Intermediate managerial

economics
 This learning task is organized in to seven
sections/chapters with respective subsections
• Section 1: Concepts of economics
• Section 2: Theories of demand and supply
• Section 3: Theories of utility and preferences
• Section 4: Theories of production and costs
• Section 5: Theories of market structures
• Section 6: Factor pricing
• Section 7: General equilibrium and Welfare
economics
 CH-1 Concepts of Economics
• There are two facts that provide the foundation for
the field of economics:
1. Human or society’s material wants are unlimited
and
2. Economic resources are scarce or limited in supply
The 1st refers to the desire of consumers, businesses,
and government to get those things that help them
realize their respective goals
The 2nd refers to anything natural or manmade that
can be used in production of goods and services.
• Economics is the science that deals with the
allocation of limited sources to satisfy unlimited
human wants...
• It is the science of constrained choice
• It is a social science, which studies how societies
allocate scarce resources in the production and
distributes of goods and services so as to attain
the maximum fulfillment of society’s material
wants.
• Economics can be divided into two main
branches:-macroeconomics and microeconomics
 Branches of Economics
• Microeconomics studies the economic behaviour of individual
economic decision makers (consumers, firms, workers, individual
households, managers...)
• It studies the interrelationships between these units
• It is concerned with the decisions taken by individual consumers
and firms
• Questions like how does a particular person or household
maximize satisfaction,
• How does a particular firm maximize profit by producing and
selling a product, etc are studied in microeconomics.
• Since the subject matter of micro economics deals with the
determination of factor prices and product prices micro
economics is called as price theory. 5
• Macroeconomics analyses how an entire ‘economy’ or
economic system performs, on a national, regional or
global level
• It does not deal with household, firm, or industry.
• It deals with magnitudes such as the total output level
in an economy,
• national income of a country,
• the overall level of prices,
• total output and total employment in the economy ,
• general price level of goods and services in the
economy, etcThe
following comparison further clarifies the distinction.d
 The Central Economic Problem
• Before, rushing into the central economic problems it
essential to focus on the causes of them.
• Reasons for emergence of economic problems:
1. Human wants are unlimited
• There is no end to human wants. As one want is satisfied,
many others crop up and this goes on endlessly.
• Again one particular want cannot be satisfied for all times to
come (e.g. want for food). After fulfilling it at a particular
time, it grows up again and again.
• Wants also differ in urgency or intensity.
• As a result, people arrange their wants in order of
preference and make a choice among them.
 2. Resources (means) to satisfy wants are limited
(scarce)
• Due to limitation of resources, the economy cannot
produce all the goods and services that the various
sections of the society need.
• That is, if more resources are allocated for the
production of one commodity, fewer resources are
left for production of other goods.
• Thus, some wants will be unsatisfied.
• Hence, an economy has to decide how to make best
possible use of its limited resources
 3. Resources have alternative uses
• The resources of an economy are not only scarce
but also have alternative uses and therefore choice
has to be made in their use. For example, a plot of
land
• Thus, the economy constantly faced with choosing
better alternative uses to which its resources should
be allocated.
• Thus, the problem of making a choice among
alternative uses of resources is called the basic or
central problem of an economy.
 Scarcity and choice:
• All participants in an economy must make choices.
• The basic economic problem that necessitates
choices is scarcity, which occurs when limited
resources are not sufficient to meet demand.
• At any one time the world can only produce a limited
amount of goods and services. This is because the
world only has a limited amount of resources.
• We can thus define scarcity is the excess of human
wants over what can actually be produced
• Scarcity forces individuals, firms, and other members
of society to decide how to use factors of production:
• Scarcity is a fundamental problem for every society.
• Due to scarcity decisions must be made regarding
• What to produce,
• How to produce it, and
• For whom to produce.
• What to produce involves decisions about the kinds
and quantities of goods and services to produce.
• How to produce requires decisions about what
techniques to use and how economic resources are to
be combined in producing output
• The for whom to produce involves decisions on the
distribution of output among members of a society.
• Economics is the study of scarcity-the study of the
allocation of scarce resources to satisfy human
wants.
• Economics helps to solve the three important
questions of what to produce, how to produce it,
and for whom to produce.
• These decisions involve opportunity costs.
• An opportunity cost is what is sacrificed to
implement an alternative action, i.e., what is given
up to produce or obtain a particular good or service
 Choice and opportunity cost
• Choice involves sacrifice. The more food you choose to buy, the
less money you will have to spend on other goods
• The term opportunity cost refers to the next best alternative.
• Opportunity cost is the cost of any activity measured in terms of
the best alternative forgone
• For example, if you have $500 and you go to the mall and see a
stereo, a jacket, and a television each costing $500, which would
you choose?
• If you rank the stereo as your 1st choice, the jacket as your 2nd ,
and the TV as your 3rd choice, which would be the opportunity
cost?
• The jacket is the opportunity cost because it is your next best
alternative. Note that the jacket and T.V. together are not the
opportunity cost because there can only be one opportunity cost.
 Economic Systems
• Every economic system has the following goals: efficiency(the
property of society getting the most it can from its scarce
resources), equity(the property of distributing economic
prosperity fairly among the members of society), security,
freedom, and incentives.
• However, each economy may rank these goals differently.
• The ranking of these goals,
• the way a country’s resources are owned and
• the way that country answers the three economic questions
• what to produce,
• how much to produce and
• how to distribute what has been produced) determine the
type of economic system of a given country.
• Due to the concept of scarcity, every economy must
address three main questions mentioned so far and
economic systems are categorized by how these
questions are answered.
• Accordingly, economic systems are categorized into:
• 1. Market economy (laissez faire)
• 2. Centrally planned (command economy)
• 3. Mixed economy
• Free market economy is an economy where all economic
decisions are taken by individual households and firms and
with no government intervention at all.
• It rely on the forces of supply and demand to answer the
three economic questions.
• In a market economy, economic decisions are decentralized
and are made by the collective insight of the marketplace,
i.e., prices resolve the three fundamental economic
questions.
• Hence, there is no government intervention in the market
to determine what, how and for whom to produce rather
they are determined by the interaction of market forces
• Command or centrally planned economy is an economy
where all economic decisions are taken by the central
authorities/government.
• A command economy is one in which the government
makes all important decisions about production and
distribution;
• that is, the government owns all the means of production
• The experience with this system, however, has not been
very successful, as evidenced by the changing economic
and political events in the 1990s in the command
economies of Eastern Europe and the former USSR.
Comparisons between Market and Planned Economy.docx
• The above two economic systems are the extremes. In
reality, there are no pure free market economies or pure
command economies
• Hence, command and market economy are in relative term.
• Mixed economy is a market economy where there is some
government intervention.
• Because of the problems of both free-market and command
economies, all real-world economies are a mixture of the two
systems.
• Under mixed economy, some resources are allocated by the
government and the rest by the market system.
• Most decisions are taken in the market place but the
government plays an important role in modifying the
functioning market
 The role of government includes:
• Sets laws and rules that regulate economic life -
intervention to control or regulate markets
• Provide certain services e.g. education, police,
defense, healthcare
• Regulate business – to ensure that there is fair
competition in the private sector
• Restricts the consuming harmful goods by making
them illegal or placing high taxes on them
 CH-2: Theory of Demand and Supply
• Meaning of Demand
• In our day-to-day life, we use the word demand in a
loose sense to mean the desire of a person to purchase
a commodity or service. But in economics it has specific
meaning.
• It states that the consumer must be willing and able
purchase the commodity, which he desire.
• Demand thus, means the desire of commodity of the
consumer backed by the purchasing power.
• Demand refers to the amount that consumers are
willing and able to purchase at a alternative price over a
given period (e.g. a week, or a month, or a year).
• One of the basis of understanding economic events and
their consequences is to have a clear idea how the
perception of demand is used in economics and how
this concept different form quantity demanded as
several readers get confused of with their difference.
• Quantity demanded is a simple single number denoting
quantity of good, which happened to change hand in
the market place.
• In other words, quantity demanded is a scalar, which
can be influenced by many variables, mainly including
price, price of related goods (substitutes,
complements), income, preference, government policy,
expectation, etc.
• The demand denotes the collection of such
observations for different prices.
• Demand implies both the desire to purchase and
ability to pay for the good.
• Moreover, demand does not refer to the particular
quantity that will be purchased at some particular
price, but refer to a series of quantities and their
associated prices.
• For example, the quantity demanded for
commodity (Q) is 4, when price is 4 and demand
refer to a series of quantities and their respective
prices given in Figure 2.1.Figure 2.docx
 The law of demand
• Law of demand expresses the functional relationship
between price and quantity demanded.
• According to the law of demand, other things being
equal, if the price of the commodity falls the quantity
demanded of it will rise and if the price of the
commodity rises, its quantity demanded will decline.
• Thus, according to law of demand, there is an inverse
relationship between price and quantity demanded,
other things remaining the same.
• Thus, the law of demand assumes that all things
other than price remain constant.
• The two explanations to the law of demand are
income effect and substitution effect.
• The reasons for law of demand are:
• People will feel poorer. They will not be able to
afford to buy so much of the good with their money.
The purchasing power of their income (their real
income) has fallen. This is called the income effect
of a price rise.
• The good will now cost more than alternative or
‘substitute’ goods, and people will switch to these.
This is called the substitution effect of a price rise.
• When we state the law of demand, we assume
the determinants of demand constant, these are
• Tastes and preference remain constant
• The number and price of substitute goods
• The number and price of complementary goods.
• Income of consumer
• Distribution of income.
• Expectations of future price changes.
• Advertisement
• Past demand
• Consumer future price and income
 Demand schedule
• The law of demand can be illustrated through a demand
schedule and through demand curve.
• A demand schedule is defined as a table which presents the
quantity demanded at each price level during a specific time
period.
• Assuming that all other factors are constant by varying the price
of the goods itself, we get an individual demand schedule for
the good Table 2.docx
• Demand schedule for an individual is refers to a table showing
the different quantities of a good that a person is willing and
able to buy at various prices over a given period of time.
• Market demand schedule is defined as a table showing the
different total quantities of a good that consumers are willing
and able to buy at various prices over a given period of time.
 Demand curve
• The demand schedule can be represented graphically as
a demand curve.
• Demand curve is graph showing the relationship
between the price of a good and the quantity of the
good demanded over a given time period
• Price is measured on the vertical axis; quantity
demanded is measured on the horizontal axis
• It slopes downward from left to right: it has negative
slope. This indicate the lower the price of the product,
the more is the person likely to buy.
• Figure 2.1 shows the market demand curve for potatoes
corresponding to the schedule in Table 2.1.Fig 2.docx
 Individual and market demand curve
• Graphically, the market demand curve for a
commodity is obtained by the horizontal
summation of the entire individual‘s demand curve
for the commodity.
• Assume that there are only two individual
consumers in the market, individual X and individual
Y.
• The individual demand schedules for these two
consumers along with the market demand schedule
is given belowIndividual and market dd curve.docx
• Determinants of Demand
• The extent of the demand for a good is determined by two
factors. These factors are:
• Price factor
• Non price (The condition of demand) factors
• Price is not the only factor that determines how much of a
good people will buy. Demand is also affected by the following
• Taste or Preference
• The more desirable people find the good, the more they will
demand. Tastes are affected by advertising, by fashion, by
observing other consumers, by considerations of health and
by the experiences from consuming the good on previous
occasions.
• The number and price of substitute goods
• Two goods are said to be substitutes, if the consumer
can substitute one for another and still maintain the
same satisfaction.
• Consider, for instance, Pepsi and Coke. An increase in
the price of Pepsi will increase the demand for Coke.
• The number and price of complementary goods.
• Two goods are said to be complements, if they are
consumed together. Sugar and tea is a typical
example. Consider a fall in the price of sugar, holding
all other factors constant, the quantity demanded of
the tea, the complementary good, increases
• Income.
• Changes in income can increase or decrease demand.
• A good whose demand increases with an increase in income
is called a normal good
• A good whose demand decreases with an increase in
income is called an inferior good
• Distribution of income.
• If national income were redistributed from the poor to the
rich, the demand for luxury goods would rise.
• Expectations of future price changes
• If the consumers, for instance, anticipate that there will be a
future price increase (inflation), then demand for the
current products, with low prices, will increase.
 Change in Quantity Demanded and
Change in Demand
• The law of demand states that other things being constant,
price and quantity demanded of a commodity are inversely
related.
• The demand curve is derived under the assumption of
Ceteris Paribus (other things remain constant) i.e., other
determinants of demand except own price are held constant.
• Thus, the demand curve shows how quantity demanded of a
commodity varies when the price of the commodity changes.
• In this case we observe change in quantity demanded simply
because of change in the price of a commodity, and the dd
curve remained unchanged (not shifted).
• Thus, if we vary only price of a commodity and hold
other determinants of, the demand curve does not
shift.
• In this case as price varies we are moving along the
same dd curve and we call this movement change in
quantity demanded.
• The following graph shows change in quantity
demanded from Q1 to Q2 or from Q2 to Q1 due to
change in price of the commodity from p1 to p2 or
from p2 to p1 respectively, ceteris paribus.Price
A.docx
• If the price of a commodity (own price) remains
constant and one or more of those other factors
affecting demand (e.g., income, taste and
preference, prices of other goods, expectation
and number of consumers) change, then the
demand curve shifts from its position either to
the right or to the left.
• Thus, when the demand curve changes its
position we call it change in demand (shift in
demand)PriceD1D0D2.docx
 Movements along and shifts in the
demand curve
• The effect of change in price(‘other things remain equal)
is given by movement along the demand curve.
• Any change in all factors that affect demand except
commodity’s own price cause shift of the demand curve.
• This represents a change in demand. The demand curve
of a normal good shifts to the right (an increase in
demand) if income rises, population size rises, if price of
substitutes rises, if price of complements falls, or if there
is a change in tastes in favor of the product.
• The opposite changes shift the demand curve to the left
(a decrease in demand).Shift in demand curve.docx
• To distinguish between shifts in and movements
along demand curves, it is usual to distinguish
between a change in demand and a change in
the quantity demanded.
• A shift in the demand curve is referred to as a
change in demand,
• whereas a movement along the demand curve as
a result of a change in price is referred to as a
change in the quantity demanded
• NB. An increase (decrease) in demand also
implies purchasing of more (less) of goods at
each price level.
• Thus, change in demand necessarily implies
change in quantity demanded, but change in
quantity demanded does not necessarily imply
change in demand.
• Change in own price causes movement along the
same demand curve without causing shift of the
demand curve while change in other factors
affecting demand cause shift in the demand curve.
 Demand function
• We can represent the relationship between the market demand for
a good and the determinants of demand in the form of an equation.
• Demand for a commodity is determined by several factors
• Hence, individual‘s demand for a commodity can be expressed in
the following general functional form, QdX = f(Px, I, Pr, T, P, E)
• Where,
• QdX = Quantity demanded of commodity ‘X’
• Px = Price of commodity x
• I = Income of the individual consumer
• Pr = Price of related commodities (substitutes or complements)
• T = Tastes and preferences of individual consumer
• P = Population
• E = Expectations
• The relationship between quantity demanded of a
good and its own price, while keeping other
determining factors constant can be specified as
Qxd = f (Px)
 
• This implies that the quantity demanded of the
commodity x is a function of its own price, other
determinants remaining constant.
• Demand equations are often used to relate quantity
demanded to just one determinant.
• Thus an equation relating quantity demanded to
price could be in the form:
• the actual equation might be: Qd=10, 000 - 200P. More
complex demand functions.
• In a similar way, we can relate the quantity demanded
to two or more determinants. For example, a demand
function could be of the form:

• Where Qd = quantity demanded; p = price of the good;

Y= income; Ps= price of substitute good; Pc= price of
complement
•
 SUPPLY ANALYSIS
• Definition of Supply 
• Supply refers to the willingness and ability of producers to
produce goods and services and make available for sale in
the market at a given price level within a set of possible
prices over certain period of time (e.g., week, month, year,
etc).
• Note that quantity supplied and supply are two different
concepts.
• Quantity supplied refers to a specific quantity that a
supplier is willing and able to provide at a specific price.
• But supply refers to the whole relationship between
possible prices of a product and the corresponding
quantities supplied.
• Law of Supply states that other things being equal the
quantity supplied of a commodity varies directly with the price
of that commodity i.e. quantity supplied increases (decreases)
as price of the commodity increases (decreases), ceteris
paribus.

• we understand that sellers are motivated to sell more at

higher prices than at lower prices.

• Supply Schedule is a table which shows how much of a good

individuals are willing and able to produce and make available
for sale in the market at different price levels during a given
period of time (week, month etc)
An individual supply schedule of coffee.docx
• The direct (positive) relationship between price of a
commodity and quantity supplied can be shown using
either the supply schedule or the supply curve.

• Supply curve of a commodity is a curve, which shows

the relationship between the quantity supplied of the
commodity at different price levels.
The Supply Curve.docx
• In drawing the supply curve we singled out price of a
commodity as the most important factor affecting the
quantity supplied of the commodity and ignored the
influences of other factors
• However in addition to own price, quantity supplied of a
commodity depends on a number of other factors.

• A fundamental analytical method used in economics is to hold

all other influences constant & focus on one important variable.

• Economists do not say price is the only variable which influence

sales but they say that price generally has very important effect
on quantity sold.

• It is to identify the influence of price of a commodity on its

quantity supplied that economists hold other variables constant
and concentrate on the relation between quantity supplied and
price, that is, the relation shown by the supply curve.
 Determinants of Supply
• Like demand, supply is not simply determined by price.
• The other determinants of supply (supply shifter) are as
follows.
• 1. Prices of Production Substitutes
• Production substitutes are goods, which a producer tends to
substitute for one another when their price changes.
• If price of a good increases other things remain, constant,
producers decrease the production of its substitute because
production of the good is more profitable than production of
its substitute.
• For example, if price of wheat increases in the market in
relation to price of teff a farmer allocates large part of its land
to wheat production instead of teff production.
• 2. Prices of factor inputs
• Other things being constant, an increase (decrease)
in the price of factors of production causes an
increase (decrease) in cost of production.
• As cost of production increases (decreases) profit -
margin decreases (increases) and therefore amount
supplied to the market decreases (increases).
• Thus, increase (decrease) in price of factor inputs
causes quantity supplied to fall (rise) of course under
the assumption of other things being constant.
• 3. Technological State of production 
• The development of the new method of
production or the invention of efficient machines
may make possible a big expansion of output at a
lower cost and so causes supply to increase. i.e.
improvement in technology causes supply to
increase and absolute technology causes supply
to decrease.
• 4. Taxes and Subsidies
• Taxes are a compulsory payment imposed on producers
or consumers.
• Subsidies are some amount of money given to producers
or consumers to supplement their expenditure.
• An increase (decrease) in tax, other thing being constant,
causes supply to decrease (increase), because producers
feel as if their cost of production were increased
(decreased).
• If subsidy to producers increases (decreases), then supply
will increase (decrease) because producers feel as if their
cost of production were decreased (increased) thereby
causing profit to increase (decrease).
• 6. Number of Producers
• As number of firms producing a good increases more and
more goods will be supplied.
• 7. Expectation of Change in Price
• Expectation of higher price in the future may cause
decrease in current supply as producers store their
outputs to sell them later at a higher price assuming other
things being constant.
• Quantity of goods kept in store is not considered as a
supply.
• Goods are considered as a supply only when they are
brought to the market.
• 8. Market Organization
• If a market for certain commodity is monopolized (i.e., there is
only a single producer) then a producer charges higher price by
producing few outputs, because, the producer faces no
competition.
• If a market for certain commodity is characterized by a perfect
competition (many producers and sellers), then producers
produce more outputs, because, there is no possibility of
increasing price to increase revenue 
• 9. Weather
• For some products, especially agricultural products weather
affects the quantity to be supplied.
• Favorable (unfavorable) weather increases (decreases) supply of
agricultural outputs.
 Change in Quantity Supplied and Change in
Supply
• Change in quantity supplied refers to the
movement along the some supply curve and it is
caused by a change in commodity's price.
• In this case only price of a commodity is allowed to
vary and other determinants of supply (e.g. Price of
production substitute, prices of factor inputs,
technological state, taxes and subsidies, no of
producer, expectation of producers and weather
etc,) are held constant  Price P3S.docx
• Change in supply refers to the shift of the supply
curve.
• If we fix price of a commodity (own price) constant
and vary any of those other factors affecting supply
(e.g. Prices of production substitute and inputs,
technological state, tax and subsidy, no of
producers, producers' expectation and weather)
• Then the supply curve changes its position, i.e., the
supply curve shifts.S1 S0 S2.docx
• Increase in supply, i.e., shift of the supply curve to
the right is caused by the following factors:
• Decrease in price of production substitute,
• Decrease in prices of inputs, improvement in
technology,
• Increase in subsidy, decrease in tax,
• Increase in number of producers,
• Expectation of lower price in the future,
• Good weather and others, ceteris paribus. 
• The supply curve shifts to the left (decrease in
supply) when the above factors change in opposite
direction.
• NB. As supply curve shifts, quantity supplied
also changes therefore change in supply
necessarily implies change in quantity supplied.

• However, change in quantity supplied does not

necessarily imply change in supply, because
change in quantity supplied can be observed by
moving along the same supply curve (without
shift in supply curve).
 Individual and Market Supply Curve
• Individual Supply Curve shows us the quantity that
a single producer is willing and able to supply at
each price level over certain period of time
• Market Supply Curve shows the total amount of
particular commodity supplied by all producers at
each price level, i.e., market supply curve is the
horizontal summation of individuals supplies at
each price level.A
hypothetical supply schedule for the production of
wheat by three individual producers over the last se
ven months.docx
• Supply Function
• The simplest form of supply equation relates supply to just
one determinant.
• Thus a function relating supply to price would be of the
form:

• Thus an actual supply equation might be something like:

• Qs = 500 + 1000P
• More complex supply equations would relate supply to
more than one determinant.
 MARKET EQUILIBRIUM
• Definition of Market Equilibrium
• Market can be considered as a mechanism or structure that
facilitates exchange of goods and services among different
economic units (e.g., firm, government, etc).
• Market does not necessarily refer to certain geographical
area.
• It can exist wherever there is a contact between buyers and
sellers without any spatial dimension attached to it
• Equilibrium is the point where conflicting interests are
balanced;
• Only at this point is the amount that demanders are willing
to purchase the same as the amount that suppliers are
willing to supply.
• It is a point that will be automatically reached in a free
market through the operation of the price mechanism.
• The price where demand equals supply is called the
equilibrium price and the quantity where demand
equals supply is called the equilibrium quantity
• In this section we will discuss market equilibrium in a
perfectly competitive market.
• A perfectly competitive market is a market, which
fulfills the following criteria,
• The followings are assumptions of perfectly
competitive market:
• 1. Large number of buyers and sellers (so that the
influence of individuals seller or buyer is insignificant.
• 2. Firms produce a homogeneous product (so that an
attempt to increase price by the producer brings loss of
market share)
• 3. Perfect information (knowledge) of the market (so
that each market participant can act according to the
market operation) 
• 4. Absence of government control of economic
activities (no government price control, no taxation, no
subsidy, etc) 
• 5.Free entry and exist of firm (no business license, no
patent right, etc) 
• 6.Free mobility of resources
• Under these assumptions no individual buyer or seller
has control over the price of a commodity.
• Both consumers and producers are price takers not
makers, i.e., price is determined by the market (by
forces of supply and demand)
• At that equilibrium, price and quantity remain
unchanged as long as we have the assumption of other
things being equal, i.e., until something operates to
change supply or demand.
 Let us return to the example of the market demand and
market supply of potatoes,
• The market demand and supply of potatoes (monthly)
Equilibrium price and output:
The Market Demand and Supply of Potatoes (Monthly)

Price of Potatoes Total Market Demand Total Market Supply

(pence per kilo) (Tonnes: 000s) (Tonnes: 000s)

20 700 (A) 100 (a)

40 500 (B) 200 (b)
60 350 (C) 350 (c)
80 200 (D) 530 (d)
100 100 (E) 700 (e)
 The determination of market equilibrium (potatoes:
monthly)
The determination of market equilibrium
(potatoes: monthly)
E e
100
Supply
D d
Price (pence per kg)

SURPLUS
80
(330 000)

60

b SHORTAGE B
40
(300 000)
a A
20

Demand
0
0 100 200 300 Qe 400 500 600 700 800
Quantity (tonnes: 000s)
 Movement to a new equilibrium
• The equilibrium price will remain unchanged only so long as
the demand and supply curves remain unchanged.
• If either of the curves shifts, a new equilibrium will be
formed.
• A change in demand; If one of the determinants of demand
changes (other than price), the whole demand curve will
shift.
• This will lead to a movement along the supply curve to the
new intersection point.
 Effect of a shift in the demand curve
Effect of a shift in the demand curve
P
S

i New equilibrium at
Pe2 point i

g h
Pe1

D2
D1
O Qe Qe Q
1 2
• A Change in Supply
• Likewise, if one of the determinants of supply changes
(other than price), the whole supply curve will shift.
• This will lead to a movement along the demand curve
to the new intersection point. For example, in the
following Figure, if costs of production rose, the
supply curve would shift to the left: to S2.
• There would be a shortage of at the old price of Pe1.
• Price would rise from Pe1 to Pe3.
• Quantity would fall from Qe1 to Qe3.
• In other words, there would be a movement along
the demand curve from point g to point k, and along
the new supply curve (S2) from point j to point k.
 Effect of a shift in supply curve
Effect of a shift in the supply curve
P
S2

S1

k
Pe3

j g New equilibrium at
Pe1 point k

D
O Qe3 Qe1 Q
• To summaries: a shift in one curve leads to a
movement along the other curve to the new
intersection point.
• Sometimes a number of determinants might
change. This might lead to a shift in both
curves.
• When this happens, equilibrium simply moves
from the point where the old curves
intersected to the point where the new ones
intersect.
 Effect of simultaneous change in demand and
supply on equilibrium price and quantity.
• If both demand and supply increase simultaneously, then the
equilibrium quantity increases but equilibrium price may
increase, decrease or remain unchanged depending on the
relative magnitude of the percentage change in demand and
supply.
• There are three cases.
• 1. If demand increases by more proportion than the supply,
the new equilibrium (e1) is attained at both higher equilibrium
price and quantity than before.
• Thus, the new equilibrium quantity (Q1) is greater than the
previous equilibrium quantity (Q0) and the new equilibrium
price (P1) is also greater than the previous equilibrium price
(P0).
• 2. If supply increases by more proportion than demand,
• Then the new equilibrium (e1) is attained at a higher
equilibrium quantity (Q1) than previous quantity (Q0) but at
a lower equilibrium price (P1) than the previous price (P0).
• 3. If both demand and supply increases by an equal
proportion
• The new equilibrium quantity is attained at a higher level
then the initial equilibrium quantity. But equilibrium price
remains unchanged.
• So far we discussed the relationship between price and
quantity demanded in terms of demand schedule and
demand curve.
• As well, we have seen the relationship between price of a
commodity and quantity supplied in terms of supply
schedule and supply curve.
• Our demand and supply curves helped us in explaining
basic concepts in demand and supply analysis such as
market equilibrium, change in demand, change in quantity
demand, change in supply, change in quantity supply, etc.
• The supply schedule (curve) or demand schedule (curve)
can also be represented by supply equation or demand
equation respectively
• E.g. if the demand and supply curve equation of a
commodity are given by:
Qd = 250 - 50P
and
Qs = 25 + 25P, respectively, where Qd, Qs and P are
quantity demanded, quantity supplied and price
respectively. The equilibrium price and quantity will be:
Qd = Qs at market equilibrium, so
250 - 50P = 25 + 25P
250 - 25 = 25P + 50P
225 = 75P
P=3
Qd = 250 - 50(3) = 100 = Qs
 ELASTICITIES

• Business -people who use economics in decision making is

interested in knowing the responsiveness of the dependent
variable (say quantity demanded) to the change in any one
of the independent variable (say price).
• Elasticity is a measure of how a variable responds to a
change in another variable. Specifically, it is a number that
tells us the percentage change that will occur in the variable
in response to one percent increase in another variable.
• Elasticity of variable Y with respect to X =
• Economists use elasticity to gauge the effectiveness of a
price change for a good or service.
• If the price of a good or service does not change as a result
of supply or demand, it is said to be inelastic.
 Elasticity of Demand
• In previous chapter we have seen that the demand for a
commodity is determined by its own price, income of the
consumer, prices of related goods etc.
• Quantity demanded of a good will change as a result of a
change in the size of any of these determinants of demand.
• The law of demand tells us that consumers will buy more of
a product at a lower price and less of a product at a higher
price.
• Elasticity tells us just how much or more the consumer will
buy at each price level.
• Firms value elasticity because it tells them just how much
of an impact their price change will actually have.
• The elasticity of demand refers to the sensitiveness
or responsiveness of quantity demanded of a good
to a change in its own price, income and prices of
related goods.
• Consequently, there are three kinds of elasticity of
demand .
They are
1. Price elasticity of demand
2. Income elasticity of demand
3. Cross elasticity of demand
 Price elasticity of demand
• Price elasticity of demand indicates the responsiveness of
the quantity demanded of a good to its own price changes.
• Price elasticity of demand is also "called elasticity of
demand".
• It is a concept that measures by how much percent will
quantity demanded changes when its price changes by
certain percent,
• The elasticity is usually symbolized by Greek letter eta (η).
Thus, it is given as

• This can be rewritten as

• This can be rewritten as
• =

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

• Ep = (Q2 - Q1) x P1 = (Q2 - Q1) x P1

• Q1 P2-P1 (P2- P1) Q1
• This type of elasticity is called point price elasticity of demand.
• Calculation of price - elasticity of demand yields negative value
because of the inverse relationship between quantity
demanded and price,
• for convenience we consider a positive value in terms of its
"absolute value".
 Demand schedule for barley
Point Price Quantity Dd
A 15 20
B 10 30
C 5 40

• From this example we can calculate 'point" price elasticity of

demand in two ways:
• 1. Considering movement from point A to B, i.e.,
• Ep = Q2 - Q1 x P1 = (30 - 20) x 15 = / -1.5 / = 1.5
• P2 - P1 Q1 (10 - 15) 20
• 2. Considering the same points but movement in opposite
direction, i.e., from B to A we get:
• Ep = Q2 - Q1 x P1 = 20 - 30 x 10 = / -0.67/ = 0.67
• P2 - P1 Q1 15-10 30
• In the first case we used point A as the base for
computation of ep whereas in the second case we used
point B as the base of computation of ep.
• In both cases the price elasticity of demand we calculated is
point price elasticity.
• Thus, one of the problems of using point price elasticity is
that it yields two different values of elasticity depending on
the direction of our movement
• In order to avoid this discrepancy in value of elasticity it is
better to use "arc" or" average" elasticity which takes the
average price and average quantity as a base for
computation.
• Let's see mathematical derivation of arc elasticity of
demand as follows:
 (Q 2  Q1) /Q 2  Q 1
e p 
2
( P 2  P1 ) / P1  P 2
2

• Ep = 2 (Q2 - Q1) x (P1 + P2)

• (Q2 + Q1) 2(P2- P1)
• Ep = (Q2 - Q1) x ( P1 + P2 ).
• (P2 - P1) (Q1 + Q2 )

• This formula is an arc elasticity formula and it is widely used

• Interpreting the Value of Elasticity
• For example, interpret when η = 0.2 and η = 2
where η is demand elasticity of price.

• When η = 0.2, a 1% increase in price leads to a

0.2% decrease in quantity demanded.

• When η = 2.0, a 1% increase in price leads to a

2% decrease in quantity demanded.
 The 5 Categories of Price Elasticity of Demand
• Depending on its magnitude, elasticity of demand
can be categorized as follows:
• 1. Perfectly inelastic demand; in this case coefficient price
elasticity of demand (Ep) is zero, i.e., change in price of the
commodity does not affect quantity demanded and the
demand curve is vertical.
ep=0
p2
p1

Q0

Perfectly inelastic demand curve

• 2. Inelastic Demand: in this case percentage change in
quantity demanded is less than percentage change in price.
• eg . a change of price by 10%, which caused quantity,
demanded to change only by 5%. Here the value of demand
elasticity lies between 0 and 1, i.e. 0 < ep < 1. Graphically it
can be shown as follows.

0 < ep < 1
P1____________

P2_______________

Q1 Q2
Inelastic Demand curve
• 3. Elastic Demand: When percentage change in quantity
demand is greater than percentage change in price, it is
said to be elastic demand.
• eg change in quantity demand by 10% which was caused
by 5% change in price.

ep > 1
P1 _____________

P2 _________________________

Q1 Q2
Elastic Demand
• 4. Unitary Price Elasticity: here percentage change in price
is equal to percentage in quantity demanded.
• e.g. As demand changes by 10% price also changes by 10%.

ep = 1
P1 __________

P2 __________________

Q1 Q2
Unit Price Elastic demand curve
• 5. Perfectly Elastic demand: The percentage change in
price is zero but percentage change in quantity demanded
is high.
• Here elasticity of demand is infinite, ep = 

ep = 
P0 _________________________________ D

Q1 Q2

Perfectly Elastic demand:

 Factors Affecting Price Elasticity of Demand
• Elasticity of demand depends on a number of things.
• Some of them are:
• 1. Availability and number of substitute: - if a commodity
has many substitutes, a change in price of one substitute
will affect quantity demanded of the other substitute highly.
• i.e., a commodity with many substitutes has larger price
elasticity
• 2. Number of alternative uses of a commodity: If a
commodity has many alternative uses it has high price
elasticity of demand,
• i.e., the higher is the number of alternative uses of a
commodity, the higher is its price elasticity.
• 3. The nature of a commodity (i.e. whether it is luxury or
necessity)
• If a commodity is a necessity-good, then its, ep is low
(inelastic demand) because whatever price level is,
consumers buy almost fixed quantity of this good.
• If a commodity is non-essential or luxury then it has high
price elasticity.
• Other factors includes;
• Time horizon of consumption,
• Durability of a good, etc
• can also affect price elasticity of demand
 Income Elasticity of Demand
• Income elasticity of demand measures % change in quantity dd due
to certain % change in income of the consumer.
• ey = (Qd/Qd) x 100
(y/y)x 100
• Where ey is income elasticity of demand
Qd is changed in quantity demand
Y is change in income of consumers.
• i.e. ey = [(Q2 - Q1)/Q1)] x 100
[(Y2 - Y1)/Y1] x 100

 Q2  Q1   Y1 
• ey =   x  Where Q1 is quantity demanded at
Y  Y   Q 
 2 1   1 income level Y1 and Q2 is quantity
demanded at income level Y2
• If income elasticity of demand for certain good
is positive,
• Then the good is said to be normal good.

• If income elasticity of a commodity is negative,

• Then the good is said to be inferior good.
• The income elasticity of demand is summarized
in Table 3.docx
 Cross Price Elasticity of Demand
• Cross price elasticity is used to measure the percentage change in
quantity demanded of a commodity, (say X) due to percentage
change in price of the other commodity, (say Y)
• exy = (Qdx) / Qdx = Qdx , Py
 py/py py Qx
• Where Qdx is changed in quantity demand of x.
py is changed in price of commodity y
Qxd is quantity demanded of x at particular price

 Q x 2  Q x1   Py1 
• exy = 
P  P 
 x  

this is point cross price elasticity
 y2 y1 
 Q x1 
• If goods are related in consumption they are either a
substitute or a complementary to each other.
• Cross price elasticity can be positive, negative or
zero.
• For a substitute goods cross price elasticity is
positive.
• For complementary goods cross price elasticity is
negative.
• If goods have no relation their cross price elasticity of
demand is zero.Summarizes
cross elasticity of demand.docx
 Application of Elasticity
• The concept of dd elasticity is useful for businesspeople.
• If a producer wants to sell more of his commodity by
reducing price then the demand curve for his product must
have elastic demand.
• If demand for the product is elastic, an increase in price
results decrease in revenue as small percentage change in
price causes large decrease in quantity sold.
• If a producer faces an inelastic demand curve for his
product he can increase his revenue by increasing price
because under this case large percentage increase in price
causes little percentage decrease in quantity demanded.
• If a producer faces inelastic demand curve, then it
cannot increase its revenue by decreasing price. 

• If demand is unitary, change in price does not

affect total revenue.

• In this case there is no need of decreasing or

increasing price, as it does not affect total revenue
of the producer.
 Chapter Four
Utility and Consumers Behavior
Aims and Objectives of this unit
After completing this unit you should be able to:
• Explain the difference between cardinal and ordinal utility
analysis
• Distinguish between total and marginal utility
• Explain indifference curve and its properties
• Understand consumer's equilibrium in consumption
• Understand budget constraints
• Distinguish between rotation and shift of budget line
• Derive budget equation
• Derive income and price consumption curves
 CONSUMER CHOICE AND THE CONCEPT OF UTILITY

• Choices and Utility

• Decisions are being made every day, every hour,
every second.
• People making decisions:
• Should I go to college?
• Should I get married?
• Should I buy this car? The choices never end.
• We always have to make choices because of
scarcity, and scarcity will always be with us.
• In this chapter, we take a close look at how we make choices.
• Some decisions seem to be based on
• Feelings or come from personal experiences.
• Other decisions take a more calculated approach,
• Some decisions are quick and impulsive, while others are based
on time-consuming research.
• Think about what factors you look at when making a choice.
• For example, to pursue your Msc in development economics
• What benefits and costs did you consider? Ultimately,
• How will your benefits exceed your costs in this decision?
• Were you influenced by your peers? Or
• were you more influenced by your parents?
• Answers to all of these questions depend on your self-interest.
• Common sense says that as the price of a product rises,
consumers will be discouraged from buying that product.
• On the other hand, people will buy more of a product if the
price is lowered.
• To understand which factors influences consumers’
decisions,
• We must take a closer look at what is called utility.
• Utility describes the satisfaction one gets from making a
choice.
• Consumers make choices that give them the greatest
satisfaction, thereby maximizing their utility.
• Each individual’s utility varies depending on the taste or
preference of that person.
 Theory of Utility
• Economists use the term utility to describe the satisfaction
or enjoyment derived from the consumption of a good or
service.
• Definition
• Utility is the level of satisfaction that is obtained by
consuming a commodity or undertaking an activity.

• The concept of utility is characterized with the following

properties:
• 1. ‘Utility’ and ‘Usefulness” are not synonymous.
• For example, paintings by Picasso may be useless
functionally but offer great utility to art lovers.
• 2. Utility is subjective. The utility of a product will vary
from person to person.
• That means, the utility that two individuals derive from
consuming the same level of a product may not be the
same.
• For example, non-smokers do not derive any utility from
cigarettes.
• 3. The utility of a product can be different at different
places and time.
 Approaches to measure Utility
• There are two major approaches of measuring utility.

• These are Cardinal and ordinal approaches.

• This section is divided into two sections.
• In Section one the Cardinal utility approach will be
discussed while.
• in Section two the concept of ordinal Utility will be
addressed.
 The Cardinal Utility theory
• Utility maximization theories are important to deal with
consumer behavior.
• Thus, in this section, you will learn about the Cardinal
Utility theory.
• Neo classical economists argued that utility is measurable
like weight, height, temperature and they suggested a unit
of measurement of satisfaction called utils.
• A util is a cardinal number like 1,2,3 etc simply attached to
utility.
• Hence, utility can be quantitatively measured.
 Assumptions of Cardinal Utility theory
• 1. Rationality of Consumers.
• The main objective of the consumer is to maximize his/her
satisfaction given his/her limited budget or income.
• Thus, in order to maximize his/her satisfaction, the
consumer has to be rational.
• 2. Utility is cardinally Measurable.
• According to this approach, the utility or satisfaction of
each commodity is measurable.
• Money is the most convenient measurement of utility.
• In other words, the monetary unit that the consumer is
prepared to pay for another unit of commodity measures
utility or satisfaction.
• 3.Constant Marginal Utility of Money.
• According to assumption number two, money is the most
convenient measurement of utility.
• However, if the marginal utility of money changes with the
level of income (wealth) of the consumer, then money cannot
be considered as a measurement of utility
• 4. Limited Money Income.
• The consumer has limited money income to spend on the
goods and services he/she chooses to consume.
• 5. Diminishing Marginal Utility (DMU).
• The utility derived from each successive units of a commodity
diminishes.
• In other words, the marginal utility of a commodity
diminishes as the consumer acquires larger quantities of it
 )

• 6. The total utility of a basket of goods depends on the

=f

quantities of the individual commodities.

• 7. If there are n commodities in the bundle with quantities,
• X , X ,... X the total utility is given by: TU = f ( X , X ...... X )
1 2 n 1 2 n

Total and Marginal Utility

• Total Utility (TU): It refers to the total amount of satisfaction
a consumer gets from consuming or possessing some specific
quantities of a commodity at a particular time.
• As the consumer consumes more of a good per time period,
his/her total utility increases.
• However, there is a saturation point for that commodity in
which the consumer will not be capable of enjoying any
greater satisfaction from it.
• Marginal Utility (MU): It refers to the additional utility
obtained from consuming an additional unit of a
commodity.
• In other words, marginal utility is the change in total utility
resulting from the consumption of one or more unit of a
product per unit of time.
• Graphically, it is the slope of total utility.
• Mathematically, the formula for marginal utility is:
TU
MU 
Q

• Where: TU is the change in Total Utility, and Q is change

in the amount of product consumed.
 Law of diminishing marginal Utility (LDMU)

• Is the utility you get from consumption of the first orange is

the same as the second orange?
• The utility that a consumer gets by consuming a commodity
for the first time is not the same as the consumption of the
good for the second, third, fourth, etc.
• The Law of Diminishing Marginal Utility States that as the
quantity consumed of a commodity increases per unit of
time, the utility derived from each successive unit
decreases, consumption of all other commodities
remaining constant.
• The LDMU is best explained by the MU curve that is derived
from the relationship between the TU and total quantity
consumed.
 Hypothetical table showing TU and MU of
consuming Oranges (X
Units of Quantity(x)
consumed 0 1st 2nd
Unit 3 rd
4th 5th 6th
unit unit Unit Unit
Unit unit

TUX 0 10 16 20 22 22 20
util utils utils utils utils utils utils

MUX 0 10 6 4 2 0 -2
 Equilibrium of a consumer
• A consumer is said to have reached his/her equilibrium
position when he/she has maximized the level of his/her
satisfaction, given budget constraints and other conditions.
• At equilibrium, the consumer is supposed to have spent
his/her entire income on the goods and services he/she
consumes.
• If we assume that the consumer consumes only two
products, say, X and Y, then the following condition should
fulfill in equilibrium:
MU x Px MU x MU y
MU y Py Px Py
• = or = = MUm

• Where: MUm –marginal utility of money

• Diagrammatically

 A
 C
PX


B
MUX

• Note that: at any point above point C like point A where MUX> Px, it pays
the consumer to consume more.
• At any point below point C like point B where MUX< Px the consumer
consumes less of X.
• However, at point C where MUx=Px the consumer is at equilibrium.
 Utility schedule for a single commodity
Quantity of TU MU MU per MU of
Orange Birr(price= money
2 birr)
0 0 - - 1
1 6 6 3 1
2 10 4 2 1
3 12 2 1 1
4 13 1 0.5 1
5 13 0 0 1
6 11 -2 -1 1
 Limitation of the Cardinalist approach
• The Cardinalist approach involves the following three
weaknesses:
• 1. The assumption of cardinal utility is doubtful because
utility may not be quantified.

• 2. Utility cannot be measured absolutely (objectively). The

satisfaction obtained from different commodities cannot be
measured objectively.

• 3. The assumption of constant MU of money is unrealistic

because as income increases, the marginal utility of money
changes.
 The Ordinal Utility Theory
• In the ordinal utility approach, utility cannot be measured
absolutely but different consumption bundles are ranked
according to preferences.
• The concept is based on the fact that it may not be possible
for consumers to express the utility of various commodities
they consume in absolute terms, like, 1 util, 2 util, or 3 util,
• But it is always possible for the consumers to express the
utility in relative terms.
• It is practically possible for the consumers to rank
commodities in the order of their preference as 1st 2nd 3rd and
so on.
 Assumptions of Ordinal Utility theory
• Like the previous approach, this approach is based on the
following assumptions:
1. The Consumers are rational-they aim at maximizing their
satisfaction or utility given their income and market prices.
2. Utility is ordinal, i.e. utility is not absolutely (cardinally)
measurable. Consumers are required only to order or rank
their preference for various bundles of commodities.
3. Diminishing Marginal Rate of Substitution (MRS):
• The marginal rate of substitution is the rate at which a
consumer is willing to substitute one commodity (x) for
another commodity (y) so that his total satisfaction remains
the same.
• When a consumer continues to substitute X for Y the rate goes
decreasing and it is the slope of the Indifference curve.
• 4. The total utility of the consumer depends on the
quantities of the commodities consumed,
• i.e., U=f ( X 1 , X 2 ...... X n )
• 5. Preferences are transitive or consistent:
• It is transitive in the senses that if the consumer prefers X
to Y, and prefers Y to Z, and then the consumer also prefers
X to Z.
• When we said consistent it means that If X is greater than Y
(X>Y) then Y not greater than X (Y not >Y).
• The ordinal utility approach is expressed or explained with
the help of indifference curves.
• An indifference curve is a concept used to represent an
ordinal measure of the tastes and preferences of the
consumer and to show how he/she maximizes utility in
spending income.
 Indifference Set, Curve and Map
• Indifference Set/ Schedule: It is a combination of goods for
which the consumer is indifferent, preferring none of any
others.
• It shows the various combinations of goods from which the
consumer derives the same level of utility.
• Indifference Curves: an indifference curve shows the
various combinations of two goods that provide the
consumer the same level of utility or satisfaction.
• It is the locus of points (particular combinations or bundles
of good), which yield the same utility (level of satisfaction)
to the consumer,
• So that the consumer is indifferent as to the particular
combination he/she consumes.
• Indifference Map: To describe a person’s preferences for all
combinations potato and meat, we can graph a set of
indifference curves called an indifference map.

• In other words it is the entire set of indifference curves is

known as an indifference map, which reflects the entire set
of tastes and preferences of the consumer.

• A higher indifference curve refers to a higher level of

satisfaction and a lower indifference curve shows lesser
satisfaction.
 Properties of Indifference Curves:
• 1. Indifference curves have negative slope (downward
sloping to the right).
• Indifference curves are negatively sloped because the
consumption level of one commodity can be increased only by
reducing the consumption level of the other commodity.
• That means, if the quantity of one commodity increases with
the quantity of the other remaining constant, the total utility
of the consumer increases.
• On the other hand, if the quantity of one commodity
decreases with the quantity of the other remaining constant,
the total utility of the consumer reduces.
• Hence, in order to keep the utility of the consumer constant,
as the quantity of one commodity is increased, the quantity of
the other must be decreased.
• 2. Indifference curves do not intersect each other.
• Intersection between two indifference curves is
inconsistent with the reflection of indifference curves.
• If they did, the point of their intersection would mean two
different levels of satisfaction, which is impossible.
• 3. A higher Indifference curve is always preferred to a
lower one.
• The further away from the origin an indifferent curve lies,
the higher the level of utility it denotes: baskets of goods
on a higher indifference curve are preferred by the rational
consumer, because they contain more of the two
commodities than the lower ones.
• 4. Indifference curves are convex to the origin.

• This implies that the slope of an indifference curve

decreases (in absolute terms) as we move along the curve
from the left downwards to the right.

• This assumption implies that the commodities can

substitute one another at any point on an indifference
curve, but are not perfect substitutes
 Banana B
Banana
 E
D IC2
C
A
IC1

Orange Orange
• As we discussed earlier, Indifference curves cannot intersect each
other. If they did, the consumer would be indifferent b/n C and E,
• since both are on indifference curve one (IC1). Similarly, the
consumer would be indifferent between points D and E, since they
are on the same indifference curve, IC2
• By transitivity, the consumer must also be indifferent between C and
D.
• However, a rational consumer would prefer D to C because he/she
can have more Orange at point D (more Orange by an amount of X).
 The Marginal rate of substitution (MRS)
• Definition: Marginal rate of substitution of X for Y is defined
as the number of units of commodity Y that must be given
up in exchange for an extra unit of commodity of X
• So that the consumer maintains the same level of
satisfaction. MRS  Number of units of Y given up
X ,Y
Number of units of X gained

• It is the negative of the slope of an indifference curve at any

point of any two commodities such as X and Y, and is given
by the slope of the tangent at that point: i.e.,
• Slope of indifference curve y
 MRS X ,Y
x
• In other words, MRS refers to the amount of one
commodity that an individual is willing to give up to get an
additional unit of another good while maintaining the same
level of satisfaction or remaining on the same indifference
curve.
• The diminishing slope of the indifference curve means the
willingness to substitute X for Y diminishes as one move
down the curve.
• Note that (MRS ) measures the amount of y that the
X ,Y

individual is willing to give up per additional unit of x

required) to remain on the same indifference curve.
• That is, MRS   Y because of the reduction in Y, MRS is
X ,Y
X
negative.
• However, we multiply by negative one and express MRS as
X ,Y

a positive value.
• The rationale behind the convexity, that is, diminishing
MRS, is that a consumer’s subjective willingness to
substitute A for B (or B for A) will depend on the amounts
of B and A he/she possesses.
• level of consumption of good X and Y
Bundle (Combination) A B C D
Orange(X) 1 2 4 7
Banana (Y) 10 6 3 1

Y 4
MRS X ,Y (between point s A and B   4
X 1
 Marginal Utility and Marginal rate of
Substitution
• The MRS is related to the MUx and the MUy is:
X ,Y

MUX
MRSX ,Y 
MUY

The Budget Line or the Price line

• The budget line is a line or graph indicating different
combinations of two goods that a consumer can buy with a
given income at a given prices.
• In other words, the budget line shows the market basket
that the consumer can purchase, given the consumer’s
income and prevailing market prices.
 Assumptions for the use of the budget line
• In order to draw the budget line facing the consumer, we
consider the following assumptions:
• 1. There are only two goods, X and Y, bought in quantities X
and Y;
• 2.Each consumer is confronted with market determined
prices, Px and Py, of good X and good Y respectivley; and
• 3. The consumer has a known and fixed money income
(M).
• By assuming that the consumer spends all his/her income
on two goods (X and Y), we can express the budget
constraint as: M  PX X PYY Where, PX=price of good X,
PY=price of good Y; X=quantity of good X; Y=quantity of
good Y; M=consumer’s money income
• This means that the amount of money spent on X plus the
amount spent on Y equals the consumer’s money income.

• Suppose for example a household with 30 Birr per day to

spend on banana(X) at 5 Birr each and Orange(Y) at 2 Birr
each. That is, .
PX  5, PY  2, M  30birr
• Therefore, our budget line equation will be:

5 X  2Y  30
 Alternative purchase possibilities of the two goods
Consumption
A B C D E F
Alternatives
Kgs of banana (X) 0 1 2 3 4 6
Kgs of Orange(Y) 15 12.5 10 7.5 5 0
Total Expenditure 30 30 30 30 30 30

• At alternative A, the consumer is using all of his /her

income for good Y.
• Mathematically it is the y-intercept (0, 15). And at
alternative F, the consumer is spending all his income for
good X. mathematically; it is the x-intercept (6, 0).
• We may present the income constraint graphically by the
budget line whose equation is derived from the budget
equation. M  P X X  PY Y
M  XP X  YP Y

• By rearranging the above equation we can derive the

general equation of a budget line,
M PX
Y   X
PY PY
M
• P Y = Vertical Intercept (Y-intercept), when X=0.

PX
•  = slope of the budget line (the ratio of the prices of
PY
the two goods)
• The horizontal intercept (i.e., the maximum amount of X
the individual can consume or purchase given his income) is
given by: M P M P M
 X
X 0  X
X X 
PY PY PY PY PX

M/PY
 B

A

M/PX
Derivation of the Budget Line

Therefore, the budget line is the locus of combinations or bundle of

goods that can be purchased if the entire money income is spent.
 Optimum of the Consumer
• A rational consumer seeks to maximize his utility or
satisfaction by spending his or her income.
• It maximizes the utility by trying to attain the highest
possible indifference curve, given the budget line.
• This occurs where an indifference curve is tangent to the
budget line so that the slope of the indifference curve
( MRS XY
) is equal to the slope of the budget line (PX /PY).
• Thus, the condition for utility maximization, consumer
optimization, or consumer equilibrium occurs where the
consumer spends all income (i.e. he/she is on the budget
line) and the slope of the indifference curve equals to the
slope of the budget line MRS  P / P
XY X Y
• The preferences of the consumer (what he/she wishes) are
indicated by the indifference curve and the budget line specifies
the different combinations of X and Y the consumer can
purchase with the limited income.
• Therefore, the consumer tries to obtain the highest possible
satisfaction with in his budget line.
• However, the consumer cannot purchase any bundle lying above
and to the right of the budget line.
• Because Indifference curves above the region of the budget line
are beyond the reach of the consumer and are irrelevant for
equilibrium consideration.
• The question then arises as to which combinations of X and Y
the rational consumer will purchase.
• Graphically, the consumer optimum or equilibrium is depicted
as follows:
 Consumer equilibrium

• At point ‘A’ on the budget line, the consumer gets IC 1 level of satisfaction.

• When he/she moves down to point ‘B’ by reallocating his total income in favor
of X he/she derives greater level of satisfaction that is indicated by IC 2.

• Thus, point ‘B’ is preferred to point ‘A’. Moving further down to point ‘E’, the
consumer obtains the greatest level of satisfaction (IC3) relative to other
indifference curves.
• Therefore, point ‘E’ (which represents combination X and Y) is the
most preferred position by the consumer since he/she attains the
highest level of satisfaction within his/her reach and point ’E’ is
known as the point of consumer equilibrium (or consumer optimum).

• This equilibrium occurs at the point of tangency between the highest

possible indifference curve and the budget line.

• Put differently, equilibrium is established at the point where the

slope of the budget line is equal to the slope of the indifference
curve.
• Mathematically, consumer optimum (equilibrium) is attained at the
point where:
PX MU X MU Y MU X P
MRS XY  , But we know   ....... MU X PY  MU Y PX ...,  X
PY PX PY MU Y PY
 Chapter Five
Theory of Production and Cost
• Theory of Production
• Production can be defined as a process by which resources
/inputs/ are transferred to final good and services.
• It requires a wide variety of inputs. By input we mean factor of
production such as land, labor, capital and entrepreneurial skill.
• The output of a firm can either be a final commodity such as
pasta or an intermediate product such as wheat (which is used
in the production of pasta) in this case.
• The output can also be a service rather than a good. Examples
of services are education, medicine, banking, legal counsel,
accounting work, communications, transportation, storage,
wholesaling, and retailing.
• The term production refers to the creation of those goods
and services which have change value.

• It is concerned with the creation of economic utilities.

• These economic utilities are of three forms; form, time and
place utility.

• Production is an activity whether physical or mental which

is directed to satisfaction of other peoples wants through
exchange.
• Essentials of productions
• No production is possible without some activity, physical or
mental
• The activity must be directed to the satisfaction of others
people’s wants. Thus, if a farmer produces wheat for self-
consumption, this activity will not be regarded as one of
production.
• Other people’s wants must be satisfied through the process
of exchange. If a teacher teaches students without any
remuneration in exchange, his service cannot be treated as
production.
• In general sense, economists have characterized the
production process as a combination of four factors: land,
labour, capital and organization or entrepreneurships.
• Land plays role in agriculture sector, while other factors
have prominence in industrial sector.
• The entrepreneur who looks after the organizational
aspects of production is the decision maker who through
the combination of the factors produces the output.
• While entrepreneurship is an important trait for the
development of any country’s economy, entrepreneur is
often considered as an innovatory
• Factors of production
• Production can also be defined as a process by which resources are
transformed into final goods and services.
• Any good or service that comes out of production process is known as
output.
• Production requires inputs like labor, land, capital and entrepreneur
ability.
• These are the production resources or the economic resources used to
produce goods and services which include:
• Land. The economy’s natural resources such as land, trees, and minerals.
• Labor. The mental and physical skills of individuals in a society.
• Capital. Goods-such as tools, machines, and factories-used in production
or to facilitate production.
• Management/entrepreneurship/-it consists special types of human
talent that helps to organize and manage other factors of production
factors like land , labor and capital.
 Definition of Production function
• Production function is a systematic way of showing the
relation between different amounts of a resource or input
that can be used to produce a product and the
corresponding output.
• The production function can be expressed in many ways:
written form, tabular, and graphical
• Production function is purely technical relation, which
connects factor inputs and outputs.
• It describes the law of proportion that is the transformation
of factor inputs into outputs during any particular time
period.
• Production functions are present either in technology of
firm or industry or of the economy as whole
• It shows how, and to what extents output changes with
variations in inputs during a specified period of time.
• Production function expresses the functional relationship
between quantities of inputs and outputs,
• It can also be expressed in mathematical equation form in
which output id the dependent variable and inputs are the
independent variables.
• The Production function is always specified for a period of
time. It is the flow of inputs resulting in a flow of output
during specified period.
• Every manufacturing firm has its own production function,
which is determined by the state of technical knowledge,
and managerial ability of that firm.
• Improvement of technical knowledge managerial ability of
the firm will bring about a new production function in the
place of the existing one.
• The new production function either gives more output with
the same quantity of original inputs or it may use smaller
quantities of inputs for the same original outputs.
• Assumptions of production function
• It is always related to a specified period of time
• Technical knowledge is assumed to be constant
• The firm in question will use the best and the most efficient
technique available
• The factors of production are divisible into invariable units
 Short run theory of production (Factor- product
relationship)
• In short-run, it is possible to increase the quantity of one input
while keeping the quantity of other inputs constant in order to
have more output.
• This aspect of production function is known as the law of
variable production.
• The law is also known as Production function with one
variable input.
• According to this law, in the production function of a firm, all
inputs are fixed except one.
• This one input is called the variable input.
• In the long-run, it is possible for a firm to change all inputs in
order to expand its business. This known as “Returns to scale”
• Let us first focus on the quantity of factors used.
• If a firm wants to increase production, it will take time to
acquire a greater quantity of certain inputs.
• For example, a manufacturer can use more electricity by
turning on switches, but it might take a long time to obtain
and install more machines, and longer still to build a second
or third factory.
• The distinction we are making here is between fixed factors
and variable factors.
• A fixed factor is an input that cannot be increased within a
given time period (e.g. buildings).
• A variable factor is one that can be increased within a given
time period.
• The distinction between fixed and variable factors allows us
to distinguish between the short run and the long run.
• The short run is a time period during which at least one
factor of production is fixed.
• In the short run, then, output can be increased only by
using more variable factors.
• The long run is a time period long enough for all inputs to
be varied.
• Given long enough, a firm can build a second factory and
install new machines.
 The law of diminishing returns
• Production in the short run is subject to diminishing
returns.
• The law of diminishing returns is one of the most famous of
all ‘laws’ of economics.
• To illustrate how this law underlies short-run production let
us take the simplest possible case where there are just two
factors: one fixed and one variable.
• Take the case of a farm. Assume the fixed factor is land and
the variable factor is labour.
• Since the land is fixed in supply, output per period of time
can be increased only by increasing the amount of workers
employed.
• But imagine what would happen as more and more workers
crowd on to a fixed area of land.
• The land cannot go on yielding more and more output
indefinitely.
• After a point the additions to output from each extra worker will
begin to diminish.
• We can now state the law of diminishing (marginal) returns as
when increasing amounts of a variable factor are used with a
given amount of a fixed factor, there will come a point when each
extra unit of the variable factor will produce less extra output
than the previous unit.
• Let us now see how the law of diminishing returns affects
total output or total physical product (TPP) (TPP is the total
output of a product per period of time that is obtained from
a given amount of inputs).
• The relationship between inputs and output is shown in a
production function (The mathematical relationship between
the output of a good and the inputs used to produce it.
• It shows how output will be affected by changes in the
quantity of one or more of the inputs).
• In the simple case of the farm with only two factors – namely,
a fixed supply of land (Ln) and a variable supply of farm
workers (Lb) – the production function would be:
• TPP = f (Ln, Lb).
• This states that total physical product (i.e. the output of the
farm) over a given period of time is a function of (i.e. depends
on) the quantity of land and labour employed.
• We could express the precise relationship using an equation.
 Table Wheat production per year from a particular farm

Wheat production per year from a particular farm (tonnes)

Number of TPP APP MPP
Workers (Lb) (=TPP/Lb) (= TPP/ Lb)

(a) 0 0 -
3
1 3 3
7
2 10 5
(b) 14
3 24 8
12
(c) 4 36 9
4
5 40 8
2
6 42 7
(d) 0
7 42 6
-2
8 40 5
 Fig Wheat production per year (tones)
Wheat production per year from a particular farm
T onnes of wheat per year T on nes of wh eat per year
d
40 Slope = TPP / L c
= APP TPP
30
Maximum
20
output
b
Diminishing returns
10 set in here
TPP = 7
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14 L = 1 b
12

10
c
8

4 APP
2

0 d Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
-2
MPP
• With nobody working on the land, output will be zero (point a).
• As the first farm workers are taken on, wheat output initially
rises more and more rapidly.
• The assumption behind this is that with only one or two workers
efficiency is low, since the workers are spread too thinly.
• With more workers, however, they can work together – each,
perhaps, doing some specialist job – and thus they can use the
land more efficiently.
• In Table 3.1, output rises more and more rapidly up to the
employment of the third worker (point b).
• In Figure 3.1 the TPP curve gets steeper up to point b. After
point b, however, diminishing marginal returns set in:
• output rises less and less rapidly, and the TPP curve
correspondingly becomes less steeply sloped.
• When point d is reached, wheat output is at a maximum: the land
is yielding as much as it can.
• Any more workers employed after that are likely to get in each
other’s way.
• Thus beyond point d, output is likely to fall again: eight workers
produce less than seven workers.
Average and marginal product;
• In addition to total physical product, two other important
concepts are illustrated by a production function: namely, average
physical product (APP) and marginal physical product (MPP)
• Average physical product: This is output (TPP) per unit of the
variable factor (Qv).
• In the case of the farm, it is the output of wheat per worker. APP
= TPP/Qv Thus in Table 3.1 the average physical product of labor
when four workers are employed is 36/4 = 9 tons per year.
• Marginal physical product:
• This is the extra output (ΔTPP) produced by employing one
more unit of the variable factor.
• Thus in Table 3.1 the marginal physical product of the
fourth worker is 12 tones.
• The reason is that by employing the fourth worker, wheat
output has risen from 24 tons to 36 tones: a rise of 12
tones.
• In symbols, marginal physical product is given by:
• MPP = ΔTPP/ΔQv;
• Thus in our example: MPP = 12/1 = 12.
 Stage of production in the short-run production
function
• Stage-I (increasing return to factor); This the region up to the
highest point on the MP curve (point b) where if additional
units of labor are employed, TP increase at an increasing rate
(MP).

• Stage-II (diminishing return to factor (labor)); This the region

from the highest point on the MP curve up to the zero MP,
where if additional units labor are employed TP still increase
but it increase at a diminishing rate.

• Stage-III (negative return to factor (labor)); this is the region

where MP is negative and this makes the total product falling.
 Returns to scale
• It refers to the change in output when all factors are
increased by the same proportion.
• In the long run all inputs are variable. Hence, returns to
scale refers to change in output as a result of change in all
factors in the same proportion.

• There are three types of returns to scale.

A. Increasing returns to scale

• Increasing returns to scale happens when an increase in all
factor inputs in a given proportion causes a more than
proportionate increase in output.
• This will result in internal and external economies of scale.
• Internal economies occur as a result of the expansion of the
individual firm.
• External economies of scale are those economies which
occur to all firms as the industry expands.
• As a result, output increases higher than the increase in
input.

B. Constant returns to scale

• Constant returns to scale happens when an increase in all
factor inputs in a given proportion causes an equal and
proportionate increase in output.
 C. Diminishing Returns to Scale

• Diminishing returns happen when an increase in all factor

inputs in a given proportion causes a less than
proportionate increase in output.

• The increase of the scale of production beyond the

optimum capacity brings diseconomies of scale in the form
of overcrowding confusion inefficiency, etc.

• This is why diminishing returns occur.

 Economies and Diseconomies of Scale
• The term economies of scale refer to the advantages resulting when a
firm increases its scale of operation.
• The firm accrues technical, financial and managerial economies from
large scale production.
• As output increases, the firm‘s average cost of producing that output is
likely to decline.
• This can happen for the following reasons:
• 1. If a firm operates on a larger scale, workers can specialize in the
activities at which they are most productive.
• 2. Scale can provide flexibility. By varying the combination of inputs
utilized to produce the firm‘s output, managers can organize the
production process more effectively.
• 3. The firm may be able to acquire some production inputs at lower cost
because it is buying them in large quantities and can therefore negotiate
better prices.
• The term diseconomies of scale refer to the
disadvantages resulting from the very large scale
production.
• As the scale of production increases much it becomes
difficult for the managers to coordinate the business.
• Similarly, the advantages of buying in bulk may have
disappeared once certain quantities are reached.
• At some point, the supply of key inputs may be limited
pushing their costs up
 Concepts and Types of costs
• Cost of production refers to payments for the factors of
production that the firm uses to produce goods and
services.
• The value of inputs required in the production of a
commodity determines its cost of output
• The firm output level is determined by cost.
• Product price are determined by the interaction of the
market forces of demand and supply in perfect market.
• The basic factor underlying the ability and willingness of
firms to supply a product in the market is the cost of
production.
• Thus, cost of production provides the floor to pricing.
 Types of costs
• There are many types of costs that a firm may consider relevant
for decision making under varying situation.
• The manner in which cost are classified or defined is largely
dependent on the purpose for which the cost data are being
outlined.
A. Explicit and implicit costs
• Explicit cost is refers to the expenses which are incurred by a
firm in buying goods and services directly.
• Examples: Monetary expenses incurred by a producer to hire
workers, purchase of raw materials, power….etc. are explicit cost.
• Implicit cost is the expenses which are imputed or self owned.
• Expense for self-employed resources, salary of the owner of the
firm, rent on own building…etc are called implicit costs.
 B. Fixed and variable costs
• Fixed cost is defined as a cost of production that does not
vary with the level of output.
• Fixed costs are associated with the very existence of a firm’s
plant and therefore must be paid even if the firm’s of rate
output is zero.
• Such costs as interest are borrowed capital, rental payments,
a portion of deprecation charges of equipment and buildings.
• Variable cost is a cost of production that varies directly with
the level of output.
• They include payment for raw materials, charge on fuel and
electricity, wage and salary of temporary staff, depreciation
charge associated with wear and tear of assets, and sales
commissions…etc.
 Costs and Inputs
• A firm’s costs of production will depend on the factors of
production it uses.
• The more factors it uses, the greater will its costs be.
• In the short run, some factors are fixed in supply.
• Their total costs, therefore, are fixed, in the sense that they
do not vary with output.
• Rent on land is a fixed cost. It is the same whether the firm
produces a lot or a little.
• The total cost of using variable factors, however, does vary
with output.
• The cost of raw materials is a variable cost.
• The more that is produced, the more raw materials are
used and therefore the higher is their total cost.
 Short-run cost Analysis
• The short run is a time period during which at least one factor of
production is fixed.
• In the short run, then, output can be increased only by using
more variable factors.
• The long run is a time period long enough for all inputs to be
varied.
• Given long enough, a firm can build a second factory and install
new machines.
• Total cost (TC)
• The total cost (TC) of production is the sum of the total variable
costs (TVC) and the total fixed costs (TFC) of production:
• TC = TVC + TFC. Consider Table 5.2 and Figure 5.2.
• They show the total costs for firm X of producing different levels
of output (Q).
 Fig 3.2 Total costs for firm X
Total costs for firm X
Output TFC TVC TC
(Q) (£) (£) (£) TC
100
0 12 0 12 TVC
1 12 10 22
80 2 12 16 28
3 12 21 33
4 12 28 40
60 5 12 40 52
6 12 60 72
7 12 91 103
40
Table 3.2

20

TFC
0
0 1 2 3 4 5 6 7 8
 • Total fixed cost (TFC)
• TFC is a cost of production that does not vary with the level
of output
• In our example, total fixed cost is assumed to be £12.
• Since this does not vary with output, it is shown by a
horizontal straight line.
• Total variable cost (TVC)
• With a zero output, no variable factors will be used. Thus
TVC = 0.
• The TVC curve, therefore, starts from the origin.
• The shape of the TVC curve follows from the law of
diminishing returns
 Average and marginal costs
• Average cost (AC) is cost per unit of production: AC = TC/Q.
• Thus if it cost a firm £2000 to produce 100 units of a
product, the average cost would be £20 for each unit
(£2000/100).
• Like total cost, average cost can be divided into the two
components, fixed and variable.
• In other words, average cost equals average fixed cost (AFC
= TFC/Q) plus average variable cost (AVC = TVC/Q):
• AC = AFC + AVC
• Marginal cost (MC) is the extra cost of producing one more
unit: that is, the rise in total cost per one unit rise in output:
MC = ΔTC/ ΔQ
• Note that all marginal costs are variable, since, by
definition, there can be no extra fixed costs as output rises.
• Given the TFC, TVC and TC for each output, it is possible to
derive the AFC, AVC, AC and MC for each output using the
above definitions.
• What will be the shapes of the MC, AFC, AVC and AC
curves?
• These follow from the nature of the MPP and APP curves
that we looked at in section 3.1 above.
• You may recall that the typical shapes of the APP and MPP
curves are like those illustrated in Figure 3.3.
 Fig 3.3 Average and marginal physical product
Average and marginal physical product

c
O utput

APP

MPP

Quantity of the variable factor

• The shape of the MC curve follows directly from the law of
diminishing returns.
• Initially, in Figure 3.4, as more of the variable factor is used, extra
units of output cost less than previous units.
• MC falls. This corresponds to the rising portion of the MPP curve in
Figure 3.3 and the portion of the TVC curve in Figure 3.2
• Average fixed cost (AFC)
• AFC falls continuously as output rises, since total fixed costs are
being spread over a greater and greater output.
• Average variable cost (AVC)
• The shape of the AVC curve depends on the shape of the APP curve.
• As the average product of workers rises (up to point c in Figure 3.3),
the average labour cost per unit of output (the AVC) falls: as far as
point y in Figure 3.4.
• Thereafter, as APP falls, AVC must rise.
 Fig 3.4 Average and marginal costs
Average and marginal costs
MC
AC
AVC
Costs £( )

x
AFC

Output (Q)
 • Average (total) cost (AC)
• AC is simply the vertical sum of the AFC and AVC curves. Note
that as AFC gets less, the gap between AVC and AC narrows.
• The Relationship between Average Cost and Marginal Cost
• As long as new units of output cost less than the average, their
production must pull the average cost down.
• That is, if MC is less than AC, AC must be falling.
• Likewise, if new units cost more than the average, their
production must drive the average up.
• That is, if MC is greater than AC, AC must be rising.
• Therefore, the MC crosses the AC at its minimum point (point z
in Figure 3.4).
• Since all marginal costs are variable, the same relationship
holds between MC and AVC
 UNIT 6 ANALYSIS OF MARKET STRUCTURE

• AIMS AND OBJECTIVES

• The purpose of the unit is to explain the meaning, elements and
different forms of markets and the determination of price of a product
under different periods, such as short run and long run.
•  
• After this unit, you will be able to;
• define the market
• list the elements of the markets
• classify the market on the basis of, area, time and nature of competition,
• determine the pice under different time periods, namely short run and
long run, and
• distinguish perfect competition from imperfect competition.
 MEANING OF THE MARKET
• The term ‘market’ is and elusive concept. The
word is generally used to describe the process
of exchange.
• The process of exchange always involves
certain elements such as goods or service,
buyers, place and time.
 ELEMENT OF MARKET
 

• Some element of markets are

• (1) there must be a commodity which is to be
dealt with
• (2) there must be buyer and sellers,
• (3) there must be a place, be it a certain
province, a country or the entire world, where
the process of exchange takes place
• (4) there must be intercourse between buyers
and sellers.
 CLASSIFICATION OF MARKET
• We may classify markets into three categories
according to factors such as area, time and nature of
competition
• On the Basis of Area
• Markets may be categorized on the basis of area they
may be further classified into
• (a) Local markets: certain commodities, which are
perishable and which are cheap have local markets.
For example, milk, fish and vegetables usually have
local markets.
• (b) National markets: there are some goods which have
national market.
• For example certain varieties of cloth, say “ Yager Lebes”
(i,e, locally made national cloth), have national market.
• There may not be a market for “Yager Lebes” in other
nations for their mode of dress is different.
• They may not wear “Yager lebes”.Similarly “Tella “ and
“Tej”, a national drink of Ethiopia, has national market.
• (c ) International markets: there are certain
commodities the transactions of which are carried on
through the world.
• For example, gold, steel, wool and tea etc..
 On the Basis of Time
 

• Markets may be classified on the basis to time.

We further classify these markets into:
• Very short period market
• Short period market
• Long period of secular markets which cover a
generation
 On the Basis of Nature of Competition
• On the basis of nature of competition, markets are classified into
two as those with perfect and imperfect competition. We shall
discuss them briefly here. They will be dealt with in detail later.

• Perfect competition:
• There are huge numbers of buyers and sellers in the market.
• Buyers and sellers are aware of the prices at which transactions
take place.
• For a commodity the same price prevails uniformly throughout
the market.
• No individual seller or buyer can influence the price in the market.
• In other words a perfect market is a market in which a firm is a
“price taker”.
• The same price of a commodity rules throughout the market.
• Imperfect competition: A market is said to be imperfect
when the buyer or seller or both are not aware of the offers
being made by others.

• Naturally, therefore, different prices come to prevail for the

same commodity at the same time in an imperfect market.

• Imperfect market is a market in which a firm is a ”price

maker”.

• In the real world, however, we cannot find a perfect

market. Especially, in this dynamic world imperfect market
is widely practiced.
 CONDITIONS FOR THE EXISTENCE OF PERFECT
MARKET
• perfect market (or perfectly competitive market) is one
type of market classified on the basis of nature of
competition.
• It is a market structure characterized by a complete
absence of rivalry among the individual firms.
• Thus perfect competition in economic theory has a
meaning diametrically opposite to the everyday use of
this term.
• In practice businessmen use the word competition as
synonymous to rivalry.
• In theory, perfect competition implies no rivalry among
firms.
 Market Structures
• Market structure refers to the number and characteristics of
the firms in it.
• Many industries or markets are dominated by a few firms
where as other contains many sellers.
• In some markets, products are homogeneous.
• In other markets, products are heterogeneous.
• Determinants of market structure include:
 Freedom of entry and exit,
 Nature of the product, homogenous (identical) or
differentiate,
 Control over supply/output,
 Control over price and
 Barriers to entry.
• The four categories of market structures are
 Perfect or pure competition,
 Monopoly ,
 Oligopoly , and
 Monopolistic competition.
• The market structure in which a firm produces and sells its
product is defined by five characteristics:
 Number of firms
 Type of product
 Price control
 Conditions of entry
 Non-price competition
 Pure Competition/Perfect Competition
• A market is said to be perfectly competitive when the
following assumptions are fulfilled.
• 1. Large number of sellers and buyers.
• The number of buyers and sellers under perfect market
are very large.
• When there are large number of sellers and buyers,
each contributing only an insignificant portion to the
total volume of goods sold and bought,
• It is difficult for any one seller or buyer or even a group
of sellers or buyers to affect the price.
• Thus each seller is a “ price taker”.
• 2. Product homogeneity:
• The product offered for sale by all sellers must be
homogenous.
• The goods offered for sale are perfect substitutes for one
another from buyers’ point of view.
• Thus, no advertising to differentiate between the products
of various sellers.
• From this condition of homogeneity of the product, it
follows that if a seller raises his price slightly above the
current level, he will lose all his customers to the other
sellers.
• Every seller under perfect competition will be content to
accept the prevailing price in the market
• 3. Free entry and exit of firms  
• The third requirement of perfect competition, implied in
the first condition itself, is that there should be absolute
freedom for firms to get in (enter) or get out (exit) of the
industry.
• Each firm is small in size, and produces only a small portion
of the total out put.
• New firms will be attracted to the industry if high profits
are earned, and some of the existing firms might leave the
industry if they continue to incur losses.
• 4. Profit Maximization
• Fourthly, each seller is aimed at maximizing profits.
• The ultimate goal is possible profit. No other goals are
pursued.
• 5. No government regulation
• The fifth requirement of perfect competition is that there is
no government intervention in the market.
• The government can not manage the activities (operations )
of the firm. 
• 6. No collusion among buyers and sellers
• The sixth condition of perfect competition is that buyers do
not gang up on sellers to force them to sell at a lower price.
• And sellers do not gang up on buyer to force them to buy at
highest price.
• 7. Perfect mobility or free movement of resources
• The factors of production are free to move from one firm to
another through out the economy.
• There is no restriction of employment and investment.
• Resources are free to move geographically from one job to
another, from low-to high paying industry, which implies
that skills can be learned easily.
• 8. Perfect knowledge
• Finally, it is assumed that all sellers and buyers have
complete knowledge of the conditions of the market.
• Buyers and sellers possess complete information
(knowledge) about the prices at which goods are being
bought and sold.
• 9. Non-price competition: In a perfectly competitive
market, non-price competition does not exist.
• Firms are content with the market price and quantities
offered.
• For market to be called perfectly competitive it must
meet some stringent conditions
1. both buyers and sellers are price taker
2. the number of firms is large
3.the are no barriers to entry
4. firms products are identical
5.there is complete information
6. selling firms are profit maximizing
entrepreneurial firms
 The Demand for a Perfectly Competitive
Firm
• The demand for a perfectly competitive firm has
little to do with prices.
• Because a company accepts the market price, the
demand for its products varies in quantities at
one price (the market price).
• The perfectly competitive firm has what is called
a perfectly elastic demand.
• The firm cannot obtain a higher profit by raising
its price or restricting its output.
• Firms obviously look at profits and if profits are being
made in an industry then resources are moved to that
industry.
• When a significant number of firms enter into a market,
the effect is to shift the market supply curve to the right.
• This brings about a decrease in the market price.
• Figure 6.1 shows that with the entry of a significant
number of new firms into the industry the effect is to
shift the firm’s demand curve downward.
• This means that firms are now decreasing their selling
prices to compete.
• This process will continue as long as there are profits
 Price Price

D S

S1

D
D1

Quantity Quantity Quantity

The Market Demand Curve Individual Firms Demand Curve

 Revenues for a Perfectly Competitive Firm
• For a perfectly competitive firm, its revenue
schedule is exactly the same as its demand
schedule (the demand curve is the same as the
revenue curve).
• The total revenue is calculated by multiplying
price by quantity.
• the following figure illustrates the revenue and
demand schedules
 Revenue and Demand schedules
Demand Schedule For Firm Revenue Schedule For Firm

Price Quantity Demanded Total Revenue Marginal Revenue

200 0 0

200 1 200 200

200 2 400 200

200 3 600 200

200 4 800 200

 SHORT RUN EQUILIBRIUM OF THE FIRM
• The firm is in equilibrium when it maximizes its profits,
defined as the difference between total cost (TC) and total
revenue (TR).
• That is total profit = TR-TC. The equilibrium of the firm may
be shown graphically in two ways.
• Either by using the TR and TC curves (called total
approach), or
• The marginal revenue (MR) and marginal cost (MC) curves
(called marginal approach).
• Here MR is the change in TR for a one-unit change in the
quality sold.
 • Total Approach
• Total profits equal total revenue (TR) minus total cost (TC).
•
• Thus, total profits are maximized when the positive
difference between TR and TC is greatest.

• The equilibrium out put of the firm is the output at which

total profits are maximized

• This can be explained with the help of the following table.

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

• So the table reveals to us the fact that total profit are maximized
( at birr 1690) when the firm produces and sells 60 units of the
commodity per time period.
• Marginal Approach
• In general, it is more useful to analyze the short run
equilibrium of the firm with the marginal revenue –
marginal cost approach.
• Marginal revenue (MR) is the change in TR for a one unit
change in the quantity sold.
• Thus, MR equals the slope of the TR curve.
• Since in perfect competition, p is constant for the firm, MR
equals p.
• The marginal approach tells us that the perfectly
competitive firm maximizes its short-run totals profits at
the out put level, when MR or p equals marginal cost (MC)
and MC is rising.
(1) (2) (3) (4) (6)
Output (Q) Price=MR MC (in Birr) AC Total Profits (in Birr)

100 8 12.00 20.00 -1200

200 8 3.00 11.50 -700

300 8 1.00 8.00 0

400 8 1.25 6.31 +676

500 8 2.50 5.55 +1225

600 8 4.25 5.33 +1602

650 8 (8.00) 5.40 +1690

700 8 8.00 5.71 +1603

800 8 24.00 8.00 0

 Profit maximisation under PC
• Remember that profit ∏=TR-TC
• Profit is maximal (loss is minimal) when the change in profit
caused by producing an additional unit of output is zero
∆∏/∆Q=0
→ ∆TR/∆Q - ∆TC/∆Q=0
→ MR-MC=0
→ MR=MC or P=MC
• Profit is maximal (loss is minimal) when the cost of producing
an additional unit of output is equal to the revenue one
receives for that unit (the market price)
• The level of profits/losses can be determined by multiplying
the difference between AR and AC with the output produced
Short-run equilibrium
 In the long run...
• However, in the long run there can be no
sustained profit or loss for firms operating in a
perfectly competitive market environment
• Why?: As long as firms are making a profit, other
firms will be tempted to enter (remember there is
free entry!) and steal some of this profit. This will
drive prices towards a level were profit is zero!
• Equally, loss-making firms will quit the market
driving the price upward...
Long-run equilibrium
 SHORT RUN PROFIT OR LOSS?

• If, at the best, or optimum, level of output,

price (p) exceeds average cost (AC) the firm is
maximizing total profits;
• if p is less than AC but greater that AVC, the
firm is minimizing total losses;
• if p is less that AVC, the firm minimizes its
total losses by shutting down.
 Monopoly
• Pure monopoly is the form of market organization in
which there is a single seller of a commodity for
which there are no close substitutes
• A firm is a monopoly if it is the sole seller of its
product and if its product does not have close
substitutes.
• The fundamental cause of monopoly is barriers to
entry:
• A monopoly remains the only seller in its market
because other firms cannot enter the market and
compete with it
• Lets see how a monopoly fits into the market
structure
• Number of firms: There is only one firm in a
monopoly. The monopolist is the market and has
no available substitutes or competitors. The firm is
the single supplier of the product.
• Type of product: The type of product a monopolist
sells is original and unique.
• There are no close substitutes, and if consumers do
not buy the product, they are choosing to do
without it completely.
• Price control: Monopolists are price makers.
• This means that they set and control their prices
for their good or service.
• They also control the quantity supplied in the
market.
• The demand curve still slopes downward for a
monopolist; however, it has the freedom to
manipulate the curve by changing quantities.
• The sources of barriers to entry or monopoly
power include:
• 1. Costs of production
• 2. Product differentiation, brand loyalty and
advertising
• 3. Ownership/control of key factors:
• 4. Legal protection:
• 5. Aggressive tactics
• 6. Tariffs and transport costs:
 Profit Maximization for Monopoly
• The profit-maximizing or best level of output for the
monopolist is the output at which MR = MC
• Depending on the level of AC at this output, the
monopolist can have profits, break even, or minimize
the short-run total losses.
• Profit maximizing level for Monopoly is when
• MR = MC
• As long as MR > MC, the monopolist will expand output
and sales because doing so adds more to TR than to TC
(and profits rise).
• The opposite is true when MR < MC. Thus total profits
are maximized where MR = MC.
• Profit is maximal (loss is minimal) when the change in
profit caused by producing an additional unit of
output is zero
∆∏/∆Q=0
→ MR=MC
• Profit is maximal (loss is minimal) when the cost of
producing an additional unit of output is equal to the
revenue one receives for that extra unit
• The level of profits/losses can be determined by
multiplying the difference between AR and AC with
the output produced
• Since there is no free entry to the market it is possible that the monopolist can
sustain its non-zero profits!
 Price Discrimination
• Until now we have considered a single-price
monopolist.
• An interesting proposition about monopolies is their
ability to charge different prices for the same product
for reasons other than costs.
• A monopolist can increase total revenue (TR) and
profits at a given level of output and total cost (TC) by
practicing price discrimination.
• This involves charging different prices for the
commodity for different quantities purchased, to
different classes of consumers, or in different markets.
• Price discrimination can take place only when
certain conditions are met:
• A monopolist has to have power: The seller must
have outright monopoly power or, at the very least,
possess an original product or idea to be able to
control output and price.
• Separation of market must be attainable: The
monopolist must be able to sway buyers into
becoming dependent on its product.
• Redistribution of product must be forbidden: When
buyers purchase the product from a monopolist, they
must not be able to resell the product or service.
 Monopolistic Competition
• In monopolistic competition there are many
firms selling a differentiated product or service.
• It is a blend of competition and monopoly.
• The competitive elements result from the large
number of firms and the easy entry.
• The monopoly element results from
differentiated (i.e., similar but not identical)
products or services.
• Product differentiation may be real or imaginary
and can be created through advertising.
• However, the availability of close substitutes
severely limits the “monopoly” power of each
firm
• Number of Sellers These firms have small market
shares that allow them to fluctuate in product
variety.
• While collusion is unlikely, firms are forced to
compete using price and non-price methods.
• Type of Product Monopolistically competitive
firms can produce products with slightly different
physical features
• Because there is differentiation in products for firms in a
monopolistically competitive firm, as a result there is
some control over their prices
• Despite the large number of firms present, the fact that
these firms act independently of one another allows
them to set output quantities and pricing.
• Entry and Exit of Market Entry for a monopolistically
competitive firm is fairly easy because firms in this
market are relatively small.
• However, it is a little tougher to enter the market
because of product differentiation and product
information
• Basic Points
• Remember these basic points:
• Firms have some price control, which results in
their ability to set prices above marginal cost.
• The short run yields profits for a monopolistically
competitive firm.
• The long run can only yield “normal profit.”
• The demand facing this type of firm is very elastic
because of the existence of many competitors
with close substitutes.
 Monopolistic Profit Maximization

• The monopolistic competitor faces a demand curve which is

negatively sloped (because of product differentiation) but
highly elastic (because of the availability of close
substitutes).
• The monopolistic competitor’s profit- maximizing or best
level of output is the output at which
• MR = MC, provided P > AVC. At that output, the firm can
make a profit, break even, or minimize losses in the short
run.
• In the long run, firms are either attracted into an industry by
short-run profits or leave it if faced with losses until the
demand curve (d) facing remaining firms is tangent to its AC
curve, and the firm breaks even (P = AC).
 Oligopoly
• Oligopoly is the form of market organization in which
there are few sellers of a product.
• If the product is homogenous, there is a pure oligopoly.
• If the product is differentiated, there is a differentiated
oligopoly.
• Since there are only a few sellers of a product, the
actions of each seller affect others. That is, the firms
are mutually interdependent.
• Pure oligopoly is found in the production of cement,
aluminum, and many other industrial products which
are virtually standardized.
• Examples of differentiated oligopolies are industries
producing automobiles, cigarettes, PCs, and most electrical
appliances, where three or four large firms dominate the
market
• Because of mutual interdependence, if one firm lowered its
price, it could take most of the sales away from the other
firms.
• Other firms are then likely to retaliate and possibly start a
price war.
• As a result, there is a strong compulsion for oligopolists not
to change prices but, rather, to compete on the basis of
quality, product design, customer service, and advertising
 Cartels and Collusions
• Collusion is an informal agreement between firms
to set output and prices with the intention of
controlling the market.
• A cartel is a formal agreement between producers
to set output and prices to control the market and
maximize profits.
• An example of a cartel is the Organization of the
Petroleum Exporting Countries (OPEC).
• Collusion and cartels are illegal in the United
States.