INTRODUCTION TO

ECONOMICS

1
CHAPTER ONE

FUNDAMENTALS OF
ECONOMICS

2
 1.1. DEFINITION AND NATURE OF
ECONOMICS
❖The word economics comes from the ancient
Greek word oikonomia.
oikos=>house
nomos =>rule or custom
So oikonomia means rule of house(household) or
management of household administration.
❖Two fundamental facts together provide a
foundation for Economics:
1. Society’s material want are unlimited.
2. Economic resources are limited in supply or
scarce

3
 Cont…
❖By society’s material wants we refer to the
desire of consumers, business (firms), and
government to get those things that help them
realize their respective goals.
❖ The goal of the consumer is to get maximum
satisfaction, the goal of the business is to
produce goods and services for profit and the
goal of the government is to satisfy the
collective wants of its citizens.

4
 Cont…
❖Human wants are not only numerous but also
expand and diversify through time. Therefore,
human wants are unlimited.
❖Resource is anything natural or man made that
can be used in production of goods and
services.
❖Thus, economic resources are the means to
produce goods and services. Examples are
various types of labor, oil deposits, minerals,
building, communication facilities etc.
❖All these resources are scarce or limited in
❖
supply.
5
 Cont…
❖ These two contradictory facts lay the
foundation for the field of Economics
❖Economics is thus a science which studies the
allocation of scarce resources in production,
consumption and distribution of goods and
services to attain the maximum fulfillment of
society’s material wants.
❖Economics is concerned with “doing the best
with what we have”.
6
 Cont…
❖From the above definition we understand the
Following points.
1. Economics is Science
2. The society faces a problem of scarcity
3. There is a problem of choice

7
 The scope of Economics
❖ From the point of view of elements of analysis,
economics has two major branches:
microeconomics and macroeconomics
A. Microeconomics
➢ Deals with economic behaviors of individual
economic units such as consumers, producers,
business firms and other economic decision
making units
➢ Deals with how the market of individual
commodities function

8
 Cont…
❖ It is concerned also with interaction among the
economic units
B. Macroeconomics
❖ Is branch of economic analysis concerned
with the economy as a whole and sub
aggregates of the economy.
❖Macroeconomics deals with aggregate units of
national economy such as national output or
Gross National Product (GDP), general price
level, inflation and national employment.

9
 Cont…
• Like macroeconomics ,microeconomics also
uses aggregates. But in microeconomics we
aggregate over the homogeneous product but
in macroeconomics the aggregation is at the
economy level

10
 Basic Classifications of Economics
Macroeconomics Microeconomics
The big picture. Study of the “A small-scale study”. Focuses
operation of the economy as a on individual entities of the
whole. It looks at aggregate economy, such as households and
data. firms.

Focuses more at focuses at the

the policy and firm level
regulatory levels.

• Both areas offer valuable outlook on the economy.

11
 Table 1. Comparison between Microeconomics and
Macroeconomics
Microeconomics Macroeconomics

✓Households’ and/or firms’ ✓National economy

economic behavior
✓Price of individual items or ✓General price level
firms
✓Price of a consumption ✓Consumer price index
good (CPI)
✓An increase in price of a ✓Inflation
commodity
Output of a factory or a firm ✓National output or GDP12
 Cont…
Microeconomics Macroeconomics

✓Output of a factory or a ✓National output or GDP

firm
✓Wage rate in an ✓National wage rate
enterprise
✓Investment of individual ✓National Investment
firm
✓Consumption of ✓National Consumption
households or individuals
✓Firm’s expense or ✓Government expenditure13
 1.2. Scarcity and Choice
Scarcity –refers to all economic resources, that a
society needs to produce goods and resources, are
finite or limited in supply
✓ It refers to the imbalance between our wants and a
means to satisfy these wants.
✓ Resources can be classified as free and economic
resources
✓ A resource is said to be free if the amount
available to society is greater than the amount
people desire at zero price.
14
 Cont…
✓A resource is said to be scarce or economic
resource if the amount available to society is
less than the amount people desire at zero price
✓Economic resource can also be divided into
four categories
i. Labor iii. Capital
ii. Land iv. Entrepreneurship

15
 Cont…
i. Labor
✓ refers to the physical as well as mental effort
of human beings in production and
distribution of goods
✓ This includes both the skilled and unskilled
labor
✓ The reward for labor is called wage

16
 Cont…
ii. Land
✓ refers to the natural resources or all the free
gifts of nature
✓It doesn’t include those resources that are
transformed, altered or improved by human
beings
✓The reward/payment for land is called rent

17
 Cont…
iii. Capital
✓ refers to all manufactured inputs that can be
used to produce other goods and services
✓ it refers to physical capital only. It doesn’t
take in to account financial capital
✓The reward for capital is called interest

18
 Cont…
iv. Entrepreneurship
✓refers to a special type of human talent that
helps to organize, manage factors of
production to produce goods and services
✓Takes risk of making losses
✓The reward for an entrepreneur is profit

19
 Cont…
➢The same logic(definition of scarce or free
resource ) is applicable for goods and services
➢ A good is said to be scarce or economic good
if the amount available to society is less than
the amount people desire at zero price
➢A good is said to be free good if the amount
available to society is greater than the amount
people desire at zero price

20
 Cont…
NB:scarcity doesn’t mean shortage
Shortage Scarcity

Specific problem Universal problem

Short term Everlasting

phenomena phenomena

21
 Cont…
✓Scarcity implies choice
✓Choice in turn implies cost(sacrification)
✓The cost is the forgone opportunity
➢Opportunity cost/opportunity lost/: is the
value of the next best alternative that must be
given up in order to obtain one more unit of
the first product

22
 Production Possibility Frontier(PPF)
❖PPF is a graph that shows the various combinations
of output that the economy can possibly produce
given the available factors of production and the
available production technology

Assumptions to draw the PPC/PPF

i. Efficiency
ii. Fixed resource
iii.Two products
iv. Fixed technology

23
 Cont…
❖Although real economies produce thousands of
goods and services, let’s imagine an economy
that produces only two goods—cars and
computers
❖Together the car industry and the computer
industry use all of the economy’s factors of
production

24
 Cont…
Figure 1

25
 Cont…
❖Figure 1 is an example of a production
possibilities frontier. In this economy, if all
resources were used in the car industry, the
economy would produce 1,000 cars and no
computers
❖If all resources were used in the computer
industry, the economy would produce 3,000
computers and no cars

26
 Cont…
❖The two end points of the production
possibilities frontier represent these extreme
possibilities
❖If the economy were to divide its resources
between the two industries, it could produce
700 cars and 2,000 computers, shown in the
figure by point A
❖Points on PPF are attainable and efficient

27
 Cont…
❖By contrast, the outcome at point D is not
possible because resources are scarce: The
economy does not have enough of the factors
of production to support that level of output
❖ In other words, the economy can produce at
any point on or inside the production
possibilities frontier(attainable but inefficient)
❖ the economy cannot produce at points outside
the frontier(Unattainable)

28
 Cont…
❖The production possibilities frontier shows one
tradeoff that society faces.
❖Once we have reached the efficient points on
the frontier, the only way of getting more of
one good is to get less of the other. When the
economy moves from point A to point C
❖For instance, society produces more computers
but at the expense of producing fewer cars

29
 Cont…
❖ Another Principles of Economics that is shown through the
production possibility frontier is opportunity cost
❖ The opportunity cost of a commodity means the amount of
a next best alternative that must be sacrificed in order to
obtain one more unit of the commodity
❖ The production possibilities frontier shows the opportunity
cost of one good as measured in terms of the other good
❖ When society reallocates some of the factors of production
from the car industry to the computer industry, moving the
economy from point A to point C, it gives up 100 cars to get
200 additional computers. In other words, when the
economy is at point A, the opportunity cost of 200
computers is 100 cars

30
 Cont…
Opportunity = The amount of the good scarified
The amount of the good gained
➢Law of Increasing Opportunity Cost – For
each additional unit of a good produced the
opportunity cost increases. Why?
➢ Because the most efficient use of the resource
in production of a good is used first.

31
 Cont…
• Is there any mechanisms to produce outside the production
possibility frontier? Or contraction ?
• Economic Growth (Causes):
1. Capital accumulation (human, capital goods)
2. Technological progress (change, ideas)
• Contraction of PPF (Causes):
1. Droughts
2. Floods
3. Earthquakes

32
 Cont…
❖For example, if a technological advance in the
computer industry raises the number of
computers that a worker can produce per week,
the economy can make more computers for any
given number of cars. These can be presented
graphically as follows;

33
 Cont…
Figure 2

34
 Cont…
❖As a result, the production possibilities frontier
shifts outward, as in Figure 2.
❖Because of this economic growth, society
might move production from point A to point
E, enjoying more computers and more cars.

35
 Cont…
❖A change in technology can symmetrical or
asymmetrical
✓If the change is in one sector =>Asymmetrical
✓If the change is in both sectors =>symmetrical

36
 1.3.The Basic Economic Questions
and Alternative Economic systems
There are three basic economic problems that any
economic unit needs to answer:
a. What to produce: Types and amounts of
commodities to be produced
b. How to produce: the answer to this question may
help determine what production method or
technique to use and what input to use. For
instance the decision may be about identifying
the best combinations of inputs or raw materials
37
 Cont…
C.For whom to produce: This question helps us
to identify potential customers

38
 Alternative Economic systems
Economic system
✓ Is a set of organizational and institutional
arrangements
✓ Established to answer the basic economic
questions
✓ There are three types of economic systems
a. Market economy
b. Command economy
c. Mixed economy

39
 A. Market Economy
❖The private ownership of resources and the use
of markets and prices to coordinate and direct
economic activity characterize the market
system, or capitalism.
❖ In this system each participant acts in his or
her own self-interest; each individual or
business seeks to maximize its satisfaction or
profit through its own decisions regarding
consumption or production

40
 Cont…
❖The system allows for the private ownership of
capital, communicates through prices, and
coordinates economic activity through markets
❖Goods and services are produced and
resources are supplied by whoever is willing
and able to do so
❖The result is competition among independently
acting buyers and sellers of each product and
resource

41
 Summary of Market economy
• Producers and consumer determine WHAT, HOW,
and FOR WHOM to produce.
• Advantages =
1. ability
to adjust to change;
2. the high degree of individual freedom (start a
business, the ability to work nights, part time job, two jobs)
3. the small degree of government involvement;
4. the ability to have a voice in the economy;
5. the variety of goods and services created;
6. the high degree of consumer satisfaction
7. high standard of living

42
 Cont…
Disadvantages =
1. inability of the market to meet every
person’s basic needs *(market failure)
2. inadequate job in providing highly
valued services like justice, education, and
health care
3. high level of personal uncertainty and
the prospect of economic failure………failure
to stabilize the economy
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 B. Command Economic System
❖The alternative to the market system is the
command system, also known as socialism or
communism.
❖In this system, the government owns most
property resources and economic decision making
occurs through a central economic plan.
❖ A central planning board appointed by the
government makes nearly all the major decisions
concerning the use of resources, the composition
and distribution of output, and the organization of
production

44
 Cont…
❖The government owns most of the business firms,
which produce according to government
directives.
❖A central planning board determines production
goals for each enterprise and specifies the amount
of resources to be allocated to each enterprise so
that it can reach its production goals

45
 Cont…
❖The division of output between capital and
consumer goods is centrally decided, and
capital goods are allocated among industries
on the basis of the central planning board’s
long-term priorities.

46
 Summary of command Economy
• A central authority determines WHAT, HOW and FOR WHOM to
produce
• Examples: North Korea, Cuba, People’s Republic of China (and the former
Soviet Union)
Advantages
• Fair distribution of income
• Absence of business fluctuation
• Absence of private monopolistic practices
Disadvantages =
1. consumer needs may not be met;
2. hard work is not rewarded;
3. necessary decision-making bureaucracy delays decision;
4. little flexibility to deal with day-to-day problems;
5. individual initiative goes unrewarded (i.e. entrepreneurs need not
apply)

47
 C. Mixed Economic Systems
• Pure capitalism and command economy are the
two extreme types of economic systems.
• The mixed economic system takes the strong
elements of the two economic systems

48
 1.4. Decision making unit and
circular flow of economic activities
❖There are three decision-making units in
closed economy.
i. Households-is an economic unit which
provides an economy with resources and uses
the money paid to it to buy goods and services
to satisfy its material wants.
ii. Firm- a firm is production unit that uses
economic resources to produce g + s and sell
them to hhs, other firms and gov’t.
49
 Cont’d
Firms makes to decisions:
1. buying of economic resources
2. Selling of their products
iii. Government
❖These economic agents interact in two markets
i. Resource/input markets
ii. Products/output markets

50
 Cont…
❖We can use two models to understand the
economic interaction among economic agents
a. Two sector circular flow model
b. Three sector circular flow model

51
 CIRCULAR FLOW OF ECONOMIC
ACTIVITY(TWO SECTOR MODEL)

HOUSEHOLDS FIRMS

52
 CIRCULAR FLOW OF ECONOMIC
ACTIVITY
PAYMENTS FOR GOODS AND SERVICES

HOUSEHOLDS FIRMS

53
 CIRCULAR FLOW OF ECONOMIC
ACTIVITY
PAYMENTS FOR GOODS AND SERVICES:
FIRMS’ REVENUE

HOUSEHOLDS FIRMS

WAGES, SALARIES,PROFITS,& RENT:

FIRMS’ COSTS OR FACTOR PAYMENTS

54
 CIRCULAR FLOW OF ECONOMIC ACTIVITY

PAYMENTS FOR GOODS AND SERVICES:

FIRMS’ REVENUE

LABOR,CAPITAL,LAND&
ENTREPRENEURSHIP
HOUSEHOLDS FIRMS

WAGES, SALARIES,PROFITS,& RENT:

FIRMS’ COSTS OR FACTOR PAYMENTS

55
 CIRCULAR FLOW OF ECONOMIC ACTIVITY

PAYMENTS FOR GOODS& SERVICES:

FIRMS’ REVENUE

LABOR,CAPITAL,LAND &
ENTREPRENEURIALSHIP
HOUSEHOLDS FIRMS

REAL GOODS & SERVICES

WAGES , SALARIES,PROFITS,& RENT:

FIRMS’ COSTS

56
 CIRCULAR FLOW OF ECONOMIC
ACTIVITY(THREE SECTOR MODEL)
PAYMENTS FOR GOODS& SERVICES:
FIRMS’ REVENUE

LABOR,CAPITAL,LAND &
ENTREPRENEURIALSHIP
HOUSEHOLDS FIRMS

REAL GOODS & SERVICES

WAGES, SALARIES,PROFITS,& RENT:

FIRMS’ COSTS OR FACTOR PAYMENTS
SUBSIDIES SUBSIDIES

GOV’T TAXES
TAXES 57
Two sector circular flow model

58
Three sector circular flow model

59
60
 CHAPTER TWO

THEORY OF DEMAND & SUPPLY

AND ELASTICITY
 Demand
Quantity Demanded – the amount(number) of
a good that a consumer is willing and able to
purchase at the given price in a given period of
time.
Demand –consumers willingness and ability
to purchase goods and services at various
prices in a specific period of time., holding all
else constant.

2
 Cont…
The relationship between price and quantity demanded
can be seen using demand schedule, demand curve,
demand function.
Demand Schedule – a table that shows the relationship
between quantity demanded and price ,ceteris paribus
Demand Curve – a graph that shows the relationship
between quantity demanded and price ,ceteris paribus
Demand Function – a mathematical expression that
shows the relationship between quantity demanded and
price, ceteris paribus
Law of Demand – All else equal, as price falls the
quantity demanded rises and vice versa. 3
Cont…

4
Market Demand Versus Individual Demand
Curve
Individual Demand Curve – is a curve that
represents the price quantity combination of a
particular good for a single buyer
Market Demand Curve – is a curve that
represents the price quantity combination of a
particular good for all buyer

5
 Cont…
Individual and market demand schedule

6
 Cont…
Individual and market demand curve
Exercise: If there are 1000 identical buyers in the market, each with a demand
function of Qdx=8-Px, then what is the market demand function?

7
 Determinants of Demand
1. Price of product itself
2. Income
3. Price of Related Goods
a. Substitute Goods
b. Complementary Goods
4. Tastes and Preferences
5. Expectations
6. Number of buyers

8
 Changes in Quantity Demand vs.
Changes in Demand
Changes in Quantity Demand –is represented
by a movement a long a given demand curve
=>This is caused by the change in the price of
the good
Changes in Demand–is represented by a shift
of the demand curve
=>This is caused by the change in the
determinants of demand other than price of the
product
9
 Cont…
1. Income
Normal Good – the higher your income the more you
consume
Examples: Sports Tickets, Cars, and Luxury Goods
↑Income
=> consume more at each P
=>↑D
Inferior Good – as income rises you consume less
Examples: Shiro wot, Cabbage
↑Income
=> consume other products
=> ↓ D
10
 Cont…
2. Price of Related Goods
Substitute Goods – two goods in which a
consumer will consume one good or the other
Examples: Pepsi or Coke, Rent Movie or Go to
Theater
↑Price of Pepsi
=> drink less Pepsi
=> purchase more Coke
=> ↑D

11
 Cont…
Complementary Goods – two goods consumed
together
Examples: gasoil and car, DVD Player and
Movie, sugar and tea
↑Price of sugar
=> consume less tea
=> consume less sugar and tea
=> ↓D
12
 Cont…
3. Tastes / Preference
New tastes for the product
=> Consume more
=> ↑D
4. Expectations
↑Price tomorrow
=> buy today instead of tomorrow
=> ↑D
5. Number of buyers
↑number of buyers
=> More of the good is consumed
=> ↑D 13
 Supply
Quantity Supplied – the amount(number) of a
good that a producer is willing and able to
offer at each price level in a given period of
time.
Supply –producers willingness and ability to
provide goods and services at different prices
in a specific period of time., holding all else
constant.

14
 Cont…
The relationship between price and quantity
supplied can be seen using supply schedule, supply
curve, supply function.
Supply Schedule – a table that shows the
relationship between quantity supplied and price
,ceteris paribus
Supply Curve – a graph that shows the relationship
between quantity supplied and price ,ceteris paribus
Supply Function – a mathematical expression that
shows the relationship between quantity supplied
and price,ceteris paribus
Law of Supply – All else equal, as price falls the
quantity supplies falls and vice versa 15
 Cont…
Supply schedule and curve

16
Market Supply Versus Individual
Supply Curve
Individual Supply Curve – is a curve that
represents the price quantity combination of a
particular good for a single seller
Market Supply Curve – is a curve that
represents the price quantity combination of a
particular good for all sellers

17
 Cont…
Individual and market supply schedule

18
 Cont…
Individual and market supply curve

19
 Changes in Quantity Supply vs.
Changes in Supply
Changes in Quantity Supply –is represented by
a movement a long a given Supply curve
=>This is caused by the change in the price of
the good
Changes in Supply–is represented by a shift of
the Supply curve
=>This is caused by the change in the
determinants of Supply other than price of the
product
20
 Determinants of Supply
1. Price of the product itself
2. Cost of Production
a. Prices of required inputs
b. Technologies used in production
2. Price of Related Products
3. Taxes and Subsidies
4. Sellers Expectation
5. Number of sellers
6. Weather condition

21
 Cont…
1. Cost of Production
a. Prices of required inputs
↑Price of labor
=>hire less people
=>produce less at current P
=>↓S
b. Technologies used in production
New technology
=> produce output for less
=> higher profit on output
=> produce more at current P
=> ↑S 22
 Cont…
2. Price of Related Products
Examples: wheat Vs teff, leather Jacket Vs leather shoe
↑Price of leather Jacket
=> produce less leather shoe
=> Produce more leather Jacket
=> ↓S of leather shoe
3. Number of sellers
↑number of sellers
=> More of the good is produced
=> ↑S
4. Expectations
↑Price tomorrow
=> Sell tomorrow instead of today
=> ↓S
23
 Cont…
5. Taxes and subsidies
↑ tax
=> Less of the good is produced
=> ↓S
↑subsidy
=> more of the good is produced
↑S
6. Weather condition(Agricultural Products)
✓ Good Vs bad weather condition
Good Weather condition
=> ↑ production of the good
=> ↑S

24
 Market Equilibrium
Market Equilibrium – occurs at a point at which
the supply and demand curves intersect.
=> occurs when there is no incentive for prices to
change (a steady state).
This occurs when QS = QD
The price at which these two curves cross is
called the equilibrium price
The quantity at which these two curves cross is
called the equilibrium quantity

25
 Cont…
Market equilibrium

26
 Cont…
• Exercise 1: From statistical studies, we know that
for 1981 the supply curve for wheat was
approximately as follows:
Supply: QS = 1800 + 240P
Where price is measured in dollars per bushel and
quantities are in millions of bushels per year.
These studies also indicate that in 1981 the
demand curve for wheat was
Demand: QD = 3550 – 266P
Find the market clearing price and equilibrium
quantity of wheat for the year1981.
27
 Cont…
Shortage (Excess Demand) – a shortage occurs
when the quantity demanded is greater than the
quantity supplied at a particular price.
Surplus (Excess Supply) – a surplus occurs
when the quantity demanded is less than the
quantity supplied at a particular price.

28
 Cont…
Figure for shortage and surplus

29
Effects of changes in demand and supply in
equilibrium price and equilibrium quantity
Events that affect demand or supply (or both)
will alter the equilibrium price and quantity.
Let’s see for the following conditions;
a. Change in demand keeping supply constant
b. Change in supply keeping demand constant
c. Simultaneous change in demand and supply
a. Change in demand keeping supply constant
I. when demand increases
Demand curve shifts to the right
Equilibrium point changes
Equilibrium price and quantity increases
p Do D1 So
F
P1
E
P0

Q
 II. when demand decreases

Demand curve shifts to the left

Equilibrium point changes
Equilibrium price and quantity decreases
p D1 Do So
E
P0
F
P1

Q
b. Change in supply keeping demand constant
I. when supply increases
Supply curve shifts to the right/outward
Equilibrium price decreases but quantity increases
So
P S1

E
P0

P1 F

D0

Q0 Q1 Q
 II. when supply decreases
Supply curve shifts to the left/inward
Equilibrium price increases but quantity decreases
S1
P S0

B
P1

P0 A

D0

Q1 Q0 Q
c. Change in both demand and supply

I. When demand increases and supply

decreases
When DD↑ ↑P* and Q* ↑
When SS ↓ ↑P* and Q* ↓
___________________________
P* ,but Q* remains indeterminate
 Cont…
II. When demand decreases and supply
increases
When DD ↓ ↑P* and Q* ↓
When SS↑ ↓ P* and Q* ↑
___________________________
P* ,but Q* remains indeterminate
 Cont…
III. When both demand and supply increase
When DD ↑ ↑P* and Q* ↑
When SS↑ ↓ P* and Q* ↑
___________________________
P* remains indeterminate, Q*
IV. When both demand and supply decrease
When DD ↓ ↓ P* and Q* ↓
When SS ↓ ↑ P* and Q* ↓
___________________________
P* remains indeterminate, Q*
 Elasticity Of Demand and Supply
Elasticity refers to responsiveness
1. Price Elasticity of Demand - measures how responsive
consumers react to price change
Price elasticity of demand =
Percentage change in quantity demanded Percentage
change in price
ED = %ΔQ
%ΔP
Point price elasticity of demand
ED = ΔQ . P
ΔP Q
Arc price elasticity of demand

ED = ΔQ . P+P’
ΔP Q+Q’ 38
 Cont…
Elasticity expresses a relationship
between two amounts
=> The percent change in quantity demanded
=> The percent change in price
The law of demand states that price and
quantity demanded are inversely related,
=> the change in price and the change in
quantity demanded have opposite signs
=> the price elasticity of demand has a negative sign
• Referring a negative number gets
cumbersome, the price elasticity of
demand is represented as an absolute value => positive
39
number
Categories of Elasticity of Demand
1. Inelastic:
✓ Elasticity is between 0 and 1.0
✓ The percent change in quantity demanded is
smaller than the percent change in price,
✓ Quantity demanded is relatively unresponsive to a
change in price
2.unit-elastic :
✓ elasticity with an absolute value of 1.0
✓ If the percent change in quantity demanded equals
the percent change in price
40
 Cont…
3.Elastic:
✓ price elasticity has an absolute value exceeding 1.0
✓ The percent change in quantity
demanded exceeds the percent change in price
4. Perfectly inelastic
✓ demand curve is vertical
✓ regardless of the price, the quantity demanded stays the same
✓ price elasticity of demand approaches zero
5. Perfectly elastic demand
✓ price elasticity of demand approaches infinity
✓ the demand curve becomes horizontal
✓ reflecting the fact that very small changes in the price lead to
huge changes in the quantity demanded

41
42
 Elasticity and Total Revenue

Price elasticity can indicate the effect of a

price change on total revenue
Total revenue (TR) is the price (p) multiplied
by the quantity demanded (q) at that price
TR = p x q

43
 Cont…
Relation between Elasticity and Total Revenue
When demand is elastic,
➢ percent increase in quantity demanded≧ percent
decrease in price
➢ Total revenue increases
When demand is unit elastic,
➢ percent increase in quantity demanded= percent
decrease in price
➢ Total revenue remains unchanged
When demand is inelastic,
➢ percent increase in quantity demanded ≦the percent
decrease in price
➢ Total revenue decreases
44
 Cont…
2. Income Elasticity of Demand
Measures the percent change in demand divided by the
percent change in income
EI = ΔQ . I
ΔI Q
Categories of Income Elasticity of Demand
✓ Goods with income elasticity less than zero are called
inferior goods => demand declines when income increases
Normal goods have income elasticity greater than zero =>
demand increases when income increases
✓ Normal goods with income elasticity greater than zero but
less than 1 are called income inelastic goods(necessary goods)
=> demand increases not as much as income does
✓ Goods with income elasticity greater than 1 are called income
elastic(luxury goods) => demand increases more than does
income does
45
 Cont…
3. Cross price elasticity of demand
Measures the percent change in demand of a good
divided by the percent change in price of an other
good.
EX = ΔQX . PY
ΔPY QX
Categories of cross price Elasticity of Demand
✓ Goods with cross price elasticity less than zero are
called complementary goods=> demand of a good
declines when price of another good increases
✓ Goods with cross price elasticity greater than zero are called
subistute goods=> demand of a good increases when price
of another good increases
✓ Goods with cross price elasticity equals to zero are called
unrelated goods=> demand of a good doesn’t change when 46
price of another good increases
 Cont…
4. Price elasticity of supply
Measures how responsive producers are to a price
change
Price elasticity of supply =
Percentage change in quantity supplied
Percentage change in price
Es = %ΔQs
%ΔP
Point price elasticity of supply
Es = ΔQs . P
ΔP Qs
Arc price elasticity of supply

Es = ΔQs . P+P’
ΔP Qs+Qs’ 47
 Categories of Supply Elasticity
The terminology for supply elasticity is the same as for
demand elasticity
➢ If supply elasticity is less than 1.0, supply is inelastic
➢ If it equals 1.0, supply is unit elastic
➢ If it exceeds 1.0, supply is elastic
➢ If it approaches to infinity, supply is Perfectly elastic
➢ If it approaches to Zero, supply is Perfectly inelastic
Exercise 2: Plot the graphs of perfectly inelastic and
perfectly elastic supply curves.
Exercise 3: Find the price elasticity of demand and supply
of wheat for the year 1981 at the equilibrium price and
quantity.
Exercise 4:If demand function is given by P=50-0.1Q.
Find the unit elastic point
48
CHAPTER THREE

THEORY OF CONSUMER
BEHAVIOR
 Meaning of Utility
Assumptions about the average consumer
1. An average consumer is rational
✓ a consumer has clear cut preference – the
consumer is able to compare any two bundles ‘a’
and ‘b’ and decide which one he/she prefer
✓ A consumer has persistent preference- if the
consumer prefers bundle ‘a’ to ‘b’ and ‘b’ to ‘c’,
then she/he prefers ‘a’ to ‘c’.
2. Consumer is not free in his/her choice-the
consumer choice is limited by his/her income
level and the price of g+s
 Cont’d……
Utility is a pleasure/satisfaction that the
consumer obtain by consuming a product.
It is a power of product to satisfy human wants.
In strict sense is doesn’t mean realized
satisfaction rather expected satisfaction.
➢ utility is subjective- the utility that two
individual derive from consumption of the
same level of product is not the same.
 Theories of utility
We have two theories of utility
✓ Cardinal utility approach- utility is measurable by
arbitrary unit of measurement called utils and it is
not comparable
✓ Ordinal utility approach- utility is not measurable
but comparable
1. Cardinal utility approach
Total utility –is total satisfaction a consumer derives
from consuming a specific quantity of a product at
particular time
Marginal utility- is extra satisfaction a consumer
derives from consuming one more unit of a product.
It is the level of utility obtained from the consumption
of each additional consumption of g+s.
Mu = dTu/dQ = ∆Tu/ ∆Q
 Numerical example for Tu&Mu
Marginal utility
Orange Total utility
consumption
0 0 -
1 10 10
2 18 8
3 24 6
4 28 4
5 30 2
6 30 0
7 28 -2
 Cont…
Fig.Tu and Mu

TU

Qd MU
 Cont…
❖From the above table and graph, we can
deduce the following points
Tu ↑ first, reaches maximum(when consumers
consume 6 units of orange) and then declines
as quantity consumed increases
Mu continuously declines(even become zero
and negative as quantity consumed increases
 Law of Diminishing Marginal Utility
➢ The law states that other things remain constant,
consuming successive units of a product gives a
consumer less and less extra satisfaction(Mu)
➢ or in other word, the MU of a goods tends to
diminish as the consumer increases the
consumption of a good beyond a certain level.
Assumptions for LDMU
✓ The consumer is rational
✓ identical product is consumed
✓ there is no time gap
✓ taste remain unchanged
 Maximizing utility
➢ Objective of a consumer is total utility
maximization
➢ this happens when the last birr spent on each
good yield equal MU.
Mathematically, the condition of maximum
satisfaction and income allocation is as follows
i. Mux = Muy = Muz
Px Py Pz
ii. Px.Qx+PyQy+PzQz = M
where M is income of the consumer
 Cont…
Consider that Eyasu has birr 10 and he consumes
two goods, X and Y. The price of good X(Px) is
birr 1 and the price of good Y(Py) is birr 2. The
total utility he gets from consumption of the gods
are given below.
Calculate
i. Fill the Mu and Mu/P for good x and good y
ii. Find the best combination of x and y that
maximizes utility
iii. Find the maximum utility
Good X ……..Px=birr 1 Good Y…….Py=birr 2

Quantity TUx Mux MUx/Px Quantity TUy Muy Muy/Py

0 0 - - 0 0 - -
1 10 10 10 1 24 24 12
2 18 8 8 2 44 20 10
3 25 7 7 3 62 18 9
4 31 6 6 4 78 16 8
5 36 5 5 5 90 12 6
6 40 4 4 6 96 6 3
7 43 3 3 7 100 4 2
Exercise: Consider that Molla has birr 12 and he
consumes two goods X and Y. The Px=2 birr
and Py= 1 birr. The TU he gets from the
consumption of the goods are given below
i. Fill the Mu and Mu/P for good x and good y
ii. Find the best combination of x and y that
maximizes utility
iii. Find the maximum utility
 Cont…
Good X ……..Px=birr 2 Good Y…….Py=birr 1

Qty Tux Mux Mux/Px Qty Tuy Muy Muy/Py

0 0 0 0
1 16 1 11
2 30 2 21

3 42 3 30
4 52 4 38
5 60 5 45
6 66 6 51
7 70 7 56
8 72 8 60
 Cont…
2.Ordinal utility approach/Theory
The ordinal theory suggests that utility is only
relatively discernible but not quantifiable, not
measurable
Utility can only be ranked by an order or a scale
of preference to show the degree of willingness
of a consumer
Since it uses indifference curves to study the
consumer behavior, the ordinal utility theory is
also known as the indifference curve approach.
 Assumptions of IC
1.Consumer is rational
2. Consumer can simply order their preference or they
only rank the utility level
3. There is a diminishing marginal rate of substitution- the
rate at which one good substitute for another in
consumer’s basket of goods diminish as the consumer
consumes more and more of the goods.
4.The TU of a consumer measured by the amount of all
items she/he consumed from his consumption basket.
5. Consumers preference for items in his/her consumption
bundle is consistent……axioms of transitivity.
 The Indifference Set, Curve and Map
The Indifference Set
✓ is a combination of goods for which the consumer is
indifferent
✓ it shows the various combination of goods from
which the consumer drives the same level of utility.
combination X Y
A 10 2
B 6 4
C 3 6
D 2 8
Each combination of good X and Y gives the consumer equal
level of utility. Thus the consumer is indifferent whether she/he
consumes combination A, B, C or D
 Cont…
Indifference Curve
✓ graphical expression combination of goods for
which the consumer equal level of utility
Indifference Map
✓ is a set of indifference curves
✓Each successive curve to the right represents
higher level of utility.
 Characteristics of indifference curves

1. The slope of indifference curve is negative :

there is some degree of substitution between
the two goods
❖ As amount of one good increase, the amount
of the other good should decrease in order to
get the same level of utility.
2. The curve is convex to the origin, i.e. the
marginal rate of substitution of two goods is
diminishing.
 Cont…
3. A curve further away from the origin means
that it stands for a higher level of preference
than the one near to the origin
4. There is no intersection for any two curves in
the indifference map
❖That is two indifference curves never cross
each other.
Marginal rate of substitution(MRS)
MRS – is rate by which the consumer is willing
to give up a good so as to obtain more of
another good, holding total utility constant
➢MRSxy =  Y /  X
➢The number of a good Y that had to be given
up for each unit of good X to maintain the
same level of utility declines, along the
indifference curve.
y(orange)

10 ……a
6 …………b IC
3…………………C.

2 4 6 X(lemons)

How many of good y(orange) the consumer is

willing to sacrifice to get 2 more unit of good
x(lemons)……4
 Budget line
Budget line - graph that shows the various
combinations of two goods that a consumer
can buy given his limited income and prices of
goods
➢The slope of the line gives the relative price of
any one good.
➢ It tells what the consumer must give up in
terms of another good in order to buy one good
 Cont…
Budget line
M/Py =20
.a

.b

M/Px=10
 Budget line…..
• Consider that dawit has a money income of birr
100, and he consume two goods X and Y. The
price of good x is birr 10 and the price of good y
is birr 5. If he spend all his income on good y, he
would buy 20 units of good y and if he spend all
his income on good x, he would buy 10 units of
good x.
Px .X + Py. Y = M
• Any combination of two goods on or within the
budget line are attainable, and
• Any combination of the two goods above the
budget line are unattainable to the consumer, b/c
s/he can’t afford to buy them.
 Cont…
➢ The slope of the budget line = -PX / Py = ∆Y/ ∆X
for the above example the slope is -2.
Therefore, the slope of budget line is the ratio of the
prices of the two goods.
It shows the market willingness not consumer
willingness to substitute one good for another.
Factors which affect budget line
1. Income (an increase and decrease in income)
2. Change in price (of one good or both)
 Maximizing Total Utility
➢A consumer gets the maximum possible utility
when he/she buys that combination of goods at
which the budget line is tangent to the highest
attainable indifference curve
➢ An equilibrium point or satisfaction unit is
1. BL and IC are tangent at each other
2. slope of BL= slope of IC
PX / PY =  Y /  X = MuX / MuY
Cont……
 CHAPTER FOUR

THEORY OF PRODUCTION AND

COST
 Definition of Production and
Production Function
Production
➢ is the process of changing inputs into output
➢Is the process of using the services of inputs to
make g+s available.
Input
is anything that can be used in the production of
g+s. include labor, capital, land and
entrepreneurship.
There are two types of inputs
 Cont….
Fixed inputs-inputs that cannot vary overtime
Or inputs whose quantity remain fixed for a
given period of time.
Example: machineries, capital
Variable inputs –those inputs whose quantity
vary overtime
• Example: labour
 Production Function
➢ shows the relationship between inputs and the
resulting output
➢ It describe the transformation of input into output.
➢ indicates the output Q that a firm produces for
every specified combination of inputs
➢ For example if we assume that there are only two
inputs, labor (L) and capital (K). We can then
write the production function as
➢ Q = F (K, L)
➢ The equation relates the quantity of output to the
quantities of the two inputs, capital and labor
Production period

The Short run vs Long run period

Showing the nature of economic adjustment in the
firm to changing economic environment.
Short run
refers to a period of time in which at least one
input remain fixed.
Long run
refers to a period of time in which all factors of
production are variable
The Short run Production Function
➢ The production function is said to short run if there
exist at least one fixed input in the production.
➢ In this case it is assumed that there is only one
variable input
➢ This variable input is usually called “labor”
➢ It is also assumed that this variable input can be
combined in different proportions with the fixed
variable input to produce various quantities of
output.
 Cont…
➢ Consider the case in which capital is fixed, but
labor is variable, so that the firm can produce
more output by increasing its labor input
➢ Imagine, for example, that you are managing a
clothing plant
➢ You have to decide how much labor to hire and
how much clothing to produce
➢ To make the decision, you will need to know how
the amount of output Q increases (if at all), as the
input of labor L increases
 Cont…
➢ The three columns in the following table(table 4.1) gives
you this information
Measurements of output
1.Total products
➢ The total amount of output produced
2.Average product
➢ The total output produced per unit of variable
input(labor)
➢ APL=Q/L
3. Marginal Product
➢ is the additional output produced as the labor input is
increased by one unit
➢ MPL= ∆Q/∆L
 Table 4.1
Amount of Labor Amount of Capital Average Product Marginal Product
Total Output (Q)
(L) (K) (Q/L) (∆Q/∆L)

0 10 0 -
1 10 10 10 10
2 10 30 15 20
3 10 60 20 30
4 10 80 20 20
5 10 95 19 15
6 10 108 18 13
7 10 112 16 4
8 10 112 14 0
9 10 108 12 -4
10 10 100 10 -8
 Stages Of Production
In SRPF there are 3 stages of production
Stage I
➢ Starts from the origin and ends at maximum point
of AP(AP=MP)
➢ TP and AP increases throughout this stage
➢ MP at first increases then starts to decline
➢ The amount of variable input is small as
compared to the fixed input. i.e. labor is
underemployed and hence fixed input is under
utilized.
 Cont…
Stage II
➢ Starts from maximum point of AP(AP=MP) the and
ends at maximum point of TP(MP = 0)
➢ AP and MP are +ve but decrease throughout this
stage
➢ TP increases but at decreasing rate
➢ The amount of variable input is proportional with
the fixed input
➢ rational producer should produce at this stage since
this stage is the optimum stage.
 Cont…
Stage III
➢ Starts from the maximum point of TP and
endless(whenever MP is negative)
➢ TP and AP decreases throughout this stage
➢ MP decreases and even negative
➢ The amount of variable input is greater as compared to
the fixed input
➢ Each additional unit of labor contributing negatively to
total product due to excess of variable input over fixed
input. i.e. over utilization due to over
employment….due to this, this stage also known as
extensive margin.
Graphically
 The law of diminishing marginal
returns
• The law states that as increasing amount of
variable input is combines with fixed inputs,
eventually the contribution of each additional
amount of the variable input to the TP
declines.
• The law starts to operate after the MP curve
reaches its maximum.
 Cont…..
• When total product is maximum, marginal
product is zero
• When Mp equals AP, AP reaches its maximum.
• whenever, MP of the variable input is less
than AP, the AP decreases.
• Whenever MP>AP, AP increases
 Production function with two variable
input
• When Labor and capital are variable input…long run
production
• Given two variable input one can produce the same
level of product by different combination of those two
input.
• A table that represent the various combination of
labor and capital which give the producer the same
level of output is called isoquant schedule or equal
product schedule.
 isoquant schedule or equal product
schedule.
Combination Capital Labor Maximum MRTs of capital
output for labor
A 1 11 60 -
B 2 7 60 4:1
C 3 4 60 3:1
D 4 2 60 2:1
E 5 1 60 1:1
• A graphical representation of isoquant
schedule is called iso product curve or equal
product curve or simply isoquant.
• Isoquant refers to those combination ot two
variable inputs that yields the same level of
output. k

labor
 Cont…
• Isoquant map is the set of isoquant or equal
product curves.
• Each successive isoquant to the right represents
higher level of total product because it reflect the
use of more of at least one of the two input.
Properties of isoquant
1. Isoquant slopes downward
2. It is concave to the origin……MRTS
3. Isoquant never cross each other
 The economic region of production

• the the region in which the producer should

produce in case of two variable input like in
the case of stage II for short run prodction.
• Implying that the producer should select
those combinations that may not employee
him/her more of labor or capital
 Marginal rate of technical substitution
(MRTS)
• Shows an entrepreneurs willingness to substitute one
input by another input so as to be efficient in
production.
• The rate at which one input is substituted by another
input to get the same level of output is called MRTS.
• MRTS = ∆L/∆K
• (See the previous example)….show that the
principle of diminshing marginal rate of technical
substitution, determining the shape of the isoquant
 Return to scale
• Is a property of production function that indicate the
relationship between proportionate change in all inputs
and the resulting change in total product.
• It is a property that apply only in the long run.
• Three types
1. constant return to scale:- %∆ in all input = %∆in output
2. Increasing return to scale:- %∆ in all input < %∆in outpt
3. Decreasing return to scale :- %∆ in all i/pt > %∆in outpt
 Increasing return to scale may occur
because of:
a. An increase in the scale of operation…using specialized
machinery
b. Greater division of labor
c. Greater degree of specialization
effect of technological change on production function
• Technological advancement makes our limited resource
more productive.
• More output from the existing level of inputs
• The existing level of output by using less of the inputs
• It shift the TP curve up(isoquant curve down) implying
that we can produce more of the product than before.
 THEORY OF COST
Cost
➢ Is the monetary value of inputs used in production of g+s
➢ two types
1. social costs- is the cost of producing an item to the society.
2. private costs- is the cost of producing an item to the
individual producer.
Private costs can be measured in two ways
❖ Accounting cost = explicit cost(the actual or out of pocket
expenditure)
❖ Economic cost = Explicit cost+ Implicit cost(the estimated
cost of non purchased input)
It is the cost of all inputs
 Analysis of costs in the short-run
➢ In the short run, some of the firm’s inputs to
production are fixed, while others can be varied as
the firm changes its output
➢ Various measures of the cost of production can be
distinguished on this basis
❖Total Cost (TC): The total cost of production has
two components:
1. Fixed cost (FC), which is borne by the firm
whatever level of output it produces
2. Variable cost (VC), which varies with the level of
output
TC = TFC + TVC
 Cont…
❖Marginal Cost (MC):
is the increase in cost that results from
producing one extra unit of output
Marginal cost is just the increase in variable
cost that results from an extra unit of output.
We can therefore write marginal cost as
MC = ∆TC/∆Q = ∆TVC/∆Q
 Cont…
Average cost (ATC):
is the cost per unit of output. Average total cost
(ATC)is the firm’s total cost divided by its level of
output.
ATC = TC/Q

ATC has two components.

Average fixed cost (AFC) is the fixed cost divided by
the level of output.
AFC = FC/Q
Average Variable Cost (AVC): is variable cost divided
by the level of output.
AVC = VC/Q
 Table for cost measurements
Average
Rate of Variable Marginal Average Average
Fixed Cost Total Cost Variable
Output Cost Cost Fixed Cost Total Cost
Cost

(FC) (VC) (TC) (MC) (AFC) (AVC) (ATC)

0 50 0 50 - - - -
1 50 50 100 50 50 50 100
2 50 78 128 28 25 39 64
3 50 98 148 20 16.7 32.7 49.3
4 50 112 162 14 12.5 28 40.5
5 50 130 180 18 10 26 36
6 50 150 200 20 8.3 25 33.3
7 50 175 225 25 7.1 25 32.1
8 50 204 254 29 6.3 25.5 31.8
9 50 242 292 38 5.6 26.9 32.4
10 50 300 350 58 5 30 35
11 50 385 435 85 4.5 35 39.5
Cost curves for a firm
The Shapes of the Cost Curves(from
fig a & b)
Fixed cost FC does not vary with output and is
shown as a horizontal line at $50.
Variable cost VC is zero when output is zero, and
then increases continuously as output increases.
Total cost curve TC is determined by vertically
adding the fixed cost curve to the variable cost
curve.
Because fixed cost is constant, the vertical
distance between the two curves is always $50.
 Cont…
Figure b shows the corresponding set of
marginal and average variable cost curve
Since total fixed cost is $50, the average fixed
cost curve AFC falls continuously from $50
toward zero
The shape of the remaining short-run cost
curves is determined by the relationship
between the marginal and average cost curves
 Cont…
Whenever marginal cost lies below average
cost,(MC<AC) the average cost curve falls.
Whenever marginal cost lies above average
cost,(MC>AC) the average cost curve rises. And
when average cost is at a minimum, marginal cost
equals average cost
The ATC curve shows the average total cost of
production
The vertical distance between the ATC and AVC
curves decreases as output increases
 Cont…
The AVC cost curve achieves its minimum point
at a lower output than the ATC curve
This follows because MC = AVC at its minimum
point, and MC = ATC at its minimum point.
Since ATC is always greater than AVC and the
marginal cost curve MC is rising, the minimum
point of the ATC curve must lie above and to the
right of the minimum point of the AVC curve.
CHAPTER FIVE

MARKET STRUCTURE
 Market Structure
Market is a mechanism that brings buyer and
seller together.
A firm’s decision concerning price and
production depends greatly on the character of
the industry in which it is operating
Economist group industries into four distinct
market structures:
❖pure competition(perfectly competitive market)
❖pure monopoly
❖monopolistic competition(monopolistically CM)
❖oligopoly
 Con‘d
These four market models differ in several
respects:
✓The number of firms in the industry
✓Whether those firms produce a standardized
product or try to differentiate their products
from those of other firms
✓How easy or how difficult it is for firms to
enter the industry
 PURE COMPETITION(PCM)
Involves a very large number of buyers and sellers
of a product.
firms producing a standardized(homogenous)
product (that is, a product identical to that of other
producers, such as corn)
Perfect knowlegde or perfect information : every
buyer and seller has full information about the
market and nature of the product.
Free entry and exit: New firms can enter or exit the
industry very easily
 PCM….con’t
Features of PCM structure
✓A PCM firm is price taker not price setter.
✓It faces a horizontal, or perfectly elastic demand
curve
✓The firms total profit obtained through
∏ = TR – TC
….Here 3 possibilities……positive or superior ec/c
profit, normal profit or incur loss
✓the firm maximize its profit when
i. MR=MC
ii. MC is rising
 Imperfect market
• The market with imperfect competition
• It exist when a single firm has a certain degree
of control over the market price of a
product.(this happen when one or more
condition of perfect market is violated.)
3 major types
✓Pure monopoly
✓Oligopoly
✓Monopolistically competitive market
 Pure monopoly
• Is the market structure in which there is only one
firms that produces a distinctive product.
• By distinctive product we mean a product which
have no close substitute.
➢ Only one supplier of a product
➢ The product has no close substitute (unique product)
➢ There is considerable entry barrier for a new
firms...legal and patent right, control over essential raw
material, technical, economies of scale, or any other
➢ A pure monopoly firm is a price setter, not price taker
➢ Profit maximizing condition is MR=MC and MC is
rising
 Pure Monopoly
is a market structure in which one firm is the
sole seller of a product or service (for example,
a local electric utility).
Since the entry of additional firm is blocked,
one firm constitutes the entire industry
Because the monopolist produces a unique
product, it makes no effort to differentiate its
product
No close substitutes
 Monopolistic competition
Is characterized by a relatively large number of sellers
producing differentiated products (clothing, furniture,
books)
The existence of non price competition: There is widespread
non price competition, a selling strategy in which one firm
tries to distinguish its product or service from all competing
products on the basis of attributes like design and
workmanship (an approach called product differentiation).
Either entry to or exit from monopolistically competitive
industries is reasonable.
No collusion among the firms
Profit maximizing condition is MR=MC and MC is rising
Like the PCM firm MCM firm earn normal profit in the long
run
 Oligopoly
involves only a few sellers of an identical or similar
product; consequently, each firm is affected by the
decisions of its rivals and must take those decisions
into account in determining its own price and
output.
A special type of oligopoly where there are only
two firms is called duopoly
The existence of few dominant firms
Firms are mutually interdependent
They produce standardize or differentiated product
There is non price competition if the product is
differentiated product
 Market Model

Characteristic Pure Competition Monopolistic Oligopoly Pure

Competition Monopoly
Number of firms A very large Many Few One
number

Type of product Standardized Differentiated Standardized or Unique; no

differentiated close
substitutes
Control over price None Some, but within rather Limited by mutual Considerable
narrow limits interdependence;
considerable with
collusion
Condition of entry Very easy, no Relatively easy Significant obstacles Blocked
obstacles

Non price None Considerable emphasis Typically a great deal, Mostly public
competition on advertising, brand particularly with relations,
names, trademarks product differentiation advertising

Examples Agriculture Retail trade, dresses, Steel, automobiles, Local utilities

shoes farm implements, many
 CHAPTER SIX

FUNDAMENTAL CONCEPTS OF
MACROECONOMICS AND
MACROECONOMIC PROBLEMS
 Fundamental Concepts of
Macroeconomics
Macroeconomics is a branch of economics which deals
with the economy as a whole.
Macroeconomics concerns are (Macroeconomics
concerned with ):
economic growth(aggregate output level)
employment
inflation (aggregate price level)
economic fluctuation
distribution of income
macroeconomic policies
international trade and resource flows(relationship
of domestic economy with the rest of the world)
 Cont…
The objectives of macroeconomics are:
Full employment – not only providing job for all
that are willing and able to work, but also full
utilization of other economic resources.
Price stability
Economic growth and rising the living standard of
the citizen
Fair distribution of income among all citizen of
the country
Less fluctuation in economic activities
 Components of macro economy
It focuses on four groups in the economy: households,
firms(the private sector), the government(the public
sector) and the rest of the world(the international
sector).
Problems of Macroeconomics
The following are the fundamental macroeconomic
problems:
1.Business cycle
2.Unemployment
3.Inflation
4.Budget and trade deficit
 1.Business Cycle
refers to the recurrent ups and downs (fluctuations)
in the level of economic activity
countries usually experience ups and downs in the
level of total output and employment through time
There are four phases of in business cycle
1. Boom or Peak
When the economy produce the highest level of
output in business cycle
It is a period of maximum output expansion and
very low level of unemployment
The economy is operating close to full capacity
Period of prosperity
 Cont…
2. Recession(contraction)
the level of economic performance declines
output, national income and employment declines
Unemployment problem began to rise
3. Trough or Depression
Lowest point in business cycle
The economy reached at low point
unemployment rate is too high but total output
reaches to low
It is the severe stage of recession.
 4. Recovery
Cont…
the economy starts to grow or recover
total output starts to raise, national income rises
and unemployment starts to decline
D Growth trend

C
 2. Unemployment

Population

Outside the
Labor force
labor force

<14yrs old&retired people

unemployed employed Full time students

Mentally retarded people
Very sick and disabled people
 Cont…
Labor force = Employed + Unemployed
Unemployment is a portion of the labor force that
is without a job but is actively searching for a
job.
Types of Unemployment
Commonly ,there are three types of
unemployment
Frictional unemployment
Structural unemployment
Cyclical unemployment
 Cont…
1. Frictional unemployment
refers to brief period of unemployment
experienced by people due to the following
reasons:
Seasonality of work.eg. Due to bad weather,…
Entrance to the labor force. If a student spends
few months looking for a jobs after graduation, he
is considered as frictionally unemployed.
Voluntary switching of job, either in search of
better jobs or the previous job doesn’t work out.
Re-entering to the labor force
 2.Structural Unemployment
refers to unemployment resulting from mismatch
between skills and locations of job seekers and
location of vacancies
Eg. A nuclear physicist may not get job in Ethiopia
Typist may not get job in the environment where
computers are not used for work
Structural Unemployment can be caused by
➢ Permanent shifts of demand for goods and services
➢ Technological change- automations and
computerization of work may force the unskilled
workers who used to produce the product manually to
be unemployed
 3.Cyclical Unemployment
Unemployment generated due to the absence
of jobs and vacancies
Happens due to deficiency in demand for
goods and services when the economy is in
recession
Frictional and structural unemployment are
known as natural level of unemployment,
because they are unavoidable.
 Measuring Unemployment
Measured by unemployment rate
TU = FU + SU + CU
UR = TU/LF
NR = (FU + SU)/LF, where:
TU-total employment SU-structural unemployment
CU-cyclical unemployment FU- frictional unemployment
NR-natural rate of unemployment LF-labor force

❖Full employment doesn’t mean zero employment

❖Economic cost of unemployment is the amount of
output that could have been produced had the
unemployed people been employed. It is the amount of
the forgone output.
 3. Inflation
Is sustainable or continuous increase in the general(average)
price level of goods and services
can be anticipated(expected to occur) or
unanticipated(actual inflation – expected inflation)
can be measured using price index or GDP deflator
Price index refers to consumer and producer index
PI = current cost of a mkt basket of g+s x 100
cost of the same mkt basket in the base yr
CPI this yr= current cost of a mkt basket of consumer g+s x 100
cost of the same mkt basket at the base yr

• The base yr is a reference year and it is usually a normal year

when there is neither natural nor man made catastrophe.
 Cont…
• Inflation rate at time t = [(CPIt – CPIt-1)/(CPIt-1)]*100
Example: consider that the consumer price index in Ethiopia
in 1992 E.C was 120 while in 1991 E.C it was 100.
calculate the inflation rate in 1992?
Inflation rate in 1992 = [(CPI1992 – CPI1991)/(CPI1991)]*100
= [(120-100)/100] * 100
= 20%
 Causes of inflation
Generally, there are two causes of inflation
Demand – pull inflation
Cost-push inflation
Demand – pull inflation
resulting from an increase in demand for goods and
services while the economy is producing at or close to
full employment
It happens when the economy attempts to spends
beyond its production capacity
Aggregate DD grows greater faster than economy's
productive capacity at full employment(aggregate SS),
which creates shortage and this pushes price upward.
 Cont…
Cost -push inflation
Arises due to a continuous decline in aggregate supply of goods and
services. This may happen due bad weather condition, an increase in
wage and price of other inputs, decline in productivity
Effects of inflation
There are two important effects of inflation:
Redistributive effect and output effect
1. Redistribution effects of inflation
Price effect – those people who consume those g+s whose price are
rising rapidly suffer more than those who consume g+s whose price
rise slowly.
Income effect - increase in price reduce the purchasing power
* redistribute income from fixed income earners to flexible income
earners
* harm savers and creditors and benefit borrowers
wealth effects- people who own assets like land and BLDG will
better off than others b/c the real value of such asset doesn’t decrease
during inflationary periods.
 Cont…
2. Output effects of inflation
it creates uncertainty – difficult for producer,
investors to make production decisions
Encourage speculation
Shorten time horizon- during inflationary
period producers, sellers and consumers
postpone or cancel their expenditure plans.
This may reduce the total output and
employment level in the economy
CHAPTER SEVEN

NATIONAL INCOME
ACCOUNTING
 National income account
➢Is an accounting record of the level of
economic activities of an economy
➢is a measure of aggregate output, income and
expenditure in an economy
Its importance:
➢To know economic performance of country
➢To observe the long run trend of the economy
➢To formulate economic policies
 Gross Domestic Product(GDP) and
Gross National Product(GNP)
GDP
is the market of currently produced final goods and
services that are produced within in the country’s
borders(boundary) during a given period of time,
usually one year.
GNP
is the market value of currently produced final goods
and services that are produced by domestically owned
factors of production during a given period of time
It measure the total output or income generated by
domestic residents’ factors of production irrespective of
where these resource are used.
 Cont…
GNP = GDP + NFI
NFI- net factor income
NFI = factor income received from abroad - factor
income received by foreigners from domestic
economy
NFI can be positive, negative or zero
NFI>0,then GNP>GDP
NFI<0,then GNP<GDP
NFI=0, then GNP=GDP
 Problems associated with measuring
GDP
The problems:
✓ Double counting
To avoid this problem we should take
o The market value of final g+s
o The value added at each stage of production
✓ Don’t include non-productive transactions…transfer payments
✓ Failing to measure non-marketed outputs since they have no
market price
-government production of public goods
-households output which produced for home consumption
purpose
- Leisure activities such as the satisfaction obtained from
recreational activities aren’t included in GDP
 Cont…..

✓It is difficult to measure outputs in the informal

sector
-the informal sector is that part of the economy which
consists of activities or output that are never report
to tax and other gov’t authorities. It include both
legal(sealing tela, tej,…) and illegal(like drug
dealing) activities
✓Distribution of income across household is not
included in GDP
✓Cost of environmental damage is not counted in
GDP.
 Measuring GDP and GNP
Three methods:
1. Product approach/value added approach
2. Expenditure approach
3. Income approach
1. Product approach
✓ Calculated by adding the market value of goods
and services produced by each sector of the
economy i.e. agriculture, service and industry
 Cont…
2.Expenditure Approach
GDP is measured by adding all spending on final final
goods and services produced in the country
The expenditures made on the final goods and services
of country can be divided into four categories.
These are
I. Personal consumption expenditure
II. Gross domestic private investment expenditure
III. Government spending on goods and services
IV. Net export
 Cont…
I. Personal consumption expenditure(C)
➢Expenditure made by households to purchase final
g+s for consumption purpose
➢They are divided into three:
1. Durable consumer goods- are those goods that can
be used for longer period of time such as cars, TV,…
2. Non-durable consumer goods- are those goods
that can be used/consumed for shorter period of time
such as food, fuel,…
3. Services- include education, haircut, transport,
health service….
 Cont…
II. Gross domestic private investment expenditure(I)
➢ Expenditure by private sectors for investment purpose
GI= Net Inv’nt + depreciation(consumption of fixed
asset)
➢ Includes three types of expenditures
1. Business investment expenditure/business fixed
investment on machinery, equipment
2.Construction expenditure-expenditure on residential
and non residential constructions
3.All increase in inventories-these is unsold output
currently produced by firms and counted in GDP as if
they were purchased by the firms’ themselves
 Cont…

III. Government spending on goods and services(G)

➢ Expenditure by local and federal government
➢ NB:All expenditures made by government will not
be counted.
Eg. Public transfer payments like pension and interest
payments on the country’s debt will not be counted
 Cont…
IV. Net export(NX)
➢It means export (X)mines import(M)
➢Imported goods are not our country's output,
these we can not include them in GDP
calculation
GDP = C+I+G+NX
 Cont…
3. Income Approach
➢GDP is measured by adding all incomes earned
by domestic factors of production to produce
goods and services
➢These factors of production are labor, land ,
capital, and entrepreneurship
 Cont…
These payments includes:\
i. Compensation of employees: the reward for labor. i.e.
Wages and salaries
ii. Rental income: the reward for land
iii. Proprietor’s income/ profits/: income earned by
entrepreneurs.
iv. Interest income: the reward for capital
v. Depreciation: allowance of capital consumption
A portion of capital goods used in the production
process that wear out or used up in the current
production process
vi. Indirect business taxes: like excise and sales tax
GDP = i + ii+ iii+ iv+ v + vi
 Nominal and Real GDP
Nominal GDP
Is monetary value of currently produced final outputs
measured at current market price
Is GDP measured at current market price
Is not useful to compare country’s economic
performance through time
Real GDP
it is the value of currently produced g+s at constant
price. or it is measure of GDP at constant price
It is calculated by dividing the nominal GDP by price
index
Real GDP = (nominal GDP/price index)x 100
 Cont…

Eg. The Ethiopian nominal GDP and the CPI for the year
1985 and 1986 was given below. Calculate the real
GDP and the economic growth?
Year nominal GDP CPI real GDP

1985 26,671.40 849.9 3138.18

1986 28,328.90 858.9 3298.28

Economic growth = RGDPt – RGDPt-1 x 100

RGDPt-1
5.1 %
 Other social account
• Net domestic product (NDP): it is the measure of the
total value of the economy without impairing the future
production capacity of the economy.
NDP = GDP – Depreciation
• National Income (NI): is the total income earned by
our factors of production irrespective of where they are
used.
NI = NDP + NFI – indirect business tax
• Personal income: income earned by persons or hhs.
PI = NI – [social security contribution + corporate
income tax + retained corporate profit] + [public
transfer payments + net interest on government debt]
• Personal disposable income(Yd): home take money
Yd = PI – personal taxes
Yd = c +s
 Income inequality and Distribution
GDP and GNP doesn’t indicate how the total output
currently produced is distributed in the economy
The distribution of income measured in two
measures
i. Functional distribution of income
✓ refers to the distribution of national income to
owners of factors of production, i.e. labor, land, ...
ii. Personal distribution of income
✓ Shows the distribution of national income to
individual families
 Cont…
The sources of income inequalities in country can
be :
i. Differences Wealth
ii. Differences Ability
iii. Discrimination: which leads to difference in
opportunities for achievements.
iv. Differences in education, energy and motivation
v. Differences in human capital and investment
choices
 GDP and Informal sector
➢Informal sector of the economy is part of the
economy which consists of activities that are never
reported to government authorities
➢These activities can be legal or illegal
➢GDP doesn’t usually include these activities due to
lack of information
➢Tax evasion is usually thought to be the major
incentive for a person to participate in the informal
sector.
➢When the size of informal sector is large , the GDP
understates the performance of the economy
 Exercise
1. Suppose that the year 2004 exports were equal to
imports and gross investment was equal to government
expenditure. Private final consumption expenditure
was twice its government expenditure and equal to birr
300 million.
a. Calculate GDP
b. Calculate GNP assuming NFI was birr 30 million
c. Calculate the value of depreciation if the value of NNP
during the year was birr 430 million?
2. Given
C = 200 + 0.02yd
G = 500, I = 400 , NX = 200 and Yd = 0.25GDP
Find GDP, Yd, C