Introduction to Economics

September 2019
Contents

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 Chapter One
Basics of Economics

Introduction
Have you ever heard anything about Economics? Yes!!! It is obvious you heard about
economics and even you talked a lot about economics in your day to day activities. And
you may have questions such as: What are resources? What does efficient allocation mean?
What are human needs? What does demand mean? What is economics? This course will
answer those questions and introduce you to the nature of economics, demand and
supply theories, theories of consumer, production, cost, market structure and
fundamental concepts of macroeconomics at large.

In this chapter you will be introduced to the subject matter of economics and the rationale
that motivates us to study economics.

Chapter objectives

After successful completion of this chapter, you will be able to:

understand the concept and nature of economics;
analyze how resources are efficiently used in producing output;
identify the different methods of economic analysis ;
distinguish and appreciate the different economic systems;
understand the basic economic problems and how they can be solved; and
identify the different decision making units and how they interact with each
other

1.1 Definition of economics

Economics is one of the most exciting disciplines in social sciences. The word economy comes
from the Greek phrase ―one who manages a household‖. The science of economics in
its current form is about two hundred years old. Adam Smith – generally known as the
father of economics – brought out his famous book, ―An Inquiry into the Nature and
Causes of Wealth of Nations‖, in the year 1776. Though many other writers expressed
important economic ideas before Adam Smith, economics as a distinct subject started with
his book.

There is no universally accepted definition of economics (its definition is controversial). This

is because different economists defined economics from different perspectives:

a. Wealth definition,
b. Welfare definition,
c. Scarcity definition, and
d. Growth definition

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Hence, its definition varies as the nature and scope of the subject grow over time. But,
the formal and commonly accepted definition is as follow.

Economics is a social science which studies about efficient allocation of scarce resources so as
to attain the maximum fulfillment of unlimited human needs. As economics is a science
of choice, it studies how people choose to use scarce or limited productive resources
(land, labour, equipment, technical knowledge and the like) to produce various commodities.

The following statements are derived from the above definition.

Economics studies about scarce resources;
It studies about allocation of resources;
Allocation should be efficient;
Human needs are unlimited
The aim (objective) of economics is to study how to satisfy the unlimited human needs
up to the maximum possible degree by allocating the resources efficiently.

1.2 The rationales of economics

There are two fundamental facts that provide the foundation for the field of economics.
1) Human (society‘s) material wants are unlimited.
2) Economic resources are limited (scarce).

The basic economic problem is about scarcity and choice since there are only limited amount
of resources available to produce the unlimited amount of goods and services we desire.
Thus, economics is the study of how human beings make choices to use scarce resources as
they seek to satisfy their unlimited wants. Therefore, choice is at the heart of all decision-
making. As an individual, family, and nation, we confront difficult choices about how to use
limited resources to meet our needs and wants. Economists study how these choices are
made in various settings; evaluate the outcomes in terms of criteria such as efficiency,
equity, and stability; and search for alternative forms of economic organization that might
produce higher living standards or a more desirable distribution of material well-being.

1.3 Scope and method of analysis in economics

1.3.1 Scope of economics

The field and scope of economics is expanding rapidly and has come to include a vast range of
topics and issues. In the recent past, many new branches of the subject have
developed, including development economics, industrial economics, transport
economics, welfare economics, environmental economics, and so on. However, the core
of modern economics is

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 formed by its two major branches: microeconomics and macroeconomics. That
means
economics can be analyzed at micro and macro level.

A. Microeconomics is concerned with the economic behavior of individual decision making

units such as households, firms, markets and industries. In other words, it deals with
how households and firms make decisions and how they interact in specific markets.

B. Macroeconomics is a branch of economics that deals with the effects and consequences
of the aggregate behaviour of all decision making units in a certain economy. In other
words, it is an aggregative economics that examines the interrelations among various
aggregates, their determination and the causes of fluctuations in them. It looks at the
economy as a whole and discusses about the economy-wide phenomena.

Microeconomics Macroeconomics
Studies individual economic units of an Studies an economy as a whole and
economy. its aggregates.
Deals with individual income, individual Deals with national income and
prices, individual outputs, etc. output and general price level
Its central problem is price Its central problem is determination
determination and allocation of of level of income and employment.
resources.
Its main tools are aggregate demand
Its main tools are the demand and supply and aggregate supply of an economy
of particular commodities and factors. as a whole.
It helps to solve the central problem of Helps to solve the central problem
‗what, how and for whom to produce‘ in of ‗full employment of resources in
an economy so as to maximize profits the economy.‘
Discusses how the equilibrium of a Concerned with the determination
consumer, a producer or an industry of equilibrium levels of income and
is attained. employment at aggregate level.
Examples: Individual income, individual Examples: national income, national
savings, individual prices, an individual firm‘s savings, general price level, national
output, individual consumption, etc.
output, aggregate consumption, etc.

Note: Both microeconomics and macroeconomics are complementary to each other. That
is, macroeconomics cannot be studied in isolation from microeconomics.

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 1.3.2 Positive and normative analysis

Is economics a positive science or normative science, or both? What is your justification?

Economics can be analyzed from two perspectives: positive economics and

normative economics.

Positive economics: it is concerned with analysis of facts and attempts to describe the world
as it is. It tries to answer the questions what was; what is; or what will be? It does not
judge a system as good or bad, better or worse.

Example:
The current inflation rate in Ethiopia is 12 percent.
Poverty and unemployment are the biggest problems in Ethiopia.
The life expectancy at birth in Ethiopia is rising.

All the above statements are known as positive statements. These statements are all
concerned with real facts and information. Any disagreement on positive statements can
be checked by looking in to facts.

Normative economics: It deals with the questions like, what ought to be? Or what
the economy should be? It evaluates the desirability of alternative outcomes based on one‘s
value judgments about what is good or what is bad. In this situation since normative
economics is loaded with judgments, what is good for one may not be the case for the
other. Normative analysis is a matter of opinion (subjective in nature) which cannot be
proved or rejected with reference to facts.

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.
Any disagreement on a normative statement can be solved by
voting.

1.3.3 Inductive and deductive reasoning in economics

The fundamental objective of economics, like any science, is the establishment of valid
generalizations about certain aspects of human behaviour. Those generalizations are known
as theories. A theory is a simplified picture of reality. Economic theory provides the basis
for economic analysis which uses logical reasoning. There are two methods of logical
reasoning: inductive and deductive.

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a) Inductive reasoning is a logical method of reaching at a correct general statement
or theory based on several independent and specific correct statements. In short,
it is the process of deriving a principle or theory by moving from facts to theories
and from particular to general economic analysis.

Inductive method involves the following steps.

1. Selecting problem for analysis
2. Collection, classification, and analysis of data
3. Establishing cause and effect relationship between economic phenomena.

b) Deductive reasoning is a logical way of arriving at a particular or specific correct

statement starting from a correct general statement. In short, it deals with conclusions
about economic phenomenon from certain fundamental assumptions or truths or axioms
through a process of logical arguments. The theory may agree or disagree with the real
world and we should check the validity of the theory to facts by moving from general to
particular. Major steps in the deductive approach include:

1. Problem identification
2. Specification of the assumptions
3. Formulating hypotheses
4. Testing the validity of the hypotheses

1.4 Scarcity, choice, opportunity cost and production possibilities frontier

1. Have you ever faced a problem of choice among different alternatives? Ifyes,
what was your decision?
2. What is scarcity? Do you think that it is differentfrom shortage? Why?

It is often said that the central purpose of economic activity is the production of goods
and services to satisfy consumer‘s needs and wants i.e. to meet people‘s need for
consumption both as a means of survival and also to meet their ever-growing demand for an
improved lifestyle or standard of living.

1. Scarcity

The fundamental economic problem that any human society faces is 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 those wants.

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 Free resources: A resource is said to be free if the amount available to a
society is greater than the amount people desire at zero
Resources price. E.g. sunshine

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.

The following are examples of scarce resources.

All types of human resources: manual, intellectual, skilled and specialized labor;
Most natural resources like land (especially, fertile land), minerals, clean water,
forests and wild - animals;
All types of capital resources ( like machines, intermediate goods, infrastructure ); and
All types of entrepreneurial resources.

Economic resources are usually classified into four categories.

Labour: refers to the physical as well as mental efforts of human beings in the
production and distribution of goods and services. The reward for labour is called wage.
Land: refers to the natural resources or all the free gifts of nature usable in
the production of goods and services. The reward for the services of land is known as
rent.
Capital: refers to all the manufactured inputs that can be used to produce other
goods and services. Example: equipment, machinery, transport and communication
facilities, etc. The reward for the services of capital is called interest.

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. The reward for entrepreneurship is called profit.

Entrepreneurs are individuals who:

o Organize factors of production to produce goods and services.

o Make basic business policy decisions.

o Introduce new inventions and technologies into business practice.

o Look for new business opportunities.

o Take risks of making losses.

Note: Scarcity does not mean shortage. We have already said that 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. Shortage is a specific and short term problem but
scarcity is a universal and everlasting problem.

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2. Choice
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. Due to the problem of scarcity,
individuals, firms and government are forced to choose as to what output to produce, in
what quantity, and what output not to produce. In short, scarcity implies choice. Choice,
in turn, implies cost. That means whenever choice is made, an alternative opportunity is
sacrificed. This cost is known as opportunity cost.

Scarcity → limited resource → limited → we might not satisfy all our

output →choice involves costs → opportunity wants
cost

3. 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.

Definition: 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.

For example, suppose the country spends all of its limited resources on the production of
cloth or computer. If a given amount of resources can produce either one meter of cloth or
20 units of computer, then the cost of one meter of cloth is the 20 units of computer
that must be sacrificed in order to produce a meter of cloth.

When we say opportunity cost, we mean that:

It is measured in goods & services but not in money costs
It should be in line with the principle of substitution.

In conclusion, when opportunity cost of an activity increases people substitute other

activities in its place.

4. The Production Possibilities Frontier or Curve (PPF/ PPC)

The production possibilities frontier (PPF) is a curve that shows the various possible
combinations of goods and services that the society can produce given its resources
and technology. To draw the PPF we need the following assumptions.

a. The quantity as well as quality of economic resource available for use during the year
is fixed.

b. There are two broad classes of output to be produced over the year.
c. The economy is operating at full employment and is achieving full production
(efficiency).
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 d. Technology does not change during the year.
e. Some inputs are better adapted to the production of one good than to the
production of the other (specialization).

Suppose a hypothetical economy produces food and computer given its limited resources
and available technology (table 1.1).

Table 1.1: Alternative production possibilities of a certain nation

Types of products Unit Production alternatives

A B C D E

Food metric tons 500 420 320 180 0

Computer number 0 500 1000 1500 2000

We can also display the above information with a graph.

Food 500 A - All points on the PPF are

attainable and efficient
420 B
Point Q is attainable but
inefficient
-

Point R is unattainable
320

180

-
C .R
Computer
0 500Q 1000 1500D 2000
E
Figure 1.1: Production Possibilities Frontier

The PPF describes three important concepts:

i) The concepts of scarcity: - the society cannot have unlimited amount of outputs even if
it employs all of its resources and utilizes them in the best possible way.

ii) The concept of choice: - any movement along the curve indicates the change in choice.
iii)The concept of opportunity cost: - when the economy produces on the PPF, production
of more of one good requires sacrificing some of another product which is reflected by
the downward sloping PPF. Related to the opportunity cost we have a law known as the
law of increasing opportunity cost. This law states that as we produce more and more
of a product, the opportunity cost per unit of the additional output increases. This
makes the shape of the PPF concave to the origin.

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The reason why opportunity cost increases when we produce more of one good is
that
economic resources are not completely adaptable to alternative uses (specialization effect).

Example: Referring to table 1.1 above, if the economy is initially operating at point B, what is
the opportunity cost of producing one more unit of computer?

Solution: Moving from production alternative B to C we have:

320 420 100
(The economy gives up 0.2 metric tons of food per
OC 500 500
2.0
1000
computer)

5. Economic Growth and the PPF

Economic growth or an increase in the total output level occurs when one or both of
the following conditions occur.

1. Increase in the quantity or/and quality of economic resources.

2. Advances in technology.

Economic growth is represented by outward shift of the PPF.

Food

New PPF

Old PPF

Computer

Figure 1.2: Economic growths with a new PPC

An economy can grow because of an increase in productivity in one sector of the economy.
For example, an improvement in technology applied to either food or computer
would be illustrated by a shift of the PPF along the Y- axis or X-axis. This is called
asymmetric growth (figure 1.3).

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 Computer

Figure 1.3: improvements in technology and quantity and/or quality

of resources on national output

1.5 Basic economic questions

Economic problems faced by an economic system 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. Therefore, any human society should
answer the following three basic questions.

What to Produce?

This problem is also known as the problem of allocation of resources. It implies that every
economy must decide 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. As economic
resources are limited we must reduce the production of one type of good if we want more of
another type. Generally, the final choice of any economy is a combination of the various
types of goods but the exact nature of the combination depends upon the specific
circumstances and objectives of the economy.

How to Produce?

This problem is also known as the problem of choice of technique. Once an economy has
reached a decision regarding the types of goods to be produced, and has determined
their respective quantities, the economy must decide how to produce them - choosing
between alternative methods or techniques of production. For example, cotton cloth can
be produced with hand looms, power looms, or automatic looms. Similarly, wheat can
be grown with primitive tools and manual labour, or with modern machinery and little
labour. 10
Broadly speaking, the various techniques of production can be classified into two
groups: labour-intensive techniques and capital-intensive techniques. A labour-intensive
technique involves the use of more labour relative to capital, per unit of output. A
capital-intensive technique involves the use of more capital relative to labour, per unit of
output. The choice between different techniques depends on the available supplies
of different factors of production and their relative prices. Making good choices is
essential for making the best possible use of limited resources to produce maximum
amounts of goods and services.

For Whom to Produce?

This problem is also known as the problem of distribution of national product. It relates to how
a material product is to be distributed among the members of a society. The economy
must decide, for example, whether to produce for the benefit of the few rich people or for
the large number of poor people. An economy that wants to benefit the maximum
number of persons would first try to produce the necessities of the whole population and
then to proceed to the production of luxury goods.

All these and other fundamental economic problems center around human needs and
wants. Many human efforts in society are directed towards the production of goods and
services to satisfy human needs and wants. These human efforts result in economic
activities that occur within the framework of an economic system.

1.6 Economic systems

The way a society tries to answer the above 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 three types of economic system. These are capitalism, command and mixed
economy.

1.6.1 Capitalist economy

Capitalism is the oldest formal economic system in the world. It became widespread in
the middle of the 19th century. 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. Government intervention in the
economy is minimal. This system is also called free market economy or market system or
laissezfaire.

Features of Capitalistic Economy

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The right to private property: The right to private property is a fundamental feature of a
capitalist economy. As part of that principle, economic or productive factors such as
land, factories, machinery, mines etc. are under private ownership.
 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.

Profit motive: Entrepreneurs, in their productive activity, are guided by the motive of
profit-making.
Competition: In a capitalist economy, competition exists among sellers or producers of
similar goods to attract customers. Among buyers, there is competition to obtain
goods. Among workers, the competition is to get jobs. Among employers, it is to get
workers and investment funds.
Price mechanism: All basic economic problems are solved through the price mechanism.
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.
Self-interest: Each individual is guided by self-interest and motivated by the desire for
economic gain.
Inequalities of income: There is a wide economic gap between the rich and the poor.
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.

Advantages of Capitalistic Economy

Flexibility or adaptability: It successfully adapts itself to changing environments.
Decentralization of economic power: Market mechanisms work as a decentralizing
force against the concentration of economic power.
Increase in per-capita income and standard of living: Rapid growth in levels of
production and income leads to higher per-capita income and standards of living.
New types of consumer goods: Varieties of new consumer goods are developed
and produced at large scale.
Growth of entrepreneurship: Profit motive creates and supports new
entrepreneurial skills and approaches.
Optimum utilization of productive resources: Full utilization of productive resources
is possible due to innovations and technological progress.
High rate of capital formation: The right to private property helps in capital formation.

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Disadvantages of Capitalistic Economy
Inequality of income: Capitalism promotes economic inequalities and creates social
imbalance.
Unbalanced economic activity: As there is no check on the economic system, the
economy can develop in an unbalanced way in terms of different geographic regions
and different sections of society.

Exploitation of labour: In a capitalistic economy, exploitation of labour (for example by

paying low wages) is common.
Negative externalities: are problems in capitalistic economy where profit maximization
is the main objective of firms. If economic makes sense for a firm to force others to
pay the impacts of negative externalities such as pollution.

1.6.2 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. In the recent past, socialism has lost its popularity and most of
the socialist countries are trying free market economies.

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.
Maximum social welfare: Command economy 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.

Advantages of Command Economy

Absence of wasteful competition: There is no place for wasteful use of productive
resources through unhealthy competition.
Balanced economic growth: Allocation of resources through centralized planning
leads to balanced economic development. Different regions and different sectors of
the economy can develop equally.

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 Elimination of private monopolies and inequalities: Command economies avoid the
major evils of capitalism such as inequality of income and wealth, private monopolies,
and concentration of economic, political and social power.

Disadvantages of Command Economy

Absence of automatic price determination: Since all economic activities are
controlled by the government, there is no automatic price mechanism.
Absence of incentives for hard work and efficiency: The entire system depends on
bureaucrats who are considered inefficient in running businesses. There is no
financial incentive for hard work and efficiency. The economy grows at a relatively
slow rate.

Lack of economic freedom: Economic freedom for consumers, producers, investors,

and employers is totally absent, and all economic powers are concentrated in the
hands of the government.

Red-tapism: it is widely prevalent in a command economy because all decisions are

made by government officials.

1.6.3 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.

Main Features of Mixed Economy

Co-existence of public and private sectors: Public and private sectors co-exist in this
system. Their respective roles and aims are well-defined. Industries of national
and strategic importance, such as heavy and basic industry, defense production,
power generation, etc. are set up in the public sector, whereas consumer-goods
industry and small-scale industry are developed through the private sector.

Economic welfare: Economic welfare is the most important criterion of the success of a
mixed economy. 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.

Economic planning: The government uses instruments of economic planning to achieve

co-ordinated rapid economic development, making use of both the private and the
public sector.

Price mechanism: The price mechanism operates for goods produced in the private
sector, but not for essential commodities and goods produced in the public sector.
Those prices are defined and regulated by the government.

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 Economic equality: Private property is allowed, but rules exist to prevent concentration
of wealth. Limits are fixed for owning land and property. Progressive taxation,
concessions and subsides are implemented to achieve economic equality.

Advantages of Mixed Economy

Private property, profit motive and price mechanism: All the advantages of a
capitalistic economy, such as the right to private property, motivation through the
profit motive, and control of economic activity through the price mechanism, are
available in a mixed economy. At the same time, government control ensures that
they do not lead to exploitation.

Adequate freedom: Mixed economies allow adequate freedom to different

economic units such as consumers, employees, producers, and investors.
Rapid and planned economic development: Planned economic growth takes place,
resources are properly and efficiently utilized, and fast economic development
takes place because the private and public sector complement each other.

Social welfare and fewer economic inequalities: The government‘s restricted control
over economic activities helps in achieving social welfare and economic equality.

Disadvantages of Mixed Economy

Ineffectiveness and inefficiency: A mixed economy might not actually have the usual
advantages of either the public sector or the private sector. The public sector might
be inefficient due to lack of incentive and responsibility, and the private sector
might be made ineffective by government regulation and control.

Economic fluctuations: If the private sector is not properly controlled by the

government, economic fluctuations and unemployment can occur.
Corruption and black markets: if government policies, rules and directives are not
effectively implemented, the economy can be vulnerable to increased corruption
and black market activities.

1.7 Decision making units and the circular flow model

There are three decision making units in a closed economy. These are households, firms
and the government.

i) Household: A household can be one person or more who live under one roof and
make joint financial decisions. Households make two decisions.

a) Selling of their resources, and

b) Buying of goods and services.

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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.
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.

The three economic agents interact in two markets:

o Product market: it is a market where goods and services are transacted/ exchanged.
That is, a market where households and governments buy goods and services
from business firms.

o 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.

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

For simplicity, let‘s first see a two sector model where we have only households and
business firms. In this case, therefore, we see the flow of goods and services from
producers to households and a flow of resources from households to business firms.

In the following diagram, the clock – wise direction shows the flow of economic resources
and final goods and services. Business firms sell goods and services to households in
product markets (upper part of the diagram). On the other hand, the lower part
shows, where households sell factors of production to business firms through factor market.
The anti – clock wise direction indicates the flow of birr (in the form of revenue, income
and spending on consumption). Firms, by selling goods and services to households, receive
money in the form of revenue which is consumption expenditure for households in the
product market. On the other hand, households by supplying their resources to firms
receive income. This represents expenditure by firms to purchase factors of production
which is used as an input to produce goods and services.

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 A Two sector model

MARKETS
Revenue FOR Spending
GOODS AND SERVICES
•Firms sell
Goods Goods and
•Households buy
and services services
sold bought

FIRMS HOUSEHOLDS
•Produce and sell •Buy and consume
goods and services
goods and services
•Own and sell factors
•Hire and use factors
of production
ofproduction

MARKETS Labour, land,

Factors of and capital
FOR
production
FACTORS OF PRODUCTION
•Households sell Income
Wages, rent, and •Firms buy
interest
= Flow of inputs
and outputs
= Flow of Birr

Figure 1.4: Circular flow of income with two sector model

We have also a three sector model in which the government is involved in the
economic activities. As shown in figure 1.5 below, the only difference of the three sector
model from the two sector model is that it involves government participation in the market.
The government to provide public services purchase goods and services from business firms
through the product market with a given amount of expenditure. On the other hand, the
government also needs resources required for the provision of the services. This resource is
purchased from the factor market by making payments to the resource owners (households).

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 A Three sector model

MARKETS
Revenue
FOR Spending
GOODS AND SERVICES
•Firms sell
Goods
•Households buy Goods and
and services
Goods services
sold and services bought
Expenditure
sold

GOVERNMENT
Subsidy Income support
• Provide social
services
FIRMS HOUSEHOLD S
• Provide supports
•P g •H o

Taxes Taxes Buy and consume

•
ro uce andsell
• Collect taxes goods and services
d ds andservices
• Buy goods and Own and sell factors

•
oo and usefactors Gov’t services Gov’t services
ire oduction
services of production
f • Hire and uses
pr factors of production

Factors of Payments
production Labour ,land,
Factors of
and capital
production MARKETS
FOR
FACTORS OF PRODUCTION Income
Wages, rent, •Households sell
•Firms buy = Flow of inputs
and interest
and outputs
= Flow of Birr

Figure 1.5: Three sector circular flow of resources

The service provided by the government goes to the households and business firms.
The government might also support the economy by providing income support to the
households and subsidies to the business firms. At this point you might ask the source
of government finance to make the expenditures, payments and additional supports
to the firms and households. The main source of revenue to the government is
the tax collected from households and firms.

18
Chapter summary

Economics is a social science which studies about efficient allocation of scarce resources so
as to attain the maximum fulfillment of unlimited human needs. Economics has two
main ranches: Microeconomics (deals with the economic behavior of individual economic
units and individual economic variables) and Macroeconomics (deals with the functions of
the economy as a whole).

Resources can be categorized as free resources (that are free gifts of nature, are unlimited
in supply) and economic resources (that are scarce such as land, labor, capital
and entrepreneurship).

Production Possibility Curve (PPC) is a curve that depicts all possible combinations of the
maximum output that can be produced in an economy with given resources and technology.
Economic system is a legal and institutional framework within which various economic
activities take place. In economics there are three basic alternative economic systems such
as Capitalistic economy, Command economy and Mixed economy. In a closed economy,
the major decision-making units are households, firms, and the government.

Review questions
Part I: Discussion questions
1. Define economics from perspective of Wealth, Welfare, Scarcity, and Growth. Which
definition more suits for economics? Why?

2. Why we study economics? Have you gained anything from this chapter? Would you
discuss them please?

3. Define scarcity, choice and opportunity cost. Can you link them in your day to day lives?
4. What do you understand by positive economics and normative economics?
5. Explain why economics deals with allocation and efficient utilization of scarce resources
only?

6. In recent years, especially around big cities, there is the problem of air pollution and the
likelihood of poisoning is high. Given this scenario, do you think that air is free resource?
Justify your answer.

7. Describe the four categories of economic resources. Which category of resources you
and your family owned?

8. What is a production possibility curve?

9. Discuss the economic system in Ethiopia over the recent three regimes (EPRDF, Derg and
imperial regime)

10. What are the central problems of an economy? Discuss them in detail.
19
Part II: Work out items

1. Assume that a certain simplified economy produces only two goods, X and Y, with given
resources and technology. The following table gives the various possible combinations of
the production of the two goods (all units are measured in millions of tons).

Opportunity Cost of
Production Possibility Good X Good Y Good X
A 0 100
B 2 90
C 4 60
D 6 20

a) Calculate the opportunity cost of the production of good X at each point. What law
does the trend in those values exhibit?

b) What changes are required for this economy to shift the PPF outward?

Suggested reading materials

A. Koutsoyiannis, Modern Microeconomics, 2nd edition, 1979
D.N.Dwivedi, 1997, Micro Economic Theory, 3rd edition., Vikas Publishing
R. S. Pindyck and D. L. Rubinfeld, Microeconomics, 2nd edition,1992
Varian, 2010, Intermediate Microeconomics: A Modern Approach, 8thedition
C.L.Cole, Micro Economics: A Contemporary Approach.
Ferguson & Gould‘s, 1989, Microeconomic Theory, 6th edition.
E. Mansfield, 1988, Microeconomics:Theory and Applications
Arnold, 2008, Microeconomics, 8thedition, International student edition

20
 Chapter Two
Theory of Demand and Supply
Introduction

Having learnt about the concept and meaning of economics as a subject and its nature,
scope, different systems and various other fundamentals in the previous chapter, we now
resort to a very important issue in economics. This is the issue of how free markets
operate. In this chapter we will forward our exploration and understanding of the vast
field of economics by focusing on two very powerful tools, namely, theory of demand and
theory of supply.

The purpose of this chapter is to explain what demand and supply are and show how
they determine equilibrium price and quantity. We will also show how the concepts of
demand and supply reveal consumers‘ and producers‘ sensitivity to price change.

Chapter 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

2.1 Theory of demand

1. Are demand and want similar? Why?

2. Why can’t we purchase all that we need or we desire to have?
3. Can we say that, with a decrease in the price of a commodity, a consumer
normally buys more of it? Why?
4. Explain why demand curves always slope downwards from left to right. Are
this? to exceptions any there

Demand is one of the forces determining prices. The theory of demand is related to
the economic activities of consumers-consumption. Hence, the purpose of the theory of
demand is to determine the various factors that affect demand.

In our day-to-day life we use the word ‗demand‘ in a loose sense to mean a desire of a
person to purchase a commodity or service. But in economics it has a specific meaning,
which is different from what we use it in our day to day activities.

21
Demand implies more than a mere desire to purchase a commodity. It states that the
consumer must be willing and able to purchase the commodity, which he/she desires.
His/her desire should be backed by his/her purchasing power. A poor person is willing to
buy a car; it has no significance, since he/she has no ability to pay for it. On the other hand,
if his/her desire to buy the car is backed by the purchasing power then this constitutes
demand. Demand, thus, means the desire of the consumer for a commodity backed by
purchasing power. These two factors are essential. If a consumer is willing to buy but is
not able to pay, his/her desire will not become demand. Similarly, if the consumer has
the ability to pay but is not willing to pay, his/her desire will not be called demand.

More specifically, demand refers to various quantities of a commodity or service that

a consumer would purchase at a given time in a market at various prices, given other
things unchanged (ceteris paribus). The quantity demanded of a particular commodity
depends on the price of that commodity.

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

2.1.1 Demand schedule (table), demand curve and demand function

The relationship that exists between price and the amount of a commodity purchased can
be represented by a table (schedule) or a curve or an equation.

Demand schedule can be constructed for any commodity if the list of prices and
quantities purchased at those prices are known. An individual demand schedule is a list of
the various quantities of a commodity, which an individual consumer purchases at various
levels of prices in the market. A demand schedule states the relationship between price and
quantity demanded in a table form.

Table 2.1 Individual household demand for orange per week

Combinations A B C D E

Price per kg 5 4 3 2 1

Quantity demand/week 5 7 9 11 13

22
Demand curve is a graphical representation of the relationship between different quantities
of a commodity demanded by an individual at different prices per time period.

5 A
4 B

3 C

2 D

1 E

0 X Quantity demanded
55 7 9 13
Figure 2.1: Individual demand curve

In the above diagram prices of oranges are given on ‗OY‘ axis and quantity demanded on ‗OX‘
axis. For example, when the price per kilogram is birr 1 the quantity demanded is
13 kilograms. From the above figure you may notice that as the price declines quantity
demanded increases and vice-versa.

Demand function is a mathematical relationship between price and quantity demanded,

all other things remaining the same. A typical demand function is given by:

Qd=f(P)

where Q d is quantity demanded and P is price of the commodity, in our case price of orange.

Example: Let the demand function be Q = a+ bP

Q P

b= (e.g. moving from point A to B on figure 2.1 above)

7 5 b= 2, where b is the slope of the demand curve

4

Q = a-2P, to find a, substitute price either at point A or B.

7= a-2(4), a = 15

Therefore, Q=15-2P is the demand function for orange in the above numerical example.

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.

23
 Table 2.2: Individual and market demand for a commodity

Price Individual demand Market

Consumer-1 Consumer-2 Consumer-3 deman
8 0 0 0 d
0
5 3 5 1 9
3 5 7 2 14
0 7 9 4 20

The following graph depicts market demand curve at price equal to 3

P rice Price Price Price

3 + 3 + 3 = 3

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

Figure 2.2: Individual and Market demand curve

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 the market
demand function is given by:

P= 10 - Q /2 ↔ Q /2 =10-P ↔ Q= 20 - 2P and Qm = (20 – 2P) 100 =2000-200P

2.1.2 Determinants of demand

The demand for a product is influenced by many factors. Some of these factors are:
I. Price of the product
II. Taste or preference of consumers
III. Income of the consumers
IV. Price of related goods
V. Consumers expectation of income and
VI. price Number of buyers in the market

24
When we state the law of demand, we kept all the factors to remain constant except the price
of the good. A change in any of the above listed factors except the price of the good will
change the demand, while a change in the price, other factors remain constant will bring
change in quantity demanded. A change in demand will shift the demand curve from its
original location. For this reason those factors listed above other than price are called
demand shifters. A change in own price is only a movement along the same demand curve.

Changes in demand: a change in any determinant of demand—except for the good‘s price-
causes the demand curve to shift. We call this a change in demand. If buyers choose
to purchase more at any price, the demand curve shifts rightward—an increase in
demand. If buyers choose to purchase less at any price, the demand curve shifts
leftward—a decrease in demand.

Price 1 When demand increases, demand

curve shifts upward (D 1) while a
decrease in demand shifts demand
2
curve downwards (D 2).
D1

D0
D2
Quantity

Figure 2.3: Shift in demand curve

Now let us examine how each factor affect demand.

I. Taste or preference

When the taste of a consumer changes in favour of a good, her/his demand will increase
and the opposite is true.

II. Income of the consumer

Goods are classified into two categories depending on how a change in income affects
their demand. These are normal goods and inferior goods. Normal Goods are goods whose
demand increases as income increase, while inferior goods are those whose demand is
inversely related with income. In general, inferior goods are poor quality goods with
relatively lower price and buyers of such goods are expected to shift to better quality
goods as their income increases. However, the classification of goods into normal and
inferior is subjective and it is usually dependent on the socio-economic development of the
nation.

25
III. Price of related goods

Two goods are said to be related if a change in the price of one good affects the demand
for another good.

There are two types of related goods. These are substitute and complimentary
goods. Substitute goods are goods which satisfy the same desire of the consumer. For
example, tea and coffee or Pepsi and Coca-Cola are substitute goods. If two goods are
substitutes, then price of one and the demand for the other are directly related.
Complimentary goods, on the other hand, are those goods which are jointly consumed. For
example, car and fuel or tea and sugar are considered as compliments. If two goods are
complements, then price of one and the demand for the other are inversely related.

IV. Consumer expectation of income and price

Higher price expectation will increase demand while a lower future price expectation
will decrease the demand for the good.

V. Number of buyer in the market

Since market demand is the horizontal sum of individual demand, an increase in the number
of buyers will increase demand while a decrease in the number of buyers will decrease
demand.

2.1.3 Elasticity of demand

1. List some goods/commodities you think that increase in their prices will not
significantly decrease their quantity demanded.
2. Can you list some products for which increase in their prices will significantly
demanded? quantity their decrease/increase

In economics, the concept of elasticity is very crucial and is used to analyze the
quantitative relationship between price and quantity purchased or sold. Elasticity is
a measure of responsiveness of a dependent variable to changes in an independent
variable. Accordingly, we have the concepts of elasticity of demand and elasticity of supply.

Elasticity of demand refers to the degree of responsiveness of quantity demanded of a good

to a change in its price, or change in income, or change in prices of related goods.
Commonly, there are three kinds of demand elasticity: price elasticity, income
elasticity, and cross elasticity.

26
 i. Price Elasticity of Demand

Price elasticity of demand means degree of responsiveness of demand to change in price.

It indicates how consumers react to changes in price. The greater the reaction the greater
will be the elasticity, and the lesser the reaction, the smaller will be the elasticity. Price
elasticity of demand is a measure of how much the quantity demanded of a good responds
to a change in the price of that good, computed as the percentage change in quantity
demanded divided by the percentage change in price.

Demand for commodities like clothes, fruit etc. changes when there is even a small change
in their price, whereas demand for commodities which are basic necessities of life, like salt,
food grains etc., may not change even if price changes, or it may change, but not in
proportion to the change in price.

Price elasticity demand can be measured in two ways. These are point and arc elasticity.

a. Point Price Elasticity of Demand

This is calculated to find elasticity at a given point. The price elasticity of demand can be
determined by the following formula. %%
QP
pd

d
E

Percentage change in quantity demanded

percentage change in price

where1 Qd % 0
X100 and
Q Q
Q0
1 0
P % X100
P PP
0

X 100
P Q

Q P
P Q

Q1 Q Q1 Q0
Pd

0 0
0
E

.
.

Q X 100
0

Thus,
0
P
1
P
0
P
In this method, we take a straight-line demand curve joining the two axes, and measure
the elasticity between two points Q o and Q 1 which are assumed to be intimately close
to each other.

27
Y

R In the diagram ‗RP‘ is the straight-line

demand curve, which connects both axes.
In the beginning at the price ON the
N Qo quantity demanded is OM. Then the price
∆P changes to ON 1 and the new quantity
N1 N1 Q1
demanded will be OM 1. The symbol ‗∆P‘
∆Q
represents the change in price while the
symbol ‗∆Q‘ shows the change in quantity
O M M1 P Quan demanded.
1 .1.1.1.1.1.1.1 D
tity
Figure 2.4: Point elasticity of demand

On a straight-line demand curve we can make use of this formula to find out the price
elasticity at any particular point. We can find out numerical elasticities also on different
points of the demand curve with the help of the above formula. It should be
remembered that the point elasticity of demand on a straight line is different at every point.

b. Arc price elasticity of demand

The main drawback of the point elasticity method is that it is applicable only when we
have information about even the slight changes in the price and the quantity
demanded of the commodity. But in practice, we do not acquire such information about
minute changes. We may possess demand schedules in which there are big gaps in price
as well as the quantity demanded. In such cases, there is an alternative method known
as arc method of elasticity measurement.

In arc price elasticity of demand, the midpoints of the old and the new values of both price
and quantity demanded are used. It measures a portion or a segment of the demand curve
between the two points. An arc is a portion of a curve line, hence, a portion or segment
of a demand curve.

The formula for measuring arc elasticity is given below.

Change in price
Original
Change in quantity plus new
demanded Original price plus
Ed
new price
quantity demanded
Symbolically,
Q1 the formula
P may be expressed thus:
0

d
QQ P
1

1
E
Qo
P
o
28
Here, Q o = Original quantity demanded
Q1 = New quantity demanded

Po = Original price
P1 = New price

We can take a numerical example to illustrate arc elasticity. 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. In terms of the above formula, the value of the arc elasticity will be

9 21
100 10 3
110 = =-- =
110 4 210 9 7
100 5

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. If the
price elasticity of demand is positive the product is inferior.

i) If 1,demand is said to be elastic and the product is luxury product

ii) If 0 1,demand is inelastic and the product is necessity

iii) If 1,demand is unitary elastic.

iv) If 0,demand is said to be perfectly inelastic.

v) If , demand is said to be perfectly elastic.

Determinants of price Elasticity of Demand

The following factors make price elasticity of demand elastic or inelastic other than changes
in the price of the product.

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- run, price elasticity of demand tends to be elastic. Because:
More substitute goods could be produced.
People tend to adjust their consumption pattern.
iii) The proportion of income consumers spend for a product:-the smaller the
proportion of income spent for a good, the less price elastic will be.
iv) The importance of the commodity in the consumers’ budget :
Luxury goods tend to be more elastic, example: gold.
Necessity goods tend to be less elastic example: Salt.

29
 ii. Income Elasticity of Demand

It is a measure of responsiveness of demand to change in income.

Q I
I Q
% Qd
Id

.
% I

Point income elasticity of demand:

Id

i) If 1, the good is luxury good.

Id

ii) If 1( and positive), the good is necessity good,

Id

iii) If 0,(negative), the good is inferior good.

iii. Cross price Elasticity of Demand

Measures how much the demand for a product is affected by a change in price of another
good.
P Q

Qx
%%

Qx
y
1

o
= .
P Qx
x
0
1

Py
xy
P
y
0
y
i) The cross – price elasticity of demand for substitute goods is positive.
ii) The cross – price elasticity of demand for complementary goods is negative.
iii) The cross – price elasticity of demand for unrelated goods is zero.

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

Calculate the cross –price elasticity of demand between the two goods. What can you say
about the two goods?
Qx
o

* .* 10 . 10
P Py Qx 1000
15 1500
10 1500 500
5 1500 67.0
o

xy
y

Therefore, the two goods are complements.

30
 2.2 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.

The law of supply: states that, ceteris paribus, as price of a product increase, quantity
supplied of the product increases, and as price decreases, quantity supplied decreases. It
tells us there is a positive relationship between price and quantity supplied.

2.2.1 Supply schedule, supply curve and supply function

A supply schedule is a tabular statement that states the different quantities of a

commodity offered for sale at different prices.

Table 2.3: an individual seller’s supply schedule for butter

Price ( birr per kg) 30 25 20 15 10

Quantity supplied kg/week 100 90 80 70 60

A supply curve conveys the same information as a supply schedule. But it shows the
information graphically rather than in a tabular form.

In this diagram the quantities of

oranges are measured along X axis
Supply curve
and prices along Y axis. The supply
curve slopes upward as we go from
the left to the right. This means, as
the price rises, more is offered for
sale and vice-versa.

Quantity

Figure 2.5 supply curve

The supply of a commodity can be briefly expressed in the following functional relationship:

S = f(P), where S is quantity supplied and P is price of the commodity.

Market supply: It is derived by horizontally adding the quantity supplied of the product by all
sellers at each price.

31
Table 2.4: Derivation of the market supply of good X

Price per Quantity Quantity Quantity Market

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

2.2.2 Determinants of supply

Apart from the change in price which causes a change in quantity demanded, the supply of
a particular product is determined by:

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.

i) Effect of change in input price on supply of a product

An increase in the price of inputs such as labour, raw materials, capital, etc causes a
decrease in the supply of the product which is represented by a leftward shift of the
supply curve. Likewise, a decrease in input price causes an increase in supply.

ii) Effect of change in Technology

Technological advancement enables a firm to produce and supply more in the market.
This shifts the supply curve outward.

iii) Effect of change in weather condition

A change in weather condition will have an impact on the supply of a number of

products, especially agricultural products. For example, other things remain unchanged,
good weather

32
condition boosts the supply of agricultural products. This shifts the supply curve of a given
agricultural product outward. Bad weather condition will have the opposite impact.

Activity: Discuss how supply is affected by the changes in prices of related goods, taxes
& subsidies, sellers’ expectations of future price of the product, and the number of
sellers in the market?

2.2.3 Elasticity of supply

It is the degree of responsiveness of the supply to change in price. It may be defined as

the percentage change in quantity supplied divided by the percentage change in price. As
the case with price elasticity of demand, we can measure the price elasticity of supply using
point and arc elasticity methods. However, a simple and most commonly used method is
point method.

The point price elasticity of supply can be calculated as the ratio of proportionate change
in quantity supplied of a commodity to a given proportionate change in its price. Thus,
the formula for measuring price elasticity of supply is:
% ℎ
Q

PP

QP

PQ
*
Q

=
% ℎ
=

Like elasticity of demand, price elasticity of supply can be elastic, inelastic, unitary elastic,
perfectly elastic or perfectly inelastic. The supply is elastic when a small change on price leads
to great change in supply. It is inelastic or less elastic when a great change in price
induces only a slight change in supply. If the supply is perfectly inelastic, it will be
represented by a vertical line shown as below. If supply is perfectly elastic it will be
represented by a horizontal straight line as in second diagram.

Infinite elasticity or
S perfectly elastic
P S
Perfectly
inelastic or
zero
elasticity
Supply
O

0 Supply

Figure 2.6: Perfectly inelastic and perfectly elastic supply curves

33
 2.3 Market equilibrium

Having seen the demand and supply side of the market, now let‘s bring demand and
supply together so as to see how the market price of a product is determined. Market
equilibrium occurs when market demand equals market supply.

-
Price At point ‗E‘ market
D S demand equals market
supply (equilibrium point)
H J

-
P is the market
(P1)
equilibrium (market
(P) E clearing) price.

-
G F M is the market
(P2) equilibrium (market
clearing) quantity.
S D

Quantity
M

Figure 2.7: market equilibrium

In the above graph, any price greater than P will lead to market surplus. As the price of
the commodity increases, consumers demand less of the product. On the other hand, as the
price of increases, producers supply more of the good. Therefore, if price increases to P 1
the market will have a surplus of HJ. If the price decreases to P 2 buyers demand to buy more
and suppliers prefer to decrease their supply leading to shortage in the market which is equal
to GF.

Numerical example: Given market demand: Q d= 100-2P, and market supply: P =( Q s /2) + 10
a) Calculate the market equilibrium price and quantity
b) Determine, whether there is surplus or shortage at P= 25 and P= 35.

Solution:

a) At equilibrium, Q d= Qs
100 – 2P = 2P – 20

4P =120

P ,30andQ 40

b) Qd(at P = 25) = 100-2(25) =50 and Qs(at P = 25 ) = 2(25) -20 =30

Therefore, there is a shortage of: 50 -30 =20 units

Qd( at P=35) = 100-2(35) = 30 and Qs (at p = 35) = 2(35)-20 = 50, a surplus of 20 units
34
Effects of shift in demand and supply on equilibrium

Given demand and supply the equilibrium price and quantity are stable. However, when
these market forces change what will happen to the equilibrium price and quantity?
Changes in demand and supply bring about changes in the equilibrium price level and
the equilibrium quantity.

i) when demand changes and supply remains constant

Factors such as changes in income, tastes, and prices of related goods will lead to a change
in demand. The figure below shows the effects of a change in demand and the
resultant equilibrium price and quantity. DD is the demand curve and SS is the supply curve.

S
D
1
D

D2
P1

P E
D1
P2 E2
D
D2
S
Quantity

M2 M M1
Figure 2.8: The effect of change in demand on market equilibrium

DD and SS curves intersect at point E and the quantity demanded and supplied is OM at OP
equilibrium price. Given the supply, if the demand increases the demand curve will
shift upward to the right. Due to a change in demand, the demand curve D 1D 1 intersects SS
supply curve at point E 1. The equilibrium price increases from OP to OP 1 and the equilibrium
quantity from OM to OM 1. On the other hand, if demand falls, the demand curve shifts
downwards to the left. Due to a change in demand, the curve D 2D 2 intersects the supply
curve SS at point E 2. The equilibrium price decreases from OP to OP 2 and the equilibrium
quantity decreases from OM to OM 2. Supply being given, a decrease in demand reduces
both the equilibrium price and the quantity and vice versa.

35
ii. When supply changes and demand remains constant
Changes in supply are brought by changes in technical knowledge and factor prices.
The following graph explains the effects of changes in supply.

S2
D S
S1

E2
P2
E
P
E1
P1

S2 S
S1 D

M2 M M1 Quantity

Figure 2.9: The effect of change in supply on market equilibrium

SS and DD intersect at point E, where supply and demand are equal at OM quantity at OP
equilibrium price. Given the demand, if the supply increases, the supply curve shifts to
the right (S 1S 1). The new supply curve, which intersects DD curve at E 1, reduces the
equilibrium price from OP to OP 1 and increases the equilibrium quantity from OM to
OM 1. On the contrary, when the supply falls, the supply curve moves to the left (S2S2) and
intersects the DD curve at point E 2 raising the equilibrium price from OP to OP 2 and
reducing the equilibrium quantity from OM to OM 2.

III) Effects of combined changes in demand and supply

When both demand and supply increase, the quantity of the product will increase
definitely. But it is not certain whether the price will rise or fall. If an increase in demand is
more than an increase in supply, then the price goes up. On the other hand, if an increase
in supply is more than an increase in demand, the price falls but the quantity increases. If
the increase in demand and supply is same, then the price remains the same.

When demand and supply decline, the quantity decreases. But the change in price will
depend upon the relative fall in demand and supply. When the fall in demand is more than
the fall in supply, the price will decrease. On the other hand, when the fall in supply is more
than the fall in demand, the price will rise. If both demand and supply decline in the same
ratio, there is no change in the equilibrium price, but the quantity decreases.

36
 Activity: Considering the initial market equilibrium offigure 2.9 above, show the
new equilibrium
1. if there is an increase in supply and proportionate increase in demand
2. if the magnitude of an increment in demand is less than an increment in
supply
3. if demand and supply change in the opposite directions

Chapter summary
Demand for a commodity refers to the amount that will be purchased at a particular
price during a particular period of time. Price of the commodity, income of the consumer,
prices of related goods, consumer‘s tastes and preferences, consumers‘ expectations and
number of buyers are considered the main determinants of demand for a commodity. The
law of demand states that, other things remaining constant, the quantity demanded of a
commodity increases when its price falls and decreases when the price rises.

Supply refers to the quantity of a commodity which producers are willing to produce and
offer for sale at a particular price during a particular period of time. Price of a
commodity, input prices, prices of related products, techniques of production, policy of
taxation and subsidy, expectations of future prices, and the number of sellers are the
main determinants of supply. Law of supply states that other things remaining the same,
the quantity of any commodity that firms will produce and offer for sale rises with a rise in
price and falls with a fall in price.

Market equilibrium refers to a situation in which quantity demanded of a commodity equals

the quantity supplied of a commodity.

Goods can be categorized as normal good (a good for which the demand increases
with increases in income), an inferior good (a good for which the demand tends to fall
with an increase in the income of the consumer), substitute goods(are those goods which
satisfy the same type of demand and can be used in place of one another),
complementary goods( are those goods which are used jointly or together), and giffen
goods(whose demand falls with a fall in their prices).

Elasticity of demand refers to the degree of responsiveness of quantity demanded of

a commodity to change in any of its determinants. There are three types of elasticity of
demand:

Price elasticity of demand, income elasticity of demand and cross price elasticity of demand.
Price elasticity of demand is determined by availability of substitutes, nature of the
commodity, proportion of income spent and time.

37
 Review questions
Part I: Distinguish between the following:
1. Normal goods and inferior goods
2. Complementary goods and substitute goods
3. Market demand and individual demand
4. Individual supply and market supply
5. Excess demand and excess supply

Part II: Short answer and workout

1. Why does the quantity of salt demanded tend to be unresponsive to changes in its price?

2. Why is the quantity of education demanded in private universities much more

responsive than salt is to changes in price?

3. To get the market demand curve for a product, why do we add individual demand
curves horizontally rather than vertically?

4. The market for lemon has 10 potential consumers, each having an individual demand
curve P = 101 - 10Q i, where P is price in dollars per cup and Qiis the number of cups
demanded per week by the ith consumer. Find the market demand curve using algebra.
Draw an individual demand curve and the market demand curve. What is the
quantity demanded by each consumer and in the market as a whole when lemon is
priced at P = $1/cup?

5. The demand for tickets to an Ethiopian Camparada film is given by D(p)= 200,000-
10,000p, where p is the price of tickets.If the price of tickets is 12 birr, calculate price
elasticity of demand for tickets and draw the demand curve

6. Given market demand Q d = 50 - P, and market supply P = Qs + 5

A) Find the market equilibrium price and quantity?

B) What would be the state of the market if market price was fixed at Birr 25 per unit?

C) Calculate and interpret price elasticity of demand at the equilibrium point.

38
7. Based on the following table which indicates expenditure of the household on a
commodity, answer the questions that follow ( The price of the good is Br.10
)

Income Quantity
( Br. / month) Demanded (
units / month )
10,000 50
20,000 60
30,000 70
40,000 80
50,000 90

A) Calculate income elasticity of demand, if income increases from Br.10, 000 to Br.
20,000 and if income increases from Br.40, 000 to Br. 50,000.
B) Is this a normal or an inferior or a luxury good? Justify.
C) Does the proportion of household income spent on this good increase or decrease as
income increases? .Why?

8. When price of tea in local café rises from Br. 10 to 15 per cup, demand for coffee rises
from 3000 cups to 5000 cups a day despite no change in coffee prices.
A) Determine cross price elasticity.
B) Based on the result, what kind of relation exists between the two goods?

Suggested reading materials

A. Koutsoyiannis, Modern Microeconomics, 2nd edition, 1979
D.N.Dwivedi, 1997, Micro Economic Theory, 3rd edition., Vikas Publishing
R. S. Pindyck and D. L. Rubinfeld, Microeconomics, 2nd edition,1992
Varian, 2010, Intermediate Microeconomics: A Modern Approach, 8thedition
C.L.Cole, Micro Economics: A Contemporary Approach.
Ferguson & Gould‘s, 1989, Microeconomic Theory, 6th edition.
E. Mansfield, 1988, Microeconomics:Theory and Applications
Arnold, 2008, Microeconomics, 8thedition, International student edition

39
 Chapter Three
Theory of Consumer Behaviour

Introduction

In our day –to- day life, we buy different goods and services for consumption. As consumer,
we act to derive satisfaction by using goods and services. But, have ever thought of how
your mother or any other person whom you know decides to buy those consumption
goods and services? Consumer theory is based on what people like, so it begins with
something that we can‘t directly measure, but must infer. That is, consumer theory is based
on the premise that we can infer what people like from the choices they make.

Consumer behaviour can be best understood in three steps. First, by examining

consumer‘s preference, we need a practical way to describe how people prefer one
good to another. Second, we must take into account that consumers face budget
constraints – they have limited incomes that restrict the quantities of goods they can
buy. Third, we will put consumer preference and budget constraint together to determine
consumer choice.

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

3.1 Consumer preferences

A consumer makes choices by comparing bundle of goods. Given any two consumption
bundles, the consumer either decides that one of the consumption bundles is strictly better
than the other, or decides that she is indifferent between the two bundles.

In order to tell whether one bundle is preferred to another, we see how the consumer
behaves in choice situations involving two bundles. If she always chooses X when Y is
available, then it is natural to say that this consumer prefers X to Y. We use the symbol ≻
to mean that one bundle is strictly preferred to another, so that X ≻Y should be
interpreted as saying that the consumer strictly prefers X to Y, in the sense that she
definitely wants the X-bundle rather than the Y-bundle. If the consumer is indifferent
between two bundles of goods, we use the symbol

40
∼ and write X~Y. Indifference means that the consumer would be just as satisfied,
according to her own preferences, consuming the bundle X as she would be consuming
bundle Y. If the consumer prefers or is indifferent between the two bundles we say that she
weakly prefers X to Y and write X ⪰ Y.

The relations of strict preference, weak preference, and indifference are not
independent concepts; the relations are themselves related. For example, if X ⪰ Y and Y
⪰ X, we can conclude that X ~Y. That is, if the consumer thinks that X is at least as good as Y
and that Y is at least as good as X, then she must be indifferent between the two bundles of
goods. Similarly, if X ⪰ Y but we know that it is not the case that X~ Y, we can conclude
that X≻Y. This just says that if the consumer thinks that X is at least as good as Y, and
she is not indifferent between the two bundles, then she thinks that X is strictly better than
Y.

3.2 The concept of utility

Economists use the term utility to describe 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. Given any two consumption bundles X and Y, the consumer
definitely wants the X-bundle than the Y-bundle if and only if the utility of X is better than the
utility of Y.

Do you think that utility and usefulness are synonymous? Do two individuals always derive
equal satisfaction from consuming the same level of a product?

In defining utility, it is important to bear in mind the following points.

‗Utility’ and ‘Usefulness’ are not synonymous. For example, paintings by Picasso may be
useless functionally but offer great utility to art lovers. Hence, usefulness is
product centric whereas utility is consumer centric.

Utility is subjective. The utility of a product will vary from person to person. That means,
the utility that two individuals derive from consuming the same level of a product
may not be the same. For example, non-smokers do not derive any utility from
cigarettes.

Utility can be different at different places and time. For example, the utility that we get
from drinking coffee early in the morning may be different from the utility we get
during lunch time.

41
 3.3 Approaches of measuring utility

How do you measure or compare the level of satisfaction (utility) that you obtain from goods
and services?

There are two major approaches to measure or compare consumer‘s utility: cardinal
and ordinal approaches. The cardinalist school postulated that utility can be measured
objectively. According to the ordinalist school, utility is not measurable in cardinal
numbers rather the consumer can rank or order the utility he derives from different goods
and services.

3.3.1 The cardinal utility theory

According to the cardinal utility theory, utility is measurable by arbitrary unit of

measurement called utils in the form of 1, 2, 3 etc. For example, we may say that
consumption of an orange gives Bilen 10 utils and a banana gives her 8 utils, and so on.
From this, we can assert that Bilen gets more satisfaction from orange than from banana.

3.3.1.1 Assumptions of cardinal utility theory

The cardinal approach is based on the following major assumptions.

1. Rationality of consumers. The main objective of the consumer is to maximize his/her
satisfaction given his/her limited budget or income. Thus, in order to maximize
his/her satisfaction, the consumer has to be rational.

2. Utility is cardinally measurable. According to the cardinal approach, the utility or

satisfaction of each commodity is measurable. Utility is measured in subjective
units called utils.

3. Constant marginal utility of money. A given unit of money deserves the same value at
any time or place it is to be spent. A person at the start of the month where he has
received monthly salary gives equal value to 1 birr with what he may give it after three
weeks or so.

4. Diminishing marginal utility (DMU). The utility derived from each successive units of a
commodity diminishes. In other words, the marginal utility of a commodity diminishes as
the consumer acquires larger quantities of it.

5. The total utility of a basket of goods depends on the quantities of the individual
commodities. If there are n commodities in the bundle with quantities n ,
the total utility is given by TU = f ( n ).

42
 3.3.1.2 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. As the consumer consumes more of a good
per time period, his/her total utility increases. However, there is a saturation point
for that commodity beyond which the consumer will not be capable of enjoying any greater
satisfaction from it.

Marginal Utility (MU) is the extra satisfaction a consumer realizes from an additional unit of
the product. In other words, marginal utility is the change in total utility that results from
the consumption of one more unit of a product. Graphically, it is the slope of total utility.

Mathematically, marginal utility is:

TU
MU
Q

where, TU is the change in total utility, and Q is the change in the amount of
product consumed.

To explain the relationship between TU and MU, let us consider the following
hypothetical example.

Table 3.1: Total and marginal utility

Quantity Total utility (TU) Marginal 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

The total utility first increases, reaches the maximum (when the consumer consumes 6
units) and then declines as the quantity consumed increases. On the other hand, the
marginal utility continuously declines (even becomes zero or negative) as quantity consumed
increases.

43
Graphically, the above data can be depicted as follows.

TU

30

TU

18
0

2 6 Quantity Consumed

MU

Quantity Consumed
0

2 6

Figure 3.1: Total and marginal utility curves

As it can be observed from the above figure,

When TU is increasing, MU is positive.
When TU is maximized, MU is zero.
When TU is decreasing, MU is negative.

3.3.1.3 Law of diminishing marginal utility (LDMU)

Is the utility you get from consumption of the first orange the same as the second or the
third orange?

The law of diminishing marginal utility 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. In other words,
the extra satisfaction that a consumer derives declines as he/she consumes more and
more of the product in a given period of time. This gives sense in that the first banana a
person consumes gives him more marginal utility than the second and the second banana
also gives him higher marginal utility than the third and so on (see figure 3.1).
44
The law of diminishing marginal utility is based on the following assumptions.
The consumer is rational
The consumer consumes identical or homogenous product. The commodity to
be consumed should have similar quality, color, design, etc.
There is no time gap in consumption of the good
The consumer taste/preferences remain unchanged

3.3.1.4 Equilibrium of a consumer

The objective of a rational consumer is to maximize total utility. As long as the additional unit
consumed brings a positive marginal utility, the consumer wants to consumer more of
the product because total utility increases. However, given his limited income and the price
level of goods and services, what combination of goods and services should he consume so
as to get the maximum total utility?

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.

MUX

Proof
Given the utility function

If the consumer buys commodity X, then his expenditure will be . The consumer
maximizes the difference between his utility and expenditure.

Max(U QX )

The necessary condition for maximization is equating the derivative of a function to

zero. Thus,

dU 0
dQ X dQX

dU 0 MUX
dQ X

45
 MUX
A

C
PX

MUX
QX

Figure 3.2: Equilibrium condition of consumer with only one commodity

At any point above point C (like point A) where MU X > P X, it pays the consumer to consume
more. When MU X < P X (like point B), the consumer should consume less of X. At point C
where MU X = P X the consumer is at equilibrium.

b) the case of two or more commodities

For the case of two or more goods, the consumer‘s equilibrium is achieved when the
marginal utility per money spent is equal for each good purchased and his money income
available for the purchase of the goods is exhausted. That is,

= and + =M

where, M is the income of the consumer.

Example: Suppose Saron has 7 Birr to be spent on two goods: banana and bread. The
unit price of banana is 1 Birr and the unit price of a loaf of bread is 4 Birr. The total
utility she obtains from consumption of each good is given below.

Table 3.2: Utility schedule for two commodities

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

46
 Recall that utility is maximized when the condition of marginal utility of one commodity
divided by its market price is equal to the marginal utility of the other commodity divided
by its market price.

MU 1 MU 2
P1 P2

In table 3.2, there are two different combinations of the two goods where the MU of the
last birr spent on each commodity is equal. However, only one of the two
combinations is consistent with the prices of the goods and her income. Saron will be at
equilibrium when she consumes 3 units of banana and 1 loaf of bread. At this equilibrium,

i) MU1/P1 = MU2/P2
3 1

banana MUbread 12
MU 3
banana Pbread 4
P

ii) P1.Q1+ P2.Q2= M

(1*3) + (4*1) = 7

The total utility that Saron derives from this combination can be given by:
TU= TU1+ TU 2

TU= 14 + 12
TU= 26

Given her fixed income and the price level of the two goods, no combination of the two
goods will give her higher TU than this level of utility.

Limitation of the cardinal approach

1. The assumption of cardinal utility is doubtful because utility may not be quantified. Utility
cannot be measured absolutely (objectively).

2. The assumption of constant MU of money is unrealistic because as income increases,

the marginal utility of money changes.

3.3.2 The ordinal utility theory

In the ordinal utility approach, 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 but 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. Therefore, the consumer need not
know in specific units the utility of various commodities to make his choice. It suffices for
him to be able to rank the various baskets of goods according to the satisfaction that each
bundle gives him.
47
 3.3.2.1 Assumptions of ordinal utility theory
The ordinal approach is based on the following assumptions.
Consumers are rational - they maximize their satisfaction or utility given their income
and market prices.
]

Utility is ordinal - utility is not absolutely (cardinally) measurable. Consumers are

required only to order or rank their preference for various bundles of commodities.

Diminishing marginal rate of substitution: The marginal rate of substitution is the rate
at which a consumer is willing to substitute one commodity for another commodity
so that his total satisfaction remains the same. The rate at which one good can be
substituted for another in consumer‘s basket of goods diminishes as the consumer
consumes more and more of the good.

The total utility of a consumer is measured by the amount (quantities) of all items
he/she consumes from his/her consumption basket.

Consumer’s preferences are consistent. For example, if there are three goods in a given
consumer‘s basket, say, X, Y, Z and if he prefers X to Y and Y to Z, then the consumer is
expected to prefer X to Z. This property is known as axioms of transitivity.

The ordinal utility approach is explained with the help of indifference curves. Therefore,
the ordinal utility theory is also known as the indifference curve approach.

3.3.2.2 Indifference set, curve and map

Indifference set/ schedule is a combination of goods for which the consumer is indifferent.
It shows the various combinations of goods from which the consumer derives the same
level of satisfaction.

Consider a consumer who consumes two goods X and Y (table 3.3).

Table 3.3: Indifference schedule

Bundle (Combination) A B C D
Orange 1 2 4 7
Banana 10 6 3 1

In table 3.3 above, each combination of good X and Y gives the consumer equal level of total
utility. Thus, the individual is indifferent whether he consumes combination A, B, C or D.

Indifference curve: When the indifference set/schedule is expressed graphically, it is called an

indifference curve. An indifference curve shows different combinations of two goods which
yield the same utility (level of satisfaction) to the consumer. A set of indifference curves
is called indifference map.

48
 A

10
B
6

C
IC3
3

D IC2
1

IC1
Orange
1 2 4 7 Orange

i) Indifference curve ii) Indifference map

Figure 3.3: Indifference curve and indifference map

3.3.2.3 Properties of indifference curves

1. Indifference curves have negative slope (downward sloping to the right). Indifference
curves are negatively sloped because the consumption level of one commodity can be
increased only by reducing the consumption level of the other commodity. In other words, in
order 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. This implies that the slope of an indifference
curve decreases (in absolute terms) as we move along the curve from the left downwards to
the right. The convexity of indifference curves is the reflection of the diminishing marginal
rate of substitution. This assumption implies that the commodities can substitute one another
at any point on an indifference curve but are not perfect substitutes.

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 it denotes. Baskets of goods on a
higher indifference curve are preferred by the rational consumer because they contain more
of the two commodities than the lower ones.

4. Indifference curves never cross each other (cannot intersect). The assumptions of
consistency and transitivity will rule out the intersection of indifference curves. Figure 3.4
shows the violations of the assumptions of preferences due to the intersection of indifference
curves.

49
 A

B
IC2
C
IC1

Good X
Figure 3.4: Intersection of indifference curves

In the above figure, the consumer prefers bundle B to bundle C. On the other hand,
following indifference curve 1 (IC1), the consumer is indifferent between bundle A and C,
and along indifference curve 2 (IC2) the consumer is indifferent between bundle A and B.
According to the principle of transitivity, this implies that the consumer is indifferent
between bundle B and C which is contradictory or inconsistent with the initial statement
where the consumer prefers bundle B to C. Therefore, indifference curves never cross each
other.
22

3.3.2.4 Marginal rate of substitution (MRS)

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. It shows a consumer‘s willingness to substitute one good for another
while he/she is indifferent between the bundles.

Marginal rate of substitution of X for Y is defined as the number of units of commodity Y that
must be given up in exchange for an extra unit of commodity X so that the consumer
maintains the same level of satisfaction. Since one of the goods is scarified to obtain more
Y X

of the other good, the MRS is negative. Hence, usually we take the absolute value of the
MRS
slope.

Number of units of Ygiven up

Number of units of X gained

To understand the concept, consider the following indifference curve.

30 A

IC
20 B

12 C
Good X
8 D

5 10 15 20
50
Figure 3.5: Indifference curve for two products X and Y
From the above graph, MRS X,Yassociated with the movement from point A to B, point B to C
and point C to D is 2.0,1.6, and 0.8 respectively. That is, for the same increase in the
consumption of good X, the amount of good Y the consumer is willing to scarify diminishes.
This principle of marginal rate of substitution is reflected by the convex shape of
the indifference curve and is called diminishing marginal rate of substitution.

It is also possible to derive MRS using the concept of marginal utility. MRS is related to
MUX and MU Y as follows.
MU
X

XY
MRS , MU
Y

Proof: Suppose the utility function for two commodities X and Y is defined as:

Since utility is constant along an indifference curve, the total differential of the utility
function will be zero.
UX

UY

dU dY 0
dX

MU dY MRS MU dX MRS
X

Similarly,
MU dX MU dY
Y

2
Example: Suppose a consumer‘s utility function is given by . Find MRS X,Y
MU
X

Solution: MRS XY
,
MU
Y

2
UX

U Y

2 MU 42
X

MUX
4 and MUY 2 Hence, MRS 4
MU XY
Y

3.3.2.5 The budget line or the price line

Do you think that the indifference curve discussed in the previous section tells us whether a
given combination of goods is affordable to the consumer? If no, what are the major
constraints to the consumer in maximizing his/her total utility?

Indifference curves only tell us about consumer preferences for any two goods but they
cannot show which combinations of the two goods will be bought. In reality, the
consumer is constrained by his/her income and prices of the two commodities. This
constraint is often presented with the help of the budget line.

51
The budget line is a set of the commodity bundles that can be purchased if the entire income
is spent. It 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.

In order to draw a budget line facing a consumer, we consider the following assumptions.
There are only two goods bought in quantities, say, X and Y.
Each consumer is confronted with market determined prices, P X and P Y.
The consumer has a known and fixed money income (M).

Assuming that the consumer spends all his/her income on the two goods (X and Y), we
can express the budget constraint as:

By rearranging the above equation, we can derive the following general equation of a
budget line.
MP
P P
X
Y

X
Y

Graphically,

Good Y

M/PY A

Good X
M/PX
Figure 3.6: The budget line

Note that:
P P
X

(the ratio of the prices of the two goods).

The slope of the budget line is given is by
Y

Any combination of the two goods within the budget line (such as point A) or along the
budget line is attainable.

Any combination of the two goods outside the budget line (such as point B)
is unattainable (unaffordable).

52
Example: A consumer has $100 to spend on two goods X and Y with prices $3 and $5
respectively. Derive the equation of the budget line and sketch the graph.

Solution: The equation of the budget line can be derived as follows.

Y
M
3X 5Y 100

20
5Y 100 3X

3 5
Y 100 X
5
Y 20 3 5
X X
33.3

When the consumer spends all of her income on good Y, we get the Y- intercept
(0,20). Similarly, when the consumer spends all of her income on good X, we obtain the X-
intercept (33.3,0). Using these two points we can sketch the graph of the budget line.

Recall that a budget is drawn for given prices and fixed consumer‘s income. Hence,
the changes in prices or income will affect the budget line.

Change in income: If the income of the consumer changes (keeping the prices of the
commodities unchanged), the budget line also shifts (changes). Increase in income causes
an upward/outward shift in the budget line that allows the consumer to buy more
goods and services and decreases in income causes a downward/inward shift in the budget
line that leads the consumer to buy less quantity of the two goods. It is important to note
that the slope of the budget line (the ratio of the two prices) does not change when income
rises or falls.

Good Y

M/Py

M/Px

Good X

Figure 3.7: Effects of increase (right) and decrease (left) in income on the budget line

53
Change in prices: An equal increase in the prices of the two goods shifts the budget line
inward. Since the two goods become expensive, the consumer can purchase the lesser
amount of the two goods. An equal decrease in the prices of the two goods, one the other
hand, shifts the budget line out ward. Since the two goods become cheaper, the consumer
can purchase the more amounts of the two goods.

Good Y

M/Py

Good X
M/Px
Figure 3.8: Effect of proportionate increase (inward) and decrease (out ward) in the prices
of both goods

An increase or decrease in the price of one of the two goods, keeping the price of the
other good and income constant, changes the slope of the budget line by affecting only the
intercept of the commodity that records the change in the price. For instance, if the price
of good X decreases while both the price of good Y and consumer‘s income remain
unchanged, the horizontal intercept moves outward and makes the budget line flatter. The
reverse is true if the price of good X increases. On the other hand, if the price of good Y
decreases while both the price of good X and consumer‘s income remain unchanged,
the vertical intercept moves upward and makes the budget line steeper. The reverse is
true for an increase in the price of good Y.

Good Y

Good X
Figure 3.9: Effect of decrease in the price of only good X on the budget line

54
 3.3.2.6 Equilibrium of the consumer

The preferences of a consumer (what he/she wishes to purchase) are indicated by

the indifference curve. The budget line specifies different combinations of two goods (say
X and Y) the consumer can purchase with the limited income. Therefore, a rational
consumer tries to attain the highest possible indifference curve, given the budget line. This
occurs at the point where the indifference curve is tangent to the budget line so that the
slope of the indifference curve (MRSXY) is equal to the slope of the budget line( / ). In
figure 3.10, the equilibrium of the consumer is at point ‗E‘ where the budget line is
tangent to the highest attainable indifference curve (IC 2).

Y* E
IC3

IC2
IC1

X
X*

Figure 3.10: Consumer equilibrium under indifference curve approach

Mathematically, consumer optimum (equilibrium) is attained at the point where:

Slope of indifference curve = Slope of the budget line
P P
X

MRS XY
Y
P P

MU
X
X

MU
Y

Example: A consumer consuming two commodities X and Y has the utility function

) 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 MRS at equilibrium.

55
 Solution
a) The budget constraint of the consumer is given by:
PX.X+ P Y.Y = M
4X+2Y= 60 …………….…………. (i)

Moreover, at equilibrium
MU
P P
X
X

MU
Y
Y
Y

2 42
X
Y

2 2
X

Y 2X 2………….………… (ii)

Substituting equation (ii) into (i), we obtain Y 14 and X 8.

MU Y 2 14 2
b) MRS
X

2
MU X 8
Y

(At the equilibrium, MRS can also be calculated as the ratio of the prices of the two
goods)

56
Chapter summary

A consumer makes choices by comparing bundle of goods. Given any two consumption
bundles, the consumer either decides that one of the consumption bundles is strictly better
than the other, or decides that he is indifferent between the two bundles. Economists use
the term utility to describe the satisfaction or pleasure derived from consumption of a
good or service. In other words, utility is the power of the product to satisfy human wants.

There are two approaches to measure or compare consumer‘s utility derived from
consumption of goods and services. These are cardinal and ordinal approaches. The
cardinalist school postulated that utility can be measured objectively. However, the
assumption of cardinal utility is doubtful because utility may not be quantified. Unlike the
cardinal theory, the ordinal utility theory says that utility cannot be measured in absolute
terms but the consumer can rank or order the utility he derives from different goods and
goods.

The ordinal/indifference curve approach is based on the consumer‘s budget line

and indifference curves. An indifference curve shows all combinations of two goods which
yield the same total utility to a consumer and the budget line represents all
combinations of two products that the consumer can purchase, given product prices and
his or her money income. The consumer is in equilibrium (utility is maximized) at the
point where the budget line is tangent to the highest attainable indifference curve.

57
 Review questions

Part I: Discussion questions

1. Explain briefly the following concepts.

A) Utility
B) Indifference curve
C) Law of diminishing marginal utility
D) Budget line
E) Consumer preference
F) Marginal rate of substitution
2. What is the basic difference between cardinal and ordinal approaches of utility?
3. Elaborate the justifications for the negative slope and convexity of indifference curve.
4. Standard indifference curves cannot intersect each other. Why?
5. Does the change in income affect the slope of the budget line? Explain.

Part III: Workout

1. A person has $ 100 to spend on two goods X and Y whose respective prices are $3 and $5.
A. Draw the budget line.
B. What happens to the original budget line if the budget falls by 25%?
C. What happens to the original budget line if the price of X doubles?
D. What happens to the original budget line if the price of Y falls to $4?

2. A rational consumer spends all of her income on two goods: Apple and Banana. Suppose
the last dollar spent on Apple increased her total utility from 60 utils to 68 utils and the
last dollar spent on Banana increased her total utility from 25 utils to 29 utils. If the price
of a unit of Apple is 2 Birr, what is the price of a unit of Banana at equilibrium?

3. Given utility function U= where P X= 12 Birr, Birr, P Y= 4 Birr and the income of the
consumer is, M= 240 Birr.

A. Find the utility maximizing combinations of X and Y.

B. Calculate marginal rate of substitution of X for Y (MRSX,Y) at equilibrium and interpret
your result.

58
4. Suppose a particular consumer has 8 birr to be spent on two goods, A and B. The unit price
of good A is 2 birr and the unit price of B is 1 birr. The marginal utility (MU) she gets from
consumption of the goods is given below.

Quantity
1 36 30
2 24 22
3 20 16
4 18 12
5 16 10
6 10 4

A) Based on the cardinal analysis, what is the combination of the two goods that
gives maximum utility to the consumer?

B) What is the total utility at the utility maximization level?

Suggested reading materials

A. Koutsoyiannis, Modern Microeconomics, 2nd edition, 1979
D.N.Dwivedi, 1997, Micro Economic Theory, 3rd edition., Vikas Publishing
R. S. Pindyck and D. L. Rubinfeld, Microeconomics, 2nd edition,1992
Varian, 2010, Intermediate Microeconomics: A Modern Approach, 8thedition
C.L.Cole, Micro Economics: A Contemporary Approach.
Ferguson & Gould‘s, 1989, Microeconomic Theory, 6th edition.
E. Mansfield, 1988, Microeconomics: Theory and Applications
Arnold, 2008, Microeconomics, 8thedition, International student edition

59
 Chapter Four
The Theory of Production and Cost

Introduction

This chapter has two major sections. The first part will introduce you to the basic concepts
of production and production function, classification of inputs, essential features of
short run production functions and the stages of short run production. The second part
mainly deals with the difference between economic cost and accounting cost, the
characteristics of short run cost functions, and the relationship between short run
production functions and short run cost functions.

Chapter objectives
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
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

4.1 Theory of production in the short run

4.1.1 Definition of production

Raw materials yield less satisfaction to the consumer by themselves. In order to get
better utility from raw materials, they must be transformed into outputs. However,
transforming raw materials into outputs requires inputs such as land, labour, capital and
entrepreneurial ability. Production is the process of transforming inputs into outputs. It can
also be defined as an act of creating value or utility. The end products of the production
process are outputs which could be tangible (goods) or intangible (services).

4.1.2 Production function

Production function is a technical relationship between inputs and outputs. It shows

the maximum output that can be produced with fixed amount of inputs and the
existing technology. A production function may take the form of an algebraic equation, table
or graph. A general equation for production function can, for instance, be described as:

60
 Q= f(X ,X
1 ,X
2 ,...,X
3 )n

where, Q is output and X1, X2, X3,…,Xn are different types of inputs.

Inputs are commonly classified as fixed inputs or variable inputs. Fixed inputs are those inputs
whose quantity cannot readily be changed when market conditions indicate that an
immediate adjustment in output is required. In fact, no input is ever absolutely fixed but
may be fixed during an immediate requirement. For example, if the demand for Beer
rises suddenly in a week, the brewery factories cannot plant additional machinery
overnight and respond to the increased demand. Buildings, land and machineries are
examples of fixed inputs because their quantity cannot be manipulated easily in a short
period of time. Variable inputs are those inputs whose quantity can be altered almost
instantaneously in response to desired changes in output. That is, their quantities can
easily be diminished when the market demand for the product decreases and vice versa.
The best example of variable input is unskilled labour.

Does a short run refer to specific period of time that is applicable to every firm or industry?
If this condition is rather unique to the firm, industry or economic variable being studied,
what is our basis to classify production as a short run?

In economics, short run refers to a period of time in which the quantity of at least one input
is fixed. In other words, short run is a time period which is not sufficient to change the
quantities of all inputs so that at least one input remains fixed. Here it should be
noted that short run periods of different firms have different durations. Some firms can
change the quantity of all their inputs within a month while it takes more than a year for
other types of firms. This sub-section is confined to production with one variable input and
one fixed input.

Consider a firm that uses two inputs: capital (fixed input) and labour (variable input). Given
the assumptions of short run production, the firm can increase output only by increasing
the

amount of labour it uses. Hence, its production function can be given

by: Q = f (L)

where, Q is output and L is the quantity of labour.

The production function shows different levels of output that the firm can produce
by efficiently utilizing different units of labour and the fixed capital. In the above short
run production function, the quantity of capital
61 is fixed. Thus, output can change only
when the amount of labour changes.
 4.1.3 Total, average, and marginal product

In production, the contribution of a variable input can be described in terms of total, average
and 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. Increasing the variable
input (while some other inputs are fixed) can increase the total product only up to a
certain point. Initially, as we combine more and more units of the variable input with the
fixed input, output continues to increase, but eventually if we employ more and more unit
of the variable input beyond the carrying capacity of the fixed input, output tends to
decline. In general, the TP function in the short-run follows a certain trend: 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. This tells us what
shape a total product curve assumes.

Marginal Product (MP): it is the change in output attributed to the addition of one unit of the
variable input to the production process, other inputs being constant. For instance, the
change in total output resulting from employing additional worker (holding other inputs
constant) is the marginal product of labour (MPL). In other words, MPL measures the
Q L

dTP
slope ofL the total product curve at a given point.

MP
dL

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. That is, as we continue to
combine more and more of the variable input with the fixed input, the marginal product of
the variable input increases initially and then declines.

Average Product (AP): Average product of an input is the level of output that each unit of
input produces, on the average. It tells us the mean contribution of each variable input to
the total product. Mathematically, it is the ratio of total output to the number of the
variable input. The average product of labour (AP L), for instance, is given by:

TP
L

Average product of labour first increases, reaches its maximum value and eventually
declines. The AP curve can be measured by the slope of rays originating from the origin to a
point on the TP curve (see figure 4.1). For example, the AP L at L2 is the ratio of TP 2 to L2. This
is identical to the 62 slope of ray a.
Output
a

TP3

TP2 TP

TP1

Units of labour (variable input)

L1 L2 L3

APL
MPL

APL

L3 Units of labour (variable input)

L1 L2
MPL

Figure 4.1: Totalproduct, average product and marginal product curves

The relationship between MP L and APL can be stated as follows.

When APL is increasing, MP L> APL.
When APL is at its maximum, MP L= APL.
When APL is decreasing, MP L< APL.

Example: Suppose that the short-run production function of certain cut-flower firm is
given by: Q= 4KL -0.6K2 where Q is quantity of cut-flower produced, L is labour
input and K is fixed capital input (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?

63
Solution:
Q 4KL -0.6K2 0.6K2 15 20L -15 -0.1L 2
a) = = 4K - -0.1L = 20 - -0.1L =
L L L L L

b) When total product (Q) is maximum, MP will be zero.

Q (4KL -0.6K2 )
= = 4K -0.2L = 0
L L
20
20 -0.2L = 0 L= = 100
0.2

Hence, total output will be the maximum when 100 workers are employed.

c) Substituting the optimal values of labor (L=100) and capital (K=5) into the original
production function (Q):
Qmax = 4KL -0.6K 2 -0.1L 2 = 4* 5* 100 -0.6* 52 -0.1* 1002 = 985

4.1.4 The law of variable proportions

The law of variable proportions states that 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. For example, if additional workers are hired to work with a constant amount of
capital equipment, output will eventually rise by smaller and smaller amounts as more
workers are hired.

This law assumes that technology is fixed and thus the techniques of production do not
change. Moreover, all units of labour are assumed to be of equal quality. Each successive
worker is presumed to have the same innate ability, education, training, and work
experience. Marginal product ultimately diminishes not because successive workers are less
skilled or less energetic rather it is because more workers are being used relative to the
amount of plant and equipment available. The law starts to operate after the marginal
product curve reaches its maximum (this happens when the number of workers exceeds L1
in figure 4.1). This law is also called the law of diminishing returns.

4.1.5 Stages of production

We are not in a position to determine the specific number of the variable input (labour) that
the firm should employ because this depends on several other factors than the
productivity of labour. However, it is possible to determine the ranges over which the
variable input (labour) be employed. To this end, economists have defined three stages of
short run production.

64
Stage I: This stage of production covers the range of variable input levels over which the
average product (APL) continues to increase. It goes from the origin to the point where the
APL is maximum, which is the equality of MPL and APL (up to L2 level of labour
employment in figure 4.1). This stage is not an efficient region of production though the MP
of variable input is positive. The reason is that the variable input (the number of
workers) is too small to efficiently run the fixed input so that the fixed input is
under-utilized (not efficiently utilized).

Stage II: It ranges from the point where APL is at its maximum (MPL=APL) to the point where
MPL is zero (from L2to L3 in figure 4.1). Here, as the labour input increases by one unit,
output still increases but at a decreasing rate. Due to this, the second stage of production is
termed as the stage of diminishing marginal returns. The reason for decreasing average
and marginal products is due to the scarcity of the fixed factor. That is, once the
optimum capital-labour combination is achieved, employment of additional unit of the
variable input will cause the output to increase at a slower rate. As a result, the marginal
product diminishes. This stage is the efficient region of production. Additional inputs are
contributing positively to the total product and MP of successive units of variable input
is declining (indicating that the fixed input is being optimally used). Hence, the efficient
region of production is where the marginal product of the variable input is declining but
positive.

Stage III: In this stage, an increase in the variable input is accompanied by decline in the total
product. Thus, the total product curve slopes downwards, and the marginal product of
labour becomes negative. This stage is also known as the stage of negative marginal
returns to the variable input. The cause of negative marginal returns is the fact that the
volume of the variable inputs is quite excessive relative to the fixed input; the fixed input is
over-utilized. Obviously, a rational firm should not operate in stage III because additional
units of variable input are contributing negatively to the total product (MP of the variable
input is negative). In figure 4.1, this stage is indicated by the employment of labour beyond
L3.

4.2 Theory of costs in the short run

4.2.1 Definition and types of costs

To produce goods and services, firms need factors of production or simply 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.

65
Economists use the term ―profit‖ differently from the way accountants use it. To
the accountant, profit is the firm‘s total revenue less its explicit costs (accounting costs).
To the economist, economic profit is total revenue less economic costs (explicit and implicit
costs).
Accounting cost is the monetary value of all purchased inputs used in production; it ignores
the cost of non-purchased (self-owned) inputs. It considers only direct expenses
such as wages/salaries, cost of raw materials, depreciation allowances, interest on
borrowed funds and utility expenses (electricity, water, telephone, etc.). These costs are
said to be explicit costs. Explicit costs are out of pocket expenses for the purchased inputs.
If a producer calculates her cost by considering only the costs incurred for purchased
inputs, then her profit will be an accounting profit.

Accounting profit = Total revenue – Accounting cost = Total revenue – Explicit cost

In the real world economy, entrepreneurs may use some resources which may not have
direct monetary expense since the entrepreneur can own these inputs himself or herself.
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. For example,
if Mr. X quits a job which pays him Birr 10, 000.00 per month in order to run a firm he has
established, then the opportunity cost of his labour is taken to be Birr 10,000.00 per month
(the salary he has forgone in order to run his own business). Therefore, economic cost is
given by the sum of implicit cost and explicit cost.

Economicprofit =Total revenue – Economic cost (Explicit cost + Implicit cost)

Economic profit will give the real profit of the firm since all costs are taken into account.
Accounting profit of a firm will be greater than economic profit by the amount of implicit
cost. 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.

4.2.2 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.

In the short run, total cost (TC) can be broken down in to two – total fixed cost (TFC) and total
variable cost (TVC). By fixed costs we mean costs which do not vary with the level of output.
They are regarded as fixed because these costs are unavoidable regardless of the level
of output. The firm can avoid fixed costs only 66
if he/she stops operation (shuts down the
business). The fixed costs may include salaries of administrative staff, expenses for building
depreciation
and repairs, expenses for land maintenance and the rent of building used for
production. Variable costs, on the other hand, include all costs which directly vary with the
level of output. For example, if the firm produces zero output, the variable cost is zero.
These costs may include the cost of raw materials, the cost of direct labour and the
running expenses of fuel, water, electricity, etc.

In general, the short run total cost is given by the sum of total fixed cost and total variable
cost. That is,

TC = TFC + TVC
Based on the definition of the short run cost functions, let‘s see what their shapes look like.

Total fixed cost (TFC): Total fixed cost is denoted by a straight line parallel to the output
axis. This is because 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. The shape
indicates the law of variable proportions in production. At the initial stage of production with
a given plant, as more of the variable factor is employed, its productivity increases. Hence,
the TVC increases at a decreasing rate. This continues until the optimal combination of the
fixed and variable factor is reached. Beyond this point, as increased quantities of the
variable factor are combined with the fixed factor, the productivity of the variable factor
declines, and the TVC increases at an increasing rate.

Total Cost (TC): The total cost curve is obtained by vertically adding TFC and TVC at each
level of output. The shape of the TC curve follows the shape of the TVC curve, i.e. the TC has
also an inverse S-shape. It should be noted that when the level of output is zero, TVC is also
zero which implies TC = TFC.

TC

TVC

TFC

Output

Figure 4.2: Short run TC, TFC and TVC curves

67
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.

a) Average fixed cost (AFC) - Average fixed cost is total fixed cost per unit of output. It is
calculated by dividing TFC by the corresponding level of output. The curve declines
continuously and approaches both axes asymptotically.
TFC
AFC
Q

b) Average variable cost (AVC) - Average variable cost is total variable cost per unit of
output. It is obtained by dividing total variable cost by the level of output.
TVC
AVC
Q
The short run AVC falls initially, reaches its minimum, and then starts to increase. Hence,
the AVC curve has U-shape and the reason behind is the law of variable proportions.

Average total cost (ATC) or simply Average cost (AC) - Average total cost is the total
c)
cost per unit of output. It is calculated by dividing the total cost by the level of output.

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

Marginal Cost (MC)

Marginal cost is defined as the additional cost that a firm incurs to produce one extra unit
of output. In other words, it is the change in total cost which results from a unit change in
output. Graphically, MC is the slope of TC function.
dTC

MC
dQ
In fact, MC is also a change in TVC with respect to a unit change in the level of output.
dTFC dTVC dTVC dTFC 0
, since
dQ dQ
MC
dQ

Given inverse S-shaped TC and TVC curves, MC initially decreases, reaches its minimum and
then starts to rise. From this, we can infer that 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.
68
 AFC
AVC
AC AC
MC MC

AVC

AFC

Q
Q1 Q2

Figure 4.3: Short run AFC, AVC, AC and MC Curves

In the above figure, the AVC curve reaches its minimum point at Q1 level of output and AC
reaches its minimum point at Q 2 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.

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

Solution:
Given TC=2Q3– 2Q2+ Q + 10 a)
TFC = 10 , TVC = 2Q3– 2Q2+ Q

b) AFC = TFC/Q = 10/Q

AVC = TVC/Q = (2Q3– 2Q2 + Q)/Q = 2Q2 – 2Q + 1

AC = TC/Q = (2Q3– 2Q2+ Q + 10)/Q= 2Q2– 2Q + 1 + 10/Q

MC = dC/dQ= 6Q2 – 4Q + 1

c) To find the minimum value of MC,

dMC/dQ = 12Q - 4 = 0
Q = 1/3

MC is minimized when Q = 0.33

69
 The minimum value of MC will be:
MC = 6Q2 – 4Q + 1
= 6(1/3)2-4(1/3) + 1=0.33

To find the minimum value of AVC

dAVC/dQ = 4Q - 2= 0

Q=0.5
AVC is minimized at Q =0.5

The minimum value of AVC will be:

AVC = 2Q2– 2Q + 1

AVC = 2 (0.5)2- 2(0.5) +1

= 0.5 – 1 + 1
= 0.5

4.2.3 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, which is constant. Given these conditions, we can
derive the relation between MC and MP L as well as the relation between AVC and APL.

i) Marginal Cost and Marginal Product of Labour

TVC where TVC

MC ,
Q
L Q

L Q

1
w

. , but
MC MPL
Q

w
Therefore, MC MP
L

The above expression shows that MC and MP Lare inversely related. When initially MP L
increases, MC decreases; when MP L is at its maximum, MC must be at a minimum and
when finally MPL declines, MC increases.

Average Variable Cost and Average Product of Labour

ii)

AVC TVC , where, TVC

Q
LQ

L Q

1
w
Q

AVC . , but AP
L

70
 AVC w
Therefore, APL

This expression also shows inverse relation between AVC and AP L. When AP L increases,
AVC decreases; when AP L is at a maximum, AVC is at a minimum and when finally AP L
declines, AVC increases.

We can also sketch the relationship between these production and cost curves using graphs.

MPL
APL

APL

Labor (L)
MPL

MC
MC
AVC AV
C

Output

Figure 4.4: relationship between short run production and cost curves

From the above figure, we can conclude that the MC curve is the mirror image of MPL curve
and AVC curve is the mirror image of APL curve.

71
Chapter summary

Production is the act of creating those goods or services that have exchange values.
The process of production requires inputs such as land, labor, capital and entrepreneurial
ability. Production function is a technical relationship between inputs and outputs. It
shows the maximum output that can be produced with fixed amount of inputs and
the existing technology. Inputs are commonly classified as fixed inputs or variable inputs.
Fixed inputs are those inputs whose quantity cannot readily be changed when market
conditions indicate that an immediate change in output is required while variable inputs are
those inputs whose quantity can be changed almost instantaneously in response to desired
changes in output.

In economics, short run refers to a period of time in which the quantity of at least one input
is fixed. In the short run, the efficient stage of production where marginal product of the
variable input is positive but declining.

The law of diminishing returns describes what happens to output as a fixed plant is used
more intensively. As successive units of a variable resource such as labor are added to a
fixed plant, beyond some point, the marginal product associated with each additional unit
of a resource declines.

Costs are the monetary values of inputs used for production purpose. Costs of production
may involve explicit costs (costs of purchased inputs) and/or implicit costs (estimated
costs of inputs self-owned inputs). Accounting cost is the monetary value of all purchased
inputs used in production. Economic cost includes the monetary value of both
purchased and non- purchased inputs. Thus, economic cost is the sum of implicit cost and
explicit cost.

In the short run, one or more of a firm‘s inputs are fixed. Fixed costs are constant
irrespective of the level output. A firm cannot avoid these costs even by producing zero
level of output. Variable costs, on the other hand, vary with the level of output directly. In
the short run, the AC, AVC and MC curves assume a U- shape due to the law of variable
proportions. Short run marginal and average variable cost curves are a mirror reflection of
the marginal product and average product of the variable input respectively.

72
Review questions

Part I: Discussion questions

1. Compare and contrast the following concepts.
a) Explicit cost and implicit cost
b) Economic cost and accounting cost
2. What is the main difference between fixed inputs and variable inputs?
3. Explain the law of variable proportions.
4. Which stage of short run production is efficient? Why?
5. Show the relationship between short-run MC and MP L both mathematically
and graphically.

6. Can accounting cost be greater economic cost? Explain.

7. The short run AVC, AC and MC are all U-shaped. Why?

Part II: Workout Questions

1
4

4
1. Suppose the production function is given by Q(L,K) = L K . Assuming capital is fixed,
find APL and MPL.

Consider the following short run production function:

2.
Q 6L2 0.4

a) Find the value of L that maximizes output

b) Find the value of L that maximizes marginal product
c) Find the value of L that maximizes average product
1 3

Given a short run cost function as TC Q3 2Q2 60Q 100, find the minimum value
3.

of AVC and MC.

Suggested reading materials

A. Koutsoyiannis, Modern Microeconomics, 2nd edition, 1979
D.N.Dwivedi, 1997, Micro Economic Theory, 3rd edition., Vikas Publishing
R. S. Pindyck and D. L. Rubinfeld, Microeconomics, 2nd edition,1992
Varian, 2010, Intermediate Microeconomics: A Modern Approach, 8thedition
C.L.Cole, Micro Economics: A Contemporary Approach.
Ferguson & Gould‘s, 1989, Microeconomic Theory, 6th edition.
E. Mansfield, 1988, Microeconomics: Theory and Applications
Arnold, 2008, Microeconomics, 8thedition, International student edition

73
 Chapter Five
Market Structure

Introduction

This chapter discusses how a particular firm makes a decision to achieve its profit maximization
objective. A firm‘s decision to achieve this goal is dependent on the type of market in which it
operates. To this effect we distinguish between four major types of markets:
perfectly competitive market, monopolistically competitive market, oligopolistic market,
and pure monopoly market.

Chapter objectives:

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

5.1. The concept of market in physical and digital space

Comprehensive definition of market according to American Marketing Association (1985) is

the process of planning and executing the conception, pricing, promotion, and distribution
of goods, services and ideas to create exchanges that satisfy individual and
organizational objectives. So market describes place or digital space by which goods,
services and ideas are exchanged to satisfy consumer need.

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. Digital marketing channels are systems on the internet that can create, accelerate
and transmit product value from producer to the terminal consumer by digital networks.
Physical market is a set up where buyers can physically meet their sellers and purchase
the desired merchandise from them in exchange of money. In physical marketing, marketers
will effortlessly reach their target local customers and thus they have more personal
approach to show about their brands. The choice of the marketing mainly depends on the
nature of the products and services.

5.2. Perfectly competitive market

Perfect competition is a market structure characterized by a complete absence of rivalry

among the individual firms.

74
 5.2.1 Assumptions of perfectly competitive market

A market is said to be pure competition (perfectly competitive market) if the

following assumptions are satisfied.

1. Large number of sellers and buyers: under perfect competition the number of sellers is
assumed to be too large that the share of each seller in the total supply of a product is
very small. Therefore, no single seller can influence the market price by changing the
quantity supply. Similarly, the number of buyers is so large that the share of each buyer
in the total demand is very small and that no single buyer or a group of buyers can
influence the market price by changing their individual or group demand for a
product. Therefore, in such a market structure, sellers and buyers are not price makers
rather they are price takers, i.e., the price is determined by the interaction of the market
supply and demand forces.

2. Homogeneous product: homogeneity of the product implies that buyers do

not distinguish between products supplied by the various firms of an industry. Product
of each firm is regarded as a perfect substitute for the products of other firms.
Therefore, no firm can gain any competitive advantage over the other firm.

3. Perfect mobility of factors of production: factors of production are free to move from one
firm to another throughout the economy. This means that labour can move from one job
to another and from one region to another. Capital, raw materials, and other factors
are not monopolized.

4. Free entry and exit: there is no restriction or market barrier on entry of new firms to
the industry, and no restriction on exit of firms from the industry. A firm may enter the
industry or quit it on its accord.

5. Perfect knowledge about market conditions: all the buyers and sellers have full
information regarding the prevailing and future prices and availability of the commodity.

6. No government interference:- government does not interfere in any way with

the functioning of the market. There are no discriminator taxes or subsidies, no
allocation of inputs by the procurement, or any kind of direct or indirect control. That is,
the government follows the free enterprise policy. Where there is intervention by the
government, it is intended to correct the market imperfection.

From these assumptions, a single producer under perfectly competitive market is a price-
taker. That is, at the market price, the firm can supply whatever quantity it would like to
sell. Once the price of the product is determined in the market, the producer takes the
price (Pm in the figure below) as given. Hence, the demand curve (D f) that the firm faces in
this market situation is a horizontal line drawn at the equilibrium price, Pm.
75
 Market demand Market Supply

Pm Df = MR= AR

Qm Quantity Quantity

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

Figure 5.1: Individual and market demand curve

5.2.2 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. Profit is the difference between total revenue and total cost.

Total Revenue (TR): it is the total amount of money a firm receives from a given quantity of
its product sold. It is obtained by multiplying the unit price of the commodity and the
quantity of that product sold.

TR=P X Q, where P = price of the product

Q = quantity of the product sold.

Average revenue (AR):- it is the revenue per unit of item sold. It is calculated by dividing the
total revenue by the amount of the product sold.

TR P.Q
Q
AR = = =>AR = P
Q
Therefore, the firm‘s demand curve is also the average revenue curve.

Marginal Revenue: it is the additional amount of money/ revenue the firm receives by selling
one more unit of the product. In other words, it is the change in total revenue resulting from
the sale of an extra unit of the product. It is calculated as the ratio of the change in total
revenue to the change in the sale of the product.

Q
MR= TR = PxQ Q
(because P is constant) => MR =P
=P Q
Q
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
76
Since the purely competitive firm is a price taker, it will maximize its economic profit only by
adjusting its output. In the short run, the firm has a fixed plant. Thus, it can adjust its
output only through changes in the amount of variable resources. It adjusts its variable
resources to achieve the output level that maximizes its profit.

There are two ways to determine the level of output at which a competitive firm will
realize maximum profit or minimum loss. One method is to compare total revenue and total
cost; the other is to compare marginal revenue and marginal cost.

a) 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.

TC TR

TC,TR

Q0 Qe Q1 Q

Note: The profit maximizing output level is Qe because it is at this output level that the
vertical distance between the TR and TC curves (or profit) is maximized.

b) 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. More specifically, the perfectly competitive
firm maximizes its short-run total profits at the output when the following two conditions are
met:
MR = MC
The slope of MC is greater than slope of MR; or MC is rising).

(that is, slope of MC is greater than zero).

77
Mathematically, ∏ =TR- TC

∏ is maximized when d
0
dQ

d dTR dTC
That is, 0
dQ dQ dQ

MR – MC = 0
MR = MC ……………… First order condition (FOC)

d 2 0
dQ
The
d2 d2TR d2TC second order condition of profit maximization is
dQ 2 2 2 0
dQ dQ
That is,
dMR
dMC
dQ 0
dQ
dMR dMC
dQ dQ
dMC dMR where dMR =slope of MR and dMC =slope of MC
dQ dQ dQ dQ

Therefore, Slope of MC > slope of MR ------- Second order condition (SOC)

Slope of MC > 0 (because the slope of MR is zero)

Graphically, the marginal approach can be shown as follows.

MC, MR MC

MR

Q* Qe Q

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.

78
 Whether the firm in the short- run gets positive or zero or negative profit depends on the level
of ATC at equilibrium. Thus, depending on the relationship between price and ATC, the firm
in the short-run may earn economic profit, normal profit or incur loss and decide to shut-
down business.

i) 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.
MC
AC

MR
P Profit
AC

Q
Qe

Figure 5.4: Economic profit a firm

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

AC

MC

Loss
AC
MR
P

Q
Qe

Figure 5.6: A firm incurring a loss

Normal Profit (zero profit) or break- even point - If the AC is equal to the market price at
iii) equilibrium, the firm gets zero profit or normal profit.

79
 MC AC

P=AC MR
(P=AC)

Qe Q

Figure 5.7: A firm earning a normal profit

[

iv) Shutdown point - The firm will not stop production simply because AC exceeds price in the
short-run. The firm will continue to produce irrespective of the existing loss as far as the
price is sufficient to cover the average variable costs. This means, if P is larger than AVC
but smaller than AC, the firm minimizes total losses. But if P is smaller than AVC, the firm
minimizes total losses by shutting down. Thus, P = AVC is the shutdown point for the firm.

AC

MC AVC

P Shut down point (P=min. AVC)

Qe Q

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=2+10q-4q2+q3

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?

80
Solution

Given: p=$10 and TC= 2+10q - 4q2+q3

A) The profit maximizing output is that level of output which satisfies the following condition

MC=MR &

MC is rising

Thus, we have to find MC& MR first

MR in a perfectly competitive market is equal to the market price. Hence, MR=10

dTR d(10q)
Alternatively,MR where TR= P.q = 10q Thus, MR 10
dq dq

MC= dTC 10 8q 3q2

dq

To determine equilibrium output just equate MC& MR

And then solve for q.

10 – 8q + 3q2= 10
- 8q + 3q2= 0
q (-8 + 3q) = 0
q = 0 or q = 8/3

Now we have obtained two different output levels which satisfy the first order
(necessary) condition of profit maximization

To determine which level of output maximizes profit we have to use the second order test
at the two output levels. That is, we have to see which output level satisfies the second
order condition of increasing MC.
To see this first we determine the slope of MC

dMC
Slope of MC =
dq = -8 + 6q

At q = 0, slope of MC is -8 + 6 (0) = -8 which implies that marginal cost is

decreasing at q = 0. Thus, q = 0 is not equilibrium output because it doesn‘t satisfy
the second order condition.

At q = 8/3, slope of MC is -8 + 6 (8/3) = 8, which is positive, implying that MC is

increasing at q = 8/3

Thus, the equilibrium output level is q = 8/3

B) Above, we have said that the firm maximizes its profit by producing 8/3 units. To determine
the firm‘s equilibrium profit we have to calculate the total revenue that the firm obtains at
this level of output and the total cost of producing the equilibrium level of output.

81
 TR = Price * Equilibrium Output
= $ 10 * 8/3= $ 80/3

TC at q = 8/3 can be obtained by substituting 8/3 for q in the TC function, i.e.,

TC = 2+10 (8/3) – 4 (8/3)2+ (8/3)3 19.18

Thus the equilibrium (maximum) profit is
= TR – TC

= 26.67 – 19.18 = $ 7.48

C) To stay in operation the firm needs the price which equals at least the minimum AVC.
Thus, to determine the minimum price required to stay in business, we have to determine
the minimum AVC.
dAVC
AVC is minimal when derivative of AVC is equal to zero. That is: =0
dQ
Given the TC function: TC = 2+10q – 4q2+q3, TVC = 10q – 4q2+ q3

TVC 10q 4q2 q3

AVC = q = = 10 – 4q + q2
q
dAVC
d10 4(q q)2 0
dq 0
dq
= -4 + 2q = 0
q = 2 i.e. AVC is minimum when output is equal to 2 units.
The minimum AVC is obtained by substituting 2 for q in the AVC function i.e.,
Min AVC = 10 – 4 (2) + 22= 6. Thus, to stay in the market the firm should get a minimum price
of $ 6.

5.2.3 Short run equilibrium of the industry

Since the perfectly competitive firm always produces where P =MR=MC (as long as P exceeds
AVC), the firm‘s short-run supply curve is given by the rising portion of its MC curve above its
AVC, or shutdown point (see figure 5.7).

The industry/market supply curve is a horizontal summation of the supply curves of

the individual firms. Industry supply curve can be obtained by multiplying the individual
supply at various prices by the number of firms, if firms have identical supply curve.

An industry is in equilibrium in the short-run when market is cleared at a given price i.e. when
the total supply of the industry equals the total demand for its product, the prices at
which market is cleared is equilibrium price. When an industry reaches at its equilibrium,
there is no tendency to expand or to contract the output.

82
 5.3. Monopoly market

5.3.1. Definition and characteristics

This is at the opposite end of the spectrum of market structures. Pure monopoly exists when
a single firm is the only producer of a product for which there are no close substitutes. The
main characteristics of this market structure include:

1. Single seller: A pure or absolute monopoly is a one firm industry. A single firm is the only
producer of a specific product or the sole supplier of the product; the firm and the
industry are synonymous.

2. No close substitutes: the monopolist‘s product is unique in that there are no good or
close substitutes. From the buyer‘s view point, there are no reasonable alternatives.
3. Price maker: the individual firm exercises a considerable control over price because it is
responsible for, and therefore controls, the total quantity supplied. Confronted with the
usual down ward sloping demand curve for its product, the monopolist can change
product price by changing the quantity of the product supplied.

4. Blocked entry: A pure monopolist has no immediate competitors because there are
barriers, which keep potential competitors from entering in to the industry. These
barriers may be economic, legal, technological etc. Under conditions of pure
monopoly, entry is totally blocked.

5.3.2. Sources of monopoly

The emergence and survival of monopoly is attributed to the factors which prevent the entry
of other firms in to the industry. The barriers to entry are therefore the sources of monopoly
power. The major sources of barriers to entry are:

i) Legal restriction: Some monopolies are created by law in public interest. Such monopoly
may be created in both public and private sectors. Most of the state monopolies in
the public utility sector, including postal service, telegraph, telephone services, radio
and TV services, generation and distribution of electricity, rail ways, airlines etc…
are public monopolies.

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. For example, Aluminum Company of America
had monopolized the aluminum industry because it had acquired control over almost all
sources of bauxite supply; such monopolies are often called raw material monopolies.

83
 iii) Efficiency: a primary and technical reason for growth of monopolies is economies of scale.
The most efficient plant (probably large size firm,) which produces at minimum cost, can
eliminate the competitors by curbing down its price for a short period and can
acquire monopoly power. Monopolies created through efficiency are known as natural
monopolies.

iv) Patent rights: Patent rights are granted by the government to a firm to produce
commodity
of specified quality and character or to use specified rights to produce the
specified commodity or to use the specified technique of production. Such monopolies
are called to patent monopolies.

5.4. Monopolistically competitive market

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 and
monopoly. The competitive element arises from the existence of large number of firms and
no barrier to entry

or exit. The monopoly element results from differentiated products, i.e. similar but not
identical products.

A seller of a differentiated product has limited monopoly power over customers who prefer
his product to others. His monopoly is limited because the difference between his
product and others are small enough that they are close substitutes for one another.

This market is characterized by:

(i) Differentiated product: the product produced and supplied by many sellers in the
market is similar but not identical in the eyes of the buyers. There is a variety of the
same product.
The difference could be in style, brand name, in quality, or others. Hence, the
differentiation of the product could be real (eg. quality) or fancied (e.g. difference in
packing).

(ii) Many sellers and buyers: there are many sellers and buyers of the product, but
their number is not as large as that of the perfectly competitive market.
(iii) Easy entry and exit: like the PCM, there is no barrier on new firms that are willing and
able to produce and supply the product in the market. On the other hand, if any firm
believes that it is not worth to stay in the business, it may exit.
(iv) Existence of non-price competition: Economic rivals take the form of non-price
competition in terms of product quality, advertisement, brand name, service to
customers, etc. A firm spends money in advertisement to reach the consumers about
the relatively unique character of its 84
product and thereby get new buyers and
develop brand loyalty. Many retail trade activities such as clothing, shoes, soap, etc
are in this type of market structure.
 5.5. Oligopoly market
This is a market structure characterized by:

Few dominant firms: there are few firms although the exact number of firms is
undefined. Each firm produces a significant portion of the total output.
Interdependence: since few firms hold a significant share in the total output of the
industry, each firm is affected by the price and output decisions of rival firms.Therefore,
the distinguishing characteristic of oligopoly is the interdependence among
firms in the industry.

Entry barrier: there are considerable obstacles that hinder a new firm from producing
and supplying the product. The barriers may include economies of scale, legal,
control of strategic inputs, etc.

Products may be homogenous or differentiated. If the product is homogeneous, we

have a pure oligopoly. If the product is differentiated, it will be a
differentiated oligopoly.

Lack of uniformity in the size of firms: Firms differ considerably in size. Some may be
small, others very large. Such a situation is asymmetrical.

Non-price competition: firms try to avoid price competition due to the fear of price wars

etc. This ensures that firms can influence demand and build brand recognition.

A special type of oligopoly in which there are only two firms in the market is known as
duopoly.

Chapter summary

Market models
Characteristics Pure Monopolistic Oligopoly Pure Monopoly
Competition Competition
Number of Large Many Few One or Single
firms
Type of Homogeneous Differentiated Homogeneous Unique, no
product or close
differentiated substitutes
Control over None Some, but within Limited by mutual Significant
price rather narrow limits interdependence and
collusion
Condition of Very easy Relatively easy Considerable Blocked
entry barriers/obstacl
Examples Agricultural Clothes, Shoes es Automobiles
Steel, Local utilities
products

85
Review questions

1. Discuss the main assumptions of perfectly competitive market

2. Describe the feature of monopolistic competition that resembles perfect competitive
and the monopolistic market structure.

3. What is the difference between real and fancied differentiation. Explain using
practical examples.

4. What are the similarities and differences between oligopoly and

monopolistically competitive market structure?

5. A firm operates in a perfectly competitive market. The market price of its product is 4

1 3
birr and the total cost function is given by TC= Q3 5Q2 20Q 50, where TC is the

total cost and Q is the level of output.

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?

Suggested reading materials

A. Koutsoyiannis, Modern Microeconomics, 2nd edition, 1979
Nicholson, W. Microeconomic theory; basic principle and extension. 5thedition
Salvatore, D (2003):Microeconomics; theory and applications, 4th edition
D.N.Dwivedi, 1997, Micro Economic Theory, 3rd edition., Vikas Publishing
R. S. Pindyck and D. L. Rubinfeld, Microeconomics, 2nd edition,1992
Varian, 2010, Intermediate Microeconomics: A Modern Approach, 8thedition
C.L.Cole, Micro Economics: A Contemporary Approach.
Ferguson & Gould‘s, 1989, Microeconomic Theory, 6th edition.
E. Mansfield, 1988, Microeconomics: Theory and Applications
Arnold, 2008, Microeconomics, 8thedition, International student edition

86
 Chapter Six
Fundamental Concepts of Macroeconomics

Introduction

Conventionally, economics is divided into microeconomics and macroeconomics.

Microeconomics studies about the individual decision making behaviour of different
economic units such as households, firms, and government at a disaggregated
level. Whereas, macroeconomics, studies about overall or aggregate behaviour of the
economy, such as economic growth, employment, inflation, distribution of income,
macroeconomic policies and international trade.

This chapter discusses major macroeconomic issues such as measurement of a

country‘s economic performance, macroeconomic problems (fluctuations in economic
system mainly reflected by inflation and unemployment), how budgetary deficit and trade
deficit occur and macroeconomic policies applied to cure the macroeconomic problems.

Chapter objectives
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;
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;

6.1. Goals of macroeconomics

Macroeconomics studies the working of an economy in aggregation or as a whole. And it

aimed at how;
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

87
In other words, the goals of macroeconomics can be given as ways towards full
employment, price stability, economic growth and fair distribution of income among citizens
of a country.

6.2. 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.

Why do we need to study NIA?

It enables us to measure the level of total output in a given period of time, and to explain
the causes for such level of performance.
It enables us to observe the long run trend of the economy.
It provides information to formulate policies and design plans.

6.2.1. Approaches to measure national income (GDP/GNP)

Before discussing different approaches of national income, it is important to understand

about the measure of the economic performance of a given country at large. Generally it is
named as GDP or GNP.

Gross Domestic Product (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. From this definition, we can infer that:
It measures the current production only.
It takes in to account final goods and services only (only the end products of various
production processes) or we do not include the intermediate products in our
GDP calculations. Intermediate goods are goods that are completely used up in the
production of other products in the same period that they themselves are produced.

It measures the values of final goods and services produced within

the boundary/territory of a country irrespective of who owns that output.

In measuring GDP, we take the market values of goods and services (GDP )
where:

o P i = series of prices of outputs produced in different sectors of an economy in

certain period
o Q i = the quantity of various final goods and services produced in an economy

Gross National Product (GNP): 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.

88
GDP and GNP are related as follows:
GNP=GDP + NFI

NFI denotes Net Factor Income received from abroad which is equal to factor income
received from abroad by a country‘s citizens less factor income paid for foreigners to
abroad. Thus, NFI could be negative, positive or zero depending on the amount of factor
income received by the two parties.
If NFI >0, then GNP > GDP
If NFI<0, then GNP < GDP
If NFI =0, then GNP =GDP

Basically, there are three approaches to measure GDP/GNP. These are:

I. Product/value added
II. approach, Expenditure
III. approach and
Income approach

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. In this case, GDP includes only
the values of final goods and services in order to avoid double counting.

Double counting will arise when the output of some firms are used as intermediate inputs
of other firms. For example, we would not include the full price of an automobile in GDP and
then also include as part of GDP the value of the tires that were sold to the automobile
producer. The components of the car that are sold to the manufacturers are called
intermediate goods, and their value is not included in GDP.

There are two possible ways of avoiding double counting.

Taking only the value of final goods and services
Taking the sum of the valued added by all firms at each stage of production

We can illustrate the two scenarios using some hypothetical examples as follows.

89
 I. Taking only the value of final goods and services.
Example:

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

GDP = 9,309+147,413+357,872 = 514,594

GNP = GDP + NFI = 514,594 +87,348 = 601,942

II. Taking the sum of the valued added by all firms at each stage of production
Example:

Stages of production Values of Cost of Value added

output (in intermediat
Farmer birr)500 0 e inputs 500
Oil factory 2000 500 1500
Retailers 2500 2000 500

Note: If all values in the economy were added, GDP would be 5000= (2500+2500). The
problem of double counting is 2500, because of considering intermediate input in the
calculation.

Expenditure Approach: here GDP is measured by adding all expenditures on final goods and
services produced in the country by all sectors of the economy. Thus, GDP can be estimated
by summing up personal consumption of households (C), gross private domestic investment
(I), government purchases of goods and services (G) and net exports (NE).

90
Personal consumption expenditure includes expenditures by households on durable
consumer goods (automobiles, refrigerators, video recorders, etc), non-durable consumer
goods (clothes, shoes, pens, etc) and services.

Gross private domestic investment is defined as the sum of all spending of firms on
plants, equipment, and inventories, and the spending of households on new houses.
Investment is broken down into three categories: residential investment (the spending of
households on the construction of new houses), business fixed investment (the spending of
firms on buildings and equipment for business use), and inventory investment (the change in
inventories of firms).

Note that gross private domestic investment differs from net private domestic investment in
that the former includes both replacement and added investment whereas the latter
refers only to added investment. Replacement means the production of all investment
goods, which replace machinery, equipment and buildings used up in the production
process. In short, net private domestic investment = gross private domestic investment
minus depreciation.

Government purchases of goods and services include all government spending on

finished products and direct purchases of resources less government transfer payments
because transfer payments do not reflect current production although they are part of
government expenditure.

Net exports refer to total value of exports less total value of imports. Note that net export
is different from the terms of trade in that the latter refers to the ratio of the value of exports
to the value of imports.

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
91
Exports 150
 Imports 200
GDP at current market price 5300
Income approach: in this approach, GDP is calculated by adding all the incomes accruing 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. For
instance, transfer payments (payments which are made to the recipients who have not
contributed to the production of current goods and services in exchange for these
payments) are excluded from national income, as these are mere redistribution of income
from taxpayers to the recipients of transfer payments. Transfer payments may take the
form of old age pension, unemployment benefit, subsidies, etc.

According to the income approach, GDP is the sum incomes to owners of factors of
production plus some other claims on the value of output (depreciation and indirect
business tax) less subsidies and transfer payments.

GDP = Compensation of employees (wages & salaries )

+ Rental income

+ Interest income
+ Profits (proprietors‘ profit plus corporate profit)
+ Indirect business taxes
+ Depreciation

- Subsidies
- Transfer payments

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

92
Limitation of GDP measurement:
The calculation of national income is not an easy task. We face a number of problems in
the estimation of national income, especially in under-developed countries like Ethiopia.

Definition of a nation: while calculating national income, nation does not mean only the
political or geographical boundaries of a country for calculating the value of final goods
and services produced in the country. It includes income earned by the nationals
abroad.

Stages of economic activities: it is also difficult to determine the stages of economic

activity at which the national income is determined i.e. whether the income should
be calculated at the stage of production or distribution or consumption. It has,
therefore, been agreed that the stage of economic activity may be decided by the
objective for which the national income is being calculated. If the objective is to
measure economic progress, then the production stage can be considered. To
measure the welfare of the people, then the consumption stage should be taken into
consideration.

Transfer payments: this also creates a great difficulty in calculating the national income.
It has generally been agreed that the best way is to consider only the disposal income
of the individuals of groups.

Underground economy: no imputation is made for the value of goods and services sold
in the illegal market. The underground economy is the part of the economy that
people hide from the government either because they wish to evade taxation or
because the activity is illegal. The parallel exchange rate market is one example.

Inadequate data: in all most all the countries, difficulty has been faced in the calculation
of national income due to lack of adequate data. Sometimes, the data are not reliable.

Non-monetized sector: this difficulty is special to developing countries where a

substantial portion of the total produce is not brought to the market for sale. It is
either retained for self-consumption or exchanged for other goods and services.

Valuation of depreciation: the value of depreciation is deducted from the gross

national product to get net national product. But the valuation of such
depreciation is full of difficulties.

Changes in price levels: since the national income is in terms of money whose value
itself keeps on changing, it is difficult to make a stable calculation which is assessed in
terms of prices of the base year.

No focus on quality: it is difficult to account correctly for improvements in the quality of

goods. This has been the case for computers, whose quality has improved
dramatically while their price has fallen sharply. It also applies to other goods such
as cars whose quality changes over time.

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 6.2.2. 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)

Net National product (NNP) : GNP as a measure of the economy‘s annual output may have
defect because it fails to take into account capital consumption allowance, which is necessary
to replace the capital goods used up in that year‘s production. Hence, net national
product is a more accurate measure of economy‘s annual output than gross national
product and it is given as:

Net National product =Gross National product – Capital consumption allowance

(NNP) (GNP) (D)

National income (NI): National income is the income earned by economic resource (input)
suppliers for their contributions of land, labour, capital and entrepreneurial ability, which
are involved in the given year‘s production activity. However, from the components of
NNP, indirect business tax, which is collected by the government, does not reflect the
productive contributions of economic resources because government contributes nothing
directly to the production in return to the indirect business tax. Hence, to get the national
income, we must subtract indirect business tax from net national product.

National Income = Net National Product – Indirect Business Tax

(NI) (NNP) (IBT)

Personal Income (PI): refers to income earned by persons or households. Persons in the
economy may not earn all the income earned as national income.

PI = NI – [social security contribution + corporate income tax + retained corporate profit]

+ [Public transfer payments (e.g. Subsidy) + net interest on government bond]

Personal Disposable Income: it is personal income less personal tax payments.

DI = PI – Personal taxes
DI = C + S where, C = personal consumption expenditure, S = Personal savings

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 6.3. 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. That is, nominal GDP = where, P is the general price level
and Q is the quantity of final goods and services produced. Therefore, any change that
can happen in the country‘s GDP is due to changes in price, quantity or both. For example, if
prices are doubled over one year, then GDP will also double even though exactly the same
goods and services are produced as the year before. Hence, GDP that is not adjusted for
inflation is called Nominal GDP.

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. By comparing the value of production in the two years at
the same prices, we reveal the change in output. Hence, to be able to make reasonable
comparisons of GDP overtime we must adjust for inflation.

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

Given the above information, we can calculate the real and nominal GDP in both years
as follows:

In 2017: In 2018:
Nominal GDP = (20 x 5) + (8 x 50) = $500 The outputs of 2018 valued at the prices
Real GDP = (20 x 5) + (8 x 50) = $500 of 2017(the base year).

Nominal GDP= (25 x 20) + (10 x 100) = $1500

Note that both the real and nominal
Real GDP = (25 x 5) + (10 x 50) = $625
GDP values are exactly the same in
the base year.

6.4. The GDP Deflator and 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. The GDP deflator is the ratio of nominal GDP in a given year to real GDP
of that year. It reflects what‘s happening to the overall level of prices in the economy.

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 GDP deflator =

We can calculate the GDP deflator based on the example above.

GDP deflator (2017) = x 100 = x 100 = 100

As both the real and nominal GDP values are exactly the same, the GDP deflator in the
base year is always 100.

x 100 = x 100= 240, which shows the price in 2018

GDP deflator (2018) =

was 140% higher than the price in base year.

The Consumer Price Index: 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.
It compares the current and base year cost of a basket of goods of fixed composition. If we
denote the base year quantities of the various goods by q'0 and their base year prices by р' 0,
the cost of the basket in the base year is ∑р' 0*q'0, where the summation is over all the goods
in the basket. The cost of a basket of the same quantities but at today's prices is ∑p' t,q' 0,
where pt is today's price. The CPI is the ratio of today's cost to the base year cost.
* *

CPI q
p q

The CPI versus the GDP Deflator

The GDP deflator and the CPI give somewhat different information about what‘s happening
to the overall level of prices in the economy. There are three key differences between
the two measures.

1) GDP deflator measures the prices of all goods and services produced, whereas the
CPI measures the prices of only the goods and services bought by consumers.
Thus, an increase in the price of goods bought by firms or the government will
show up in the GDP deflator but not in the CPI.

2) GDP deflator includes only those goods produced domestically. Imported goods are
not part of GDP and do not show up in the GDP deflator.

3) The CPI assigns fixed weights to the prices of different goods, whereas the GDP deflator
assigns changing weights. In other words, the CPI is computed using a fixed basket of
goods, whereas the GDP deflator allows the basket of goods to change over time as
the composition of GDP changes.

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 6.5. The Business Cycle

Business cycle refers to the recurrent ups and downs in the level of economic
activity. Countries usually experience ups and downs in the level of total output and
employment over time. For some period of time the total output level may increase
and other times it may decline. With the fluctuation in the overall economic activity, the
level of unemployment also moves up and down.

Growth trend
Level of
output

Business
cycl
Boom e /peak

Boom/peak

Tro ugh/
de ression
p
Time

Figure 6.9: The business cycle

A business cycle is a fluctuation in overall economic activity, which is characterized by the

simultaneous expansion or contraction of output in most sectors. We can identify four phases
in the business cycle.

Boom/peak: it is a phase in which the economy is producing the highest level of output in
the business cycle. It is the point which marks the end of economic expansion and the
beginning of recession. In this phase, the economy‘s output is growing faster than its long-
term (potential) trend and is therefore unsustainable. Due to very high degree of
utilization of resources, unemployment level is low; business is good; and it is a period of
prosperity.

Recession/contraction: during a recession phase, the level of economic performance

generally declines. Total output declines, national income falls, and business generally
decline. As a result, unemployment problem rises. When the recession becomes
particularly severe, we say the economy reaches depression or trough. This period can
cause hardship on business and citizens.
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Trough/Depression: - this phase is the lowest point in a business cycle. It marks the end of a
recession and the beginning of economic recovery/expansion. During this period, there is
an excessive amount of unemployment and idle productive capacity.

Recovery/Expansion: - during this phase, the economy starts to grow or recover, i.e. there is
an option of economic activity between a trough and a peak. In this phase, more and
more resources are employed in the production process; output increases,
unemployment level diminishes and national income rises. When this expansion of the
economy reaches its maximum, the economy once again comes to another boom or peak.

Note that:
One business cycle includes the point from one peak to the next peak or from one trough
to the next.
A business cycle is a short-term fluctuation in economic activities.
The trend path of GDP is the path GDP would take if factors of production were fully
employed.
Business cycles may vary in duration and intensity.

6.6. Macroeconomic Problems

6.6.1. Unemployment

Can we say that every person who does not have a job is unemployed?

Problem of unemployment is one of the major issues dealt in macroeconomics.

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 which are normally named as productive population. To better
understand what unemployment is, it is important to begin with classifying the whole
population of a country into two major groups: those in the labour force and those outside
the labour force.

Labor force includes group of people within a specified age (for instance, people whose ages
are greater than 14 are considered as job seekers though formal employment requires a
minimum of 18 years of age bracket) who are actually employed and those who are
without a job but are actively searching for a job, according to the Ethiopian labour law.
Therefore, the labour force does not include: Children <14 and retired people age >60,
and also people in mental and correctional institutions, and very sick and disabled people
etc.
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A person in the labour force is said to be unemployed if he/she is without a job but is
actively searching for a job.

Labour force = Employed + Unemployed

Types of unemployment

1. Frictional unemployment: refers to a brief period of 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

2. Structural unemployment: results from mismatch between the skills or locations of job
seekers and the requirements or locations of the vacancies. E.g. An agricultural
graduate looking for a job at ―Piassa‖. The causes could be change in demand
pattern or technological change.

3. Cyclical unemployment: 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

Note: Frictional and structural unemployment are more or less unavoidable; hence, they are
known as natural level of unemployment.

Measurement of rates 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

When the unemployment rate is equal to the natural rate of unemployment, we say the
economy is at full employment. Therefore, full employment does not mean zero
unemployment.

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 6.6.2. Inflation

It is the sustainable increase in the general or average price levels commodities. Price
index serves to measure inflation. Two points about this definition need emphasis. First, the
increase price must be a sustained one, and it is not simply once time increase in prices.
Second, it must be the general level of prices, which is rising; increase in individual prices,
which can be offset by fall in prices of other goods is not considered as inflation.

Rate of inflation = *100

where, Pt is price index ( eg. CPI) at time t and Pt-1 is price index at time t-1.

Causes of inflation

The causes of inflation are generally classified into two major groups: demand pull and cost
push inflation.

A. Demand pull inflation: according to demand pull theory of 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 toofew 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.

Economic effects of inflation

1. Generally inflation reduces real money balance or purchasing power of money. This will
in turn reduce the welfare of individuals.

2. Banks charge their customers nominal interest rate for their loans. Nominal interest
rate however is determined based on inflation rate as it is represented by Fisher‘s
equation. is П and rate interest real is r rate, interest nominal is I where, r+П I=
inflation rate.

Increase in inflation rate will raise the nominal interest rate and the opportunity cost
of holding money. If people are to hold lower money balances on average, they must
make more frequent trips to the bank to withdraw money. This is metaphorically
called the shoe-leather cost of inflation.

3. Inflation reduces investment by increasing nominal interest rate and creating

uncertainty about macroeconomic policies.

4. Inflation redistributes wealth among individuals. Most loan agreements specify a

nominal interest rate, which is based on the rate of inflation expected at the time of the
agreement. If inflation turns out to be higher than expected, the debtor wins and the
creditor loses because the debtor repays the loan with less valuable dollars. If
inflation turns out to be 100
 lower than expected, the creditor wins and the debtor loses because the repayment
is worth more than the two parties anticipated.
5. Unanticipated inflation hurts individuals with fixed income and pension.
6. 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.

6.6.3. Trade deficit and budget deficit

Budget deficit

The overriding objectives of the government‘s fiscal policy are building prudent public financial
management, financing the required expenditure with available resource and refrain
from possibility of unsustainable fiscal 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).

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. The accumulation of
past borrowing is the government debt. Debate about the appropriate amount of
government debt in the United States is as old as the country itself. Alexander Hamilton
believed that ―a national debt, if it is not excessive, will be to us a national blessing,‖ while
James Madison argued that ―a public debt is a public curse‖.

When we see Ethiopian case, to augment available domestic financing options, the
government opted to finance its fiscal deficit from external sources on concessional terms. In
particular, the Government of Ethiopia finances its budget by accessing external loans on
concessional terms. As a rule of thumb, non-concessional loans cannot be used to finance
the budgetary activities. On the other hand, external non-concessional loans are used to
finance projects that are run by State Owned Enterprises. In recent years, the government
accessed loans from international market on non-concessional terms to finance feasible and
profitable projects managed by State Owned Enterprises (SOEs). The country‘s total
public debt contains central government, government guaranteed and public enterprises.

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Trade deficit

The national income accounts identity shows that net capital outflow always equals the
trade balance. Mathematically,
S−I = NX.
Net Capital Outflow = Trade Balance
Net cash out flow is Saving(S) – Investment (I)
Balance of Trade = Merchandize Exports – Merchandize Imports

If this balance between S − I and NX is positive, we have a trade surplus, so we say that
there is a surplus in the current account. In this case, we are net lenders in
world financial markets, and we are exporting more goods than we are importing.

If the balance between S − I and NX is negative, we have a trade deficit then we say
that there is a deficit in the current account. In this case, we are net borrowers in
world financial markets, and we are importing more goods than we are exporting.

If S − I and NX are exactly zero, we are said to have balanced trade because the value
of imports equals the value of exports.

6.7. Macroeconomic policy instruments

The ultimate policy objective of any country in general is to have sustainable economic
growth and development. Policy measures are geared at achieving moderate inflation
rate, keeping unemployment rate low, balancing foreign trade, stabilizing exchange and
interest rates, etc and in general attaining stable and well-functioning macroeconomic
environment.

6.7.1. Monetary policy

Monetary policy refers to the adoption of suitable policy regarding the control of money
supply and the management of credit which is important measure for adjusting aggregate
demand to control inflation. It is concerned with the money supply, lending rates and
interest rates and is often administered by a central bank.

Monetary policy is a highly flexible stabilization policy tool. For instance, during economic
recession where output falls with a fall in aggregate demand, monetary policy aims at
increasing demand and hence production as well as employment will follow the same
pattern of demand. In contrast, at the time of economic boom where demand exceeds
production and treat to create inflation, the monetary policy instruments are utilized that
could offset the condition and achieve price stability by counter cyclical action upon money
supply.

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Government monetary policy regulation is under responsibilities of Central Banks. Central
Bank controls the money supply to control nominal interest rates. Investment and
saving decisions are based on the real interest rate. When government lowers interest
rate, firms borrow more and invest more. Higher interest rates mean less investment.

6.7.2. Fiscal policy

Fiscal policy involves the use of government spending, taxation and borrowing to influence
both the pattern of economic activity and also the level and growth of aggregate demand,
output and employment. It is important to realize that changes in fiscal policy affect both
aggregate demand (AD) and aggregate supply (AS). Most governments use fiscal policy to
promote stable and sustainable growth while pursuing its income redistribution effect to
reduce poverty. Fiscal policy therefore plays an important role in influencing the
behaviour of the economy as monetary policy does. The choice of the government fiscal
policy can have both short and long term influences. The most important tools of
implementing the government fiscal policy are taxes, expenditure and public debt.

Traditionally fiscal policy has been seen as an instrument of demand management. This
means that changes in government spending, direct and indirect taxation and the budget
balance can be used to help smooth out some of the volatility of real national output
particularly when the economy has experienced an external shock.

Fiscal policy decisions have a widespread effect on the everyday decisions and behaviour of
individual households and businesses. Thus, it is mainly used to achieve internal balance, by
adjusting aggregate demand to available supply. It also promotes external balance by
ensuring sustainable current account balance and by reducing risk of external crisis. In
general, it helps promote economic growth through more and better education and health
care.

Major functions of fiscal policy

Allocation: The first major function of fiscal policy is to determine exactly how funds will be
allocated. This is closely related to the issues of taxation and spending, because the allocation
of funds depends upon the collection of taxes and the government using that revenue for
specific purposes. The national budget determines how funds are allocated. This means that
a specific amount of funds is set aside for purposes specifically laid out by the government.
The budget allocation is done on the basis of aggregated development objectives such as
recurrent vs capital expenditures or sectoral allocation (economic and social developments).

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Distribution: The distribution functions of the fiscal policy are implemented mainly through
progressive taxation and targeted budget subsidy. Virtually allocation determines how
much will be set aside and for what purpose, the distribution function of fiscal policy is to
determine more specifically how those funds will be distributed throughout each segment of
the economy. For instance, the government might apportion a share of its budget
toward social welfare programs, such as food security and asset building for the most
vulnerable and disadvantaged in society. It might also allocate for low-cost housing
construction and mass transportation.

Stabilization: Stabilization is another important function of fiscal policy in that the purpose of
budgeting is to provide stable economic growth. Government expenditure needs particularly
in developing countries such as Ethiopia are unlimited. But its source of financing is limited.
Thus without some restraints on spending or limiting the level of expenditure with available
financial resources the economic growth of the nation could become unstable, creating
imbalances in external sector as well as resulting in high prices.

Development: The fourth and most important function of fiscal policy is that of promoting
development. Development seems to indicate economic growth, and that is, in fact, its
overall purpose. However, fiscal policy is far more complicated than determining how much
the gov- ernment will tax citizens in a given year and then determining how that money will
be spent. True economic growth occurs when various projects are financed and carried out
using budg- etary finance. This stems from the belief that the private sector cannot grow
the economy by itself. Instead, government input and influence are needed. The
government is responsible for providing public goods, reduce externalities and correct
market distortions in order to pave the way for private sector.

The underlying principles of the tax policies in Ethiopia are as follows:

To introduce taxes that enhance economic growth, broaden the tax base and
increase government revenue;

To introduce taxes that are helpful to implement social policies that

discourage consumption of substances that are hazardous to health and social
problems;

To introduce tax system that accelerate industrial growth and achieve transformation
of the country and to improve foreign exchange earnings, as well as create
conducive environment for domestic products to become competitive in the
international commodity markets;
To ensure modern and efficient tax system that supports the economic development;
To make the tax system fair and equitable;
To minimize the damage that may be caused by avoidance and evasion of tax; and
To promote a tax system that enhances saving and investment.
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Chapter summary

Macroeconomics is branch of economics which studies about overall or aggregate behaviour

of the economy such as economic growth, employment, inflation, distribution of
income, macroeconomic policies and international trade.

Basically, economic performance of a given country is measured by GDP/GNP. The method of

measuring the aggregate output and income based on the principle of the circular flow
economic activity is named as National Income Accounting. There are three approaches
to measure GDP/GNP; namely, product/value added approach, expenditure approach and
income approach.

The other basic issue in macroeconomics is business cycle and it refers to the recurrent ups
and downs in the level of economic activity. Countries usually experience ups and downs
in the level of total output and employment over time. In connection to this,
unemployment and inflation are among the major macroeconomic problems.
Unemployment refers to group of people who are in a specified age (labor force), who are
without a job but are actively searching for a job. Inflation is a situation of continuous
increase in the general price level. It is a sustained increase in the general price level.
Based on the sources of inflation, we can identify demand two types of inflation: cost push
and demand pull inflation.

The ultimate policy objective of any country in general is to have sustainable economic
growth and development. Monetary policy refers to the adoption of suitable policy regarding
the control of money supply and the management of credit which is important measure
for adjusting aggregate demand to control inflation. It is concerned with the money supply,
lending rates and interest rates and is often administered by a central bank. Fiscal
policy involves the use of government spending, taxation and borrowing to influence both
the pattern of economic activity and also the level and growth of aggregate demand, output
and employment

105
Review questions

1. What is the difference between GDP and GNP? Which one is a better measure of
the economic performance of a country?

2. What is unemployment? How can we measure it?

3. What is inflation? What are its causes? What is its impact on the economy?
4. Discuss the three major differences between CPI and GDP deflator.
5. Consider the following information for a particular economy.
Total population = 60 million Number of employed = 30 million
Total labor force = 40 million Natural rate of unemployment = 12%

a) Find the total unemployment rate

b) Calculate the cyclical unemployment rate

6. Consider an economy that produces and consumes Bread and Automobile. Data for
two different years 2005 and 2010 is given in the following table.

Year 2005 2010

Price of Automobiles $ 5000 $ 6000
Price of a loaf of bread $10 $20
Number of automobiles produced 100 120
Number of loaves of bread produced 500,000 400,000

Using the year 2005 as a base year,

a) Calculate the nominal and real GDP of 2010.

b) Find the value of GDP Deflator for the year 2010 and interpret.
c) Calculate the inflation rate in 2010.

Suggested reading materials

Mankiw, G. (2000) Macroeconomics, 5thed., Worth Publishing

Dornbusch, R. and S. Fischer (1994) Macroeconomics, 2nd ed, New York: McGraw-Hill
International Edition.
Pentecost, E. (2000), Macroeconomics: An Open Economy Approach, Macmillan Press
Ltd.
Branson, W. (1989) Macroeconomic Theory and Practice, 3re ed., New York Harper &
Row Publishers.
Jones, C. (2003) Introduction to Economic Growth, 2nd ed., New York and London:
W.W. Norton & Company.
Pilbeam K. (1990) International Finance, 2nded., Macmillan Press Ltd.

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