure on good x:𝑸𝒙 𝑷𝒙
Max(𝑼 − 𝑸𝒙 𝑷𝒙 )
𝒅𝑼 𝒅 𝑸𝒙 𝑷𝒙
− =𝟎
𝒅𝑸𝒙 𝒅𝑸𝒙
𝒅𝑼
− 𝑷𝒙 = 𝟎
𝒅𝑸𝒙
𝑴𝑼𝒙 − 𝑷𝒙 = 𝟎
𝑴𝑼𝒙 = 𝑷𝒙

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 Contd……………………………………..
Graphically,
MUX
A


PX C


 B

MUX
QX

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 Contd……………………………………..
Note:
If MUx > Px, utility can be maximized by increasing
the consumption of X.
If the MUx < Px, utility can be maximized by
reducing the consumption of X.

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 Equilibrium of a Consumer
b) the case of two or more commodities
For the case of two or more goods, the consumer‘s
equilibrium is achieved when
𝑴𝒖𝒙 𝑴𝒖𝒚 𝑴𝒖𝒛
= = & 𝒙𝑷𝒙 + 𝒚𝑷𝒚 + 𝒛𝑷𝒛
𝑷𝒙 𝑷𝒚 𝑷𝒛

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 Numerical Example
Income = 7 Birr, Price of banana = 1 Birr, Price of bread = 4 Birr
Banana Bread
Quantity TU MU MU/P Quantity TU MU MU/P
0 0 - - 0 0 - -
1 6 6 6 1 12 12 3
2 11 5 5 2 20 8 2
3 14 3 3 3 26 6 1.5
4 16 2 2 4 29 3 0.75
5 16 0 0 5 31 2 0.5
6 14 -2 -2 6 32 1 0.25
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 Required
Find consumer’s equilibrium level of banana
and bread
 Total utility derived from equilibrium level
of banana and bread

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 The ordinal utility theory
 it is not possible for consumers to express the
utility of various commodities they consume in
absolute terms, like 1 util, 2 utils, or 3 utils
However, it is possible to express the utility in
relative terms. The consumers can rank
commodities in the order of their preferences as
1st, 2nd, 3rd and so on.

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 Indifference set, curve and map
Indifference set/ schedule is a combination of
goods for which the consumer is indifferent
expressed in table form.
Example:
Bundle A B C D
(Combination)
Orange 1 2 4 7

Banana 10 6 3 1

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 Con’t………………………………………………..
Indifference curve shows different combinations
of two goods which yield the same utility (level of
satisfaction) to the consumer.
When the indifference set/schedule is expressed
graphically

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 Con’t………………………………………………….
Indifference Map: is a set of indifference curves

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 Properties of indifference curves
1) Indifference curves have negative slope
(downward sloping to the right).
 to keep the utility of the consumer constant, as the quantity of one
commodity is increased the quantity of the other must be decreased.
2) Indifference curves are convex to the origin.
 The slope of an indifference curve decreases (in absolute terms) as we move
along the curve from the left downwards to the right. It is also the
reflection of the diminishing marginal rate of substitution.
3) A higher indifference curve is always preferred
to a lower one.
 The further away from the origin an indifferent curve lies, the higher
the level of utility
4) Indifference curves never cross each other
(cannot intersect). B>C implies AB>AC
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 Marginal Rate of Substitution
Marginal rate of substitution is a rate at which
consumers are willing to substitute one commodity
for another in such a way that the consumer
remains on the same indifference curve.
# 𝒖𝒏𝒊𝒕𝒔 𝒐𝒇 𝒚 𝒈𝒊𝒗𝒆𝒏 𝒖𝒑 ∆𝒚
𝑴𝑹𝑺𝒙𝒚 = =−
# 𝒖𝒏𝒊𝒕𝒔 𝒐𝒇 𝒙 𝒈𝒂𝒊𝒏𝒆𝒅 ∆𝒙
It is the slope of indifference curve.

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Con’t……………………………………………

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 Con’t………………………………………………
MRSX,Y associated with the movement from point
A to B, point B to C and point C to D
∆𝑦 20 − 30 −10
𝐴 𝑡𝑜 𝐵 𝑀𝑅𝑆𝑥𝑦 = = = = −2 = 2
∆𝑥 10 − 5 5
∆𝑦 12 − 20 −8
𝐵 𝑡𝑜 𝐶 𝑀𝑅𝑆𝑥𝑦 = = = = −1.6 = 1.6
∆𝑥 15 − 10 5
∆𝑦 8 − 12 −4
𝐶 𝑡𝑜 𝐷 𝑀𝑅𝑆𝑥𝑦 = = = = −0.8 = 0.8
∆𝑥 20 − 15 5

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 Con’t……………………………………………….
It is also possible to derive MRS using the concept
of marginal utility. MRSX ,Y is related to MUX and
MUY as follows.
𝑴𝑼𝒙
𝑴𝑹𝑺𝒙,𝒚 =
𝑴𝑼𝒚

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 Con’t………………………………………………
Proof
𝑈 = 𝑓 𝑥, 𝑦
𝜕𝑈 𝜕𝑈
𝑑𝑈 = 0 ≫ 𝑑𝑥 + 𝑑𝑦 = 0
𝜕𝑥 𝜕𝑥
≫ 𝑀𝑈𝑥 𝑑𝑥 + 𝑀𝑈𝑦 𝑑𝑦 = 0
𝑀𝑈𝑥 𝑑𝑥 𝑀𝑈𝑦 𝑑𝑦
≫ =−
𝑀𝑈𝑦 𝑑𝑥 𝑀𝑈𝑦 𝑑𝑥

𝑀𝑈𝑥 𝑑𝑦
≫ = − = 𝑀𝑅𝑆𝑥,𝑦 Similarily
𝑀𝑈𝑦 𝑑𝑥
𝑀𝑈𝑌 𝑑𝑥
≫ =− = 𝑀𝑅𝑆𝑥,𝑦
𝑀𝑈𝑥 𝑑𝑦
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 Con’t………………………………………………
Example: Suppose a consumer‘s utility function is
given by 𝑈 𝑥, 𝑦 = 𝑥 4 𝑦 2
Find
a) 𝑀𝑈𝑥 & 𝑀𝑈𝑦
𝜕𝑈(𝑥, 𝑦)
𝑀𝑈𝑥 = = 4𝑥 3 𝑦 2
𝜕𝑥
𝜕𝑈(𝑥, 𝑦)
𝑀𝑈𝑦 = = 2𝑥 4 𝑦
𝜕𝑦

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 Con’t………………………………………………
b) 𝑀𝑅𝑆𝑥,𝑦 &𝑀𝑅𝑆𝑦,𝑥
𝑀𝑈𝑥 4𝑥 3 𝑦 2 2𝑦
𝑀𝑅𝑆𝑥,𝑦 = = 4
=
𝑀𝑈𝑦 2𝑥 𝑦 𝑥
𝑀𝑈𝑦 2𝑥 4 𝑦 𝑥
&𝑀𝑅𝑆𝑦,𝑥 = = 3 2=
𝑀𝑈𝑥 4𝑥 𝑦 2𝑦

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 The budget line (the price line)
Constraint is often presented with the help of the
budget line.
What is Budget Line?
 The Budget line is a graph which shows the various
combinations of two goods that a consumer can
purchase given his/her limited income and the
prices of the two goods.

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Assumptions to draw a budget line
There are only two goods bought in quantities, say,
X and Y.
Each consumer is confronted with market
determined prices, PX and PY.
The consumer has a known and fixed money
income (M).

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 Con’t………………………………………………..
Budget constraints
𝑃𝑥 𝑥 + 𝑃𝑦 𝑦 = 𝑀
Solve for y
𝑃𝑦 𝑦 = 𝑀 − 𝑃𝑥 𝑥
𝑀 − 𝑃𝑥 𝑥
𝑦=
𝑃𝑦
𝑀 𝑃𝑥
𝑦= − 𝑥
𝑃𝑦 𝑃𝑦

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Con’t………………………………………………..
Good Y

M/PY

B
A


Good X
M/PX

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 Numerical Example
Example: A consumer has birr100 to spend
on two goods x and y with prices birr 2 and
birr 5 respectively.
a) Derive the equation of the budget line and
b) sketch the graph.

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 Effect of change in income and price
Change in income but assume both price are
constantGood Y

M/Py

Good X
M/Px
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 Con’t…………………………………..
Change in price but assume income is
constant
Good Y

M/Py

Good X
M/Px
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 Con’t…………………………………..
Change price of one of the two goods

Good Y

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Equilibrium of the consumer
Y

Y* E
IC3

IC2
IC1

X
X*

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 Con’t……………………………………………….
Mathematically, consumer optimum (equilibrium) is
attained at the point where:
Slope of indifference curve = Slope of the budget
line
𝑃𝑥 𝑀𝑈𝑥
𝑀𝑅𝑆𝑥,𝑦 = 𝑏𝑢𝑡 𝑀𝑅𝑆𝑥,𝑦 =
𝑃𝑦 𝑀𝑈𝑦
𝑀𝑈𝑥 𝑃𝑥
=
𝑀𝑈𝑦 𝑃𝑦

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Con’t………………………………………….
𝑀𝑈𝑥 𝑀𝑈𝑥
=
𝑝𝑥 𝑃𝑦

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Con’t…………………………………………………..
Example: A consumer consuming two
commodities X and Y has the utility function
𝑈 𝑥, 𝑦 = 𝑥𝑦 + 2𝑥 The prices of the two
commodities are 4 birr and 2 birr respectively.
The consumer has a total income of 60 birr to be
spent on the two goods.
a) Find the utility maximizing quantities of good x
and y.
b) Find the 𝑀𝑅𝑆𝑥𝑦 at equilibrium.
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End of Chapter
Three
 BYE BYE CHAPTER
THREE
WELCOME CHAPTER
FOUR
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 Chapter Four
The Theory of Production
and
Cost
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After successful completion of this
chapter, you will be able to:
define production and production function
differentiate between fixed and variable
inputs
describe short run total product, average
product and marginal product
compare and contrast the three stages of
production in the short run

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explain the difference between accounting
cost and economic cost
describe total cost, average cost and
marginal cost functions
explain the relationship between short run
production functions and short run cost
functions

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 Theory of production in the short run

What is the production?

Production is the process of transforming
inputs into outputs.
The end products of the production process
are outputs which could be tangible (goods)
or intangible (services).
Production function is a mathematical
representation of the relationship between
input and output(Production).

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 Con’t……………………………………………

Inputs are commonly classified as

fixed inputs or
variable inputs
Fixed inputs are those inputs whose quantity
cannot be manipulated easily in a short
period of time.
Eg. Buildings, land and machineries

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 Con’t……………………………………………

Variable inputs are those inputs whose

quantity can be manipulated easily in a short
period of time.
Eg. Unskilled labour

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 Production period
Short Run refers to a period of time in
which the quantity of at least one input is
fixed.
production with one variable input and one
fixed input.
capital (fixed input) and labour (variable
input).
Q = f (L)
where, Q is output and L is the quantity of
labour.
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 Production period
Long Run refers to a period of time in which
the quantity of all inputs are variable.
Q = f (L,k)
where, Q is output and L is the quantity of
labour and k is capital.

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 Total, Average & Marginal Product
Total product (TP): it is the total amount of
output that can be produced by efficiently
utilizing specific combinations of the
variable input and fixed input.
Trends of TP
it initially increases at an increasing
rate,then increases at a decreasing rate,
reaches a maximum point and eventually falls
as the quantity of the variable input rises.

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Trends of TP

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 Con’t………………………………………………..
Marginal Product (MP): it is the change in
output attributed to the addition of one unit
of the variable input to the production
process.
MPL measures the slope of the total product
curve at a given point.
∆𝑇𝑃 𝑑𝑇𝑃
𝑀𝑅𝐿 = =
∆𝐿 𝑑𝐿

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 Trend of MP
Trend of MP
In the short run, the marginal product of the
variable input first increases, reaches its
maximum and then decreases to the extent
of being negative.

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Graphically

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 Average Product
Average Product (AP): Average product of
an input is the level of output that each unit
of input produces, on the average.

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 Con’t……………………………………………
It tells us the mean contribution of each
variable input to the total product.
Mathematically
𝑇𝑃
𝐴𝑃𝐿 =
𝐿
Trend of AP
Average product of labour first increases,
reaches its maximum value and eventually
declines.

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Graphically

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The relationship between MPL and APL

 When APL is increasing, MPL > APL.

 When APL is at its maximum, MPL = APL.
 When APL is decreasing, MPL < APL

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Graphically

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NUMERICAL EXAMPLE

 Suppose that the short-run production function

of certain cut-flower firm is given by:
𝑸 = 𝟒𝑲𝑳 − 𝟎. 𝟔𝑲𝟐 − 𝟎. 𝟏𝑳𝟐 (K=5).
a) Determine the average product of labour (APL)
function.
b) At what level of labour does the total output
of cut-flower reach the maximum?
c) What will be the maximum achievable amount
of cut-flower production?
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Con’t…………………………………..

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 The law of variable proportions
(the law of diminishing returns)
According to the law of variable proportion
as successive units of a variable input(say,
labour) are added to a fixed input (say,
capital or land), beyond some point the
extra, or marginal product that can be
attributed to each additional unit of the
variable resource will decline.

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 Stages of production
three stage of production

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 Stage One
Range
Origin -𝐴𝑃𝐿 is max (𝑀𝑃𝐿 = 𝐴𝑃𝐿 )
Characteristics
𝑀𝑃𝐿 > 𝐴𝑃𝐿
𝑀𝑃𝐿 𝑟𝑒𝑎𝑐𝑕𝑒𝑠 max before 𝐴𝑃𝐿 max
No of Variable input < fixed input
Over utilization of VI
Underutilization of FI
THEREFORE it is inefficient region
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 Stage Two
Range
 𝐴𝑃𝐿 is max (𝑀𝑃𝐿 = 𝐴𝑃𝐿 )-𝑀𝑃𝐿 = 0(𝑇𝑃𝐿 𝑖𝑠 𝑚𝑎𝑥
Characteristics
 𝑀𝑃𝐿 < 𝐴𝑃𝐿
 No of Variable input & fixed input proportional
 Efficient utilization of VI & FI
 THEREFORE it is efficient region (rational
producer operate at this stages of production)

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 Stage Three
Range
After𝑇𝑃𝐿 is max (MPL is zero)
Characteristics
𝑀𝑃𝐿 < 𝐴𝑃𝐿
MPL is negative
No of Variable input > fixed input
Under utilization of VI & overutilization of
FI
THEREFORE it is not efficient region
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Theory of costs in the short
run
Definition and types of costs
To produce goods and services, firms need
inputs.
To acquire these inputs, they have to buy
them from resource suppliers.
Cost is, therefore, the monetary value of
inputs used in the production of an item.

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 Accounting cost
It is the monetary value of all purchased
inputs used in production.
It is out of pocket expenses for the
purchased inputs.(it is direct cost)
Eg.
Expenses on Labour(Wage/salaries)
Expenses on capital(interest)
Utility expenses (eletricity,water
&telephone)
Cost of raw material
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 Economic Cost
Economic cost of producing a commodity
considers the monetary value of all inputs
(purchased and non-purchased).
 Calculating economic costs will be difficult
since there are no direct monetary expenses
for non-purchased inputs.
The monetary value of these inputs is
obtained by estimating their opportunity
costs in monetary terms. The estimated
monetary cost for non-purchased inputs is
known as implicit cost.
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Con’t………………………………………….
Economic Cost Accounting Cost

Explicit cost
+ Explicit Cost
Implicit cost

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Con’t………………………………………….
Economic profit Accounting profit

=total revenue –( =total revenue –

explicit cost + explicit
Implicit cost)
=total revenue – =total revenue –
Economic Cost accounting cost

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Con’t………………………………………………
Note
Economic profit will give the real profit of
the firm since all costs are taken into
account.

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Con’t………………………………………………
If implicit costs were not exist, and If all
inputs are purchased from the market,
accounting and economic profit will be the
same.
However, if implicit costs exist, then
accounting profit will be larger than
economic profit by the amount of implicit
cost.

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 Total, average and marginal
costs in the short run
A cost function shows the total cost of
producing a given level of output.
It can be described using equations, tables
or curves.
 A cost function can be represented using an
equation as follows.
 C = f (Q), where C is the total cost of
production and Q is the level of output.

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 Total Cost in the short run
Total cost (TC) can be broken down in to two
a)Total fixed cost (TFC) &
b)Total variable cost (TVC)

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 Fixed Cost
By fixed costs we mean costs which do not
vary with the level of output & unavoidable
The firm can avoid fixed costs only if he/she
stops operation (shuts down the business).

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 Con’t………………………………………
Examples of fixed cost
salaries of administrative staff,
 expenses for building depreciation and
repairs,
expenses for land maintenance and the
rent of building

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 Variable cost
Variable costs are all costs which directly
vary with the level of output. For example,
if the firm produces zero output, the
variable cost is zero.
Example of Variable cost
cost of raw materials,
the cost of direct labour and
the running expenses of fuel, water,
electricity, etc.
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Con’t………………………………………………
𝑻𝑪 = 𝑻𝑭𝑪 + 𝑻𝑽𝑪

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 Shapes of TFI,TVC & TC
Total fixed cost (TFC): Total fixed cost is
denoted by a straight line parallel to the
output axis. Why a such shape?
such costs do not vary with the level of
output.
Total variable cost (TVC): The total
variable cost of a firm has an inverse S-
shape. Why a such shape?
The shape indicates the law of variable
proportions in production.
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 Shapes of TFI,TVC & TC
Total Cost (TC): The total cost curve is
obtained by vertically adding TFC and TVC at
each level of output.
the TC has also an inverse S-shape.
Note:
when the level of output is zero, TVC is also
zero which implies TC = TFC.

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Con’t………………………………………………
TC

TVC

TFC

Output

Figure 4.2: Short run TC, TFC and TVC curves

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 Per unit costs
 From total costs functions we can derive
per-unit costs. These are even more
important in the short run analysis of the
firm.

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Con’t………………………………………………
a) Average fixed cost (AFC):Average fixed
cost is total fixed cost per unit of output.
𝑨𝑭𝑪 = 𝑻𝑭𝑪/𝑸
SHAPE: The curve declines continuously and
approaches both axes asymptotically.
b) Average variable cost (AVC):Average variable
cost is total variable cost per unit of output.
𝑨𝑽𝑪 = 𝑻𝑽𝑪/𝑸
SHAPE: the AVC curve has U-shape and the
reason behind is the law of variable
proportions.
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Con’t………………………………………………
c) Average total cost (ATC) or simply Average
cost (AC):is the total cost per unit of
output.
𝑨𝑪=𝑻𝑪⁄𝑸

𝑻𝑽𝑪 𝑻𝑭𝑪
Equivalently, 𝑨𝑪 = + = 𝑨𝑽𝑪 + 𝑨𝑭𝑪
𝑸 𝑸
Thus, AC can also be given by the vertical
sum of AVC and AFC.

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 Marginal Cost
d) Marginal Cost (MC)
Marginal cost is defined as the additional cost
that a firm incurs to produce one extra unit of
output.
∆𝑇𝐶 𝑑𝑇𝐶
𝑀𝑐 = =
∆𝑄 𝑑𝑄
Graphically, MC is the slope of TC function
and U shaped.

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Con’t………………………………………………
∆𝑻𝑪 𝒅𝑻𝑪
𝑴𝑪 = = 𝒃𝒖𝒕 𝑻𝑪 = 𝑻𝑽𝑪 + 𝑻𝑭𝑪
∆𝑸 𝒅𝑸

𝒅𝑻𝑽𝑪 𝒅𝑻𝑭𝑪 𝒅𝑻𝑭𝑪

𝑴𝑪 = + 𝒃𝒖𝒕 =𝟎
𝒅𝑸 𝒅𝑸 𝒅𝑸

𝒅𝑻𝑽𝑪
𝑴𝑪 =
𝒅𝑸

Department of Economics,2021/22
Con’t………………………………………………
Given inverse S-shaped TC and TVC curves,
MC initially decreases, reaches its minimum
and then starts to rise.
the reason for the MC to exhibit U shape is
also the law of variable proportions.
 In summary, AVC, AC and MC curves are
all U-shaped due to the law of variable
proportions.

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Con’t………………………………………………
AFC
AVC
AC
AC
MC MC

AVC

AFC

Q
Q1 Q2

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Con’t……………………………………..
From the figure, the AVC curve reaches its
minimum point at Q1 level of output and AC
reaches its minimum point at Q2 level of
output.
The vertical distance between AC and AVC,
that is, AFC decreases continuously as
output increases.
It can also be noted that the MC curve
passes through the minimum points of both
AVC and AC curves.

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Numerical Example
Suppose the short run cost function of a
firm is given by: 𝑻𝑪 = 𝟐𝑸𝟑 – 𝟐𝑸𝟐 + 𝑸 + 𝟏𝟎.
a) Find the expression of TFC & TVC
b)Derive the expressions of AFC, AVC, AC
and MC
c) Find the levels of output that minimize
MC and AVC and then find the minimum
values of MC and AVC

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short run production & cost curves
The relationship between short run
production and cost curves
Suppose a firm in the short run uses labour
as a variable input and capital as a fixed
input
Let the price of labour be given by w.

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i) Marginal Cost and Marginal Product of Labour
𝑑𝑇𝐶 𝑑𝑇𝑉𝐶 𝑑𝑇𝐹𝐶
𝑀𝐶 = = +
𝑑𝑄 𝑑𝑄 𝑑𝑄
𝑑𝑇𝐹𝐶
𝑏𝑢𝑡 = 0 𝑎𝑛𝑑 𝑇𝑉𝐶 = 𝜔𝐿
𝑑𝑄
𝑑(𝜔𝐿) 𝑑𝐿
𝑀𝐶 = =𝜔
𝑑𝑄 𝑑𝑄
𝑑𝑄 𝑑𝐿 1
𝑏𝑢𝑡 = 𝑀𝑃𝐿 & =
𝑑𝐿 𝑑𝑄 𝑀𝑃𝐿
1 𝜔
𝑆𝑜 𝑀𝐶 = 𝜔 =
𝑀𝑃𝐿 𝑀𝑃𝐿
Department of Economics,2021/22
 Con’t………………………………………..
The above expression shows that MC and
MPL are inversely related.
When initially MPL increases, MC
decreases; when MPL is at its maximum,
MC must be at a minimum and
When finally MPL declines, MC increases.

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ii)Average Variable Cost & Average Product
of Labour
𝑇𝑉𝐶
𝐴𝑉𝐶 = 𝑊𝑕𝑒𝑟𝑒 𝑇𝑉𝐶 = 𝜔𝐿
𝑄
𝜔𝐿 𝐿 𝑄 𝐿 1
𝐴𝑉𝐶 = = 𝜔 𝐵𝑢𝑡 = 𝐴𝑃𝐿 & =
𝑄 𝑄 𝐿 𝑄 𝐴𝑃𝐿
𝜔
𝐴𝑉𝐶 =
𝐴𝑃𝐿

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 Con’t………………………………………..
This expression also shows inverse relation
between AVC and APL.
When APL increases, AVC decreases; when
APL is at a maximum, AVC is at a minimum
and
When finally APL declines, AVC increases.
In conclude, the MC curve is the mirror
image of MPL curve and AVC curve is the
mirror image of APL curve. graphically

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Con’t………………………………………..
MPL
APL

APL

Labor (L)
MPL

MC
MC
AVC
AVC

Output

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End of Chapter
Four
 Chapter Five
Market Structure

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At the end of this chapter you will be able to:
differentiate market in physical and digital space
explain the characteristics and equilibrium
condition of perfectly competitive market
differentiate between different types of imperfect
market structures

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 The concept of market
WHAT IS MARKET?
Market describes place or digital space by
which goods, services and ideas are
exchanged to satisfy consumer need.

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 The concept of market
Market can be digital or physical market
 Digital marketing is the marketing of
products or services using digital
technologies, mainly on the internet but also
including mobile phones, display advertising,
and any other digital media.
Physical marketing is the marketing of
products or services using a specified place
or location.

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 Market Structure
What is market structure?
Deals with number of buyers & sellers and the
condition of exit.
There are four market structure
1.Perfectly competitive market
2.Monopolistic
3.Pure monopoly
4.Oligopoly

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 Perfectly Competitive Market
What is perfectly competitive market?
Perfect competition is a market structure
characterized by a complete absence of
enmity among the individual firms.

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 Characteristics of PCM
1. Large number of sellers and buyers
2. No single seller can influence the market
price by changing the quantity supply.
3. Sellers and buyers are price takers.
4. The price is determined by the market
supply and demand forces.

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 Con’t………………………………………………………………….

5. Homogeneous product
6. Perfect mobility of factors of production
7. Free entry and exit
8. Perfect knowledge about market
conditions
9. No government interference

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 Con’t………………………………………………………………….

The demand curve (Df) that the firm

faces in this market situation is a
horizontal line drawn at the equilibrium
price.

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Con’t…………………………………………………………………
Market demand Market Supply

Pm Df = MR= AR

Qm Quantity Quantity

(a): Market demand and supply (b): Demand curve of a firm

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 Short run equilibrium of the firm
The main objective of a firm is profit
maximization.
 If the firm has to incur a loss, it aims to
minimize the loss.
If the firm has got a revenue, it aims to
maximize the gain.
Profit is the difference between total
revenue and total cost.

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 Con’t………………………………………….
Total Revenue (TR): it is the total amount of
money a firm receives from a given quantity
of its product sold.
𝑻𝑹 = 𝑷𝑸
Average revenue (AR):- it is the revenue per
unit of item sold.
𝑻𝑹 𝑷𝑸
𝑨𝑹 = = =𝑷
𝑸 𝑸
Therefore, the firm‘s demand curve is also the
average revenue curve.
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 Con’t…………………………………………………….
Marginal Revenue: it is the additional amount
of money/ revenue the firm receives by
selling one more unit of the product.
𝒅𝑻𝑹 𝒅(𝑷𝑸) 𝒅𝑸 𝒅𝑷
𝑴𝑹 = = =𝑷 +𝑸 =𝑷
𝒅𝑸 𝒅𝑸 𝒅𝑸 𝒅𝑸

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 Con’t…………………………………………………..
Thus, in a perfectly competitive market, a
firm‘s average revenue, marginal revenue and
price of the product are equal, i.e. AR = MR =
P =Df
Since the purely competitive firm is a
price taker, it will maximize its economic
profit only by adjusting its output.

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 Approaches to profit maximization
1) Total Approach (TR-TC approach)
In this approach, a firm maximizes total
profits in the short run when the (positive)
difference between total revenue (TR) and
total costs (TC) is greatest.
𝝅 = 𝑻𝑹 − 𝑻𝑪

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Con’t………………………………………………

TC,TR

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 Con’t…………………………………………………….
2) Marginal Approach (MR-MC)
In the short run, the firm will maximize profit
or minimize loss by producing the output at
which marginal revenue equals marginal cost.
i. MR = MC
ii. The slope of MC is greater than slope of
MR; or MC is rising).
(that is, slope of MC is greater than zero)

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 Con’t…………………………………………………….
Proof
𝝅 = 𝑻𝑹 − 𝑻𝑪
F.O.C

𝒅𝝅 𝒅𝝅 𝒅𝑻𝑹 𝒅𝑻𝑪
= 𝟎, = − =𝟎
𝒅𝑸 𝒅𝑸 𝒅𝑸 𝒅𝑸
𝑴𝑹 − 𝑴𝑪 = 𝟎,
𝑴𝑹 = 𝑴𝑪

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 Con’t…………………………………………………….
S.O.C

𝒅𝟐 𝝅 𝒅𝟐 𝝅 𝒅𝟐 𝑻𝑹 𝒅𝟐 𝑻𝑪
< 𝟎, 𝟐 = − 𝟐 <0
𝒅𝑸𝟐 𝒅𝑸 𝒅𝑸 𝟐 𝒅𝑸

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 Con’t……………………………………………………
Graphically,

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 Con’t………………………………………………….
The profit maximizing output is Qe, where
MC=MR and MC curve is increasing.

 At Q*,MC=MR, but since MC is falling at

this output level, it is not equilibrium output.

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 Con’t………………………………………………….
Whether the firm in the short- run gets
positive or zero or negative profit depends on
the level of ATC or AC at equilibrium.
𝝅 = 𝑻𝑹 − 𝑻𝑪
𝝅 = 𝑷𝑸 − 𝑨𝑪𝑸
𝝅 = 𝑸(𝑷 − 𝑨𝑪)
If 𝒑 > 𝑨𝑪, 𝑬𝒄𝒐𝒏𝒐𝒎𝒊𝒄 𝒑𝒓𝒐𝒇𝒊𝒕
If 𝒑 < 𝑨𝑪, 𝑳𝒐𝒔𝒔
If 𝒑 = 𝑨𝑪, 𝑵𝒐𝒓𝒎𝒂𝒍 𝒑𝒓𝒐𝒇𝒊𝒕 𝒐𝒓 𝒛𝒆𝒓𝒐 𝒑𝒓𝒐𝒇𝒊𝒕 (𝑩𝒓𝒆𝒂𝒌 𝒆𝒗𝒆𝒏)

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 Economic/positive profit
If the AC is below the market price at
equilibrium, the firm earns a positive profit.
Equal to the area between the ATC curve
and the price line up to the profit maximizing
output.

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 Loss
If the AC is above the market price at
equilibrium, the firm earns a negative profit
(incurs a loss) equal to the area between the
AC curve and the price line.

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 Normal Profit
If the AC is equal to the market price at
equilibrium, the firm gets zero profit or
normal profit(Break even).

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 Shutdown point
Thus, P = min AVC is the shutdown point for
the firm.

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 Con’t……………………………………………………..
Graphically,

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Example
Suppose that the firm operates in a
perfectly competitive market. The market
price of its product is $10 . The firm
estimates its cost of production with the
following cost function:
𝑻𝑪 = 𝑸𝟑 − 𝟒𝑸𝟐 + 𝟏𝟎𝑸 + 𝟐
a) What level of output should the firm
produce to maximize its profit?
b) Determine the level of profit at equilibrium.
c) What minimum price is required by the firm
to stay in the market?
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 Con’t……………………………………………………..
a) Given: 𝑻𝑪 = 𝑸𝟑 − 𝟒𝑸𝟐 + 𝟏𝟎𝑸 + 𝟐 & P= 10$
TR=PQ=10Q F.O.C. MR=MC
𝒅𝑻𝑹
𝑴𝑹 = = 𝟏𝟎
𝒅𝑸
𝒅𝑻𝑪
𝑴𝑪 = = 𝟑𝑸𝟐 − 𝟖𝑸 + 𝟏𝟎
𝒅𝑸
Using marginal approach
𝑴𝑹 = 𝑴𝑪
𝟑𝑸𝟐 − 𝟖𝑸 + 𝟏𝟎 = 𝟏𝟎
𝟑𝑸𝟐 − 𝟖𝑸 = 𝟎

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 Con’t……………………………………………………..
𝑄 3𝑄 − 8 = 0
𝑄∗ = 0 & 𝑄∗ = 8 3
To determine which level of output
maximizes profit we have to use the second
order test at the two output levels.

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 Con’t……………………………………………………..
S.O.C MC is rising or increase in the slope of
MC.
𝑑𝑀𝐶
𝑆𝑙𝑜𝑝𝑒 𝑜𝑓 𝑀𝐶 = >0
𝑑𝑄
𝑑𝑀𝐶
= −8 + 6𝑄
𝑑𝑄
𝑑𝑀𝐶
AT 𝑄 = 0
∗
= −8 + 6 0 = −8 < 0 ×
𝑑𝑄<0
8 𝑑𝑀𝐶 8
AT 𝑄 = ∗
= −8 + 6 = −8 + 16 = 8 >
3 𝑑𝑄 3
. Thus, the equilibrium output level is q = 8/3
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 Con’t……………………………………………………..
b) 𝜋 = 𝑇𝑅 − 𝑇𝐶
8 80
𝑇𝑅 = 𝑃𝑄 = 10 ∗ = = 26.66
3 3
𝑇𝐶 = 𝑄3 − 4𝑄2 + 10𝑄 + 2
2
8 3 8
𝑇𝐶 = ( ) −4 + 10
3 3
512 256
𝑇𝐶 = − + 10
27 9
512 − 313 199
𝑇𝐶 = = = 7.37
27 27
𝜋 = 𝑇𝑅 − 𝑇𝐶 = 26.66 − 7.37 = 19.29
Department of Economics,2021/22
 Con’t……………………………………………………..
C) AVC is minimal when derivative of AVC is equal
𝒅𝑨𝑽𝑪
to zero. That is: =𝟎
𝒅𝑸
𝑻𝑪 = 𝑸𝟑 − 𝟒𝑸𝟐 + 𝟏𝟎𝑸 + 𝟐 but
𝑻𝑽𝑪 = 𝑸𝟑 − 𝟒𝑸𝟐 + 𝟏𝟎𝑸
𝑻𝑽𝑪
𝑨𝑽𝑪 = = 𝑸𝟐 − 𝟒𝑸 + 𝟏𝟎
𝑸
𝒅𝑨𝑽𝑪
= 𝑶 ≫ 𝟐𝑸 − 𝟒 = 𝟎
𝒅𝑸
𝑸=𝟐
AVC is minimum when output is equal to 2
units.
Department of Economics,2021/22
 Con’t……………………………………………………..
Minimum value of AVC is 𝑸𝟐 − 𝟒𝑸 + 𝟏𝟎
but Q=2
Min 𝑨𝑽𝑪 = 𝟐𝟐 − 𝟒 𝟐 + 𝟏𝟎 = 𝟔
Thus, to stay in the market the firm
should get a minimum price of $ 6.

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 MONOPOLY MARKET
DEFINITION
Pure monopoly exists when a single firm is
the only producer of a product for which
there are no close substitutes.

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 MAIN CHARACTERISTICS
1) Single seller
2) No close substitutes
3) Price maker
4) Price setter
5) Blocked entry

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 Sources of monopoly
i. Legal restriction: Some monopolies are
created by law in public interest.
 monopoly can be public and private sectors.

Eg. postal service, telegraph, telephone

services, radio and TV services, generation and
distribution of electricity, rail ways, airlines
etc… are public monopolies.

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 Con’t……………………………………………………..
ii. Control over key raw materials: Some
firms acquire monopoly power from their
traditional control over certain scarce and key
raw materials that are essential for the
production of certain other goods.
iii. Efficiency (Natural monopolies): The
most efficient plant (probably large size firm,)
which produces at minimum cost(Economies of
scale), can eliminate the competitors by
curbing down its price for a short period and
can acquire monopoly power.

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 Con’t……………………………………………………..
iv. Patent rights (patent monopolies): Patent
rights are granted by the government to a
firm

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Monopolistically competitive market
Definition
This market model can be defined as the
market organization in which there are
relatively many firms selling differentiated
products.
It is the blend of competition(from many #
of firms) and monopoly (barrier to entry &
differentiated product)

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Characteristics of monopolistic com
1. Differentiated product: similar but not
identical in the eyes of the buyers.
 the differentiation of the product could be
real (eg. quality) or fancied (e.g. difference
in packing).
2. Many sellers and buyers
3. Easy entry and exit
4. Existence of non-price competition

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 Oligopoly market
Characteristics
i. Few dominant firms
ii. Interdependence
iii. Entry barrier
Products may be homogenous or
differentiated
V. Lack of uniformity in the size of firms
Vi. Non-price competition

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Summary

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 Market models
Characterist
ics Pure Monopolistic Oligopoly Pure
Competition Competition Monopoly

Number of Large Many Few One or

firms Single

Type of Homogeneous Differentiated Homogeneous or Unique, no

product differentiated close
substitutes

Control over None Some, but Limited by Significant

price within rather mutual
narrow limits interdependence
and collusion
Condition of Very easy Relatively easy Considerable Blocked
entry barriers/obstacl
es
Examples Agricultural Clothes, Shoes Steel, Local
products Department of Economics,2021/22 Automobiles utilities
That Brings us
the end of
Chapter Five
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End of Chapter Five
Welcome Chapter
Last

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 Chapter Six
Fundamental
Concepts of
Macroeconomics
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After completing this chapter, you will be
able to:
Define GNP and GDP and able to measure
national income by using the expenditure or
income or product approach;
Differentiate between nominal GDP and real
GDP and decide which is better to measure
economic performance;
explain the concept of business cycle;

Department of Economics,2021/22
 Con’t……………………………………………………………………………..
briefly discuss the types of unemployment;
understand about inflation, causes of
inflation and its impact on the economy and
explain budgetary deficit and its ways of
financing;

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Major macroeconomic issues
 Economic performance
 Macroeconomic problems
 Macroeconomic policies

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 Goals of Macroeconomics
To achieve high economic growth
To reduce unemployment
To attain stable prices
To reduce budget deficit and balance of
payment (BoP) deficit
To ensure fair distribution of income

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 The National Income Accounting
National Income Accounting (NIA) is an
accounting record of the level of economic
activities of an economy.
It is a measure of an aggregate output,
income and expenditure in an economy.

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 Economic Performance
Economic performance can be measured by
1. Gross Domestic Product(GDP)
2. Gross National Product(GNP)

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 1. What is GDP?
it is the total value of currently produced
final goods and services that are produced
within a country‘s boundary during a given
period of time, usually one year.
only currently produced good
Only final goods (ignores intermediate goods)
 within the boundary/territory of a country
 irrespective of who owns that output.

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 Con’t………………………………………………
Mathematically,
𝑮𝑫𝑷 = 𝑷𝒊 𝑸𝒊

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 2.What is GNP?
It is the total value of final goods and
services currently produced by domestically
owned factors of production in a given period
of time, usually one year, irrespective of
their geographical locations.
only currently produced good
Only final goods (ignores intermediate goods)
domestically owned factors of production
irrespective of their geographical locations.
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 Con’t…………………………………………………
Mathematically,
𝑮𝑵𝑷 = 𝑮𝑫𝑷 + 𝑵𝑭𝑰
Where NFI is Net Factor Income
NFI=income received from abroad by a
country‘s citizens less factor income paid for
foreigners to abroad.

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The relationship between NFI,GNP&GDP

If NFI >0, then GNP > GDP

If NFI<0, then GNP < GDP
If NFI =0, then GNP =GDP

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 Approaches to measure GDP
there are three approaches to measure
GDP/GNP.
I. Product/value added approach,
II. Expenditure approach and
III. Income approach

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 Product Approach
In this approach, GDP is calculated by adding
the market value of goods and services
currently produced by each sector of the
economy.

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Why only final good s & services?
in order to avoid double counting

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Avoiding Double Counting
possible ways of avoiding double counting
1) Taking only the value of final goods and
services
2) Taking the sum of the valued added by all
firms at each stage of production

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Example on Value Add Approach

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 Expenditure Approach
 GDP is measured by adding all expenditures
on final goods and services produced in the
country by all sectors of the economy.

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 GDP using Total Expenditure
Sectors Value of Output (in million birr)
Agriculture and allied activities 9309
- Agriculture 7000
- Forestry 1000
- Fishing 1309
Industry 147413
- Mining & quarrying 9842
- Large & medium scale manufacturing 91852
- Electricity & water 13717
- Construction 32002
Service 357 872
- Banking insurance and real estate 121704
- Public administration & defense 36605
- Health 20000
- Education 32509
- Domestic & other services 147054
4. Net factor income from abroad 87348

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Con’t…………………………………………………….
GDP = 9,309+147,413+357,872 = 514,594
GNP = GDP + NFI = 514,594 +87,348 = 601,942

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 Con’t…………………………………………..
𝑮𝑫𝑷 = 𝑪 + 𝑰 + 𝑮 + 𝑵𝑿

Where:
personal consumption of households (C),
gross private domestic investment (I),
government purchases of goods and services (G) and
net exports (NX)

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 Example: GDP at current market price measured using
expenditure approach for a hypothetical economy.
Types of expenditure Amount (in million Birr)
1. Personal consumption expenditure 4500
Durable consumer goods 1500
Non-durable consumer goods 2000
Services 1000
2. Gross private domestic investment 600
Business fixed investment 250
Construction Expenditure 300
Increases in inventories 50
3. Government expenditure on goods and services 250
Federal government 100
State government 150
4. Net export -50
Exports 150
Imports 200
GDP at current market price 5300
Department of Economics,2021/22
 Income Approach
in this approach, GDP is calculated by adding
all the incomes accumulating to all factors of
production used in producing the national
output.
It is crucial, however, to note that some
forms of personal incomes are not
incorporated in the national income.
Transfer payments may take the form of old
age pension, unemployment benefit,
subsidies, etc.
Department of Economics,2021/22
 Con’t……………………………………………………
GDP = Compensation of employees (wages &
salaries )
+ Rental income
+ Interest income
+ Profits (proprietors‘ profit plus corporate
profit)
+ Indirect business taxes
+ Depreciation
- Subsidies
- Transfer payments
Department of Economics,2021/22
Example
Items Value (in million Birr)
1) Compensation of Employees 45623.71
2) Rental Income 1249.32

3) Proprietor‘s Income 10561.21

4) Corporate Profits 16960.33

Subtotal (corporate and proprietor‘s) 27521.54

5) Net interest 5189.73

6) Depreciation 503.84

7) Indirect Business Taxes 476.51

8) Subsidy (11368.95)

Gross Domestic Product 69195.70

9) Income from abroad 2036.20

10) Payments to abroad (11231.90)

NFI (9195.70)
Gross National Income 60000.00

Department of Economics,2021/22
 Other Income Accounts
Apart from GDP and GNP, there are also other
social accounts which have equal importance in
macroeconomic analysis. These are:
 Net National Product (NNP)
 National Income (NI)
 Personal Income (PI)
 Personal Disposable Income (PDI)

Department of Economics,2021/22
 NNP
Net National product(NNP) =
Gross National product (GNP)
–
Capital consumption allowance (D)

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 NI
National Income (NI) =
Net National Product(NNP)
–
Indirect Business Tax (IBT)

Department of Economics,2021/22
 PI
Personal Income(PI) =
National Income(NI)
–
[social security contribution + corporate
income tax + retained corporate profit]
+
[Public transfer payments (e.g. Subsidy)
+
net interest on government bond]
Department of Economics,2021/22
 DI
DI(Disposeable Income)
=
PI – Personal taxes
Or
DI = C + S

Department of Economics,2021/22
 Nominal versus Real GDP
Nominal GDP is the value of all final goods
and services produced in a given year when
valued at the prices of that year.
Any change that can happen in the country‘s
GDP is due to changes in price, quantity or
both.
Nominal GDP that is not adjusted for
inflation is called Nominal GDP.

Department of Economics,2021/22
 Cont.………………………………………..
Real GDP is the value of final goods and
services produced in a given year when
valued at the prices of a reference base
year.
Here real GDP is adjusted for inflation.

Department of Economics,2021/22
Example: Consider an economy producing two goods,
X and Y.
Year Product Quantity Unit
price
($)
2017 X 20 5
(base
year) Y 8 50

2018 X 25 20

Y 10 100
Department of Economics,2021/22
 Con’t…………………………………………………
In 2017: In 2018:
Nominal GDP = (20 x 5) + (8 The outputs of 2018 valued at
x 50) = $500 the prices of 2017(the base
Real GDP = (20 x 5) + (8 x year).
50) = $500 Nominal GDP= (25 x 20) + (10
x 100) = $1500
Note that both the real and Real GDP = (25 x 5) + (10 x 50)
nominal GDP values are = $625
exactly the same in the base
year. Department of Economics,2021/22
The GDP Deflator & the Consumer Price
Index(CPI)
The GDP Deflator: The calculation of real
GDP gives us a useful measure of inflation
known as the GDP deflator.
𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝑮𝑫𝑷
𝑮𝑫𝑷 𝒅𝒆𝒇𝒍𝒂𝒕𝒐𝒓 =
𝑹𝒆𝒂𝒍 𝑮𝑫𝑷
The Consumer Price Index(CPI):is an
indicator that measures the average change in
prices paid by consumers for a representative
basket of goods and services.

Department of Economics,2021/22
 Cont…………………………………………….
Mathematically, The CPI is the ratio of
today's cost to the base year cost.

Department of Economics,2021/22
 The CPI versus the GDP Deflator
GDP Deflator CPI

Prices of all goods Prices of consumers

goods
Only domestically Includes imported
produced good goods
Assigns changing weight Assigns fixed weight

Department of Economics,2021/22
 The Business Cycle
Business cycle refers to the recurrent ups and
downs in the level of economic activity.

Graphically

Department of Economics,2021/22
Department of Economics,2021/22
 Boom/peak:
It is the maximum point in the business
cycle
output is maximum
very high degree of utilization of
resources,
unemployment level is low;
business is good; and it is a period of
prosperity.

Department of Economics,2021/22
 Recession/contraction:
economic performance generally declines.
Economy falls,
business generally decline and
unemployment problem rises.

Department of Economics,2021/22
 Trough/Depression
The lowest point in a business cycle.
Output is vey low
there is an excessive amount of
unemployment
idle productive capacity.

Department of Economics,2021/22
 Recovery/Expansion
the economy starts to grow or recover
more and more resources are employed in
the production process
output increases,
unemployment level diminishes and
national income rises.

Department of Economics,2021/22
 Macroeconomic Problems
Unemployment
Unemployment refers to group of people who
are in a specified age (labour force), who are
without a job but are actively searching for a
job.
In the Ethiopia context, the specified age
is between 14 and 60

Department of Economics,2021/22
 Con’t…………………………………………………
the labour force does not include:
 Children <14 and retired people age
>60
 people in mental and correctional
institutions
 very sick and
 disabled people etc.
 Full time students
Labour force = Employed + Unemployed

Department of Economics,2021/22
 Types of unemployment
there are three major types of unemployment
1) Frictional Unemployment
2) Structural Unemployment
3) Cyclical Unemployment

Department of Economics,2021/22
 Frictional Unemployment
unemployment experienced due to:
Seasonality of work E.g. Construction
workers
Voluntary switching of jobs in search of
better jobs
Entrance to the labor force E.g. A student
immediately after graduation
 Re-entering to the labor force

Department of Economics,2021/22
 Structural Unemployment
It results from mismatch between
 the skills or
 locations of job seekers and the
vacancies
 the requirements

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 Cyclical Unemployment
It results due to absence of vacancies. This
usually happens due to
deficiency in demand for commodities/
 the low performance of the economy to
create jobs. E.g. During recession

Department of Economics,2021/22
 Con’t…………………………………………….
Note:
Frictional and structural unemployment are
more or less unavoidable; hence, they are
known as natural level of unemployment.
 cyclical unemployment is avoidable type of
unemployment

Department of Economics,2021/22
 Mathematical expression of unemployment
Total unemployment = Frictional + Structural + Cyclical unemployment

Natural level of unemployment = Frictional unemployment + Structural unemployment

= Total unemployment - Cyclical unemployment

Natural rate of unemployment = Natural unemployment /labor force

Unemployment rate = total unemployment / labor force

Department of Economics,2021/22
 Con’t………………………………………………..
NOTE
When the unemployment rate is equal to the
natural unemployment rate , we say the
economy is at full employment.
Therefore, full employment does not mean
zero unemployment.

Department of Economics,2021/22
 Inflation
It is the sustainable increase in the general
or average price levels of commodities. Price
index serves to measure inflation.

Department of Economics,2021/22
 Causes of inflation
A. Demand pull inflation:
inflation results from a rapid increase in
demand for goods and services than supply of
goods and services. This is a situation where
―too much money chases too few goods.
B. Cost push or supply side inflation:
 it arises due to continuous decline in aggregate
supply. This may be due to bad weather,
increase in wage, or the prices of other inputs.

Department of Economics,2021/22
Economic effects of inflation
1. reduces real money balance or purchasing
power of money
2. reduce the welfare of individuals.
3. Fisher‘s equation. I= r+П Increase in
inflation rate will raise the nominal interest
rate and the opportunity cost of holding
money. shoe-leather cost of inflation.

Department of Economics,2021/22
 Con’t………………………………..
5. inflation reduces investment by increasing
nominal interest rate and creating uncertainty
about macroeconomic policies.
6. Inflation redistributes wealth among individuals
7. Unanticipated inflation hurts individuals with
fixed income and pension.
8. High inflation is always associated with
variability of prices which induces firms to change
their price list more frequently and requires
printing and distributing new catalogue. This is
known as menu cost of inflation
Department of Economics,2021/22
 Budget deficit and Trade Deficit
Budget Deficit:
The government receives revenue from
taxes and uses it to pay for government
purchases.
Any excess of tax revenue over government
spending is called public saving, which can be
either positive (a budget surplus) or negative
(a budget deficit).

Department of Economics,2021/22
 Con’t…………………………………………………
When a government spends more than it
collects in taxes, it faces a budget deficit,
which it finances by borrowing from internal
and external borrowing.

Department of Economics,2021/22
Department of Economics,2021/22