PRINCIPLES OF ECONOMICS

SOS-311

LECTURE NOTES

ASTU,2016/2017
 TABLE OF CONTENTS

Contents
CHAPTER ONE ..................................................................................................... 1
1.1. Introduction .............................................................................................. 1
1.2. Definitions, Scope and Nature of Economics .......................................... 1
1.3. Fundamental Problems of Economics and Alternative Economic
Systems ............................................................................................................... 5
1.4. Scarcity, Production Possibility curve and opportunity cost.................... 7
1.5. Decision Making Unit and Circular flow of economic activities........... 11
1.5.1. Decision Making Units ....................................................................... 11
1.5.2. Circular Flow of Economic Activities ............................................ 12
1.6. Lesson Summary .................................................................................... 13
CHAPTER TWO .................................................................................................. 15
THEORY OF DEMAND AND SUPPLY (ANSWER TO................................... 15
RESOURCE ALLOCATION).............................................................................. 15
2.1. Introduction ............................................................................................ 15
2.2. Lesson Objectives .................................................................................. 15
2.3. The Concept of Market Structure ........................................................... 15
2.4. Perfectly Competitive Market ................................................................ 16
2.5. Demand and Supply ............................................................................... 17
2.5.1. Demand and Demand Schedule ...................................................... 17
2.5.2. Determinants of Demand ................................................................ 21
2.5.3. Supply Schedule and Curve ............................................................ 23
2.5.4. Determinants of Supply .................................................................. 26
2.6. Market Equilibrium ................................................................................ 28
2.7. Elasticity of Demand and Supply ........................................................... 34
CHAPTER THREE .............................................................................................. 45
THEORY OF CONSUMERS BEHAVIOR ......................................................... 45
3.1. Introduction ............................................................................................ 45
3.2. Lesson Objective .................................................................................... 45
3.3. Cardinal Utility Approach to Consumers Behavior ............................... 46
3.4. Ordinal Utility Approach ....................................................................... 53
3.4.1. Indifference Curve .......................................................................... 55

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 3.4.2. Consumer’s Budget Constraint ....................................................... 60
3.4.3. The consumer’s Optimum and the Demand Curve......................... 64
3.5. Lesson Summary .................................................................................... 72
CHAPTER FOUR ................................................................................................. 75
THE THEORY OF PRODUCTION ..................................................................... 75
4.1. Introduction: Definition and basic concepts of Production .................... 75
4.2. Production in the short run: Production with one variable input ........... 77
4.3. The concept of Total Product (TP), Marginal Product (MP) and Average
Product (AP) ..................................................................................................... 78
4.4. Stages of Production in the short-run or Efficient Region of
Production in the short-run ............................................................................... 82
CHAPTER FIVE THEORY OF COSTS AND PROFIT MAXIMIZATION ...... 84
5.1. Introduction ............................................................................................ 84
5.2. Short-run Cost ........................................................................................ 84
5.3. Profit Maximization of a Competitive Firm........................................... 91

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 CHAPTER ONE
1.1. Introduction

This lesson will try to acquaint students with basic economic concepts and
terminologies, which are necessary to understand the subject matter of economics.
It will try to present some reasons why you as a student learn economics. The two
fundamental facts, limited resources and unlimited wants, which provide a reason
for the existence of the subject of economics, are also briefly explained.
The lesson will present in some detail the basic economic problems, which are
common to all countries, and how they are solved in different economic systems.
The lesson will also provide basic concepts about scarcity of economic resources
and production possibility curve which shows the various combinations of two
goods that an economy can provide when its resources are fully employed. The
circular flow of economic activities presents how decision-making units interact in
the market economy system.
Objective
After working through this lesson, you should be able to

 Define economics
 Explain the nature and scope of economics
 Understand different methods of economic analysis
 Explain the relationship between economic resource and the issue of
scarcity
 Understand the concept of opportunity cost and production possibility
curve

1.2. Definitions, Scope and Nature of Economics

Why do you study Economics?

Economics is a word commonly used in our daily conversation. What is economics

and why do you need to learn economics? Before defining economics first let us
try to see the reasons why people want to study economics. Many people study
economics for various reasons. Some people want to study economics because
they hope to make money. Some, on the other hand, need to study economics
because they feel illiterate if they cannot know and understand the law of demand
and supply. Many want to learn economics because they want to know and
understand how budget deficit and inflation will affect their future life.

Generally, knowledge about economics is important because each one of us faces

economic problem at different level and makes economic decision throughout our
life knowingly or unknowingly. For instance, on a personal level, we often make
some personal decisions like, which job should we take? How can we best spend
our income? Shall we buy or rent a house? And so on. If someone enters in
business, he will face many economic decisions like, what to produce or what type

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of service to provide? How and in what quantity to produce? And so on. Also in
politics, we face many economic decisions like, how much the nation should spend
on defense, on health care and environment, on education and on different physical
infrastructure? Even as a voter, we evaluate candidates partly on the basis of their
economic view. That is, on the basis of their view on unemployment, on inflation
and over all on their socio-economic program.

In short, economic literacy is important because economic issues facing

government and individual shape the future of the nation and affect the well being
of its citizen. Therefore, for these and the like reasons, it is essential that
economics be made accessible to every one.
What is Economics?
Before defining economics, we better first introduce some terminologies, which
are necessary for better understanding of the definition of economics.

Resources
Resource is anything that can be used to produce good and services. Resources are
also called inputs or factors of production. Resources (factors of production or
inputs) are divided into four categories namely,

i. Land
ii. Labor
iii. Capital
iv. Entrepreneurship

i. Land: - Is a natural gift, which includes all natural resources which are found
inside and on the surface of the land. These are like:

 Different Minerals
 Soil, River, Lake Pond
 Timber or Forest Resource
and other natural materials necessary to produce goods and services.

ii. Labor: - Is mental and physical human effort (ability) used in the production
process. The skill and amount of labor will be important in determining level and
quality of production.

iii. Capital:- Capital is man made means of production used in the production
process here belongs resources like:-
 Machineries, equipments, tools used in the production process.
 Buildings and materials attached to it
 And financial capital

iv. Entrepreneurship:- It is managerial skill of organizing and combining

the above three resources for production purposes. The above resources cannot be
productive and be changed into goods and services with out the creative effort of

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 entrepreneur. Entrepreneur is an individual who organizes resources for
production, introduces new product or techniques of production.
The principal role of Entrepreneur includes
 Introduces new product and new method of production
 Sets the overall direction of the firm
 He is a risk taker
Factors of production are combined differently by entrepreneur in the production
process and will be converted into goods and services.

Inputs (Resources) Output

Land, Labor, Capital, (production process) (Goods and Services)

Entrepreneur
Goods Vs Services
The distinction between goods and services is based on whether the output
(product) is tangible or intangible.Tangible Goods are those like, clothes, shoes,
beverage, automobile and the like. These are good feasible and can be sensed it
existence. Intangibles Goods are those like haircut, computer repairs, teaching,
consultation and so on.

Fundamental Facts
There are two fundamental facts, which constitute the economizing problems and
provide foundation for the subject economics. These are unlimited wants and
limited economic resources.
a) Society's wants for material goods and services are unlimited: Our needs
for goods and services are insatiable or can not be satisfied because,

i/ Wants are multiplicative:- Introduction of a new commodity

creates need for many other commodity. For example, purchasing
of a car creates needs for parking place, fuel, oil and so on.

ii/ Wants are recurrent:- Even if a specific want is satisfied at a

particular time, it may recur. Take for instance food consumption.
Need for food may reoccur several times a day. The same thing is
true for clothing. In short people will consume most of the
commodity money times throughout their life.

iii/ Wants Multiply Endlessly. If one want is satisfied, the need for
another arises. If we satisfy our need for food in a particular period
of time, need for cloth arise and if we satisfy our need for it, need
for shelter comes. In such manner human wants multiply
continuously.

iv/ Human nature is accumulative:- People accumulate things

beyond their present need. Even if all needs were satisfied at a

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 particular period of time, people would like to keep it more for the
consumption sometimes in the future.
In general, people have insatiable desire for goods and services to raise their
standard of living.
b) Limited Economic Resources: - Economic resources like various types of
labor, natural resources, capital and entrepreneur ability we use to produce
goods and services are limited. If economic resources are not sufficient to
produce all goods and services needed by a society, then we have to make
choice as to which good to produce first.
Thus, unlimited wants and limited resources will give us the
problem of scarcity. Because of scarcity, economic resources
must be allocated efficiently. Scarcity implies resources are
insufficient to produce all goods and services desired by
consumers or society as a whole. To solve this and related
issues we have a discipline called Economics. Therefore,
economics is the study of how scarce resource is allocated
among alternative and competing material wants in order to
maximize the consumption of material goods and services.

In addition to the above concepts, there are others which are very important in
understanding this course. Some of them are given below.

Microeconomics Vs Macroeconomics
Economics is typically divided into two parts, microeconomics and
macroeconomics. Microeconomics is the part of economics, which studies
decision making undertaken by individuals (households) and by firms. It studies
the behavior of individual components of the economy like, households and
business firms. Macroeconomics, on the other hand, is the part of economics,
which studies the behavior of the economy taken as a whole. It deals with
phenomenon at overall economy level like, unemployment, inflation and national
income. It studies the function of the economy taken as a whole.

Positive Economics Vs Normative Economics

Positive Economics is economic analysis that uses positive analysis. It is an
economic analysis strictly limited to make purely descriptive statements of
scientific prediction.
For example, if the price of oil increases relative to all other prices, then the
amount that people will buy will fall. Here economics will tell us what will happen
if some action is taken.

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Normative Economics, on the other hand, is analysis involving value judgment.
Here the economics will tell us what should be done. For example, if the price of
oil goes up, people will buy less of it, therefore, we should not allow the price to
go up. Such statement is a normative economic statement.

The Functions of Economics

Economics helps to make decision in various aspects. It helps make production
decision, exchange of production and consumption decision. Economics will also
addresses issues like development, inflation, poverty, public finance and the like.
The goal of economics is to bring about
 Full employment
 Economic growth
 Price Stability
 Balance of International trade and finance
 Equitable distribution of income, etc.
1.3. Fundamental Problems of Economics and Alternative Economic
Systems

As we have mentioned it earlier, because of scarcity, there must be a choice in the

use of economic resources. The important characteristics of economic resources
are that they can be put into alternative uses. Society, therefore, must choose the
best ways of using scarce resources. Nations be it rich or poor, developed or under
developed, will all face the problem of choice.

In other words, all countries, regardless of their wealth and level of development,
face three basic economics problems, namely;
i. What to produce?
ii. How to produce?
iii. For whom to produce?
i. What to produce? What commodity in what quantity to produce? How
much of each of the many possible goods and services will be produced?
This is about choice among the available enterprise.

ii. How to produce? Who is going to produce? What resources and

technology will be used to produce the selected product or service? Here is
about a choice among different technology.

iii. For whom to produce? Once the commodity is produced who will get it?
Here the society tries to address the problem of distribution of national
income among members of the society. Do we have a society in which a
few are rich and many poor? Or all share the national income on equal
basis.
The answer to these questions depends upon the ownership of economic resources.
These three economic problems are common to all societies but their solution
varies from country to country. In other words, different economic systems try to
solve these problems differently. Economic System is the set of organizational

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arrangements and institutions that are established to solve the economic problems
what, how and for whom to produce. Economic systems are different from each
other on the basis of:-
 The ownership of means of production (resources)
 The method by which economic activities are coordinated and directed
Historically, four different types of economic systems are observed. These are,
i. Pure capitalism (free market economy)
ii. Command Economy System (Socialism)
iii. Mixed Economy System (Hybrid Economy)
iv. Traditional Economy (Customary Economy)

i. Free Market Economy (Capitalist Economy System): Under this system

economic resources are privately owned and economic activities are
coordinated through market mechanism through price system. Major
Characteristics of Market Economy are:
a) Private Property: Individuals have full right to own and accumulate
private property.
b) Freedom of Entrepreneurial Activity: Individuals or firms are
free to
 Establish any kind of business firms
 Produce goods and services
 To buy any amount of economic resource
 To sell goods and services
c) Freedom of choice: Households are free to choose things they buy
and sell.
d) Self Interest: is the motivating factor for both households and
business firms. Self-interest is a guiding force to carry out economic
activities.
e) Competition: is the regulating factor of self-interest. Competition is
given by large number of firms acting independently and a free entry
and exit of firms in and out of the market. This competition regulates
the different interest of firms and households.
f) Government: plays limited role. It provide legal framework for
normal functioning of the market and its elements.
Thus, under this economic system, the three basic economic problems can
be solved by price mechanism. The question of what to produce is
answered as those goods and services for which the households are willing
to spend their income, i.e., the money (birr) vote of consumers determines
what to produce..

The question of how to produce is answered using the least cost producing
technology, i.e., to produce as much output as is possible at lowest possible costs
Using the cheapest resource combinations. Lastly, the question of for whom to
produce is solved by the price mechanism in such a way that those who can pay
higher possible price will get the product produced. In other words the one who

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will pay the highest price will get the commodity produced. Note that the question
of for whom to produce amounts to asking who will get the produce once the it is
produced.

In general, the market economy is believed to lead to innovation and quality

production through competition and freedom of choice.

ii. Command Economy System (Socialism): In this economic system, means

of production or economic resources are owned by state or by a
community. Economic activities are coordinated by a central government.
Social welfare is the guiding force for economic activities. The role of
market and competition is eliminated by law. Freedom of choice is curbed
by what society can afford for all.
Decision concerning the basic economic problems or all decision about production
and distribution is made by the central government.

iii. Mixed Economy System: Is one in which, there exist both government
and market economy system. It is supposed to combine good elements of
both market and socialist economy.

iv. Traditional Economy: - In this economy system production and

distribution are coordinated by custom. Technological change and
innovation are constrained by tradition. Economic activities are considered
secondary to religion and cultural value. Thus, basic economic problems
are solved by custom rule or tradition passed on from father to son.
1.4. Scarcity, Production Possibility curve and opportunity cost
Why we are concerned with the fundamental problems, how and for whom to
produce? These problems arise because people want to consume far more than an
economy can produce. If human desire were fully satisfied, we don't need to worry
about the efficient use of resources. Because all of us could have as much as we
please and no one would care about the distribution of income among people.

But, the reality is somewhat different. Because, we cannot have all we want from
nature without sacrifices. The law of scarcity states that goods are scarce because
there are no enough resources to produce all the goods that people want to
consume. This implies there is always tradeoff between alternative choices. The
tradeoff between alternatives choices can be examined by simple model called
production possibility model. The Production Possibility Model (PPM) shows the
maximum combination of two goods that can be produced if all resources are fully
employed.

Trade off is graphically represented by a production possibility curve (PPC). PPC

is a line representing all possible maximum combination of two goods that can be
produced. The production possibility curve (PPC) is based on the following
assumptions.
 Economy produces only two goods
 Resources are fixed

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  No unemployment or under employment
 Technology is given

To explain how tradeoff occurs, consider the following production possibility

model. Suppose a country can produce two commodities, corn and tractor.

Table 1- 1 Production Possibility Schedule

Tractor in Corn in Tradeoff

1000 mil. tone Tractor Corn
A 0 6
B 5 5 +5 -1
C 10 4 +5 -1
D 14 3 +4 -1
E 17 2 +3 -1
F 19 1 +2 -1
G 20 0 +1 -1

From above table, if all resources are used in the production of corn alone, the
maximum amount corn that can be produced is 6 mill ton. Similarly, if all the
available resources are used only in the production tractor, the maximum amount
that can be produced is 20 thousand tractors. These are two extreme possibilities.
In between, various combinations of corn and tractor can be produced. Since
resources are limited and fully employed, increase in the production of one of the
two products require the shifting of resources away from the production which
leads to a fall in amount produced of another product. In other words, there is a
tradeoff between corn and tractor.

Tradeoff here implies the economy can only produce more of tractor if it gives up
some of the corn production. The value of trade off is called opportunity cost.
Opportunity Cost is the value (amount) that must be sacrificed to attain
something. That is,
the amount sacrificed of one good
Opportunity Cost 
the amount obtained of other good
In our example the amount of corn, which must be sacrificed to get one more unit
of tractor, is the opportunity cost of tractor. For example, initially if the economy is
at point or alternative B and moves to alternative C, the opportunity cost of tractor
is 0.2 unit of corn (0.2 mill). That is,
54 1
  0.2
10  5 5
Which implies to produce one more unit of tractor the country should give up 0.2
million tons of corn. Similarly the opportunity cost of corn if the economy moves
from C to B will be:-
10  5 5
 5
54 1

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Meaning the economy moves from C to B the opportunity cost of producing one
unit of corn is 5. That is, the economy should give up 5 thousands of tractor in
order to produce 1 million tons of corn. This is shown graphically by using
production possibility curve as shown below. The curve shows that if the society
wants to have more corn, it must have less of tractor. Each point on the production
possibility curve represents maximum output that can be produced by the economy
if all resources are fully employed at a given technology.

Whenever, the economy is operating on the production possibility at a point like A,

B, C, D, E, F, G then we say that the economy is operating efficiently. Points ying
outside the production possibility curve, like R would be superior to any point on
the curve, but such points are unattainable, with the limited supplies of resources
and fixed technology. Where as point such as S, which lies below the production,
possibility curve represents situation that is not efficient. Because such point
represents a situation where resource are underemployed. From this point it is
possible to increase both products and only one product without decreasing the
other one.

Tractor
G
20 F R
19 E
17 D
D
14
C
C
10

5 B
S

A
0 Corn
1 2 3 4 5 6
Figure 1- 1 Production and Possibility Curve

Roles of Production Possibility Curve

 It illustrates and provides the basic definition of economics
 It will illustrate and provide a rigorous definition of scarcity

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  It also illustrates the concept of scarcity
Change in Production Possibility Curve
Our discussion on production possibility curve was based on the assumption of
fixed resources, full employment, and fixed technology. Whenever there is a
change in the above assumption the production possibility curve changes as well.
To see this change let us relax these assumptions one by one to see its effect on the
production possibility curve.
a) Change in the resources availability. When the country's resource
increase or decrease the PPC shift accordingly. If the available resource
increase the PPC shifts outwards. If the available resource decrease the
PPC shifts in wards.
(a) (b)
Increase in resource Decrease in resource
Tractor

Tractor
Corn Corn
Figure 1- 2 Shift in PPC due to charge in the available resources.

The question, however, is that how can resources increase? Before giving answer
to this equation, first let us look at the nature of goods that can be produced by the
economy. Goods that can be produced in the economy can be either capital good or
consumption good. Consumption Goods are goods produced for direct
consumption. Such goods will not contribute to future consumption. These are
goods like food, items, clothing, and the like. Capital Goods, on the other hand,
are goods produced in order to produce other goods and services. They are not
produced for direct consumption. Such goods contribute to future consumption.
Examples of such goods are, tractor, tools, equipment, and the like.

One way of increasing economic resources is producing more capital goods (in our
example tractor) and less consumption goods (like corn). Thus, if a country
produces more capital good and less consumption goods, it can accelerate
economic growth because the country will add more to its capital stock. More
capital stock implies the ability to produce more additional output next period. The
ability of a country to produce greater level of output represented by the outward
shift of its production possibility curve is called Economic Growth.
b) Change in Technology (The effect of Technological Progress on
PPC)
If technological progress occurs in the production of both goods, the production

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 possibility curve shifts outward as shown below.

Tractor
Corn

Figure 1- 3 Shift in PPC due to change in technology

But when technological progress occurs in the production of only one good, the
production possibility curve rotates outwards.

Technological Progress Technical progress

in the production of tractor in the production of corn

Tractor
Tractor

Corn
Corn
Figure 1- 4 Change in PPC when technological change occurs in the production of one
good.

1.5. Decision Making Unit and Circular flow of economic activities

1.5.1. Decision Making Units

What are the major decision making units in the economy?

Major decision-making units in the economy are households, business firms and
government.

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Households:- Households are consumers of final goods and services produced
by the economy. Consumers are the owners of economic resources like land, labor,
and capital. They earn income from their labor and from the property they own.
Households are generally assumed to maximize their well-being or what
economists call "utility”.

Business Firms: - Business firms are the producing unit in the economy. They
hire workers and pay for the use of various property owned by households. They
use economic resources to produce goods and services needed by households and
other firms.
Firms come in all size and forms. However, regardless of their size all firms share
common objective, i.e. profit maximization.

Government: The term government used to broadly include all government and
quasi-government bodies at the federal state and local level. Unlike the
households and business firms, government is not assumed to have a single goal.
In a pure market economy system the role of the government is limited to such
activities like law entertainment. Generally, how the market economic system
functions can be shown using the simple model called circular flow diagram
shown on the next page.
1.5.2. Circular Flow of Economic Activities

The circular flow diagram tries to illustrate how an economic system works and
how solutions to the basic economic problems are made. It also captures the
interrelationship between resource markets and product markets. Households need
goods and services on which they spend their income. Business firms need
economic resources owned by households to produce goods and services needed
by households.
To buy goods and services, Households will sell their economic resources like,
labor, capital, land and entrepreneur skill and generate income which will be spent
on goods and services produced by business firms as shown in figure 5 below.
Business firms will pay for the resources in the resource market in the form of
wage (for the labor resource), interest rate (for capital) and rent (for land) and use
these resources to produce goods and services demanded by households. There are
two different markets in the diagram: resource market and product market.
In the resource market economic resources are traded. From the resource market
money in the form of consumers' income flow to households and economic
resources flow to business firms. Similarly in the product market, money income
in the form of revenue of low to business firms and goods and services flow to
households. Generally, both households and firms participate in both markets but
on different side of each, once as a demander then as a supplier.

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 Consumption
Revenue of Firms Expenditure

Flow of goods & Flow of goods & services

services
Product Market

Business
Firm Households

Flow of resource
Flow of resource

Firms’ expenditure Resources

on economic resources

Income to resource owner

1.6. Summary
Though different people have different motive to study economics, knowledge
about economics in general is essential because everyone faces economic problems
at different level and makes economic decision throughout his/her life knowingly
or unknowingly. Therefore, economic literacy is important because economic
issues facing government and individuals shape the future of the nation and affect
the well being of its citizen.

Limited economic resources and unlimited societal wants for material goods and
services are two fundamental facts, which lay foundation for economics discipline
and economizing problems. Economic resources like, different types of labor, land,
capital and entrepreneurial skill are limited. Whereas society’s need for goods and
services are unlimited as wants are multiplicative, recurrent and human nature is
accumulative. The limited resource and unlimited wants will give rise to the
problem of scarcity.
Economics is therefore, the study of how scarce resources are allocated among
alternative and competing material wants in order to maximize the consumption of
goods and services.

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The basic divisions in economics are microeconomics and macroeconomics.
Microeconomics studies the behavior of individual components of the economy
like, households and business firms. Macroeconomics on the other hand deals
with phenomenon at the overall economy levels like, unemployment, inflation and
national income. Economics can be positive or normative. Positive economics
uses positive analysis and is limited to make purely descriptive statement of
scientific prediction. Normative economics involves value judgment and it tell us
what should be done.

The three major or fundamental problems of economics are what to produce? how
to produce? and for whom to produce? These problems are universal to all
countries regardless of their level of development. However, different countries
having different economic system use different approach to solve them. Economic
system is the set of organizational arrangement and institutions established to solve
the fundamental economic problems, what, how and for whom to produce.
Economic systems are different from each other on the basis of the ownership of
economic resources and the method by which economic activities are coordinated.
The four economic systems are free market economy, command economy, mixed
economy and traditional economy system.

Production Possibility Curve (PPC) shows the various combinations of two types
of goods that an economy can produce when its resources are fully employed. If a
society produces on the PPC efficiency is said to be achieved. Society can produce
on the PPC only when full-employment and full-production are realized. If the
quantity of economic resources is increased, or the quality of resources is
improved, or there is advance in technology the PPC expands and this implies that
there is economic growth. If there is no change in these economic resources, the
country cannot increase the quantity the other good. In this case producing more
of one required producing less of the other good, with full employment. This
reflects the concept of opportunity cost. Opportunity cost is the amount of one
product, which must be given up to obtain additional unit of another product.

Households, business and government are the major decision make unit of the
economy. While household attempts to maximize their utility, firms want to
maximize their profit. The link between them is shown by circular flow diagram.

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 CHAPTER TWO
THEORY OF DEMAND AND SUPPLY (ANSWER TO
RESOURCE ALLOCATION)
2.1. Introduction

In a free market economic system, economic resources are allocated through price
mechanism. Price will coordinate and lead the economic activities. You will learn
how price is determined in this economy system. Actually price is determined by
market forces. That is by the interaction of market demand and supply. This
lesson gives you a good understanding about demand and supply and factors that
affects them. Issues related to market equilibrium and factors affecting it will also
be explained. The lesson also gives you some basic concept concerning
responsiveness of consumers and producers for the change in their determinants.
Some basic mathematical approaches are employed to make the lesson more
understandable.

2.2. Lesson Objectives

After studying this Chapter, you should be able to-

 Understand the different types of market structure
 Know basic assumptions of free market economy or perfect
competition.
 Define demand and explain the law of demand
 Understand determinants of demands
 Define supply and explain the law of supply
 Understand determinants of supply
 Understand how price in market economy system is determined
 Explain the concept of responsiveness of consumers as well as
producers for the change in the determinants of demand and supply.

2.3. The Concept of Market Structure

Market is a place or condition in which buyers and sellers meet to exchange goods
and services for the price they agree on. In the theory of the firm we are concerned
with the question, how prices of commodities are determined in the market? The
determination of price of a commodity depends on the number of sellers and buyer
in the market. The number of buyers and sellers determine the nature and degree
of competition in the market.

The nature and degree of competition makes or create the structure of the market.
Thus, the market structure is determined or defined by the nature and degree of
competition in market. Depending on the number of sellers and the degree of
competition, the market structure is broadly classified as follows.

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 i. Perfect competition (competitive market)
ii. Imperfect market (noncompetitive market ):here belong market
structures like:-
A. Monopoly market structure
B. Monopolistic competition and
C. Oligopoly
This course gives focus only to the perfectly competitive market and how prices of
goods and services are determined in this market structure.
2.4. Perfectly Competitive Market
The perfectly competitive market is based on the following assumptions.
1. Large number of buyers and sellers acting independently
2. Product homogeneity: - This means the technical characteristics of the
product as well as the service associated with its sale and delivery are
identical. In other way, there is no way in which a buyer could
differentiate among the products of different firms. If the product were
differentiated the firm would have some discretion in setting its price.
These assumptions of large number of firms and product homogeneity together,
imply that the individual firm is price taker.
3. Free entry and exit of firms: - There is no barrier to entry or exit
from the industry where industry is defined as a group of firms
producing similar or homogeneous product. Entry or exit may take
time, but firms have freedom of movement in and out of the industry.
This assumption is supplementary to the assumption of large number of
firms. If barrier exists, the number of firms in the industry may be
reduced.
4. Profit Maximization objective:- The goal of a firm is profit
maximization
5. No or minimum government intervention: There is minimum or
no government intervention in the market. Tariff, subsidy rationing of
production and the like mechanisms by the government do not exist
6. Perfect Mobility of Factors of Production: - Factors of
production including labor are free to move from one firm to another
throughout the economy.
7. Perfect knowledge or information: All buyers and sellers have
complete knowledge about the price, availability and quantity of output.
In other words, decision is made under certainty.
Given these conditions, there will be competition among sellers. And this
competition will lead to the efficient production and use of resources. All markets
that will not fulfill the above conditions are said to be imperfect or non-
Competitive Market. Under these conditions, price can coordinate and lead the
economic activities. In short, price in Perfectly Competitive Market plays the
following roles:.

16
  In product market price signals consumers’ preferences and thus
will determine what goods and services will be produced and how
much of them each.
 In resource market, price indicates relative scarcity of the resources
and thus it determines the use of factors of production.
2.5. Demand and Supply
2.5.1. Demand and Demand Schedule

The price of goods and services influence the consumer’s demand in that high
price discourages consumption and, in contrast, low price encourages additional
purchases.
But, what is Demand? Demand is the amount of goods and services that
consumers are willing to buy at a particular price, other thing remaining
unchanged. An individual's demand for a good is the quantities of it that the
consumer is willing and able to buy at each specific price, over some given period
of time, other things remaining the same. A table showing the relationship between
the price of a good and the quantity demanded per period of time, other things
remained constant, is known as Demand Schedule. For example, consider
individual demand schedule for meat per month.

Table 2- 1 Individual Demand Schedule for Meat

Price of meat Quantity demanded

per k.g. in birr in k.g. per month

15 2

12 5

8 8

4 10

The graphical representation of demand schedule is called demand curve.

Demand Curve is a diagram showing the relationship between the price of goods
and the quantity demanded per period of time.

17
 Price

14

12

10
8

4
D
2

Quantity
2 4 6 8 10 12 14

Figure 2- 1 Individual Demand Curve for meat

Demand can also be mathematically represented by a demand equation.

Qd  a  bP
Where Qd and P stand for Quantity demanded and Price respectively and ‘a’ and
‘b’ are constants.
Consider the following demand equation for meat Q  15  P . Using this demand
equation, the demand schedule can be determined as follows:

Table 2- 2 Demand schedule from demand equation

Price in birr Quantity in kg
15 0
10 5
5 10
1 14

18
 Price

15

10

5
D

Quantity
5 10 15
Figure 2- 2 Demand Curve from Demand Equation

As we can clearly observe the relationship between price of a commodity and the
quantity demanded is inverse. i.e., as price increases people will buy less and vise
versa. This condition is given by the law of demand. Law of Demand states that
when price of a commodity goes up the quantity demanded falls or people will buy
less of it, other things being equal.
Why do we observe Law of Demand?
Two fundamental reasons explain why the quantity demanded of a commodity is
inversely related to its price. One is substitution effect and the other is income
effect.

Substitution Effect: In real life we are all able to substitute one product
for another to satisfy our need (demand). This is commonly called the
principle of substitution. If the relative price of one particular good goes
up, we most likely shift in favor of the lower priced good and against the
higher priced good. For example, the price of Coca-Cola and Pepsi-Cola is
most of the time the same why? What will happen if the price of Coca-
Cola goes up while the price of Pepsi-Cola remains the same? Other things
unchanged, people most likely buy Pepsi-Cola rather than Coca-Cola.
Because of this price change Pepsi-Coca is now relatively cheaper. People
will substitute Pepsi-Cola for Coca-Cola as a result demands for Coca falls
as its price increase.

Income Effect: - If the price of one commodity goes down while our
income and prices of other goods stay the same, our ability to purchase
goods in general goes up. In other words with the same amount of money
income we can buy more of that commodity. Generally, the price fall of
one good will increase our purchasing power and we feel wealthier, thus,
we buy more of that good.

19
Market Demand
Till now what we have seen is individual demand. What important is market
demand because price is determined by market demand, not by individual demand.
We use the analysis of individual demand to derive the market demand. Market
Demand is the demand of all consumers in the market place for a particular good
or services. The market demand for a particular good is the sum of all individual
consumers' demand for it.
The following table, table 2., shows how the market demand schedule is obtained
by adding all individual demand schedules by supposing that there are two
consumers in the meat market.
Table 2.3 Market Demand Schedule
Quantity
Quantity
Price of Meat in demanded of Market demand
demanded of
birr/kg individual A (QA + QB)
individual B (QB)
(QA)
15 2 4 6
12 4 7 11
10 7 12 19
8 9 15 24
4 12 20 32

Market Demand Curve: - Is the horizontal summation of all individual demand

curves. We can derive the market demand curve from individual consumers'
demand curve by adding the quantity demanded by each buyer in the market at
each specific price (Fig. 2.3 below)
Mathematically, the market demand can be derived from individual demand
equation as well. Suppose the market is composed of only two consumers whose
demand equation is given by:-
QA  10  2P
QB  6  3P
Since the market demand is a summation of all individual demands in the market,
to obtain the market demand equation, we simply add individual demand functions
of the two consumers. Thus,
(MD) = QA + QB
MD = (10-2P) + (6-3P)
MD = 16-5P
Where MD is Market Demand.

20
 P
P P
6
6 6
5
5 4
4 4
3
3 2
2 2
1
1
Q
Q Q
4 8 12 16 18 20
2 4 6 8 10 12 3 6 9
14 Consumer B Market Demand
Consumer A

Fig. 2.3 Driving Market Demand from Individual Demand Curves (Panel C)
2.5.2. Determinants of Demand
Determinants of demand or factors affecting demand can be grouped into two
categories, price factor and non-price factor.
i. Price Factor: - Price affects demand negatively as stated by the law of
demand. Any change caused by price is called change in quantity
demand. In other words price change leads to a change in quantity
demanded. Change in quantity demanded is represented by a movement
along the demand curve. In figure 2.4, change in demand is shown by a
movement from point A to point B which is an increase in quantity
demanded followed by price fall from P1 to P2.
Price
A
B

Quantity
Fig. 2.4 Change in quantity demands
ii. Non-Price Factor (Non-Price determinant of demands)
These factors are also known as demand shifters. Any change caused by these
factors is called Change in Demand.
Change in demand is graphically represented by a shift in the entire demand
curve. Diagram 2.5 panel a and b shows increase and decrease in demand
respectively.

21
 (a) (b)
Price
Price

P
P D1
D D0

Q1 Q2 Quantity Q1 Q2 Quantity

2.5. Increase (a) and Decrease (b) in demand

Increase in demand is represented by upward shift in demand panel (a) (fig 2.5),
which implies with the same price more is demanded. Figure 2.5 (panel (b) shows
decrease in demand implying that with the same price less quantity is purchased.
Some of the factors which causes change in demand are:-
a. Income of the consumer
b. Prices of related goods
c. Consumers' expectation
d. Taste and Preference
e. Number of buyers, etc
a. Consumers' Income: For most goods an increase in income will
increase demand. Goods for which the demand increases with income
increase is called Normal Goods.

When income of consumers increases demand for Normal good increases,

i.e., the demand curve shift to the right as goods for which demand goes
down as income increase are called Inferior Good. When income of
consumers increase demand for inferior goods decrease, i.e., the demand
curve shift to the left.
b. Prices of Related Goods:- When we say related goods, we are
referring to goods having interrelated demand. There are two types of
related goods; substitute and complementary goods.
Substitute Goods:- Two goods are substitute, when either of one
can be used for consumption. For example coffee and tea. Coca Cola
and Pepsi cola and white teff and Red teff are some of the substitute
goods. In making consumption decision, consumer is influenced by the
relative prices of the competing goods (price of substitute goods).
For example if the price of Coca Cola falls while the price of Pepsi
Cola remain unchanged, demand for Pepsi cola will decrease. Because,
consumers will find that Pepsi is relatively expensive than coca cola
and they will substitute by for coca cola.

22
 Complementary Goods: Two goods are complements when both are
used together for consumption. These are goods, which are consumed
jointly. This means that the use of one necessitates the use of the other
commodity. Tea and Sugar, Camera and Film Injera and Wot are some
of the example of Complementary Goods. For complementary good,
if price of one good increases(decreases), demand for its complement
falls (rises). That is, for complementary goods, the price increase
(decrease) of one good (other things remained unchanged) will shift
down (up) ward the demand curve of the other good.

c. Taste and Preference: Economics has few or no theory about taste

of a good. Taste is mostly taken as preferences. A change in
consumers' taste in favor of a good can shift its demand up wards and
change in consumers' taste against a good will decrease demand for that
good.

d. Consumers' Expectation: Consumers' expectation about future price,

future income and availability of goods may inspire them to buy more
or less of a particular good without a change in its current price.

e. Number of Buyer (Population): An increase in population in the

economy shifts the market demand upward for most products. Hence,
increase population implies an increase the number of buyers.

Table 2.4 Summary of factors affecting demand and their

Effect
Factors Their effect on demand
Own price (price factor) Change in quantity demand (Movement along the demand curve)
Income of Consumer Change in Demand (Shift the Curve)
Price of related good Change in Demand (Shift the Curve)
Taste Change in Demand (Shift the Curve)
Consumer's expectation Change in Demand (Shift the Curve)
Population (No. Buyer) Change in Demand (Shift the Curve)

2.5.3. Supply Schedule and Curve

In a market economy, while buyers of a product constitute the demand side of the
market, sellers of that product make supply side of the market. By supply we mean
the quantity of goods that a firm (producer) is willingly imply produce and offer
for sale at a particular price, other things held constant. Supply may be defined as a
schedule, which shows the various amounts of a product, which a producer is
willing and able to produce and make available for sale in the market over specific
timer period, at a given price, Ceteris Paribus (other things held constant).

23
 Supply Schedule: Is a table showing the relationship between market price and
the quantity supplied per period of time, Ceteris paribus. Consider the following
supply schedule for meat.

Table 2.5 Individual Supply Schedule for Meat

Quantity of meat
Price of meat
supplied in Kg.
per kg. in birr
20 30
15 20
12 11
10 8
8 5
4 0

The graphical representation of supply schedule is called Supply Curve. When we

plot each pair of values from the supply schedule in table above on a graph and
join the resulting points we get the producer's supply curve as shown in figure 2.6

Supply equation (supply function) is a mathematical model, which shows the

relationship between quantity supplied and factors affecting it.
Qs = c + dP
where: Qs = Quantity supplied and P = Price of product

Price
Supply Curve

30

25

20

15

10

Quantity
5 10 15 20 25 30

Fig. 2.6 Individual Supply Curve for Meat

24
The law of supply
The law of supply states that when producers get higher price for their product
than the current one, they will supply more of it. Thus, there is a direct
relationship between price and quantity supplied.
Market Supply
Market Supply is a summation of all individual supplies in the market place. It is
the supply of all firms in the market place for a particular goods or services.
Market Supply Curve
Is the horizontal summation of individual supply curve. Suppose the meat market
is composed of only two producers and supply schedule of each producer is
presented in table 2.6
Table 2.6 Market Supply Schedule for Meat
Price of meat Supply by Supply by Market supply
per/kg. producer A producer B A+B = Sm
20 A
30 B
20 50
15 20 15 35
12 11 9 20
10 8 7 15
8 5 0 5

30
Supply Curve
25

20

15

10

10 20 30 40 50 60

Fig. 2.7 Market Supply Curve for Meat

25
2.5.4. Determinants of Supply
Like in the case of demand, determinants of supply can also be grouped into price
factor and non-price factor (non-price determinant).

i. Price Factor: Price affects supply positively as stated in the law of

supply. Any change caused by own price of a good is called Change in
Quantity Supplied. When only the price of the good changes quantity
supplied also changes, i.e., the movement along the supply curves. A
movement along the supply curve is called change in quantity supplied and
is shown in fig. 2.8

P2
B
P1 A

Q
Q1 Q2

Fig. 2.8 Movement along the supply curve (a movement from point A to B)
ii. Non-Price Determinants of Supply:-These factors are also known as
supply shifters. Any change caused by one of these factors is called change
in supply. Change in supply is graphically shown by the movement of the
entire supply curve either to the right or to the left. The supply curve shifts
to the right when supply increases and it shifts to the left when supply
decreases. Shift in supply is depicted in fig. 2.10

26
P
S’’

S’

Fig. 2.10 Change in Supply Curve

Some of the nonprice factors which causes change in supply are:-

a. Input prices (cost of production)
b. Technology
c. Tax and subsidy
d. Producers Expectation
e. Prices of related good, etc...
a. Prices of Input (Cost of Production): If one or more inputs
price goes down the supply curve will shift to the right. That is, more
will be supplied at each price. This happens because the cost of
production will go down as a result producers will use more inputs.
More inputs use implies more will be produced as a result more is
supplied.
b. Technology: Technology usually increases productivity and reduces
effort. When there is a new technology, more good can be produced
with the same amount of input use.
c. Tax and Subsidy:-Tax is the amount of money paid to the
government for owning properties and undertaking a particular activity.
Taxes like sale's tax is effectively on addition to cost of production cost
and therefore, reduces supply.
Subsidy: is the financial and/or material support given to producers or
consumers to encourage production, or consumption or a particular
economic behavior. Subsidy is just like negative tax. Subsidy will do
the opposite of tax. Production subsidy will reduce cost of production

27
 there by increase production. As production increases more will be
supplied.
d. Producers Expectation: A change in the producer's expectation of
the future price of the product can affect the producers' current
willingness to supply. If the producers expect that future price for a
good will fall then they would like to sell it now. This will result in
increase in supply of that good.
e. Prices of Other Goods: Change in the price of other good may
affect the supply of a good. If price of other goods increases, then
producers may be attracted by the price increase of this good and may
produce that product. A farmer for instance producing corn and wheat,
may decide to produce corn only if the price of wheat fall. This will
increase supply of corn.
Table 2.7 Determinants of Supply and their effect on the supply
Curve

Factors Affecting
Their Effect on Supply
Supply
Change in quantity supplied (change along the supply
Own Price
curve)
Input Price Change in supply (shift the curve)
Technology Change in supply (shift the curve)
Tax and Subsidy Change in supply (shift the curve)
Producers Expectation Change in supply (shift the curve)
Price of other goods Change in supply (shift the curve)

2.6. Market Equilibrium

Supply and Demand become especially significant when they are put together.
Sellers offer product for sale when they anticipate demand or willingness to pay.
Buyers on the other hand can convert their want in to demand only if there is
supply. The two interact to determine (create) the market price. Let us put the
supply schedule and demand schedule side by side and see how the market force
determine market price.
Table 2.8 Interactions of Market Forces
Quantity Quantity
Price/Unit Qs - Qd Pressure on price
Demand (Qd) Supplied (Qs)
5 9 18 +9 Downward pressure
4 10 16 +8 ()

3 12 12 0 No
2 15 7 -8 Upward pressure ()
1 20 0 -20 

28
The market price or equilibrium occur at the price level were quantity demanded
equal quantity supplied.
At price above 3 sellers will offer more quantity than consumers will buy. This
results in surplus of some quantity of products. Surplus means wastage of limited
resources. So sellers have a choice of:-
 Cutting back their product
 Stopping producing that product for a while
 Cutting the price level
These all put pressure on price to fall.
At the price below 3, consumers want more products than the producer offer the
sale. Some who wants more of this product will not be able to buy them even if
they are willing to pay more. This shortages of products put pressure on price to
rise.
Only at price of 3 the number of product offered for sale and the number of
quantity that buyer are willing to buy are equal each other. When supply and
demand equal each other, the market is said to be at equilibrium. And the price at
this point is called Equilibrium Price or Market Clearing Price. It is market-
clearing price, because at this price neither there is shortage or surplus of the good.

Price
S

PE E

D
Quantity
QE
Fig. 2.11 Market Equilibrium (PE = Equilibrium price and Quantity at
equilibrium = QE)

Price S
Price D D
S

P1
Surplus Shortage
PE E P2

Qty
Q QQ Qs QD
QDD s
S Quantity

Fig 2.12 Surplus in the market Fig 2.13 Shortage in the market
29
P1 represents price above the equilibrium price, PE. At this price, Fig. 2.12 shows a
condition where there is a surplus in the market place by shaded amount. At price
P1, which is above the equilibrium price PE, Qs unit, will be supplied where as
quantity demand is only Qd. The net effect is surplus of that product by the
amount Qd Qs.
The shortage situation is shown in figure 2.13. At price below the equilibrium
price (PE) like P2, producers are willing to supply only Qs unit of a good while
consumers are willing to buy Qd unit of that good. The net effect is that there will
be shortage of that product by the amount Qs Qd. Let us look at some numerical
examples of market equilibrium,
Example 1
Suppose the market demand and supply of a commodity is given by the following
equation.
Qd = 80 - P
Qs = 60+3P
Where: Qd = Quantity demanded
Qs = Quantity supplied
P = Price of a good
At equilibrium Qd = Qd,. Thus, 60+3P = 80 – P and rearranging equation , we get
80-60 = 4P
20= 4P
P=5
Substituting 5 for price either in demand or supply function to determine quantity
at equilibrium
Qd = 80-5 Qs = 60+3(5)
Qd = 75 Qs = 6+15
Qs = 75
Thus, at price 5 quantity demanded equals to quantity supplied.
Example 2
The market demand and supply for soap is estimated to be as given below.
Qd = 175 - 20 P
Qs = -25+ 80 P
a) Determine equilibrium price and equilibrium quantity of soap
b) If the price of soap is 3 birr, will there be shortage or surplus
of soap in the market? By how much ?
Solutions
a) A equilibrium QD = Qs
175-20P = -25+80P
200=100P
P = 2 (Equilibrium price)
Qd at price = 2
QD = 175-20 (2)
QD = 175-40
QD = 135
QD = Qs = 135 at equilibrium

b) QD at price 3 Q3 = at price 3
QD = 175-20 (3) Qs = -25+80(3)

30
 QD = 175-60 Q3 = -25+240
QD = 115 Qs = 215

At price equal 3 birr the amount supplied is greater than the amount demanded.
Thus there will be surplus. The surplus is given by the difference between supply
and demand, i.e,
225 - 115 = 100
When price of soap equals 3 birr there will be surplus of soap by 100 units, and
this surplus pushes down price.
Change in Equilibrium Price and Quantity
The Market Equilibrium might change when change in demand or supply or
change in both takes place. Corresponding to the change in market forces, three
possibilities can be considered.
a) Change in Demand Only: Changes in any one of the non-price
determinants will result either in increase or decrease in market
demand. When market demand increases without any change in market
supply, both equilibrium price and quantity increases. Where as a
decrease in demand curve result fall in both equilibrium price and
quantity.
b) Change in Supply Only: Changes in any non-price
determinant of supply discussed in previous sections will cause the
market supply to increase or decrease. Given the demand curve,
increase in supply will result fall in equilibrium price but increase in
equilibrium quantity.
c) Change in both Supply and Demand:- There are three possible
cases of simultaneous change in supply and demand.
i. Increase in both demand and supply:-
When both market demand and supply increases simultaneously
equilibrium quantity increases. But the change in equilibrium
price depends upon the magnitude of change in supply and
demand. If both are increased by the same magnitude, there
will be no change in equilibrium price. If market demand
increases more than supply increase equilibrium price will
increase otherwise equilibrium price falls.
ii. Decrease in both Demand and Supply
When both market demand and supply decreased
simultaneously, equilibrium quantity decreases as well but the
change in price again depends upon the magnitude of change in
demand and supply. If demand changes more than supply,
equilibrium price will fall. But supply decrease more than
demand decrease, equilibrium price will increase.
iii. Supply and Demand Change in Different Direction.
If supply increases and demand decreases, equilibrium price
falls by a greater amount than when the two changes are
considered in isolation. Whether equilibrium quantity increases

31
 or decreases as a result of these changes depends upon the
relative changes of market demand and supply. The other
alternative is that supply decreases and demand increases.
These change have a price increasing effect, but equilibrium
quantity may increase or decrease depending on the magnitude
of change in demand and supply. If fall in supply is greater than
the increase in demand, equilibrium quantity decreases. But
decrease in supply is less than increase in demand, equilibrium
quantity rather increase.
Price control and its effect on market equilibrium.
In free market economy system, the role of the government is assumed to be
limited and will not intervene in the market mechanism.

However, this is not always true. Sometimes the government intervene into the
market by establishing price control mechanism for some goods. The government
price control can be either in the form of price ceiling or price floor.
Price Ceiling: Is the maximum price level set by the government for goods and
services. It is legal maximum price that can be charged for a particular goods and
services. Above this price level no one can sell his product. It is a measurement
taken to protect consumers against high price. Imposing price ceiling creates a
shortage of that good and creates black market. Figure 2.14 Illustrates the effect
of price ceiling on the market equilibrium.
Price

D
Figure 2.14. The effect of price ceiling on market equilibrium
Quantity
32
The above figure illustrates the condition where a government imposes price ceiling P C
which is below the equilibrium price PE. At the price level of Pc the quantity demanded
will be Qd. But the quantity supplied at is price is only Qs. Since the quantity demand is
much greater than the quantity supplied. As a result there will be shortage of the product
by the amount indicated by the shaded area. Shortage of that product however, creates
favorable condition for the creation of black market. Black market is a place where goods
and services are illegally traded or a place where illegal goods and services are traded.

Since price is fixed to at Pc there will not be supply beyond Qs, hence the new supply curve
will be S’. Therefore, price in black market will be bid up to P b which is a new equilibrium
price because that is where the new supply curve S’ intersects the demand curve at E’.
Price Floor: is a minimum price level below which a good or services can not be sold.
This is a measurement taken to protect producers. If the government imposes price floor
(Pf) above the equilibrium price (Pe) the quantity supplied will be Qs. At this price quantity
demanded is only Qd. Since the price is above equilibrium price there will not be any
demand beyond Qd. As a result the new demand curve will be D’. Under this condition
quantity supplied (Qs) is much greater than quantity demand resulting surplus of the
product. Because of surplus of the product the price in black market will bid down the price
to Pb, which is a new equilibrium price, because that is where the new demand curve D’
intersects the supply curve at E’. Figures 2.15 illustrate the impact of price floor on the
market equilibrium.
Price

Fig.2.14 The Effect of price floor on market Equilibrium

Quantity
33
Generally, the government intervention into the market mechanism with the
objective of either to protect consumers or to support producers may not achieve
the defined objectives; rather it encourage trading goods and services in a back
market at the price level not desired by the government.

2.7. Elasticity of Demand and Supply

Consider the law of demand, when the price of a good goes up people will buy less
of it and if the price falls then people will buy more of it. Similarly, the law of
supply state that, when the price of a good goes up firms willingly offer for sale
more of that good and vise versa. The question however is that what is the
magnitude of the responsiveness of consumers as well as producers for such price
change? Economists have got the mechanism to measure the responsiveness of
people (households and business firms) for the price change. This measurement is
called Elasticity. Elasticity is the measurements of responsiveness of consumers
and producers for the change in the determinants of demand and supply.
Elasticity can be elasticity of demand and elasticity of supply.

2.7.1. Elasticity of Demand

Elasticity of demand is the measurement of responsiveness of demand for the

change in the determinants of demand. There are many elasticity of demand as the
number of determinants of demand. The most common types of elasticity of
demand are of the following:-
 Price elasticity of demand (own price elasticity of demand)
 Cross price elasticity of demand
 Income elasticity of demand
I. Price Elasticity of Demand (Own Price Elasticity of Demand)
 p : Price elasticity (own price elasticity) of demand is a measurement of
the responsiveness of demand for the change in the commodities own price.
Point Vs Arc price elasticity of demand.
 Point elasticity of demand:- is used to measure price elasticity of
demand when the change in price is very small or at a point. Thus,
price elasticity of demand is measured as a percentage change in
quantity demanded resulting from a percentage change in price.

This can be written as

Q
where represents slope of the demand curve
P

34
 Q
Suppose the demand function is Qd  a  bP . Then, = - b which
P
is slope of the demand curve.
Price Elasticity of demand is therefore, p = - b x P/Q
Where p = Price elasticity of demand
-b = Slope of the demand curve
P = Price of a commodity
Q = Quantity Demanded
Example: Consider the following demand and supply equation.
P = 20-0.5 Q and P = 16+0.5Q
Using this information determine price elasticity of demand at
the equilibrium point and interpret the result!
Solution
First we need to determine the value of price and quantity at
equilibrium.
16 + 0.5Q = 20-0-5 Q.
Q=4 P = 18
Slope of the demand curve –b = -2
p =b P
Q

If the price of a good increases by 1 percent, quantity demanded

will fall by 9 percent. Similarly if the price falls by 1%, quantity
demanded will increase by 9%. The negative sign of the price
elasticity of demand shows, the fact that the relationship between
price of a good and quantity demanded is inversely related to each
other. The price elasticity of demand always has a negative value,
this as the demand curve is downward sloped. To avoid possible
confusion caused by the negative value of elasticity, economists by
convention have agreed to ignore the negative sign, in most
literature the price elasticity of demand is presented with positive
value.
 Arc Elasticity of Demand: Arc Elasticity measurement is used when
the change in price is relatively large. That is, it measures elasticity
between to points. It is an estimation of an average elasticity of an arc.

35
 Price
A

Output
Fig. 2.16 Arc Elasticity

Arc elasticity measures an average elasticity of the segment AB. If the demand
curve or the segment AB is linear, then arc elasticity will be a best estimator of the
true value of price elasticity of demand. Arc elasticity of demand is determined
as:-

ΔQ P1  P2 
εp X
ΔP Q1  Q 2 
Where Q = Change in quantity demanded (Q2 – Q1)

Example:
The price of sugar was 6 birr per kilo. Due to unfavorable harvest in sugarcane
the price has raised to 8 birr per kilo. Because of this price change the quantity
purchased falls from 16 million quintals to 14 million quintals of sugar. What is
the arc price elasticity of demand for sugar.
εp 
14 - 16
X
8  6  0.466
8-6 14  16
If the price of sugar increases or decreases by 1%, quantity demanded of sugar
decreases or increases by 0.466% respectively.
The value of price elasticity of demand varies from zero to infinite.
- Price elasticity of demand is elastic when the value of elasticity is
greater than one (  p > 1, elastic demand)
- Price elasticity of demand is inelastic when the value of elasticity is less
than one (  p < 1, inelastic demand)
- Price elasticity of demand is unitary elastic when the value of price
elasticity of demand is equal to one (  p = 1, unitary elastic demand)
- Price elasticity of demand is perfectly elastic, when the value of price
elasticity of demand is infinite (  p = , perfectly elastic demand)
- Price elasticity of demand is perfectly inelastic, when the value of
elasticity equals to than zero, (  p = 0, perfectly inelastic demand)
Graphically this can be sown as: -

36
 P
Ep >1

Ep = 1

Ep <1
Q
O

Figure 2. 17 Elasticity of Demand

When demand is perfectly inelasticity, no matter by how much price changes the
quantity demanded will not change at all. Demand curve for such goods is vertical
or fixed as shown in figure 2.18.
When demand is perfectly elastic, a small change in price will result to zero
demand of that good.
Price
Price
D

Quantity Quantity
Figure 2.18 Perfectly inelastic Figure 2.19 Perfectly elastic
demand demand
Determinants of Price Elasticity of Demand
We have said that, the value of price elasticity of demand ranges from zero to
infinity. What determine these differences in the value of price elasticity of
demand? Some of the determinants of price elasticity of demand are of the
following.
a) The existence of similar or substitute good. Demand for a good
which has a close substitute tends to be elastic. Whenever there is a slight
change in the price of one of such goods it will be substituted by other
similar good. But if the goods has no close substitute, demand for it is
inelastic.
b) Nature of the good: The nature of the good means whether the good is
necessity or not. Necessity goods like food items, where the demand
cannot be postponed have inelastic demand. On the other hand,
consumption of luxury goods can be postponed, and demand for such
goods tends to be elastic.

37
c) The percentage that commodity represents in a consumer total
budget. Demand for those goods on which a consumer spends very small
proportion of his income will be inelastic. But demand for those goods on
which a consumer spends the largest proportion of his income will be
elastic.
d) The length of time allowed (available) to adjust to change in
price. When price of a good changes, a consumer does not respond
immediately to the change in price. However, over a period of time, the
consumer is able to adjust his expenditure pattern to the price change.
Thus, the longer the time allowed for adjustment, the higher would be its
elasticity.
II. Cross Price Elasticity of Demand
Demand for a good is also affected by the change in the price of related goods.
Consumers also respond for the change in the price of related goods by either
cutting their consumption or by increasing their consumption.
Cross price elasticity measures responsiveness of demand for the change in the
relative price of related goods. For example, Cross Price Elasticity of Demand
between good A and good B ( ε AB ) measures the responsiveness of quantity
demanded of good A, when there is a change in the price of some other good B.

percentage change in quantity demanded good A

ε AB 
percentage change in price of good B
ΔQA P1B  P2B
ε AB  
ΔPB Q1A  Q 2A

The cross price elasticity can have both positive and negative value, which
determine the nature of the relationship between these two goods. The cross–price
elasticity of demand is zero if the two goods are not related at all. When cross
price elasticity of demand is positive, the two goods are substitute. When to goods
are complementary the cross price elasticity between goods will have negative
value.

Example:
Due to unknown reason the price of beef meat increased from 10 birr per kilo to 14
birr per kilo. As a result of this change the quantity demanded of chicken increase
from 21 thousand per month to 27 thousand. Determine the cross price elasticity
of demand between beef meet and chicken and determine the nature of the
relationship of these two goods?
Solution
a) Coefficient of cross price elasticity
27 - 21 14  10 5/ 4
ε AB     0.75
14 - 10 27  21 24 / 48
b) Interpretation

38
  When the price of beef meat increases by 1%, the quantity demanded of
chicken also increases by 0.75% and vice versa.
 These two goods are substitute because when the price of beef meat
goes up people will substitute it by purchasing more quantity of chicken
and less of beef.
III. Income Elasticity of Demand
Income of consumer is one of the determinants of demand. A consumer also
responds to the change in their income by consuming more or less of a good.
Income Elasticity of Demand (I) measures the responsiveness of demand for the
change in consumer’s income. It shows the way in which a consumer’s purchase
of a good change as a result of change in his income, other thing being constant.
percentage change in quantity demanded
εI 
percentage change in income
ΔQ I1  I 2
εI  
ΔI Q1  Q 2
Where Q = change in quantity demanded (Q2-Q1), I = Change in income, I1 and
I2 = Income of consumer. The coefficient of income elasticity of demand can have
both positive and negative values. When the value of income elasticity of demand
is positive (EI> 0), the good is normal. Where as negative value of income
elasticity of demand (EI< 0) implies the good is inferior.
Example
Use the information given in the table below to determine: -
A) Income elasticity of demand of the two goods
B) Interpret the result and determine the nature of these goods.
Table 2.9: Given Information to determine Income Elasticity

Income Consumption Per year

Year Per Year Commodity X Commodity Y
1996 1500 500 units 1000 units
1997 2500 1500 units 500 units

Solution
A) Income elasticity of demand for good X
1500 - 500 1500  2500
ε IX  
2500 - 1500 500  1500
1000 4000
ε IX   2
1000 2000
Income elasticity of demand for good Y
500 - 1000 1500  2500
ε IY  
2500 - 1500 500  1000
- 500 4000
ε IY    -1.33
1000 1500
B) i. If the consumer’s income increases by 1 %, quantity demanded will
increase by 2%. Thus, commodity X is a normal good.

39
 ii. When is the consumer's income increases by 1 %, quantity demanded of
commodity Y decreases by 1.33%. Therefore, commodity Y is an inferior
good.
2.7.3 Elasticity of Supply
As we have tried to measure responsiveness of demand for the change in the
determinants of demand, we can also determine the responsiveness of supply for
the change in its determinant.
Elasticity of supply is the measurement of responsiveness of quantity supplied
when one of the supply determinants (price) changes.
percentage change in quantity supplied
εS 
percentage change in income
To determine elasticity of supply we can use both point as well as arc elasticity
approach depending upon the magnitude of change in the price of a commodity.
Point Elasticity
Q P
εS  
P Q
Q
where = slope of the supply curve
P
Thus, ε S = slope x P/Q …… point elasticity measurement
Arc elasticity of supply
ΔQ P1  P2
εS  
ΔP Q1  Q 2
As in the case of price elasticity of demand, the price elasticity of supply may vary
from zero to infinity.
a) When the quantity of a good supplied changes little for a larger changes
in its price, supply is said to be inelastic i.e., ε S <1
b) When the quantity of a good supplied changed by a greater amount than
the change in its price, supply is elastic i.e., ε S > 1
c) When the quantity of a good supplied changed by the same amount as
the change in price, supply is called unitary elastic supply with the
coefficient of elasticity, ε S = 1
If the coefficient of elasticity of supply equals to zero, ε S = 0 supply is said to be
perfectly inelastic. It means there is no effect of price change on quantity supplied.
The supply curve will be vertical as shown in figure 2.20
Price ε S =0

Quantity

Fig. 2.20 perfectly inelastic supply

40
e) If supply is perfectly elastic, the coefficient of elasticity of supply, ε S = .
That
means infinite quantity is supplied at the ruling price. The supply curve
horizontal as shown below.

Price
εS =

Quantity
Fig. 2.21 perfectly elastic supply
Determinants of Elasticity of Supply

Length of time available for adjustment. The price elasticity of supply is

influenced by the length of time, which required for adjusting supply to change in
price. In very short period of time, supply is perfectly inelastic. This is because the
quantity supplied is limited to the quantity already available in the market and it
cannot be increased whatever price is offered. In the short-run there is no time to
change all factors of production to make necessary adjustments to the prevailing
price change. In the longrun, however, there is sufficient time to adjust all factors
of production and hence supply is much more elastic than in the short-run.

Availability of factors production. If the factors of production are available in

required amount supply is relatively elastic. Possibility to produce alternative
goods. If it is easy to switch over to the production of other goods. supply will be
elastic.

2.8 Summary

The market structure is determined or defined by the nature and degree of

competition. The market structure is classified as perfectly competitive market and
imperfect market. Monopoly market structure, monopolistic competition and
oligopoly market structure are typical examples of imperfect market.
Competitive market structure is characterized by a complete of rivalvy among
individual firms. This market structure is based on assumptions like, large number
of buyers and sellers, product homogeneity, free entry and exit of firms, profit
maximization motive of firms, perfect mobility of factors of production, perfect
knowledge or information and no or minimum government intervention into the
market system.

In perfectly competitive market, the economic activity is coordinated by price

system. The roles of price in market economy system are:-
- Signaling consumers preferences
- Determining what goods and services need to be produced and
how much each of them
- Indicating relative scarcity of the economic resources
- Determining the use of factors of production

41
Price in the market place is determined by market forces. The market demand and
market supply are the two market forces that determine the market price through
their interaction.

Demand describes the behavior of consumers. Demand for a product explain not
only want for it but also it express willingness and ability to pay. The law of
demand states the inverse relation between quantity demanded and price of a good,
other things held constant. Demand schedule is a table showing the relationship
between the price of a good and the quantity demanded per period time, other
things remained constant. Where as demand curve is a diagram showing the
relationship between the price of goods and quantity demanded per period of time,
other things held constant.

Factors affecting demand can be grouped in to price factor and non-price factor
called non price determinants of demand. The movement along the same demand
curve caused by the change in the price of the good itself is known as change in
quantity demanded. If other factors except the price of the good itself change the
whole demand curve shifts its position either to the right or to the left and this is
known as change in demand.

Some of these non-price determinants of demand are:-

 Income of a consumer: When income of a consumer increases demand

for normal good increases where as demand for inferior good decreases.
 Price of related good: For substitute good, if the price of one good
increase demands for the other good which is substitute good decreases.
 For complementary goods if the price of one increases, demand for the
other (complementary) good decreases and if the price of one decrease
demand for the other increase.
 Consumers’ expectation: If expectations of future price rise, it increases
current demand for a good and expectation of future price fall reduces
current demand for it.
 Taste: If the test of the consumer is in favor of the good, demand for it
increases and if the taste of the consumer is against the good demand for it
falls.
 Number of buyer: Increase in number of consumers demand for good
and services will increase as well. Where as fall in number of buyers will
decrease demand for goods and services in general.

The other side of a market is supply. Supply represents one of the market forces
that determine the price level in the market. By supply we mean the quantity of
goods that firms (producers) are willing to produce and offer for sale at a particular
price and at a given period of time, other thing held constant.

The law of supply states that there is a direct relationship between price and
quantity supplied, other things being equal. As in the case of demand, factors

42
affecting supply can be price of a good itself and non-price factors called non-
price determinants of supply. Any change caused by change in the goods own
price is called change in quantity supplied. Change caused by non-price
determinants of supply is called Change in Supply represented by the shift of
the entire supply curve either to the right or to the left.

Some of the non-price determinants of supply are input price or cost of production,
technology, tax and subsidy, producers’ expectation about future price of a good
and price of related goods. The interaction of these market demand and market
supply will determine the market price called equilibrium price. Market
equilibrium occurs when supply and demand are in balance, i.e., when quantity
demanded equals to quantity supplied. The price that equates quantity demand and
quantity supplied is called Market Clearing Price or Equilibrium Price. Market
equilibrium occurs when supply and demand are in balance, i.e., when quantity
demanded equals to quantity supplied. The price that equals quantity demand and
quantity supplied is called Market Clearing Price. At this price level there will
be no surplus and shortage of goods in the market that is why market is said to be
at equilibrium or in balance.

At all prices above the equilibrium price there is always surplus and at price below
the equilibrium position there will be shortage of the product. Shortage always
pushes up the price and surplus pushes it down wards. The market equilibrium
might change when change in demand or supply or change in both takes place.
The summary of the effect of change in supply and demand on equilibrium price is
presented in table 2.10 below.

In some cases the government intervene into the market by impose price control
mechanism for some goods. The price control can be in the form of price ceiling
or price from floor. Price ceiling are maximum price fixation by law. Price ceiling
usually, causes shortage. Whereas price floor are minimum price fixed by the law.
Price floor causes surplus of the product.
Table 2.10: The summary of the effect of change in demand and supply on
market equilibrium.
Change Effect on equilibrium price and
quantity
D , Supply constant P and Q
D , supply constant P  and Q 
S , and demand is constant P  and Q 
S  and demand is constant P  and Q
S and D  P  and Quantity Indeterminate
S  and D  D and price indeterminate
S  and D  Q  and Price indeterminate

The economic consequence of a price control creates either shortage or surplus of a

product in the market and encourage the creation of black market and price in the
black market will be undesired by the government.

43
Both consumers and producers respond to the change in the determinants of
demand and supply. Economist uses the concept of elasticity to measure their
responsiveness. Elasticity of demand measures the responsiveness of demand for
the change in the determinants of demand. The main measure of the elasticity of
demand is price elasticity of demand, income elasticity of demand, and cross price
elasticity of demand. Price elasticity of demand measures the responsiveness of
quantity demanded for the change in the commodities own price. When price
elasticity of demand ( ε p ) greater than one ( ε p >1), demand is elastic, when ε p <1,
demand is inelastic. When ε p , demand is elastic. When ε p = 1, demand is unitary
elastic. The price elasticity of demand equals infinite and zero, when demand is
perfectly elastic and perfectly inelastic respectively. The main determinants of the
price elasticity of demand are, the availability of similar or substitute good, nature
of the good, the percentage that commodity represents in the consumer’s income
and time available for adjustment for the change in price.

For normal goods the income elasticity of demand is positive, and for inferior
goods it is negative. The cross price elasticity of demand is positive for substitute
goods, negative for complementary goods and zero if the goods are unrelated.

Elasticity of supply measures the responsiveness of quantity supplied for the

change in the price of goods. The main factors influencing the elasticity of supply
are length of time, availability of factors of production and possibility to produce
alternative goods.

44
 CHAPTER THREE
THEORY OF CONSUMERS BEHAVIOR
LESSON STRUCTURE
3.1 Introduction
3.2 Lesson Objective
3.3 Cardinal Utility Approach
3.4 Ordinal Utility Approach
3.4.1 Indifference Curve
3.4.2 Consumers Budget Constraints
3.4.3 Consumers Optimum and Demand Curve
3.5 Summary

3.1. Introduction

In previous lesson you have familiarized yourselves, with the concept and laws of
demand and supply. This lesson will focuses on consumers behavior. Consumers
as one of the decision-making unit they own economic resources. They generate
income from the sell or use of their economic resources. This lesson explains how
consumers make decision in order to achieve their objective, i.e., to maximize their
utility. You will learn how a consumer decide how much of the each of the
available goods to consume with their limited income, and market prices in order
to maximize their utility. You will also learn how a demand curve is derived from
consumers’ optimization decision.

3.2. Lesson Objective

After studying this lesson you should be able to:-
 Understand the existence of different approaches to the analysis of
consumer’s behavior
 Explain the concept of total and marginal utility
 Understand how consumer’s optimum is determined in cardinal approach
 Know the concept of indifference curve and marginal rate of substitution
 Understand the consumer’s budget constraint
 Explain the technique of determining consumer’s equilibrium in the
ordinalist approach
 Derive the demand curve from consumer’s optimum

Recall the concept of demand, i.e., demand is a quantity that a consumer is willing
to buy at a given price, other things being constant. Again, recall the law of
demand. The law of demand state that as the price of a commodity increases,
demand for it decreases. The questions, however, we are concerned are,
 How does a consumer decide how much of a good to buy at a given price?
 Why does a consumer buy more of a good when its price decreases?

45
The answer to these questions lies in the theory of consumer’s behavior. By
consumer behavior we mean how consumer decide on the basket of goods and
services they consume. As a consumer, we take many decisions in our daily life.
The why consumer takes decision on different problem is called Consumer’s
decision making behavior.

The analysis of consumer’s behavior is based on the following assumptions:-

 Consumer is rational being aiming at maximizing his utility (satisfaction)
 Consumer has a full knowledge of all the available commodity, their price
and his income.
However, economists are divided on the question of measurability of utility. Neo-
classical economists argue that utility is quantitatively measurable. Modern
economist on the other hand argue that utility is only ordinal in nature.
Accordingly there are two approaches to the analysis of consumers behavior.
Namely:-
1) Cardinal Utility Approach
2) Ordinal Utility Approach

3.3. Cardinal Utility Approach to Consumers Behavior

The cardinal school postulates that utility can be measured. Different suggestion,
however, have been made as to the appropriate measurement of utility.
According to some economist, under certainty (complete knowledge of market
condition and income over a planning period) utility can be measured in a
monetary unit. That is, by the amount of money the consumer is willing to
sacrifice for additional unit of a commodity. Others, on the other hand suggested
that the measurement of utility is a subjective unit called Utils.

Generally, cardinalist approach is based on the following assumption:

1. Rationality: Consumer is rational. That is he/she aims at maximizing

his/her utility subject to his/her income.
2. Cardinal Utility: Utility is a cardinal concept. The utility of each
commodity is measurable and the most convenient measurement is money.
3. Constant Marginal Utility of Money: The value of one unit of
money to consumer remain constant, regardless of the level of his money
stock. And each unit of money has utility equal to one. This assumption is
necessary if money is used as the measurement of utility.
4. Diminishing Marginal Utility: The utility gained from successive unit of
a commodity consumed decreases as a consumer consumes a larger
quantity of it.
5. Utility: is independent of the quantity of the individual commodity. If
there are n commodities in the bundle with quantities X1, X2, X3 …… Xn
the total utility is then U = f (X1, X2, X3 ……. Xn). Utility is also additive,
i.e., U (X1) + U (X2) +V (X3) ……… +U (Xn_) = Total Utility (U).

46
6. Consumer Income: is constant and all is spent on the same product. That
is, saving gives no positive utility to the consumer.
7. Consumer: cannot influence the market price of goods and services.

The Concept of Total and Marginal Utility

The concept of cardinal utility enables us to define the total utility (TU) and
marginal utility (MU) in quantitative form.

Total Utility (TU)

Total Utility (TU) is defined as a sum of all utilities derived from all the units
consumed. For example, if a consumer consumes 4 units of a commodity and
derives U1, U2, U3 and U4 utils from the successive units consumed, then TU =
U1+U2+U3+U4. If he consumes n units, then the total utility (TU) from n units may
be expressed as:-
TUn = U1 + U2 + U3+……… Un
In case the number of commodities consumed is greater than one, then
TU= TUx TUy + TUz + ……… TUn
Where subscripts X, Y, Z and n represents different commodities. For instance
consider the case of an individual consuming banana and his utility derived from
the consumption of successive units of banana is given in table 3.1
Table 3.1 Utility Schedule for banana in utils

Quantity of Banana
0 1 2 3 4 5
Consumed

Total Utility 0 5 7 9 10 10

Total Utility can also be graphically represented by total utility curve

TU
10
8

6
TU
4

O 1 2 3 4 5 Quantity

Fig. 3.1 Total Utility Curve

47
 Marginal Utility (MU)

Marginal Utility (MU) can be defined as total utility derived from the last unit of a
commodity consumed. In quantitative terms, marginal utility is the change in the
total utility resulting from unit change in commodity consumed. That is,
ΔTU
MU =
ΔQ
Where TU = Change in Total Utility
Q = Change in quantity consumed.
Table 3.2 below presents a numerical illustration of marginal utility of banana.
Table 3.2 Total and Marginal Utility
Quantity of Banana Total Utility Marginal Utility
0 0 -
1 5 5
2 7 2
3 9 2
4 10 1
5 10 0

Graphically Marginal Utility of banana can be depicted as follows (Fig.3.2)

Utility

2 Marginal Utility

Quantity
0
1 2 3 4 5
Figure 3.2 Marginal Utilities

48
The Law of Diminishing Marginal Utility:
The law of diminishing marginal utility is central to the cardinal utility analysis of
the consumer behavior. This law states that as the quantity consumed of a
commodity increases, over a unit of time, the utility derived by the consumer from
the successive units goes on decreasing, provided the consumption of all other
goods remain unchanged.

This law stems from the facts that :-

i. The utility derived from a commodity depends on the intensity of
the need for that commodity
ii. As more and more quantity of a commodity is consumed the
intensity of desire decreases and therefore, the utility derived from
the marginal unit decrease.

Consumer’s Equilibrium: One Commodity Case

The utility maximizing consumer reaches his equilibrium position when allocation
of his expenditure is such that the last cents spent on each commodity yields the
same utility. The question, however, is how does a consumer reach at this
position?

To explain consumer’s equilibrium, let us begin gain with a simple one commodity
case. Suppose there is one commodity, commodity X is available for
consumption. Since both his money income and commodity X have utility for
him, he can either spend his money income on commodity X or retain it with
himself. If marginal utility of commodity X (MUx) is greater than marginal utility
of money income (MUm), total utility can be increased by exchanging money for
the commodity. In other words a utility maximizing consumer exchange his
money income for the commodity as long as MUx> MUm. In our assumption
marginal utility of commodity like X is subjected to diminishing marginal rate of
utility. Whereas marginal utility of money (MUm) is constant and equal to unity.

Therefore, the consumer will exchange his money income for commodity X as
long as MUx> Px (MUm). The consumer continues to exchange his money income
for commodity X until the marginal utility of commodity X equals to the marginal
utility of money. That is, MUx = Px (MUm) Alternatively, the consumer reaches at
equilibrium where:-

MU X
1
PX

The consumer’s equilibrium for a single commodity case is graphically depicted in

figure 3.1.
The horizontal line Px (MUm) represents the constant utility of money which is
equal to unit price of a commodity X and MUx curve represents the diminishing
marginal utility of a commodity X . The Px (MUm) line and MUx curve interest at

49
point E, where marginal utility of commodity X equals to marginal utility of
money income. Therefore, point E is the point of equilibrium.

Marginal Utility
X
E Px (Mum)

X Quantity of X
Figure 3.3. Consumer’s Equilibrium

Consumers Equilibrium: The General Case: (The law of equi-

marginal Utility)
We have explained above consumer’s equilibrium for a single commodity. In
reality, however, a consumer consumes a large number of goods. The MU
schedules of different commodities may not be the same. Some commodities yield
higher utility and some lower. A utility maximizing consumer consumes
commodities in order of their utilities. He picks up the commodity, which yields
the highest utility followed by the commodity yielding the second highest utility
and so on. He switches his expenditure from one commodity to another in
accordance, with their marginal utility. He continues to switch his expenditure
from one commodity to the other until he reaches a stage where MU of each
commodity is equal per unit of expenditure.

Therefore, the consumer optimum follows the law of equi-marginal utility. We can
use a single commodity case to determine the general case.
For commodity X, equilibrium occurs when MUx = Px (MUm) since MUm =1
MUx = Px and this can be written as:-
MU X
1
PX
For commodity Y, equilibrium occurs where:-
MUY = Py
Or
MU Y
1
PY
For commodity Z, equilibrium implies:
MUz = Pz and

50
 MU Z
1
PZ
Therefore, consumers equilibrium for more than one commodity will be,
MU X MU Y MU Z
 
PX PY PZ
The two commodity case provides the basis for generalizing the consumer’s
equilibrium. Accordingly, for two commodities X and Y, consumer’s equilibrium
occurs where:-
MU X MU Y

PX PY
The above expression may be written as:-
MU X P
 X
MU Y PY
In general, the equi-marginal rule of consumer’s equilibrium based on cardinal
utility approach may be explained in three ways. The consumer maximizes his
satisfaction by:
a) Equating MUm with marginal utility of a commodity
b) By equating MU of all goods weighed by their price in a two or more
commodities case and
c) By equalizing MU of each cents spent on all goods and services.
Derivation of Demand Curve
The logic of consumer’s equilibrium provides a convenient basis for the derivation
of individual demand curve for a commodity. To derive the demand curve we
consider a single commodity case. According to cardinal utility approach a
consumer reaches at equilibrium when MUx = Px. The same equilibrium condition
can be used to derive consumer’s demand curve for commodity X as shown in
figure 3.4 (a). Suppose that the consumer is in equilibrium at point E1 at price P3
consuming X1, unit of that commodity. If the price of commodity X falls to P2, he
will move to a new equilibrium position at E2 and consumes X2 unit of that
commodity. Similarly if the price falls to P1 his equilibrium position will be E3
and quantity of X purchased at this point is X3

51
 Quantity of Y
E3
P3

Marginal Utility & Price

P3

P2 E2
P2

P1 E1 P1

X 1 X2 X3 Quantity of X
MUX

Price

P1 a Derivation of Demand Curve

Figure 3.4

b corresponding to equilibrium point

P2 quantity combinations
In Figure 3.4, the price
E3 is shown at point A. Similarly, the price quantity combinations corresponding
to equilibrium points,
P3 E2 and E1 have been shown at point B and C respectively.
c
By joining the points like A, B and C we get the demand curve for commodity X.
The demand curve, Dx , is the usual downward sloping demand curve.
DX

rdinal proach
X1 X2 X3 Quantity of X
Figure 3.4 Derivation of Demand Curve

There are some basic weaknesses in the cardinalist approach. These are:-

a) The assumption that utility is a cardinal concept i.e., utility is cardinally

(objectively) measurable is doubtful. Utility is a subjective concept, which
cannot be measured objectively.
b) The assumption of constant marginal utility of money is also unrealistic.
Because, marginal utility of money is also like all other goods is subjected
to change. And, thus, it cannot serve as a measure of utility derived from
goods and services.
c) The psychological law of diminishing marginal utility has been established
from introspection (personal feeling). This law is accepted as an axiom
without empirical verification.

52
 d) The cardinal utility approach is on the basis of Ceteris Paribus assumption.
As a result it ignores the substitution and income effect. This approach
considers that, the effect of price change on demand is exclusively price
effect. This assumption is also unrealistic because price effect may include
income and substitution effect as well.

3.1 Check Your Progress

1. What is meant by utility?

2. Explain the difference between Total Utility and Marginal Utility!
3. What are the assumptions of Cardinal Utility?
4. Explain the law of diminishing Marginal Utility!
5. What is meant by the consumer’s equilibrium?

3.4. Ordinal Utility Approach

The ordinalist school suggests that utility is not cardially measurable, but is an
ordinal in magnitude. That is, the consumer may not know the specific unit of
utility derived from different commodity. But he is able to rank or order different
basket of good in utility.

The modern theory of consumer’s behavior is on the basis of consumers

preference. The ordinalist utility approach is also on the basis of the following
assumptions:-
1. Rationality: The consumer is assumed to be rational aiming at maximizing
his total utility given his income and market price.
2. Utility is Ordinal: The consumer can rank or order his preferences

In other words, any two bundles of goods A and B can be compared in preferences
by the consumer and his comparison lead to one of the following outcome.
- Bundle A is preferred to basket B or
- Bundle B is preferred to bundle A or
- A and B are equally preferred.

The consumer cannot simply say, I can not compare A and B

3. Consistence of Choice: The consumer is assumed to make consistent

choice. That is, if one time he preferred bundle A to B, he will not choice
bundle B over A another time. Thus, if A is preferred to B then B is not
preferred over A.

4. The consumer’s choice is transitive: For any three bundle, A, B, and

C, if A is preferred to B and B is preferred to C the n A is preferred to C.
Similarly, if A is indifferent to B and B is indifferent to C, then A is
indifferent to C.
5. Flexibility: Any bundle is at least good as itself.
53
6. Non-Satiation: In any two consumption bundle A and B, A is preferred
to B, if A contains, at least more of one commodity. That is, more is
preferred to less under normal condition.
7. Diminishing Marginal Rate of Substitution:
Example:
Consider a consumer choosing between two commodities X and Y. Amount of X
and Y are scaled along the horizontal and vertical axis in figure 3.5 Four possible
combinations of X and Y are being considered by the consumer. The baskets
represented by the points A, B, C and D in the diagram.

Commodity Y

B A

C
D

Commodity X
Figure 3.5 Alternative Consumption Baskets

Note that basket A represents more of both commodities than basket D. Also,
basket A has as much as of commodity Y as has basket B, and more of commodity
X: In comparison with basket C; Basket A has as much of X and more of
commodity Y.
What does the law of preference (the above assumption) tell us? It tells us only
two things:-
- The consumer is capable of ranking all four combination and
- If A is preferred to B and B to D, then by transitivity A must be
preferred to D.

Generally, ordinalist school simply say that individuals tends to make consistent
choice, that the law of preference represents a good approximation of actual
behavior of consumer and thus, the law of preference are rules of rational choice.

Therefore, what we call utility reflects nothing more than ordering preferences.
The statement basket A is preferred to basket B is the same as saying basket A has
higher utility than Basket B. Utility is therefore, the order value whose relative
magnitude indicates direction or magnitude of preferences.

54
 3.4.1. Indifference Curve

As we have tried to assign value (either ordinal or cardinal) to the consumer’s

preference, it is also possible to describe preferences graphically. Indifference
curve is a graphical representation of consumer’s preference.
An indifference curve is the locus of different combinations of two commodities,
which yields the same level of satisfaction. All points on the same indifference
curve are equally preferred or has equal utility to the consumer.
Figure 3.6 provides a typical example of indifference curve. Point a, b and c on
indifference curve (IC) represents different combinations of two goods, X and Y.
But all these combinations are equally desirable to the consumer and hence have
equal value of utility.

Commodity Y

a
b
IC
c

Commodity X
Figure 3.6 Indifference Curve
In figure 3.6, bundle 'a' is equally preferred to 'b' and 'b' to 'c'
Indifference Map: Shows all the indifference curve which rank the preference of
the consumer (Fig. 3.7)

Commodity Y

Commodity X
55
 Figure 3.7 Indifference Map
Combination of two goods on higher indifference curve yield higher level of
satisfaction and are preferred. Combination of goods on lower indifference curve
yield lower utility.
Properties of Indifference Curve
Indifference curve have the following properties.
a) Indifference curves have a negative slope: The negative slope of
indifference curve implies that the two commodities are substitute for each
other and that if quantity of one-commodity decreases, quantity of the other
commodity must increase if the consumer has to stay at the same level of
satisfaction.
b) Indifference curves are convex to the Origin: Indifference curves
are not only negatively sloped, but are also convex to the origin. The
convexity of indifference curves implies
 The two commodities are not perfectly substitute one for another
 The marginal rate of substitution (MRs) between the two goods
decreases as a consumer moves along the indifference curve.
c) Indifference curves do not intersect each other. If two different
curves cross each other it would be violation of transitivity assumption in
consumer’s preference.
Let us see what happen when two indifference curves IC1 and IC2, intersect each
other at point C as shown in Fig. 3.8. Consider two other points. Point B on the
indifference curve, IC1 and point A on indifference curve, IC2.

Commodity Y

Commodity X
Figure 3.8 Intersecting Indifference Curve

Points like, A, B and C represents three different combinations of commodities X

and Y. Not that combination C is common to both indifference curves. It implies

56
that, Basket A is equally preferred to Basket C, (A = C) and basket C is equally
preferred to basket B. By implication, A is equally preferred to basket B. That is:-
A = C, C=B but, A B
But combination A is not equally preferred to combination B and this implying the
violation of the assumption of transitivity of consumer’s preference.
d) Upper indifference curve represents a higher level of satisfaction than
the lower ones. An indifference curve placed above and to the right to
another represents a higher level of satisfaction than the lower one. The
reason is that an upper indifference curve contains all along its length a
larger quantity of one or both the goods than the lower indifference
curve. And a larger quantity of a commodity is supposed to yield a
greater satisfaction than the smaller quantity of it.
The Marginal Rate of Substitution (MRS)
The slope of an indifference curve is called Marginal Rate of Substitution.
Marginal Rate of Substitution has an important economic meaning.
Marginal Rate of Substitution (MRS) is a rate at which one commodity can be
substituted for another, without changing the level of satisfaction. The MRS
between two commodities, X and Y, may also be defined as the ratio of quantities
of X and Y required to replace one another under the condition that total utility
remain the same. It implies that the units of commodity Y that must be given up in
exchange for an extra unit of commodity X so that the consumer maintain the same
level of satisfaction.

Mathematically, MRS between commodity X and Y can be shown as:-

MRSxy = this is when X is substituted for Y.

MRSyx = when Y is substituted for X and is calculated as,

MRSyx = which implies,
MRSyx=
Rearranging we obtain MRSyx = X/ Y
Diminishing Marginal Rate of Substitution
Marginal Rate of Substitution diminishes as we move along the indifference curve.
In other words, marginal rate of substitution (MRS) decreases as the consumption
of X increases and the consumption of Y decreases.
Figure 3.9 shows the consumer’s movement from point A to B, from B to C from
C to D.
Commodity Y

B
C

D IC

57

Commodity X
 Fig. 3.9 Diminishing Marginal Rate of Substitution

As a consumer moves down wards from A to B, from B to C and from C to D, for

a constant quantity of changing (Y), he requires an increased quantity X (i.e., X,
<X2<X3<Y4). As a result
Y1 Y2 Y3
 
X 1 X 2 X 3
The slope of indifference curve (MRS) diminishes for two reasons. The negative
slope of the indifference curve implies the two commodities are substitute to each
other to only a limited extent. That is, two goods regarded to be substitute goods
are not perfect substitution for each other. If they are perfectly substitute the
indifference curve will be a straight line with negative slope.

Since most goods are not perfect substitute, the subjective value attached to the
additional quantity of a commodity decreases faster in relation to the other
commodity whose total quantity is decreasing. Therefore, when the quantity of
one commodity (say x) increases and that of other commodities (Y) decrease, it
becomes difficulty for the consumer to scarifies more unit of commodity Y for one
unit of X. Thus, he will be demanding increasing, units of X to maintain the level
of his satisfaction. As a result the MRs decreases.
When the combination of two goods at a point of indifference curve is such that it
includes a larger quantity of one commodity say (Y) and smaller quantity of the
other commodity (X), then consumer’s capacity to sacrifice Y is greater than to
sacrifice X.
Therefore, he can sacrifice a larger quantity of Y in favor of a smaller quantity of
X. This is an observed behavioral rule that the consumer’s willingness and
capacity to scarifies a commodity is greater when its stock is greater and it is lower
when the stock of a commodity is smaller. As a result MRs decreases.

Shape of Indifference Curve

The shape of an indifference curve reflects the nature and degree of substitution
between two goods.
1. Linear indifference Curve:- When the shape of indifference curve is
straight line as shown in the figure below then the two goods, X and Y are
perfectly substitute to each other. This will occur when the consumer is
willing to substitute these two good on one to one basis.

58
 Commodity Y

Commodity x
X

Figure 3.10. Indifference Curve of Perfectly Substitute Goods

2. Fixed Proportion of L-shaped Indifference curve

When two goods are always consumed together in a fixed proportion the
indifference curve will have L-shape as shown in figure 3.11

Commodity Y

59
Commodity X
 Fig. 3.11 IC Curve for perfectly complete goods

When two goods are perfectly complement the indifference curve will have this
shape. A typical example of such goods are, right and left shoes. Under normal
condition they are used at a fixed proportion. Increasing only right shoe will not
bring any change in consumer’s Satisfaction.

3. Smooth-Convex-Indifference curve

This form of indifference curve assumes continuous substitutability between two

goods. The ordinalist theory adapted this form of indifference curve because it is
simple to handle by simple rule of calculus and most goods are not perfectly
substitute to each other.

Commodity Y

Commodity X

Fig. 3.12 Indifference curve representing continuous substitutability of good X and

Y

3.4.2. Consumer’s Budget Constraint

A rational and utility maximizing consumer would like to reach the highest
possible indifference curve on his indifference map. That is, to reach at the highest
utility giving indifference curve.

However, his choice to the level of preference is limited by availability of income

and market prices of commodities. This limitation is called Consumer’s Budget

60
 Constraint. The consumer budget constraint for two commodity model can be
expressed as:-
I= Px X + PyY. ……. Consumer’s budget equation for two commodity, X
and Y.
Where: I = Income of consumer
Px = Price of Commodity X
Py = Price of Commodity Y
X and Y are quantity of commodity X and Y respectively.
Given his income and market prices of commodity X and Commodity Y, he can
buy only limited quantity of the two goods.
From his budget constraint the amount of X and Y that can be purchased is
obtained as follows:
X = I/ Px - Py/ Px Y if Y = 0 then X = I/ Px

Y = I/ Py - Px / Py X if X = 0, then Y = I/Py

The consumer’s budget constraint is graphically represented by a line called

consumer’s Budget Line (Figure 3.13)
Commodity Y

B
Commodity X
O

Fig. 3.13 Consumer’s Budget Line

The slope of the budget line is the price ratio of commodity X and commodity Y.
Slope of the line AB can be determined as follows,

61
Thus, slope =

Example:
Consider a consumer consuming two goods X and Y. The price of commodity X
and commodity Y is 5 birr and 4 birr per unit respectively. If the consumer’s
income is 100 birr
a) Formulate his budget equation
b) Draw his budget line

Solution
a) The consumer budget equation is given by I = Px X + PyY
Thus 100= 5x+4Y

b) The budget line of the consumer given the above information is

depicted as:-

Commodity Y

25

20

15

10
Commodity X
0 10 15 20

Fig.3.14. Consumer’s budget line

Shift in the budget Line

The budget line changes its position following the change in consumer’s income
and price of commodities. If consumer’s income increases while prices of
commodity X and Y remain the same, budget line shifts, upward, but it remains
parallel to the original budget line.
62
As shown in figure 3.15, given the consumer’s income I, Px and Py the budget line
is given by AB. When I increases (prices remain the same), the budget line shifts
to CD.

Commodity Y

B D
Commodity X

Figure 3.15. Effect of change in income on the budget line.

Change in the prices of commodities changes the position of the budget line. If
price of commodity X falls while price of Y and consumers income remain the
same the budget line will rotate and the budget lines moves from AB to AB' as
shown in figure 3.16.
When price of commodity Y decreases while price of commodity X and income
of a consumer remain unchanged the budget line will rotate to the position of AB
to A’B as shown in figure 3.16 .

63
 Commodity Y

Commodity X

Figure 3.16. Change in the price of X and Y.

3.4.3. The consumer’s Optimum and the Demand Curve

So far we have equipped ourselves with necessary tools of consumer’s behavior
analysis. The consumer’s decision problem is that, to determine how much each of
the available commodity to consume (purchase) in order to maximize his
satisfaction at the existing market prices of commodities and his limited income.
Consumer’s optimum is a choice of a set of goods and services that maximize the
level of satisfaction subjected to limited income. The optimization decision
implies bring together consumer’s preference given by his indifference map and
his constraint given by his budget line.
A consumer reaches at optimum when he ends up on the highest possible
indifference curve, given his budget constraints.

This occurs at the point of tangency between an indifference curve and the budget
line.
At the point of tangency between an indifference curve and the budget line the
slope of both curves is equal.
As we have said earlier, the slope of the indifference curve is called Marginal
Rate of Substitution (MRS) and the slope of the budget line equals to the price
ratio of the two commodities.

Thus, at optimum (equilibrium) MRSxy = Px/Py

And MRSxy = Y/X: The above relationship can be written as:-
MRSxy = Y/X = Px/Py
By definition Y/X = MUx/MUy the optimum can be expressed as:

MUx/MUy = Px/Py rearranging this equation we obtain,

64
 MUx /Px = MUy/Py this indicate that the equilibrium conditions are
identical in both cardinal and ordinal approach.

Consumer’s equilibrium condition can be graphically represented as shown in figure

3.17.

Commodity Y

Commodity X

Fig. 3.17 Consumer’s Optimum

In the above figure, at point E, MRSxy = Px/Py. Therefore, the consumer is in

equilibrium consuming XE and YE units of commodity X and Y respectively. The
tangency of indifference curve, IC2 with the budget line indicated that IC2 is the
highest possible indifference curve, which the consumer can reach, given his
budgetary constraint and the prices conditions.

Another fact which is obvious from Figure 3.18 is that, due to budget constraints
the consumer cannot move to an indifference curve placed above and to the right.
For instance, his income would be insufficient to buy any combination of two
goods at the curve IC3.

In summary, a utility maximizing consumer, given his income, taste and

preferences and prices of goods, will attain his equilibrium when marginal rate of
substitution (MRS) equals to price ratio of commodities under consideration.

Numerical Example
Consider a consumer having only 4 birr which will be spent on two goods, X and
Y. The price of X is 1 birr per unit while the price of Y is only 0.50 birr per unit
If the consumer’s Total Utility (TU) schedule is given in the table below determine
the optimum consumption of these two good that maximize his total utility.
Total Utility Marginal Utility
Quantity Commodity Commodity MUx MUy MUx/Px MUy/Py
X Y
0 0 0 - - - -
1 20 9 20 9 20 18
2 32 17 12 8 12 16
3 37 24 5 7 5 14

65
4 40 30 3 6 3 12
5 42 35 2 5 2 10
6 42 39 0 40 0 8

The consumer equilibrium in both approaches implies MUx/ Px = MUy/Py This

condition is met when X= 2 and Y = 4. We can check, weather the income of a
consumer is sufficient to buy these quantity of X and Y i.e. ,(2,4) at the prevailing
market price.
4 = 1(2) + 0.5 (4)
4 = 2+2 . Thus, consumers optimum consumption of good X and Y that
maximizes his utility at the prevailing market price and his income is 2 unit
of X and 4 units of Y.

3.2. Check Your Progress

1. What is an indifference curve?

2. What are the properties of Indifference curve?
3. Explain the economic importance of the slope of an indifference curve?
4. Explain why the marginal rate of substitution (MRS) diminishes as we
move along the indifference curve.!
5. What is consumer’s optimum and when it occurs?

The effect of price and Income change on consumer’s equilibrium

As prices of commodities or income of a consumer change the consumers

equilibrium will also change. Let us look at these effects separately on consumer’s
equilibrium. The effect of Income change on consumer’s equilibrium. Here first
we will examine the effect of change in consumer’s income on his consumption
behavior, assuming that other things remain unchanged.

When consumer’s income changes, his capacity to buy goods and services
changes, other things remain the same. This change is shown by a parallel shift up
wards or down wards of the budget line. As a result the consumer equilibrium will
change accordingly. This condition is given in figure 3.12. Suppose initially the
consumer is at equilibrium at point a. When income of a consumer, increases, the
consumer budget line will shift from LL’ to MM’. As a result consumer’s moves
to a new equilibrium position at point b.
A further increase in consumer’s income, keeping others things constant will lead
to further shift of the budget line from MM’ to NN’. As a result the consumers
new equilibrium will be point C.

By joining different equilibrium points like, a, b, and c we get a line called Income
Consumption Curve (ICC)

ICC
N
66
odity Y

M
c
 Fig. 3.18 The effect of income change on consumer’s equilibrium

Income Consumption Curve (ICC) refers to a locus of points representing various

combinations of two commodities purchased by the consumer at different level of
his income; all other things remain the same.
The above figure shows the effect of income change on the quantity consumed of
two normal goods as both goods equilibrium quantity increased with income
increase.
Income Effect on Inferior Goods
An inferior good is one whose consumption decreases with the increase in
consumer’s income. In other words, when income effect on the consumption of a
commodity is negative, the commodity is said to be inferior. For example, when
income increases, consumption of inferior good decreases. Figure 3.18 and 3.19
presents the case of negative income effect. Figure 3.18 presents ICC for X as an
inferior good. Its consumption falls from X2 to X1 when consumers’ income
increase and his budget line shifts from LL’ to MM’. The income effect on
commodity Y consumption of commodity X is, therefore, negative. Similarly in
figure 3.19-income effect only is negative because Y is an inferior commodity.

Commodity Income Consumption Curve

YY
N

E3
M

L E2

E1

Commodity X
L' M' N' 67
Figure 3.19. Income effect for inferior good (Y) and inferior good (X)

Commodity Y

E1
E2
E3
Income Consumption Curve

Commodity X

Fig. 3.20. Income Effect for inferior good (Commodity Y)

In fact, whether a commodity is a normal good or an inferior good depends on
whether income-effect on its consumption is positive or negative. If income effect
is positive, the commodity is considered to be a normal good and if it is negative,
the commodity is said to be an inferior good.

Thus, income consumption – curve may take various shapes depending on whether
a commodity is normal good or an inferior good.
Engle Curve
The income consumption curve may be used to derive Engel curves. An Engel
curve is a function showing the relationship between equilibrium quantity
purchased of a commodity and the level of income. In other words an Engel curve
shows the relationship between consumer’s income and his money expenditure
on a particular good. The derivation of Engel curve from the income
consumption curve is illustrated in figure 3.20. The income consumption curve in
figure 3.20 shows the consumption of commodity X increases from X1 to X2 and to
X3 as income increases from I1, I2, and I3. In the same figure, income levels have
been shown on the vertical axis. The quantity demanded of X plotted in relation
to the corresponding levels of income represents Engle Curve, as shown in figure
3.21.(b)

68
Total Income

Figure 3.21. Derivation of Engel Curve

The shape of Engel curve depends upon the shape of income consumption curve.
The Engel curve in figure 3.2P (b) represents the Engel curve for normal good.
Which shows the positive income effect on consumption of commodity X. The
Engel curve for inferior goods will have a down ward slope, which shows the
negative effect of income on the consumption of the inferior good.

The Effect of Price Change on Consumer’s Equilibrium

As prices of a commodity change while price of other commodities and income of

consumer remain unchanged, the budget line rotates in wards or outwards.
If the price of one of the two commodities say X falls while income and price of
other commodities remain unchanged the budget line will rotate outwards, i.e., the
budget line will shift from LL’ to LM as shown in figure 3.21. As a result the
consumer moves from the initial equilibrium point E1 to E2 and consumption of

69
commodity X increases from X1 to X2. This shift takes place due to increase in
consumer’s purchasing power in terms of X with increased purchasing power the
consumer can buy more of X or more of both the goods. As a result, the consumer
reaches a higher indifference curve IC2 and his new equilibrium at E2 occurs to the
right of his original equilibrium, provided that X is a normal good.

Comm. Y

L Price Consumption Curve

E3
E2
E1

Comm. X
L' M' N'
X1 X2 X3

Fig. 3. 22 The effect of price change on Equilibrium

Figure 3.22 shows successive fall in price of commodity X which changes the
consumers equilibrium from E1 to E2 to E3. By joining the point of equilibrium
E1, E2 and E3 we get a curve called Prince Consumption Curve (PCC).
Price Consumption Curve is a locus of points of equilibrium on indifference
curves, resulting from the change in price of a commodity. It shows the change in
consumption basket due to change in the price of commodity X.

Derivation of Individual Demand Curve

The main purpose of the entire exercise in indifference approach is to construct the
individual demand curve for a commodity. An individual demand curve shows the
relationship between the quantity demanded of a commodity, say X and its price
(Px), under Ceteris Paribus assumption. Thus, to derive an individual demand
curve we need different levels of Px and the corresponding quantity demanded of
commodity X. This information can be obtained from the price consumption curve.
The Price Consumption Curve (PCC) in figure 7.22 (a) contains the information
required for constructing the individual demand curve for commodity X. The
derivation of the demand curve is shown in figure 7.23 (b).

L 70
 Fig. 3.23 Deriving Demand Curve

The demand curve is derived by mapping PCC from commodity X and commodity
Y space to price (Px) and quantity of commodity X space in the above diagram.

Panel (a) at figure 3.23 shows the derivation of PPC, when the price decreases
form P1 to P2 and then P3, the budget line rotates to the right, from LL' to LM' and
then to LN'. As a result, the consumer moves from equilibrium point E1 to E2 and
finally to point E3 on the PPC.

The demand curve may be constructed directly from figure 2.23(a). This has been
shown in figure 2.3 (b). The vertical axis of panel (b) measures the price of
commodity X and P1, P2 and P3 represents the three prices we have considered in
panel (a). We know that quantity consumed at P1 is X1. If we extend the cordinate
E1X1 to the X-axis of panel (b), it intersects the line P1 at E1. By repeating the
same process for price P2 and P3, we get points E2 and E3. By joining the points E1,
E2 and E3 we get the demand curve Dx. The precise shape and slope of the demand
curve depends, however, on the direction in which income and substitution effects
of fall in the price of goods.

71
 3.5. Summary

The theory of consumer’s behavior try to address questions like, how does a
consumer decide how much of a good to buy at a given price? And why does a
consumer buy more of a good when its price decreases? By consumer behavior we
mean how consumers decide on the basket of goods and services they consume.
The way consumer takes decision on different problem is called Consumers
Decision Making Behavior. Utility is the amount of satisfaction to be obtained
from a good or services at a particular time. However, economists are divided on
the issue of measurability of utility. Neoclassical economists argue that utility is
numerically measurable. According to modern economist utility cannot be
measured numerically rather it can only be compared or ordered. Accordingly, we
have to approach to the analysis of consumers behavior namely, cardinal approach
and ordinal approach.

According to cardinal utility approach utility is cardinal concept. That is, the
utility of each commodity is measurable and the most convenient measure is
money. In order money to serve as the measurement of utility, the cardinal
approaches assume the marginal utility of money to be constant. This means the
value of one unit of money to consumer remain constant, regardless of his money
stock change and each unit of money has utility equals to one. Total Utility (TU)
in a sum of all utilities derived from the entire unit consumed. The additional
satisfaction (utility) received over a given period by consuming one more unit of a
good is called Marginal Utility. Marginal Utility measures the slope of total
utility. Marginal utility or additional utility gained from successive unit of a
commodity consumed diminishes as a consumer consumes more and more of that
commodity. The law of diminishing marginal utility is observed because of the
fact that, the utility derived from a commodity depends on the intensity or urgency
of the need for that commodity. As more and more quantity of a commodity is
consumed the intensity of desire decreases and therefore, the utility derived from
the marginal utility decreases.

In the Cardinal Approach, consumers equilibrium is established, when the

marginal utilities per money spent are equal on each good purchased and
consumer’s money income available for the purchase of goods has been exhausted.

Ordinal Approach is an alternative approach to the analysis of consumer’s

behavior. According to this approach utility is not cardinally measurable, but is an
ordinal in magnitude. That is, the consumer may not know the exact unit of utility
derived from different commodity but he is able to rank or order different baskets
of goods in utility.

Indifference curve is the graphical representation of consumers’ preference. An

indifference curve is a locus of points each showing or representing a different
combination of two goods, which yield the same level of satisfaction to the
consumer. The properties of an indifference curve are; they are convex to the

72
origin, they do not cross each other, indifference curves are down ward slopped
and the upper indifference curve represents a higher level of satisfaction than the
lower one.

The slope of an indifference curve has an important economic meaning and it is

called Marginal Rate of Substitution (MRS). Marginal Rate of Substitution
(MRS) is a rate at which one commodity can be substituted for another, with out
changing the level of satisfaction. Marginal Rate of Substitution diminishes as we
move along the same indifference curve. The shape of an indifference curve
reflects the nature and the degree of substitution between two goods. When two
goods are perfectly substitute to each other, the shape of the indifference curve will
be linear. When two goods are always consumed at fixed proportion or when two
goods are perfectly complement to each other, the indifference curve assumes “L”
shape. Smooth-Convex Shape of an indifference Curve reflects continuous
substitutability between two goods. The ordinalist theory adopted this form of
indifference curve as most goods are not perfectly substitute to each other.
Consumer’s choice to the level of consumption (preference) is limited by
availability of money income and market prices of commodities under
consideration. This limitation is called consumer’s budget constraint. A
consumer’s budget constraint is graphically represented by a line called
Consumer’s Budget Line. The budget line indicates all combinations of the
goods for which total expenditure equals income. A budget line is a boundary of
consumption for the goods. The budget line changes (shifts) its position following
changes in consumer’s income and prices of the commodity X and Y remain the
same, budget line shifts either upwards or down wards, but it remains parallel to
the original budget line.

If price of one of the commodities fall while price of the other commodity and
income of a consumer remain the same the budget line will rotate either in wards
or outwards.

Consumer’s optimum is a choice of a set of goods and services that maximizes the
level of satisfaction. Subjected to limited income.

A consumer reaches at optimum when he ends up on the highest possible

indifference curve, given his budget constraint. And this occurs at the point of
tangency between an indifference curve and the budget line.

For a consumer to attain equilibrium the following conditions must be fulfilled.

First, the budget line is tangent to the highest attainable indifference curve.
Second, the indifference should be convex to the origin at the point where the
budget line is tangent to the indifference curve. In general, a utility maximizing,
consumer given his income, taste and presences and price of goods, will attain his
equilibrium when marginal rate of substitution (MRS) equals to price ratio of
commodities under consideration.

73
Income consumption curve (ICC) refers to a locus of points representing various
combination of two goods purchased by the consumer at different level of his
income, all other things remain the same.

The income consumption curve may take different shape depending on whether a
commodity is normal good or an inferior good. Engel Curve is derived form
income consumption curve. Engel Curve is a function showing the relationship
between equilibrium quantity purchased of a commodity and the level of income.
It shows the relationship between consumer’s income and his money expenditure
on a particular good.

Price Consumption Curve (PCC) is a locus of points of Equilibrium on

indifference curves, resulting from the change in price of a commodity. It shows
the change in consumption basket due to change in the price of a commodity. The
price consumption curve contain the information required for constructing the
individual demand curve for a given commodity. The demand curve is derived by
mapping price consumption curve from commodity space to price and quantity
space. The precise shape and slope of the demand curve depends, however, on the
direction in which income and substitution effects of fall in the price goods.

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 CHAPTER FOUR
THE THEORY OF PRODUCTION
4.1. Introduction: Definition and basic concepts of Production

Production: Is the creation of anything (good or services) that has economic value
either to consumers or producers

Production Function: is the maximum quantity of output that can be produced

from the given amount of available inputs for a given technology. It represents a
purely technical relationship which connects factors (inputs) to products (outputs)
at any particular time period. In other words, it describes the technical relationship
between inputs and output in physical unit.
Production Process: Is the manner (the way) in which inputs are transformed into
output. Usually a commodity can be produce by different processes. In other words
there are different processes in producing a particular output. However, the
production process includes only those processes which are technically efficient.
Technical efficiency: refers to producing or obtaining the maximum possible
output from a given level of input.
Economic Efficiency: Is doing things at the lowest possible cost.
Producing a particular product involves the use of different inputs, like, labor,
capital, land, raw materials, technology and the like. However, the economic
theory reduces these inputs to only two inputs, that is, to only labor and capital
inputs. This is because of the fact that some inputs like land and technology are
fixed to the producers and some like raw materials can be included in these two
inputs specifically into the capital inputs. Therefore, the general functional form
can be stated as;

Q= f(L, K) ……………………….(1)

Where, Q Output in physical units, L refers to labor inputs, and K is capital inputs

Production function 1 implies that the total output produced is a function of labor
and capital inputs used in the production process. This means, increasing output

75
(Q) requires increasing the use of labor and capital inputs. The question, however,
is that, is it possible to increase output by increasing both labor and capital inputs
simultaneously? The answer to this question depends upon the time period which
can be short or long-run.
In the long run its possible to increase output by increasing both labor and capital
inputs at the same times. In the short-run, however, it is not possible to change all
inputs at the same time as some inputs become fixed. Accordingly, we have
production in the short run and production in the long run.
Longrun : is a time period (planning horizon) which is sufficient enough to
change the quantities of all inputs. Thus, all inputs are variable and there is no
fixed input.
Short run: refers to a period of time which is so short that it is not possible to
change all factors of production and hence some inputs are fixed by definition.
This chapter focus only on the short run production which is also known as
production with one variable inputs or the law of variable proportion.

Fixed Vs Variable inputs

In economics, inputs can be classified as fixed and variable. Fixed inputs are those
inputs whose quantity can not readily be changed when market conditions indicate
that an immediate change 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 shoots up suddenly in a week, the brewery factories cannot plant
additional machinery over night to respond to the increased demand. It takes long
time to buy new machineries, to plant them and use for production purposes. Thus,
the quantity of machinery is fixed for some times such as a weak. Buildings,
machineries and managerial personnel are examples of fixed inputs because their
quantity cannot be manipulated easily in short time periods.
Variable inputs, on the other hand, are those inputs whose quantity can be changed
almost instantaneously in response to desired changes in output. That is, their
quantity can easily be diminished when the market demand for the product
decreases and vise versa. The best example of variable input is unskilled labor. In
our previous example, if the brewery factory had idle machinery before the market

76
demand increased, the factory can easily and immediately respond to the market
condition by hiring laborers.

4.2. Production in the short run: Production with one variable

input
Short run production function is a production function which combines at least one
fixed input with variable input. The short run production is based on the following
assumptions

Assumption of short run production analysis

In order to simplify the analysis of short run production, the classical economists
assumed the following conditions:
1. Perfect divisibility of inputs and outputs
This assumption implies that factor inputs and outputs are so divisible that one can
hire, for example a fraction of labor, a fraction of manager and can produce a
fraction of output, such as a fraction of automobile.
2. Limited substitution between inputs
Factor inputs can be substituted each other up to a certain point, beyond which
they cannot be substituted each other. In other words, resources are not perfect
substitutes for one another as they are not identical.
3. Constant technology
It is assumed that level of technology of production is constant in the short run.
Suppose a firm that uses two inputs: Capital (which is a fixed input) and labor
(which is variable input). Given the assumptions of short run production, the firm
can increase output only by increasing the amount of labor it uses. Output varies
with the variation of the variable input. Hence, its production function is:
Q = f (L) K - being constant
Where Q is the quantity of production (Output)
L is the quantity of labor used, which is variable, and
K is the quantity of capital (which is fixed)

77
The production function shows different levels of output that the firm can obtain
by efficiently utilizing different units of labor and the fixed capital. In the above
short run production function, the quantity of capital is fixed. Thus output can
change only when the amount of labor used for production changes. Hence, Q is a
function of L only in the short run.

4.3. The concept of Total Product (TP), Marginal Product (MP)

and Average Product (AP)
Total Product (TP)

Total product is the total amount of output that can be produced in physical unit.
The total product curve, thus, represents various levels of output that can be
obtained from efficient utilization of various combinations of the variable input,
and the 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, increasing the unit of the variable input may
not help output increase. Even as we employ more and more unit of the variable
input beyond the carrying capacity of a fixed input, output may tends to decline.
Thus, increasing the variable input can increase the level of output only up to a
certain point, beyond which the total product tends to fall as more and more of the
variable input is utilized. This tells us what shape a total product curve assumes.
The shape of the total variable curve is nearly S-shapeas shown in the figure
below.
Average Product (AP):
It as output produced per unit of labor input used in the production process. The
AP of an input is the ratio of total output to the number of variable inputs.
totalprodu ct TP
APlabor  
numberofL L

The average product of labor first increases with the number of labor (i.e. TP
increases faster than the increase in labor), and eventually it declines. However,

78
average product can never be zero or negative as it is a ratio of two positive
numbers (total output and employed labor)
Marginal Product (MP)
It is additional output produced by additional unit of labor input. It is a rate of
change in the total output associated with a unit change in labor inputs.
The marginal product of a variable input is the addition to the total product
attributable to the addition of one unit of the variable input to the production
process, other inputs being constant (fixed). Before deciding whether to hire one
more worker, a manager wants to determine how much this extra worker (L =1)
will increase output. The change in total output resulting from using this additional
worker (holding other inputs constant) is the marginal product of the worker. If
output changes by Q when the number of workers (variable input) changes by
∆L, the change in output per worker or marginal product of the variable input,
denoted as MPL is found as
Q dTP
MPL = or MPL 
L dL
Thus, MPL measures the slope of the total product curve at a given point. In the
short run, the MP of the variable input first increases, reaches its maximum and
then tends to decrease to the extent of being negative. That is, as we continue to
combine more and more of the variable inputs with the fixed input, the marginal
product of the variable input increases initially and then declines.
The neoclassical production function can be graphically represented as follows.
The following figures shows how the TP, MP and AP of the variable (labor) input
vary with the number of the variable input.

79
 Output a

TP3

TP2 TP

TP1

L1 L2 L3
Units of labor (variable
APL, MPL input)

APL

L1 L2 L3 Units of labor (variable input)

MPL

Fig 3.1 Total product, average product and marginal product curves:
As the number of the labor hired increases (capital being fixed), the TP curve first
rises, reaches its maximum when L3 amount of labor is employed, beyond which it
tends to decline. Assuming that this short run production curve represents a certain
car manufacturing industry, it implies that L3 numbers of workers are required to
efficiently run the machineries. If the numbers of workers fall below L3, the
machine is not fully operating, resulting in a fall in TP below TP3. On the other

80
hand, increasing the number of workers above L3 will affect the production process
negatively because only L3 number of workers can efficiently run the machine.
Increasing the number of workers above L3, rather results in lower total product
because it results in overcrowded and unfavorable working environment. This fact
is given by the law of diminishing return.
The Law of Diminishing Return ( LDMR) state that, as the use of a variable
input added to a give level of fixed input initially the total output increases at
increasing rate and later it will increase at decreasing rate. Eventually a point
will be reached at which the additional unit of input results a decrease in the
level of output. so that output decreases.
Note that, the Law of diminishing marginal returns is based on two very
important assumptions. These are the existence of constant technology and
homogeneous labor

Marginal product curve increases until L1 number of labor are employed and
reaches its maximum at L1, and then it tends to fall. The MPL is zero at L3 (when
the TP is maximal); beyond which its value assumes negative value indicating that
each additional worker above L3 tends to create over crowded working condition
and reduces the total product. Thus, in the short run (where some inputs are fixed),
the marginal product of successive units of labor hired increases initially, but not
continuously, resulting in the limit to the total production. Geometrically, the MP
curve measures the slope of the TP. The slope of the TP curve increases (MP
increases) up to L1, it decreases from L1 to L3 and it becomes negative beyond L3.

The average product curve increases up to L2, beyond which it continuously

declines. The AP curve can be measured by the slope of raise originating from the
origin to a point on the TP curve. For example, the APL at L2 is the ratio of TP2 to
L2.
The Relationship between AP and MP of Variable Input
The relationship between MPL and APL can be stated as follows:
 For all number of workers (Labor) below L2, MPL lies above APL.
 At L2, MPL and APL are equal.

81
  Beyond L2, MPL lies below the APL
 Total product reaches maximum when marginal product is zero.
Thus, the MPL curve passes through the maximum of the AP L curve from above.
This relationship between APL and MPL can be shown algebraically as follows:

4.4. Stages of Production in the short-run or Efficient Region of

Production in the short-run
We are now not in a position to determine the specific number of the variable input
(labor) that the firm should employ. Because, this depends on several other factors
than the productivity of labor such as the price of labor, the structure of input and
output markets, the demand for output, etc. However, it is possible to determine
ranges over which the variable input (labor) be employed.

To do best with this, let us refer back to fig 3.1 and divide it into three ranges
called stages of production. The production of a firm in the short run can be
divided in to three stages of production.
 Stage I – ranges from the origin to the point of equality of the AP L and
MPL.
 Stage II – starts from the point of equality of MP L and APL and ends at a
point where MP is equal to zero.
 Stage III – covers the range of labor over which the MPL is negative.
Graphically, the three stages of production are indicated bellow

82
83
 CHAPTER FIVE
THEORY OF COSTS AND PROFIT MAXIMIZATION

5.1. Introduction
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 production of an item. Economics
theory distinguishes between short run costs and long run costs.
Short run costs: Is the time period which is so short that it is not possible for a
particular producer to alter or change its plant size. Hence, the firm works with
whatever equipment and factor size it already has. In short, short run costs are
costs over a period during which some factors of production (usually capital
equipment and management) are fixed. Thus, in the short-run there are both
variable and fixed costs.
The long- run costs are the cost over a period long enough to permit the change of
all factor of production. In the long run the firm can acquire new machinery and it
can also build new building for production purpose. Hence in the long run all cost
are variable.
5.2. Short-run Cost
All costs incurred in the short run is called Total Cost (TC). In the traditional
theory of the firm, total costs are split into two components. These are Total Fixed
Costs (TFC) and Total Variable Costs TVC:
Total Fixed Cost (TFC): Are costs that will not vary with the level of output
produced. Once such cost is incurred its level will remain unchanged regardless of
the level of output produced. Some of the examples of TFC are:
▫ Salaries of administrative staff (Secretary, Management, Guards , etc.
▫ Expenses for building depreciation and repairs.
▫ Expenses for land and maintenance
▫ The rent of building used for production, etc.

84
Quantity if
output 0 1 2 3 4 5 6
TFC 100 100 100 100 100 100 100

TFC

100 TFC

Q
Total variable cost (TVC)
Are costs which will vary with the level of output produced. These costs are
dependent on the amount of output produced. If the firm wants to produce more of
its product then it has use more of variable inputs. The total variable cost of a firm
has an inverse s- shape. The shape indicates the law of variable proportions in
production. According to this law, at the initial stage of production with a given
plant, as more of the variable factor (s) is employed, its productivity increases.
Hence, the TVC increases at a decreasing rate. This continues until the optimal
combination of the fixed and variable factors is reached. Beyond this point, as
increased quantities of the variable factors(s) are combined with the fixed factor (s)
the productivity of the variable factor(s) declined, and the TVC increases by an
increasing rate.

. TVC

Co
st

Q
85
Total Cost (TC)
Total cost is a summation of total fixed cost and total variable cost at any level of
output. That is,
TC + TFC +TVC
The following table illustrates the relationship between total cost and its two cost
components

Output (Q) TVF TVC TC

0 100 0 100
1 100 50 150
2 100 84 184
3 100 108 208
4 100 128 228
5 100 138 238
6 100 150 250
7 100 180 280
8 100 230 330
9 100 290 390

The Total cost curve has similar shape to that of the total variable cost.

Cost
TC
TVC

TFC

Average cost Curves

In fact total costs will give only general picture about the cost of production.
However, for decision making purpose most useful information about the cost is
obtained from the average costs. Here we will look at average costs of the above
cost components.
Average Fixed Cost(AFC): This is fixed cost per unit of output produced and is
calculated as follow. AFC = TFC/Q , Where TFC represents Total Fixed cost and
Q is total output. Since TFC is constant, increase the level of output will
continuously decrease AFC. As the level of output increases AFC approaches to
zero but it will never be zero (unless TFC is zero).

86
 Quantity TFC AFC
0 100
1 100 100
2 100 50
4 100 25
5 100 20
10 100 10
20 100 5

Graphically, the AFC is a rectangular hyper parabola. The AFC curve is

continuously decreasing curve, but decreases at a decreasing rate and can never be
zero. Thus, AFC gets closer and closer to zero as the level of output increases,
because a fixed amount of cost is being divided by increasing level of output.

AFC

Average Variable Cost

It is variable cost per unit of output. The AVC is similarly obtained by dividing the
TVC with the corresponding level of output.

TVC
AVC 
Q

87
Average variable cost has in general U shape reflecting the law of diminishing
return.
AVC
Cost

Q
F
Average Total Cost
C
It is total cost per unit of output produced .ATC is obtained by dividing the TC by
the corresponding level of output. It shows the amount of cost incurred to produce
each unit of successive outputs.

TC
AC 
Q
Or It is a summation of AFC and AVC ( ATC = AFC + AVC)
ATC will have the same “U”shape curve as AVC. It drops sharply at the beginning
because both AFC and AVC are falling. But it will raise when AVC raises

Cost

ATC

AVC

Q
Marginal Cost (MC)
The marginal cost is defined as the additional cost that the firm incurs to produce
one extra unit of output. The MC is the change in total cost which results from a
unit change in output i.e. MC is the rate of change of TC or TVC with respect to

88
output. Simply it measures the slope of both TC and TVC. One thing to be noted
here is that, the additional cost that the firm incurs to produce the 10th unit of
output is not equal to the additional cost of producing the 1000th unit. They would
be equal if the TC curve is straight line.

ΔTC
MC 
ΔQ
MC
Cost

Q
Short-run Average cost Curves
By putting all unit cost curves including marginal cost in the same quadrant we can
see clearly the relationship among different unit cost curves. The graph below
depicts the short-run average cost curves.

Cost MC ATC

AVC

AFC

Q
Relationship among Unit Cost curves
Both AVC and ATC are U – shaped, reflecting the law of diminishing return,
however, the minimum of ATC occurs to the right of the minimum point of the
AVC ( see the above figure) this is due to the fact that ATC includes AFC which
continuously decreases as the level of output increases. After the AVC has reached
its lowest point and starts rising, its rise is over a certain range is more than offset

89
by the fall in the AFC, so that the ATC continues to fall (over that range) despite
the increase in AVC.
However, the rise in AVC eventually becomes greater than the fall in AFC so that
the ATC starts increasing. The AVC approaches the ATC asymptotically as output
increases.
In general the following relation can be obtained from the above graph.
 When MC is below the AVC and ATC, both AVC and ATC are falling
 When MC is above the AVC and ATC (MC > AVC , MC >ATC), both AVC and
ATC are raising
 MC intersects both AVC and ATC at their minimum point. That is, MC =AVC
when AVC is at its minimum and MC=ATC when ATC is at its minimum.
Numerical example of costs
Given the following cost information complete the table!

Q TFC TVC TC AFC AVC ATC MC

0 60 0
1 60 30

2 60 40

3 60 45

4 60 52

5 60 75

6 60 120

Relationship between short run average costs and short run-production

Short run AVC and MC curves are the mirror reflection (along the horizontal axis)
of short run APL and MPL curves. Maximum of MPL corresponds to the minimum
of MC. The maximum of APL corresponds to the minimum of AVC.

90
 AP, MP

AP

MP

Labor
MC, AVC
MC
AVC

Q
5.3. Profit Maximization of a Competitive Firm
How much a competitive firm should have to produce? A firm operating in a
competitive market has to produce the quantity that maximizes its profit. In other
words, equilibrium occurs when it produces that level of output which maximizes
its profit, given the market price.
The concept of profit
Profit is the difference between Total Revenue and Total Cost. That is,
 = TR – TC where  = Profit, TR is Total Revenue and TC is
Total Cost

Total Revenue (TR)

Firm generates revenue from the sale of its product and it is the product of price
and quantity of the product sold.
TR = P*Q where P stands for unit price and Q quantity of the product.
Since in a competitive market unit price is constant and the firm is a price taker,
TR is a linear function of quantity of output. If the unit price is Birr 5 per unit the
TR is determined as follows

91
Unit Price (P) 5 5 5 5 5 5
Quantity (Q) 0 1 2 3 4 5
Total Revenue (TR) 5 5 10 15 20 25

TR
TR

Q
Average Revenue (AR)
Average revenue is revenue per unit of output. In a competitive market Average
revenue is equal to unit price of a commodity and is obtained by dividing TR by
quantity of output (Q).
AR = TR/Q = P …………….. Why?

TR TR

P AR=MR

Q
Marginal Revenue (MR)
It is additional revenue from the additional unit of output. It is a rate of change in
total revenue associated with a unit change in output. Marginal revenue measures
the slope of total revenue.
MR = Δ TR/ Δ Q
In a competitive market MR = P ……….why?
So far we have tried to explain the concept of TR and its components. Now let us
re-state the previous point. The firm is at equilibrium when it chooses the quantity
that maximizes its profit.
There are two approaches to determine the level of output that maximizes profit.
These are;
• Total approach ( TC and Total Revenue approach)

• Marginal Approach

Total approach

92
 In this approach TR and TC are used to determine the quantity that the firm has to
produce to get the maximum possible profit. Profit is maximized at level of output
that makes the difference between TR and TC is large. Profit is maximum at a
point where TR exceeds TC by larger amount.

TC
TR,TC TR

Q1 Q* Q2 Q

In the above figure it can be shown that, At Q1 and Q2 TR and TC are equal to
each other and hence both point represents a quantity that make profit equal to
Zero. The firm will not choose the amount at which TC > TR (these are quantity
less than Q1 and Quantity greater than Q2.
Profit is maximum at the point where the area between TR and TC is large. Larger
area occurs at the point where the slope of TR is just equals to the slope of TC.
Q* refers to the profit maximizing level of output, because the vertical distance
between TR & TC is the highest at this point (i.e. profit is the highest). Where as,
for all output levels below Q1and above Q2 profit is negative because TC is above
TR.
Marginal Approach

Another approach to determine the profit maximizing output is using marginal

analysis. It is indeed the continuation of the previous approach. In the previous
approach we have said that, profit is maximum at a place on the graph where the
TR curve exceeds the TC curve by the larger amount. This occurs when the slope
of the TR is equals to the slope of TC. That is at equilibrium:
Slope of TR = Slope of TC

93
Slope of TR is MR and the slope of TC is MC. Hence the profit maximization
output is occurred at a point where MR =MC This can be graphically represented
as follows.

MC,MR

MC

MR/P/

Q1 Q* Q

From the above figure it can be noted that MR =MC at two points, at Q1 and at Q*.
The profit maximizing output is the one at which MR =MC at the increasing part
of MC. In other words the MR must intersect MC at the increasing part of MC.
Hence, equilibrium output is Q* not at Q1.
In the above figure we have determined the profit maximizing output. However,
the above analysis will not enable us to determine the level of profit. To determine
the level of profit, we need information about the ATC. The figure below
incorporate ATC curve so that we can determine profit or loss in our analysis.

MC, ATC MC

ATC
P

Q
Profit in this analysis is on the bases of average or unit profit and is calculated as
follows.
Profit/Unit = (TR/Q) – (TC/Q)

94
Profit per unit = P- ATC
In the above figure total profit is given by the shaded area. However, it does not
mean that the firm will always make profit. Weather a firm makes profit or not
depends up on the position/level of ATC. Depending on the level of ATC different
scenarios may emerge.
1. When P > ATC; In this case the firm makes profit. This is the case which is
presented above and is presented again as follows. The profit is the
shaded area.

MC
ATC

P MR=AR

Q*
2. When a P=ATC, the firm is in a break even condition. That is there is no
profit or loss (Profit = 0).
MC ATC

P MR = AR

Q*
3. When P<ATC, the firm is incurring loss. When this situation happens the
firm faces two decision problems. One is to continue in business with the
existing loss. The other is to shut down the business. The decision is made
by considering the value of Average Variable Cost.
a) If the market price is greater than AVC, the firm is covering the costs of
all variable inputs and costs of some fixed inputs. Hence the firm has
to continue in business. In which cases the profit maximization is
equivalent to loss minimization. This loss minimization condition is
depicted as follows.

95
 ATC
MR
AVC

P MR=AR

Loss minimization

Q*
b) If the market price is just equals to AVC, the firm should shut-down its
business. The short-run shut-down price condition is depicted as
follows.

ATC
Cost MC
AVC

MR=AR
P

Short-run shutdown
point

Q* Q
Deriving the Supply Curve
The supply curve of a firm is derived from the firm’s optimization decision. The
portion of the marginal cost curve above represents the short run supply curve of a
firm. The following figure presents how supply curve is derived from the firm’s
equilibrium point that would occur at different price level.

96
 P
MC

E3
2 MR3 P3
E2 Supply Curve
MR2
P2
E1 MR1
2 P1

Q
Q1 Q2 Q3

97
 CHAPTER SIX: OVERVIEW OF MACROECONOMICS

6.1. NATIONAL INCOME ACCOUNTING

National income accounting is accounting system that is used to measure aggregate

economic activities. It is an official measurement of the flow of income and
product in a given economy. Students, aggregate economic activity or total output
(income) of an economy for given period can be represented by GDP/ GNP.
Therefore, before we start to deal with the accounting process let us differentiate
between GDP and GNP first.

Gross Domestic Product (GDP) is the market value of all final goods and services
produced in a country in a given year. This can be represented by the total income
of everyone in the economy or total expenditure made on the economy’s goods and
services by different agents.

On the other hand Gross National Product (GNP) is the total market value of goods
and services produced by the nationality of a given country for a given period of
time. From this definition we can easily identify that unlike GDP, GNP would
includes some output produced by a citizen of a country living abroad and
excludes the output produced by the nationality of other country under taking
production in that country. Therefore, GNP can be obtained from GDP by adding
net factor payment on GDP.

GNP = GDP+ Net factor payment.

Where net factor payment or income is the difference between factor payment
from aboard and factor payment to abroad. In other words receipts of factor
income (wage, profit and rent) from the rest of the world subtracted from payment
of factor income to the rest of the world. For example Ethiopians who own
apartments in New York earn rental income for their building. This income earned

98
included in GDP calculation of US but not part of GNP of USA but it is included
in GNP of Ethiopia.

6.1.1. Real and Nominal GDP

Up to now in GDP accounting, we implicitly assume that the economic activity of
an economy valued at current market prices. The aggregate that is obtained by
measuring economic activity at current market price is termed as nominal GDP.
Consider for example an economy producing only two goods banana and coffee.
To find a nominal GDP of such economy, simply sum up the total value of banana
and coffee at current market prices. That is, nominal GDP = (Price of banana x
Quantity of banana) + (price of coffee x Quantity of coffee).

Students, the problem with such type of valuation of goods and services is that it
could not reflect the cause for change in GDP resulted from change in price or
change in quantity of output overtime. There are cases where GDP changes
without any change in amount of output of an economy when there is change in
prices. For illustration consider the prices and amount of output (banana and
coffee) produced from 2004 to 2007 for the hypothetical economy as given in table
1.4

Table 1.5 the total amount of output of two goods economy with their market prices of
hypothetical economy.
Year Price of Quantity of Price of Quantity of coffee(tone)
banana/kg banana(tone) coffee/kg
2004 2.00 10,000.00 5.00 20,000.00
2005 2.50 10,500.00 8.00 20,500.00
2006 3.00 10,600.00 10.00 20,600.00
2007 5.00 10,600.00 30.00 20,600.00

Let us compute the nominal GDP of the economy for 2006 and 2007 to see the
impact of price on the value of total output (GDP).

99
Nominal GDP of 2006 = (2006 price of x 2006 amount of banana +2006 price of
coffee) x
2006 amount of coffee. = (3x10, 600) + (10x20, 600)
= 31,800+206,000=237,800 =237,800
Nominal GDP in 2007 = (2007 Price of banana x 2007 amount of banana) +
(2007 price of banana x amount of coffee in 2007)
= 5x10, 600) + (30x20, 800)
= 53,000 + 718,000
= 771,000

This example show that the nominal GDP in 2007 increases without an increase in
the amount of output produced because of increase in price. Therefore, it is
misleading to use nominal GDP to say something about the performance of the
economy (growth)
A better way of measuring the state of an economy is measuring the economy’s
total output by avoiding the impact of price. This can be possible by using real
GDP. Real GDP is the value of goods and services measured using constant or
base year price. It is computed after adjusting for change in price from year to
year. Therefore, to compute real GDP first set a base year price and then value all
the output produce in different year at the selected base year price. For instance,
let us set a base year price for the above hypothetical economy to be 2004, then the
real GDP of 2006 and 2007 can be computed as follows.

Real GDP= (2004 price of x 2006 Quantity of banana) + (2004 price of coffee)
(2004
Quantity of coffee)
= (2x10, 000) + (5x20, 600) 11200+103000=114,000
Real GDP= (2004 price of banana) (2007 quantity of banana) + (2004 price)
(2007
Quantity of coffee)
= (2x10, 600) + (5x20, 600)

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 =11,200+103,000
=114,000
When price held constant, the real GDP varies from year to year only when the
quantities produced vary. Thus real GDP measure changes in physical output in
the economy between different time periods by valuing all goods produced in two
periods at the same prices. This is done in order to make GDP in different periods
comparable and able to identify the real changes in the amount of goods and
services produced in different time. In the above example between 2006 and 2007
there is no change in the amount of goods produced. The calculate GDP also
reflects the same thing.

6.1.2. Goods and Earning Flow and Approaches of measuring GDP

Dear students, how can we measure GDP/GNP of an economy? Well it is
important first to distinguish whether GDP is a flow concept or a stock concept to
perform the measurement process.
A stock concept is a quantity of something measured at a given point in time,
where as a flow concept refers to amount of a given object flow measured per unit
of time.
To illustrate flow and stock concept, the amount of water in bath tub and the
quantity of water added to bath tub is used. The amount of water in the tub is a
stock where as the quantity of water added and leak out from the tub per unit
represents a flow.
GDP of a given economy measure in the same manner as the amount of water
moving in to and out of the bath tub. This implies GDP is a flow concept. It tells
us the amount of dollars/birrs flowing among different economic agent (firms,
households and other) per year or months. Such flow of birr (income) among
economic agents in the form of expenditure and income can be represented by
circular flow of income. GDP measurement (accounting) therefore, involves the
measures of total income/expenditure through the loop of circular flow of income
as indicated in figure 1.1.
Income
Factor input

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Firms
 House hold

Goods and service

Expenditure

Figure 1.1. Circular flow of income and product

Let us illustrate the flow of income and product among economic agents that is
measured as GDP represented by figure 1.1 of circular flow of income and
products. Have you notice what the arrow in circular flow represented? The upper
two arrows represent factor market. It is a market in which factor input exchange
for income. Households by providing inpusuch as labor and capital to firms, they
earn income. So it measures the flow of income from firms to households in return
to factor input. The bottom arrows on the other hand represent product market. It
is a market in which households spends their income earned in the factor market
on goods and services produced by firms.

GDP measures such flow of income and output in the economy. Depending upon
the route we follow to measure the flow of income and output, it is possible to
identify three different approaches used to measure GDP. These are income
approach, expenditure approach and value added approach. The three methods
result in the same value of GDP since the expenditure of one agent becomes the
income for others.

1. Income approach

In circular flow of income we have seen than there is flow of income in the form of
expenditure on goods and services as well as spending on factor inputs. As
indicated above if we follow the different route of circular flow of income, it is
possible to come up with different method of measuring GDP of a given economy.
It is approaching the same thing from different angles. In case of income approach
the returns (income) to factors of input such as labor, Land and capital sum up

102
together to arrive at the amount of output produced in a given economy per unit of
time. This is summing up income flow to households following the top outer
arrow of figure 1.1. In this approach, depending up on the owner of factor input,
the components of GDP includes the following:
 Employment compensations payment made for labor in the form of wages
and salaries.
 Rents payments for use of land, building and other capital input.
 Interest income received by households on their saving deposit.
 Profit payments made to the owner of firms in return to the output
produced after deduction of cost of production. It is the sum of proprietor
profit and corporate profit. Proprietor’s profit is the net income of
proprietorship and partnership, where as corporate profit undistributed
share holder profit which includes corporate income tax, dividends and
retained earnings.

Aggregating together the above returns to factor input will gives national income
of an economy. So to arrive at GDP Indirect business tax and depreciations are
added to national income. Students why indirect business tax and depreciations
are added to national income to compute GDP?
Depreciation represents consumption of fixed capital which can be considered as
cost of production. Indirect business tax such as sales taxes are payments that
represent the difference between what buyers pay for final product and what users
receives from excise and sales taxes. Since it is the income generated through
production process but not earned by factor owners indirect business taxes are
considered as the income created in the country during the specific time. This
implies indirect business tax and depreciation enter the income side in the process
of GDP computation.

The following table represents an example of GDP computation for hypothetical

economy using income approach.

Table 1.1. GDP of hypothetical economy in billions of dollars

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 Component of GDP Values in dollars
Wages and salaries $6,657.4
Rents $153.8
Interest rate $ 546.7
Profit $2,020.9
National Income $9,378.8
Plus depreciation $ 1,479.9
Plus Indirect business tax $885.9
Minus net foreign factor $38.2
income
Plus statistical discrepancy $90.4
GDP $21,252.00

2. Expenditure Approach
In case of income approach we have tried to measure the value of the total amount
of economy’s output by summing up the total amount of income generated in the
process of producing goods and services by factor owners. Alternative to income
approach, the value of total output in the economy can be measured by aggregating
expenditure made on final goods and services in the product market. Such
approach of measuring GDP is known as expenditure approach.
Expenditure approach GDP accounting represents the demand for final goods and
services. This demand (expenditure) for domestically produced goods comprise of
four main components depending up on who makes the expenditure.

These are consumer expenditure (C), Business investment (I) Government

expenditure (G), and foreign expenditure or net export (NX). Consumption
spending (C) is the spending made on domestically produced final goods and
services by household. It includes expenditure made on durable and non-durable
goods and services.

Business investment spending (I) is spending made on goods and services which
are used for production of other goods. It includes business fixed investment such
as spending on new plants and equipment by firms, residential investment and
inventory investment (investment made to change firm’s inventories of goods).

104
Government purchase or spending (G) is spending made on domestic goods and
services by federal, state and local government. It includes investment made by
government on different types of infrastructures, military equipment and spending
made for services of government employees.

Net export (NX) represents the value of goods and services exported minus value
of other countries produces and supply to us. It is the net expenditure made on
domestically produced goods and services by foreigners, which is income for
domestic producers.

GDP = C +I +G + NX.
In summary according to expenditure approach GDP of an economy can be
computed by adding up the expenditure made on output produced in a given
economy. For illustration purpose the product side of 1987 USA GDP with its
component is shown in Table 1.2.

Table 1-2 GDP and it components, in $ billions in 1987 for USA

Component of GDP Amount of spending

 Personal consumption expand………………………………………….$4527.00

o Durable goods…………………………………….… $3012.00
o Non durable goods…………………………………… $422.00
o Services goods…………………………………………$998.00
 Business investment………………………………………………………$713.00
o Business fixed investment ……………………………$713.00
o Structures………………………………………………$447.00
o Producers durables……………………………………. $140.00
o Residential Structure………………… ………………. $307.00
 Net export…………………………………………………………………$123.00

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 o Exports……………………………………………….…$482.00
o Import…………………………………………………..$551.00
 Government spending…………………………………………………....$925.00
Federal Gov’t spending…………………………………..$382.00
National defence……………………………………$295.00
Others………………………………………………. $ 87.00
State and local………………………………………$543.00

__________________________________________________________________
______
Activity 1.3
Given the following information on national income accounts of hypothetical
economy for
the year 2008

GDP $6,000
Gross investment 800
Net investment 200
Consumption 4,000
Government expenditure 1,100
Government budget balance 30
Net factor payment from abroad 100
Corporate profit 2233

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 Sales from inventory 122

 Determine i) Net export iii) tax

ii. NDP iv)
GNP
____________________________________________________________
_____________________________

Other measures of output/income

Alternative to GDP, other measures are used to represent the total output produced
in an economy. Let us identify how to determine these measures based on GDP.
 Net domestic product (NDP):– It represents the value of total output of an
economy after net out depreciation.
NDP = GDP - depreciation.
 Net national product (NNP)-measures the value of total output produced
by a citizen of a given country within a specified time after subtracting the
consumption of fixed capital (depreciation).
NNP=GNP – Depreciation
 National Income (NI) – It is the total income earned by resource owner
from current production. National income can be computed in two ways.
First, by summing up the factor incomes earned in producing total output.
Second, it can be obtained by adjusting net national income through
subtracting indirect business tax from NNP.

NI = NNP - Indirect business tax (e.g. sales tax)

NI = GNP - Depreciation – Indirect business tax
NI = wages and salaries + proprietors income + Rental income
+corporate profit +Interest income.
National income can be also determined from NDP after making adjustment for
net foreign income. It is the difference between incomes generated by foreigners

107
found in domestic economy in return to their factor input and income earned by
domestic citizen abroad in return to factors input.
 Personal income is the amount of income that households and non
corporate businesses receive. It can be obtain from national income after
series of adjustment. First reduces from the national income the amount of
corporate earnings but add payments to its share holders (retain earning and
taxes). Secondly increase the national income by the amount government
pay transfers to individuals. Thirdly, national income is adjusted for
interest rate that households earn rather than interest rate paid by firms.

NI= NDP-Indirect business tax +net foreign factor income

Personal income (PI) =National Income-corporate profit
- Social Insurance contributions.
- Net interest
+ Dividends
+ Government transfer
+ Personal interest income
 Disposable personal income- Households non corporate business income
that is really to spend after tax and non tax payments. Disposable income
would be either consumed or saved.
Disposable income (DI) = personal income-Personal tax and non-tax
payments
DI = consumption + saving
The following table shows the necessary adjustment that should be made to arrive
at disposable income starting from gross national product (GDP).

Table 1-4 computation of other measures of economic activities by making possible on

GDP
Income stream Amount in billion
Gross domestic product ……………………………....................……….
$9,963.00
Less depreciation……………………………………… (1,257.00)

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Net domestic product (NDP)……………………………..................…. . 8,706.00
Less indirect business tax……………………………… (770.00)
Plus net foreign factor income ………………………… (4.00)
Less statistical discrepancy ………………………................…… 70.00
National income (NI)……………………………………… 8,002.00
Less net interest ………………………………................……..... 50.00
Less corporate taxes………………………………….. (284.00)
Less retained earning ……………………………… (244.00)
Less social security………………………………….. (827.00)
Plus transfer payments……………….......……....................……. 1,068.00
Plus person interest…………………...……...................……….. 617.00
Personal income (PI)………………………….................……………….. 8,282.00
Less personal taxes ………………….................……………….. 1,292.00
Disposable
income………………………...........................................………………. 6, 990.00

Exercise 1.1.
Given the following component of GDP (total value of expenditure and income)
for hypothetical economy, find its GDP using both expenditure and income
approach.

Component of GDP Value in million

 Consumption expenditure……………….. $6,757.00
 Wages and salaries………………………. $ 5638.00
 Investment on plants and equipments…… $1,833.00
 Government expenditure………………… $1,744.00
 Proprietors income………………………… $6,88.00
 Corporate profit…………………………….… $946.00
 Export…………………………………… $1,097.00
 Rents…………………………………….. $140.00
 Interest income………………………………$524.00
 Sales taxes…………………………………. .$770.00

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  Imports………………………………… …$1,468.00
 Depreciation……………………………. .$1,257.00

Find i). NDP

ii). NI by making the necessary adjustment on GDP

The GDP deflator and other measures of General Price

Economist and policy makers use change in general level of price to measure the
performance of an economy in combination with the level of GDP. To measure the
general price of an economy they use GDP deflator and consumers and producer
price index. Thus describe the most commonly used index used to measure general
price includes GDP deflator, consumer price index and producer price index.

GDP deflator
GDP deflator also called the implicit price deflator for GDP is defined as the ratio
of nominal GDP to real GDP.
N
om
i
nald
GDPP
Q P
GDP deflator =  
Re
alGD
P PQ
b P
b

Where P-current price of goods, Pb-base year price and Q-Quantity of good
produced.
GDP deflator measures the price of output (goods) relative to its price in the base
year. It shows whether the price of goods increase or decreases in reference to the
base year price.
For the hypothetical economy represented by table 1.3, GDP deflator for year 2006
computed as:
N
om
ina
lGD
P o
f20
06
GDP Deflator of 2006 = Rea
lGDP
of2
006

237
,800
= 1 2
085
14,00
0
This means there is an increase general level of price by 208.5 percent in 2006
relative to general price of 2004.

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As the name indicates it also used to deflate nominal GDP to get real GDP.

NGDP
Real GDP=
GDP deflator
Consumer price index (CPI)
CPI is the most commonly used price index to measure the general price level of
an economy. It represents price of a fixed basket of goods and services purchased
by a typical consumer relative to the same basket of goods and services in some
base year. For example if a typical consumer buy 10 unit of Banana and 3 unit of
coffee then the CPI for the two consumption good can be computed as:

10  current price of Banana 3 current price of coffee

CPI= 
10  baseyear price of Banana 3 base year priceof coffee

CPI for the indicated goods shows that, how much the basket of goods costs
currently relative to what it cost in the base year.
Alternative to consumer price index, cost of producer goods would be measured by
an index called producer price index. Producer price index measures the price of
typical basket of goods bought by firms.
Students, from the above description of consumer price index and GDP deflator, it
is possible to identify three points in which they differ even though their
differences are not large in practices.
Firstly, GDP deflator measures the price of both consumer and producer goods
produced in the economy, where as CPI measures the prices of goods and services
bought by consumers only. 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. Secondly,
GDP deflator includes only those goods produced domestically, Imported goods
are not part of GDP and don’t show up in the GDP deflator. Hence an increase in
prices of imported goods affects CPI but not GDP deflator. Lastly, CPI is
computed using fixed basket of goods where as GDP deflator allows the basket of
goods to change overtime as the composition of GDP changes.

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6.2. Fluctuation in Economic Activities
6.2.1. Business Cycle
Dear students, one of the basic purposes of macroeconomics is to answer these
questions how and why economies grow and what causes the recurrent ups and
downs of the economy. These ups and downs of the economy, in the short run
are known as business cycle. It is a regular pattern of expansion and contraction
in economic activity around trend growth. All industrialized societies are subject
to recurrent fluctuations in economic activity. Even though the fluctuation
characterizes all macro variables, in most case business cycle primarily represents
fluctuation of output or GDP along the trend.

The classification of the cycles is indicated in figure 1.5 If the variables on the
vertical axis was output then the economy can be thought of as moving through
four distinct phase: phase A -boom or peak , phase B-recession or contraction,
phase –c depression (trough) and phase-D is recovery(expansion).

Actual output
Growth trend

A B C D

Time
Fig 1.5 phases of business cycle

The line from the origin shows the trend growth, long run change in the level of
output over time when full employment of resources is achieved. The deviation of
output from the trend level (Output gap) shows the change in level of employment

112
of resources from full employment level according to the classical school. Positive
output gap shows over employment of resources and utilization of improved
method of production according to classical macroeconomist who believes that the
amount of input used and productivity determine the output level of the economy.

6.2.2. Inflation and unemployment

In the previous section we study about how to measure the value of output
produced in an economy with different parameters such as GDP and others income
measures. In this section we will consider other measures of performance of the
economy Known as inflation and unemployment. Specifically, we will
discuss/issues related to different aspect of inflation and unemployment like its
meaning, measurement and effect of inflation as well as the relationship between
inflation and unemployment.

Inflation
In a broad sense, inflation is defined as a sustained rise in the general level of
prices. Two points about this definition need emphasis. First, the increase price
must be a sustained one, and it is not simply a once for all increase in prices.
Second, it must be the general level of prices, which is rising; increase in
individual prices, which can be offset by falling in prices of other goods is not
considered as inflation. Thus, we define inflation rate (Πt) as:

t P
P t
Πt = x100
Pt1

Where Pt is overall price index (CPI, GDP deflator) for time –t

Pt-1 is over all price index for time t-1

Cause of inflation
Theories that deal with the causes of inflation generally classified into two major
groups: Demand pull and cost push factors.

(i)Demand pulls factors.

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Inflation Caused by a rapid increase in demand for goods and services than supply
of goods and services (fixed level of goods and services supplied). The reason may
be:
 increase in demand for goods more rapidly than supply.

 monetary expansion. Increase in money supply (additional flow of

money in the economy) will increase demand for new investment and
rises aggregate demand for goods and services.

Cost-push factors (supply side)

There are non-demand factors that cause inflation. During 1958 recession in
western countries, aggregate demand was declining but prices do not decline. In
recent times, it is common experience to have inflationary condition combine with
rate of high unemployment when there is economic stagnation. Such conditions,
which are, not demand side factors are explained by supply side factors.
Cost-push inflation occurs when different factors that increase cost of
production (increases price of input) and other structural bottleneck cause firms to
reduce the supply of goods and services below existing demand.

Measuring Inflation

Economic effect of inflation

Inflation affects economic agents which depend on the market for their income and
consumption of goods and services in different ways. .
1. inflation reduces purchasing power of money.
2. Inflation reduces investment by increasing nominal interest rate and creating
uncertainty about macroeconomic policies.

114
3. Inflation increases uncertainties about macroeconomic policy and adversely
affects the public decision making ability.
4. Inflation redistributes wealth among individuals. For example long term loan
contract agreement specify at nominal interest rate which is based on the rate
of expected inflation at the time of agreement. If expected inflation different
from what it is expected to be, real return that debtor pay creditor differ from
what the parties anticipates.
5. Unanticipated inflation hurts individuals with fixed income (pension). Workers
often agree on a fixed nominal pension when given labor services for
retirement ages. As a result their income remains constant while prices
increase and then causes reduction in purchasing power of their income.

Some economist believes that moderate level of inflation (2 to 3) percent per year
is good to stimulate the economy.

1.4.2. Unemployment
In the previous section, we have discussed about the meaning, cause and
consequences of inflation. In this section we will study about other social evil
known as unemployment. It is one of macroeconomic problem that affect people
most directly and severely. Unemployment causes reduced living standard and
psychological distress. This is why economist study unemployment to come up
with public policies that is used to reduce unemployment.
Students, let us begin our discussion by defining what we mean by the term
unemployment. Unemployment is a situation in which able bodied persons willing
to work at prevailing wage rate do not able to find job. It is measured by rate of
unemployment, which represents the percentage of those people who wants to
work but cannot get any job.

115
 Noofu
ne
mpl
oye
d
Unemployment rate = ( l
abo
rfo
rc
e
)
100where labor force is all

persons over age 16 who are either working for paid job or actively seeking paid
employment.

Types of unemployment
1. Frictional unemployment: The concept of frictional unemployment can
be better understood with reference to the classical postdate of full employment.
There is no unemployment at full employment. If there is any, it is temporary
and quickly wiped out through an automatic process of market mechanism and
adjustment. Such type of unemployment is said to be frictional unemployment.
The reason behind frictional unemployment is that it takes time to match workers
with jobs.
Neoclassical focused on the imperfections in the labor and product markets in
real world resulted from lack of information to explain frictional unemployment.
The flow of information about job candidates and job vacancies is imperfect.
Geographical mobilties of workers are not instantaneous, in addition, workers
difference in preference and jobs have different attributes. For all these reasons,
searching for an appropriate job takes time and effort. Such type of
unemployment that created due to the time to get job is known frictional
unemployment.
2. Structural unemployment
Structural unemployment arises due to structural change in dynamic economy
and wage rigidity. Such structural change includes change in the structure or
sectoral composition of the economy due to technological change. That is
gradual decline of some kind of industries production and the emergence of new
industries. This situation makes some peoples with certain specific skill out of
the labor demand resulting in structural unemployment. Technological change
also alters the demand pattern of different kind of skills. Some skills become
obsolete and less efficient resulting mismatch between labor demand and supply.
The second reason for structural unemployment is wage rigidity. Workers are
unemployed sometimes not because of the skill gap at on-going wage rate but,

116
 the supply of labor exceeds the demand. The wage rate did not adjust to full
employment level due to different factors. Some of them are presented as
follows.
Minimum wage law
Minimum wage law is a law which set a legal minimum wages that firms pay
their employee with different skills. This will cause wage rigidity not to adjust
to equilibrium level and creating unemployment.
Unions and collective bargaining
The wages of unionized workers are determined not by the equilibrium of supply
and demand. It is determined by collective bargaining between labor union
leader and management. In most cases they agree on wage above equilibrium
level associated with a certain level of unemployment
Efficiency wage argument
According to efficiency wage theory higher wages make workers more
productive. So if wage increase the productivity of workers, firms will not cut
the wage of workers even though there is excess labor supply. As economists
argue high wage increase wage productivity in different ways:

 Higher wage enable workers to afford nutritious food and then have better
health condition. If workers become healthier they can supply more labor and
effectively undertake different activities they are assigned to.
 It also reduce labor turnover. The more firms pay its workers, the greater
their incentive to stay with the firm. Therefore firms reduce labor turn over (cost
and time of hiring and training new workers) by paying their employee higher
wage.
 High wage reduce adverse selection in labor market. That is higher wage
select quality (better performing) workers among less efficient workers.
 High wage reduces the problem of moral hazard that exists between
workers and firms. This is because when workers paid high wage above
equilibrium, it improve workers effort with minimum monitoring.
All the above factors make wage rate rigid above the full employment equilibrium
point resulting in structural unemployment.

117
 3. Cyclic unemployment
Cyclic unemployment is unemployment created associated with short run
fluctuation of the economy. Workers become unemployed for some period when
their job evaporates due to recession and returns to job when there is expansion in
economic activities.

Cost of unemployment
Students, we have seen some of the economic impact of inflation and its control
mechanism in the previous section. But some of inflation controlling measures
results in increase in unemployment. This kind of situation creates a dilemma for
policy makers as to whether or not to control inflation. Therefore, the cost of
inflation should be identified and compared with the cost of unemployment to
choose optimal policy that used to manage the economy. For this purpose first let
us identify some of the costs of unemployment.

6.3. Measures to control inflation

Economists agree that inflation beyond a certain level is bad and causes different
type of disastrous to the economy. Therefore, it should be controlled by using
appropriate mix of fiscal and monetary policies. However, following the
controversy on what cause inflation, there is also controversy on methods to
control inflation. At the same time, there are divergences of opinion on the
effectiveness of fiscal and monetary policies in the policy mix. Monetarists argue
that monetary measures should given prime role in anti inflationary policy mix,
while fisicalists argue on the contrary. In addition to monetary and fiscal policies,
other policy intervention measures used to control inflation. Therefore, the
following policy measures are used in combination to control inflation.
1. Monetary measures
2. Fiscal measures
3. wage and price control
4. Indexations

Monetary measures

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As we discussed before, classical macroeconomists argue that inflation is any time
a monetary phenomena. That is inflation originate from increase in money supply
in excess of its optimal level. Therefore, they hold the view that control of money
supply through appropriate monetary policy (Bank rate, reserve requirement ratio,
open market operation) greatly effective in controlling inflation.

Fiscal measures
Keynesians or fiscalists argue that inflation originates in the real (product) sector
due to an increase in aggregate demand in excess of aggregate supply. The excess
demand may result from the increase in expenditure by households, firms and
government. They emphasize that the excess demand arises mainly due to
excessive government expenditure. Therefore, fiscal policy or the budgetary
measure are a more powerful and effective weapon to control demand pull
inflation. When excess demand is caused by the government expenditure in excess
of real output, the most effective policy measure is to cut public expenditure. On
the other hand if the excess demand is caused by the private expenditure, that is,
the expenditure by households and firms, taxation of incomes is a more appropriate
measure to control inflation since taxation reduces disposable income.

Price and wage control measures.

Monetary and Fiscal policies are ineffective in controlling cost push inflation.
Thus if the inflationary condition is the result of cost push, it is advisable to
introduce price and wage control measures rather than using monetary and fiscal
policy.

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