Module No 1

Introduction to
Economics
• Fundamentals of Economics
• Definition and scope of economics
• The nature of the economic problem
• Finite resources and unlimited wants
• Definitions of the factors of production and their rewards, definition of
opportunity cost, the influence of opportunity cost on decision making.
• Microeconomics and Macroeconomics
• The role of markets in allocating resources
• The market system
• Introduction to the price mechanism
• Demand, Supply and Price determination
• Price elasticity of demand and supply (PED)
Basics of Economics
• What are resources?
• What does efficient allocation mean?
• What are human needs?
• What does demand mean?
• What is economics?
• This course will answer these questions and introduce you to the nature of
economics, demand and supply theories, theories of consumer, production, cost,
market structure and fundamental concepts of macroeconomics at large.
Definition of economics
• The word economy comes from the Greek phrase, “one who manages a
household”.
• There is no universally accepted definition of economics.
• This is because different economists defined economics from different
perspectives:
• Wealth definition,
• Welfare definition,
• Scarcity definition, and
• Growth definition
• But, the formal and commonly accepted definition is as follow.
• Economics is a social science which studies about efficient allocation of scarce
resources so as to attain the maximum fulfillment of unlimited human needs.
• As economics is a science of choice, it studies how people choose to use scarce or
limited productive resources (land, labour, equipment, technical knowledge and
the like) to produce various commodities.
• The following statements are derived from the above definition.
• Economics studies about scarce resources;
• It studies about allocation of resources;
• Allocation should be efficient;
• Human needs are unlimited
• The aim (objective) of economics is to study how to satisfy the unlimited human
needs up to the maximum possible degree by allocating the resources efficiently.
The rationales of economics
• There are two fundamental facts that provide the foundation for the field of
economics.
• Human (society‘s) material wants are unlimited.
• Economic resources are limited (scarce).
• The basic economic problem is about scarcity and choice since there are only
limited amount of resources available to produce the unlimited amount of goods
and services we desire.
• Thus, economics is the study of how human beings make choices to use scarce
resources as they seek to satisfy their unlimited wants. Therefore, choice is at the
heart of all decision-making.
• As an individual, family, and nation, we confront difficult choices about how to
use limited resources to meet our needs and wants.
• Economists study how these choices are made in various settings; evaluate the
outcomes in terms of criteria such as efficiency, equity, and stability; and search
for alternative forms of economic organization that might produce higher living
standards or a more desirable distribution of material well-being.
Scope of economics
• The field and scope of economics is expanding rapidly and has come to include a
vast range of topics and issues.
• In the recent past, many new branches of the subject have developed, including
development economics, industrial economics, transport economics, welfare
economics, environmental economics, and so on.
• However, the core of modern economics is formed by its two major branches:
microeconomics and macroeconomics.
• That means economics can be analyzed at micro and macro level.
• Microeconomics is concerned with the economic behavior of individual decision
making units such as households, firms, markets and industries.
• In other words, it deals with how households and firms make decisions and how
they interact in specific markets.
• Macroeconomics is a branch of economics that deals with the effects and
consequences of the aggregate behaviour of all decision making units in a certain
economy.
• In other words, it is an aggregative economics that examines the interrelations
among various aggregates, their determination and the causes of fluctuations in
them.
• It looks at the economy as a whole and discusses about the economy-wide
phenomena.
• Both microeconomics and macroeconomics are complementary to each other.
• That is, macroeconomics cannot be studied in isolation from microeconomics.
Positive and normative analysis
• Is economics a positive science or normative science, or both? What is your
justification?
• Economics can be analyzed from two perspectives: positive economics and
normative economics.
• Positive economics: It is concerned with analysis of facts and attempts to
describe the world as it is.
• It tries to answer the questions what was; what is; or what will be?
• It does not judge a system as good or bad, better or worse.
• Example:
• The current inflation rate in Ethiopia is 12 percent.
• Poverty and unemployment are the biggest problems in Ethiopia.
• The life expectancy at birth in Ethiopia is rising.
• All the above statements are known as positive statements.
• These statements are all concerned with real facts and information.
• Any disagreement on positive statements can be checked by looking in to facts.
• Normative economics: It deals with the questions like, what ought to be?
• Or what the economy should be?
• It evaluates the desirability of alternative outcomes based on one‘s value
judgments about what is good or what is bad.
• In this situation since normative economics is loaded with judgments, what is
good for one may not be the case for the other.
• Normative analysis is a matter of opinion (subjective in nature) which cannot be
proved or rejected with reference to facts.
• Example:
• The poor should pay no taxes.
• There is a need for intervention of government in the economy.
• Females ought to be given job opportunities.
• Any disagreement on a normative statement can be solved by voting.
Inductive and deductive
reasoning in economics
• The fundamental objective of economics, like any science, is the establishment of
valid generalizations (theories) about certain aspects of human behaviour.
• Economic theory provides the basis for economic analysis which uses logical
reasoning. There are two methods of logical reasoning: inductive and deductive.
• Inductive reasoning is a logical method of reaching at a correct general
statement or theory based on several independent and specific correct
statements.
• In short, it is the process of deriving a principle or theory by moving from facts to
theories and from particular to general economic analysis.
• Inductive method involves the following steps.
• Selecting problem for analysis
• Collection, classification, and analysis of data
• Establishing cause and effect relationship between economic phenomena.
• Deductive reasoning is a logical way of arriving at a particular or specific correct
statement starting from a correct general statement.
• In short, it deals with conclusions about economic phenomenon from certain
fundamental assumptions or truths or axioms through a process of logical
arguments.
• The theory may agree or disagree with the real world and we should check the
validity of the theory to facts by moving from general to particular.
• Major steps in the deductive approach include:
• Problem identification
• Specification of the assumptions
• Formulating hypotheses
• Testing the validity of the hypotheses
Scarcity, choice, opportunity
cost and production possibilities
frontier
• Have you ever faced a problem of choice among different alternatives? If yes,
what was your decision?
• What is scarcity? Do you think that it is different from shortage? Why?
• It is often said that the central purpose of economic activity is the production of
goods and services to satisfy consumer’s needs and wants i.e. to meet people’s
need for consumption both as a means of survival and also to meet their ever-
growing demand for an improved lifestyle or standard of living.
• Scarcity
• The fundamental economic problem that any human society faces is the problem
of scarcity.
• Scarcity refers to the fact that all economic resources that a society needs to
produce goods and services are finite or limited in supply.
• But their being limited should be expressed in relation to human wants.
• Thus, the term scarcity reflects the imbalance between our wants and the means
to satisfy those wants.
• Resources
• Free resources: A resource is said to be free if the amount available to a society is
greater than the amount people desire at zero price. e.g. sunshine
• Scarce (economic) resources: A resource is said to be scarce or economic
resource when the amount available to a society is less than what people want to
have at zero price.
• The following are examples of scarce resources.
• All types of human resources: manual, intellectual, skilled and specialized
labor;
• Most natural resources like land (especially, fertile land), minerals, clean
water, forests and wild - animals;
• All types of capital resources (like machines, intermediate goods,
infrastructure ); and
• All types of entrepreneurial resources.
• Economic resources are usually classified into four categories.
• Labour: refers to the physical as well as mental efforts of human beings in the
production and distribution of goods and services. The reward for labour is called
wage.
• Land: refers to the natural resources or all the free gifts of nature usable in the
production of goods and services. The reward for the services of land is known as
rent.
• Capital: refers to all the manufactured inputs that can be used to produce other
goods and services. Example: equipment, machinery, transport and
communication facilities, etc. The reward for the services of capital is called
interest.
• Entrepreneurship: refers to a special type of human talent that helps to organize
and manage other factors of production to produce goods and services and takes
risk of making loses. The reward for entrepreneurship is called profit.
• Entrepreneurs are individuals who:
• Organize factors of production to produce goods and services.
• Make basic business policy decisions.
• Introduce new inventions and technologies into business practice.
• Look for new business opportunities.
• Take risks of making losses.
• Choice
• If resources are scarce, then output will be limited.
• If output is limited, then we cannot satisfy all of our wants. Thus, choice must be
made.
• Due to the problem of scarcity, individuals, firms and government are forced to
choose as to what output to produce, in what quantity, and what output not to
produce.
• In short, scarcity implies choice. Choice, in turn, implies cost.
• That means whenever choice is made, an alternative opportunity is sacrificed.
• This cost is known as opportunity cost.
• Scarcity → limited resource → limited output → we might not satisfy
all our wants →choice involves costs → opportunity cost
• Opportunity cost
• In a world of scarcity, a decision to have more of one thing, at the same time,
means a decision to have less of another thing. The value of the next best
alternative that must be sacrificed is, therefore, the opportunity cost of the
decision.
• Definition: Opportunity cost is the amount or value of the next best alternative
that must be sacrificed (forgone) in order to obtain one more unit of a product.
• For example, suppose the country spends all of its limited resources on the
production of cloth or computer. If a given amount of resources can produce
either one meter of cloth or 20 units of computer, then the cost of one meter of
cloth is the 20 units of computer that must be sacrificed in order to produce a
meter of cloth.
• When we say opportunity cost, we mean that:
• It is measured in goods & services but not in money costs
• It should be in line with the principle of substitution.
The Production Possibilities
Frontier or Curve (PPF/ PPC)
• The production possibilities frontier (PPF) is a curve that shows the various
possible combinations of goods and services that the society can produce given
its resources and technology. To draw the PPF we need the following
assumptions.
• The quantity as well as quality of economic resource available for use during
the year is fixed.
• There are two broad classes of output to be produced over the year.
• The economy is operating at full employment and is achieving full production
(efficiency).
• Technology does not change during the year.
• Some inputs are better adapted to the production of one good than to the
production of the other (specialization).
• Suppose a hypothetical economy produces food and computer given its limited
resources and available technology.

• We can also display the above information with a graph.

• The PPF describes three important concepts:
• The concepts of scarcity: - the society cannot have unlimited amount of outputs
even if it employs all of its resources and utilizes them in the best possible way.
• The concept of choice: - any movement along the curve indicates the change in
choice.
• The concept of opportunity cost: - when the economy produces on the PPF,
production of more of one good requires sacrificing some of another product
which is reflected by the downward sloping PPF.
• Related to the opportunity cost we have a law known as the law of increasing
opportunity cost.
• This law states that as we produce more and more of a product, the opportunity
cost per unit of the additional output increases.
• This makes the shape of the PPF concave to the origin.
• The reason why opportunity cost increases when we produce more of one good
is that economic resources are not completely adaptable to alternative uses
(specialization effect).

• Example: Referring to table 1.1 above, if the economy is initially operating at

point B, what is the opportunity cost of producing one more unit of computer?
• Solution: Moving from production alternative B to C we have:

• The economy gives up 0.2 metric tons of food per computer

Economic Growth and the PPF
• Economic growth or an increase in the total output level occurs when one or both
of the following conditions occur.
• Increase in the quantity or/and quality of economic resources.
• Advances in technology.
• Economic growth is represented by outward shift of the PPF.
• An economy can grow because of an increase in productivity in one sector of the
economy. For example, an improvement in technology applied to either food or
computer would be illustrated by a shift of the PPF along the Y- axis or X-axis. This
is called asymmetric growth (figure 1.3).
Basic economic questions
• Economic problems faced by an economic system due to scarcity of resources are
known as basic economic problems.
• These problems are common to all economic systems.
• They are also known as central problems of an economy.
• Therefore, any human society should answer the following three basic questions.
• What to Produce?
• This problem is also known as the problem of allocation of resources.
• It implies that every economy must decide which goods and in what quantities
are to be produced.
• The economy must make choices such as consumption goods versus capital
goods, civil goods versus military goods, and necessity goods versus luxury goods.
• As economic resources are limited we must reduce the production of one type of
good if we want more of another type.
• Generally, the final choice of any economy is a combination of the various types
of goods but the exact nature of the combination depends upon the specific
circumstances and objectives of the economy.
• How to Produce?
• This problem is also known as the problem of choice of technique.
• Once an economy has reached a decision regarding the types of goods to be
produced, and has determined their respective quantities, the economy must
decide how to produce them - choosing between alternative methods or
techniques of production.
• For example, cotton cloth can be produced with hand looms, power looms, or
automatic looms.
• Similarly, wheat can be grown with primitive tools and manual labour, or with
modern machinery and little labour.
• Broadly speaking, the various techniques of production can be classified into two
groups: labour-intensive techniques and capital-intensive techniques.
• A labour-intensive technique involves the use of more labour relative to capital,
per unit of output.
• A capital-intensive technique involves the use of more capital relative to labour,
per unit of output.
• The choice between different techniques depends on the available supplies of
different factors of production and their relative prices.
• Making good choices is essential for making the best possible use of limited
resources to produce maximum amounts of goods and services.
• For Whom to Produce?
• This problem is also known as the problem of distribution of national product.
• It relates to how a material product is to be distributed among the members of a
society.
• The economy must decide, for example, whether to produce for the benefit of
the few rich people or for the large number of poor people.
• An economy that wants to benefit the maximum number of persons would first
try to produce the necessities of the whole population and then to proceed to
the production of luxury goods.
• All these and other fundamental economic problems center around human needs
and wants.
• Many human efforts in society are directed towards the production of goods and
services to satisfy human needs and wants.
• These human efforts result in economic activities that occur within the
framework of an economic system.
Economic systems
• The way a society tries to answer the above fundamental questions is
summarized by a concept known as economic system.
• An economic system is a set of organizational and institutional arrangements
established to answer the basic economic questions.
• Customarily, we can identify three types of economic system.
• These are capitalism, command and mixed economy.
Capitalist economy
• Capitalism is the oldest formal economic system in the world.
• It became widespread in the middle of the 19th century.
• In this economic system, all means of production are privately owned, and
production takes place at the initiative of individual private entrepreneurs who
work mainly for private profit.
• Government intervention in the economy is minimal.
• This system is also called free market economy or market system or laissez faire.
• Features of Capitalistic Economy
• The right to private property: The right to private property is a fundamental
feature of a capitalist economy. As part of that principle, economic or productive
factors such as land, factories, machinery, mines etc. are under private
ownership.
• Freedom of choice by consumers: Consumers can buy the goods and services
that suit their tastes and preferences. Producers produce goods in accordance
with the wishes of the consumers. This is known as the principle of consumer
sovereignty.
• Profit motive: Entrepreneurs, in their productive activity, are guided by the
motive of profit-making.
• Competition: In a capitalist economy, competition exists among sellers or
producers of similar goods to attract customers. Among buyers, there is
competition to obtain goods. Among workers, the competition is to get jobs.
Among employers, it is to get workers and investment funds.
• Price mechanism: All basic economic problems are solved through the price
mechanism.
• Minor role of government: The government does not interfere in day-to-day
economic activities and confines itself to defense and maintenance of law and
order.
• Self-interest: Each individual is guided by self-interest and motivated by the
desire for economic gain.
• Inequalities of income: There is a wide economic gap between the rich and the
poor.
• Existence of negative externalities: A negative externality is the harm, cost, or
inconvenience suffered by a third party because of actions by others. In
capitalistic economy, decision of firms may result in negative externalities against
another firm or society in general.
• Advantages of Capitalistic Economy
• Flexibility or adaptability: It successfully adapts itself to changing environments.
• Decentralization of economic power: Market mechanisms work as a
decentralizing force against the concentration of economic power.
• Increase in per-capita income and standard of living: Rapid growth in levels of
production and income leads to higher per-capita income and standards of living.
• New types of consumer goods: Varieties of new consumer goods are developed
and produced at large scale.
• Growth of entrepreneurship: Profit motive creates and supports new
entrepreneurial skills and approaches.
• Optimum utilization of productive resources: Full utilization of productive
resources is possible due to innovations and technological progress.
• High rate of capital formation: The right to private property helps in capital
formation.
• Disadvantages of Capitalistic Economy
• Inequality of income: Capitalism promotes economic inequalities and creates
social imbalance.
• Unbalanced economic activity: As there is no check on the economic system, the
economy can develop in an unbalanced way in terms of different geographic
regions and different sections of society.
• Exploitation of labour: In a capitalistic economy, exploitation of labour (for
example by paying low wages) is common.
• Negative externalities: are problems in capitalistic economy where profit
maximization is the main objective of firms. If economic makes sense for a firm to
force others to pay the impacts of negative externalities such as pollution.
Command economy
• Command economy is also known as socialistic economy.
• Under this economic system, the economic institutions that are engaged in
production and distribution are owned and controlled by the state.
• In the recent past, socialism has lost its popularity and most of the socialist
countries are trying free market economies.
• Main Features of Command Economy
• Collective ownership: All means of production are owned by the society as a
whole, and there is no right to private property.
• Central economic planning: Planning for resource allocation is performed by the
controlling authority according to given socio-economic goals.
• Strong government role: Government has complete control over all economic
activities.
• Maximum social welfare: Command economy aims at maximizing social welfare
and does not allow the exploitation of labour.
• Relative equality of incomes: Private property does not exist in a command
economy, the profit motive is absent, and there are no opportunities for
accumulation of wealth. All these factors lead to greater equality in income
distribution, in comparison with capitalism.
• Advantages of Command Economy
• Absence of wasteful competition: There is no place for wasteful use of
productive resources through unhealthy competition.
• Balanced economic growth: Allocation of resources through centralized planning
leads to balanced economic development.
• Different regions and different sectors of the economy can develop equally.
• Elimination of private monopolies and inequalities: Command economies avoid
the major evils of capitalism such as inequality of income and wealth, private
monopolies, and concentration of economic, political and social power.
• Disadvantages of Command Economy
• Absence of automatic price determination: Since all economic activities are
controlled by the government, there is no automatic price mechanism.
• Absence of incentives for hard work and efficiency: The entire system depends
on bureaucrats who are considered inefficient in running businesses.
• There is no financial incentive for hard work and efficiency.
• The economy grows at a relatively slow rate.
• Lack of economic freedom: Economic freedom for consumers, producers,
investors, and employers is totally absent, and all economic powers are
concentrated in the hands of the government.
• Red tapism: it is widely prevalent in a command economy because all decisions
are made by government officials.
Mixed economy
• A mixed economy is an attempt to combine the advantages of both the
capitalistic economy and the command economy.
• It incorporates some of the features of both and allows private and public sectors
to co-exist.
• Main Features of Mixed Economy
• Co-existence of public and private sectors: Public and private sectors co-exist in
this system. Their respective roles and aims are well-defined. Industries of
national and strategic importance, such as heavy and basic industry, defense
production, power generation, etc. are set up in the public sector, whereas
consumer-goods industry and small-scale industry are developed through the
private sector.
• Economic welfare: Economic welfare is the most important criterion of the
success of a mixed economy. The public sector tries to remove regional
imbalances, provides large employment opportunities and seeks economic
welfare through its price policy. Government control over the private sector leads
to economic welfare of society at large.
• Economic planning: The government uses instruments of economic planning to
achieve coordinated rapid economic development, making use of both the
private and the public sector.
• Price mechanism: The price mechanism operates for goods produced in the
private sector, but not for essential commodities and goods produced in the
public sector. Those prices are defined and regulated by the government.
• Economic equality: Private property is allowed, but rules exist to prevent
concentration of wealth. Limits are fixed for owning land and property.
Progressive taxation, concessions and subsides are implemented to achieve
economic equality.
• Advantages of Mixed Economy
• Private property, profit motive and price mechanism: All the advantages of a
capitalistic economy, such as the right to private property, motivation through the
profit motive, and control of economic activity through the price mechanism, are
available in a mixed economy. At the same time, government control ensures that
they do not lead to exploitation.
• Adequate freedom: Mixed economies allow adequate freedom to different
economic units such as consumers, employees, producers, and investors.
• Rapid and planned economic development: Planned economic growth takes
place, resources are properly and efficiently utilized, and fast economic
development takes place because the private and public sector complement each
other.
• Social welfare and fewer economic inequalities: The government’s restricted
control over economic activities helps in achieving social welfare and economic
equality.
• Disadvantages of Mixed Economy
• Ineffectiveness and inefficiency: A mixed economy might not actually have the
usual advantages of either the public sector or the private sector. The public
sector might be inefficient due to lack of incentive and responsibility, and the
private sector might be made ineffective by government regulation and control.
• Economic fluctuations: If the private sector is not properly controlled by the
government, economic fluctuations and unemployment can occur.
• Corruption and black markets: If government policies, rules and directives are
not effectively implemented, the economy can be vulnerable to increased
corruption and black market activities.
Review questions
Part I: Discussion questions
• Define economics from perspective of Wealth, Welfare, Scarcity, and Growth.
Which definition more suits for economics? Why?
• Why we study economics? Have you gained anything from this chapter? Would
you discuss them please?
• Define scarcity, choice and opportunity cost. Can you link them in your day to day
lives?
• What do you understand by positive economics and normative economics?
• Explain why economics deals with allocation and efficient utilization of scarce
resources only?
• In recent years, especially around big cities, there is the problem of air pollution
and the likelihood of poisoning is high. Given this scenario, do you think that air is
free resource? Justify your answer.
• Describe the four categories of economic resources. Which category of resources
you and your family owned?
• What is a production possibility curve?
• Discuss the economic system in Ethiopia over the recent three regimes (EPRDF,
Derg and imperial regime)
• What are the central problems of an economy? Discuss them in detail.
• Part II: Work out items
• Assume that a certain simplified economy produces only two goods, X and Y, with
given resources and technology. The following table gives the various possible
combinations of the production of the two goods (all units are measured in
millions of tons).

• a) Calculate the opportunity cost of the production of good X at each point. What
law does the trend in those values exhibit?
• b) What changes are required for this economy to shift the PPF outward?
Theory of Demand and Supply
• In this topic we will forward our exploration and understanding of the vast field of
economics by focusing on two very powerful tools, namely, theory of demand
and theory of supply.
• The purpose of this chapter is to explain what demand and supply are and show
how they determine equilibrium price and quantity.
• We will also show how the concepts of demand and supply reveal consumers’
and producers’ sensitivity to price change.
• After covering this topic, you will be able to:
• understand the concept of demand and the factors affecting it;
• explain the supply side of a market and the determinants of supply;
• understand how the market reaches equilibrium condition, and the possible
factors that could cause a change in equilibrium and
• explain the elasticity of demand and supply
Theory of demand
• Are demand and want similar? Why?
• Why can’t we purchase all that we need or we desire to have?
• Can we say that, with a decrease in the price of a commodity, a consumer
normally buys more of it? Why?
• Explain why demand curves always slope downwards from left to right. Are there
any exceptions to this?
• Demand is one of the forces determining prices. The theory of demand is related
to the economic activities of consumers-consumption.
• Hence, the purpose of the theory of demand is to determine the various factors
that affect demand.
• In our day-to-day life we use the word “demand” in a loose sense to mean a
desire of a person to purchase a commodity or service.
• But in economics it has a specific meaning, which is different from what we use it
in our day to day activities.
• Demand implies more than a mere desire to purchase a commodity.
• It states that the consumer must be willing and able to purchase the commodity,
which he/she desires.
• His/her desire should be backed by his/her purchasing power. A poor person is
willing to buy a car; it has no significance, since he/she has no ability to pay for it.
• On the other hand, if his/her desire to buy the car is backed by the purchasing
power then this constitutes demand.
• Demand, thus, means the desire of the consumer for a commodity backed by
purchasing power.
• These two factors are essential.
• If a consumer is willing to buy but is not able to pay, his/her desire will not
become demand.
• Similarly, if the consumer has the ability to pay but is not willing to pay, his/her
desire will not be called demand.
• More specifically, demand refers to various quantities of a commodity or service
that a consumer would purchase at a given time in a market at various prices,
given other things unchanged (ceteris paribus).
• The quantity demanded of a particular commodity depends on the price of that
commodity.
• Law of demand: This is the principle of demand, which states that , price of a
commodity and its quantity demanded are inversely related i.e., as price of a
commodity increases (decreases) quantity demanded for that commodity
decreases (increases), ceteris paribus.
Demand schedule (table),
demand curve and demand
function
• The relationship that exists between price and the amount of a commodity
purchased can be represented by a table (schedule) or a curve or an equation.
• Demand schedule can be constructed for any commodity if the list of prices and
quantities purchased at those prices are known. An individual demand schedule
is a list of the various quantities of a commodity, which an individual consumer
purchases at various levels of prices in the market. A demand schedule states the
relationship between price and quantity demanded in a table form.
• Demand curve is a graphical representation of the relationship between different
quantities of a commodity demanded by an individual at different prices per time
period.
• In the above diagram prices of oranges are given on ‘OY’ axis and quantity
demanded on ‘OX’ axis.
• For example, when the price per kilogram is birr 1 the quantity demanded is 13
kilograms.
• From the above figure you may notice that as the price declines quantity
demanded increases and vice-versa.
• Demand function is a mathematical relationship between price and quantity
demanded, all other things remaining the same. A typical demand function is
given by:
• Qd = f(P) where Qd is quantity demanded and P is price of the commodity, in our
case price of orange.
• Example: Let the demand function be Q = a+ bP
• (e.g. moving from point A to B on figure 2.1 above)
• = -2 where b is the slope of the demand curve
• Q = a-2P to find a, substitute price either at point A or B.
• 7= a - 2(4), a = 15
• Therefore, Q = 15 - 2P is the demand function for orange in the above numerical
example.
• Market Demand: The market demand schedule, curve or function is derived by
horizontally adding the quantity demanded for the product by all buyers at each
price.
Determinants of demand
• The demand for a product is influenced by many factors. Some of these factors
are:
• Price of the product
• Taste or preference of consumers
• Income of the consumers
• Price of related goods
• Consumers expectation of income and price
• Number of buyers in the market
• When we state the law of demand, we kept all the factors to remain constant
except the price of the good.
• A change in any of the above listed factors except the price of the good will
change the demand, while a change in the price, other factors remain constant
will bring change in quantity demanded.
• A change in demand will shift the demand curve from its original location.
• For this reason those factors listed above other than price are called demand
shifters. A change in own price is only a movement along the same demand
curve.
• Changes in demand: a change in any determinant of demand—except for the
good’s price causes the demand curve to shift.
• We call this a change in demand.
• If buyers choose to purchase more at any price, the demand curve shifts
rightward—an increase in demand.
• If buyers choose to purchase less at any price, the demand curve shifts leftward—
a decrease in demand.
Elasticity of demand
• In economics, the concept of elasticity is very crucial and is used to analyze the
quantitative relationship between price and quantity purchased or sold.
• Elasticity is a measure of responsiveness of a dependent variable to changes in an
independent variable.
• Accordingly, we have the concepts of elasticity of demand and elasticity of supply.
• Elasticity of demand refers to the degree of responsiveness of quantity
demanded of a good to a change in its price, or change in income, or change in
prices of related goods.
• Commonly, there are three kinds of demand elasticity: price elasticity, income
elasticity, and cross elasticity.
• Price Elasticity of Demand
• Price elasticity of demand means degree of responsiveness of demand to change
in price. It indicates how consumers react to changes in price. The greater the
reaction the greater will be the elasticity, and the lesser the reaction, the smaller
will be the elasticity.
• Price elasticity of demand is a measure of how much the quantity demanded of a
good responds to a change in the price of that good, computed as the percentage
change in quantity demanded divided by the percentage change in price.
• Demand for commodities like clothes, fruit etc. changes when there is even a
small change in their price, whereas demand for commodities which are basic
necessities of life, like salt, food grains etc., may not change even if price changes,
or it may change, but not in proportion to the change in price.
• Price elasticity demand can be measured in two ways. These are point and arc
elasticity.
• Point Price Elasticity of Demand This is calculated to find elasticity at a given
point.
• The price elasticity of demand can be determined by the following formula.
• In this method, we take a straight-line demand curve joining the two axes, and
measure the elasticity between two points Qo and Q1 which are assumed to be
intimately close to each other.
• On a straight-line demand curve we can make use of this formula to find out the
price elasticity at any particular point.
• We can find out numerical elasticities also on different points of the demand
curve with the help of the above formula.
• It should be remembered that the point elasticity of demand on a straight line is
different at every point.
• Arc price elasticity of demand
• The main drawback of the point elasticity method is that it is applicable only
when we have information about even the slight changes in the price and the
quantity demanded of the commodity.
• But in practice, we do not acquire such information about minute changes. We
may possess demand schedules in which there are big gaps in price as well as the
quantity demanded.
• In such cases, there is an alternative method known as arc method of elasticity
measurement.
• In arc price elasticity of demand, the midpoints of the old and the new values of
both price and quantity demanded are used.
• It measures a portion or a segment of the demand curve between the two points.
• An arc is a portion of a curve line, hence, a portion or segment of a demand
curve.
Determinants of price Elasticity
of Demand
• The following factors make price elasticity of demand elastic or inelastic other
than changes in the price of the product.
• The availability of substitutes: the more substitutes available for a product, the
more elastic will be the price elasticity of demand.
• Time: In the long- run, price elasticity of demand tends to be elastic. Because:
• More substitute goods could be produced.
• People tend to adjust their consumption pattern.
• The proportion of income consumers spend for a product:-the smaller the
proportion of income spent for a good, the less price elastic will be.
• The importance of the commodity in the consumers’ budget :
• Luxury goods → tend to be more elastic, example: gold.
• Necessity goods → tend to be less elastic example: Salt.
• Income Elasticity of Demand
• Cross price Elasticity of Demand
Theory of supply
• Supply indicates various quantities of a product that sellers (producers) are
willing and able to provide at different prices in a given period of time, other
things remaining unchanged.
• The law of supply: states that, ceteris paribus, as price of a product increase,
quantity supplied of the product increases, and as price decreases, quantity
supplied decreases. It tells us there is a positive relationship between price and
quantity supplied.
Supply schedule, supply curve
and supply function
• A supply schedule is a tabular statement that states the different
quantities of a commodity offered for sale at different prices.
• A supply curve conveys the same information as a supply schedule. But it shows
the information graphically rather than in a tabular form.
• The supply of a commodity can be briefly expressed in the following functional
relationship:
• S = f(P), where S is quantity supplied and P is price of the commodity.
• Market supply: It is derived by horizontally adding the quantity supplied of the
product by all sellers at each price.
• Determinants of supply
• Apart from the change in price which causes a change in quantity demanded, the
supply of a particular product is determined by:
• price of inputs ( cost of inputs)
• technology
• prices of related goods
• sellers‘ expectation of price of the product
• taxes & subsidies
• number of sellers in the market
• weather, etc.
• Effect of change in input price on supply of a product
• An increase in the price of inputs such as labour, raw materials, capital, etc causes
a decrease in the supply of the product which is represented by a leftward shift of
the supply curve.
• Likewise, a decrease in input price causes an increase in supply.
• Effect of change in Technology
• Technological advancement enables a firm to produce and supply more in the
market. This shifts the supply curve outward.
• Effect of change in weather condition
• A change in weather condition will have an impact on the supply of a number of
products, especially agricultural products. For example, other things remain
unchanged, good weather condition boosts the supply of agricultural products.
This shifts the supply curve of a given agricultural product outward. Bad weather
condition will have the opposite impact.
Elasticity of supply
• It is the degree of responsiveness of the supply to change in price. It may be
defined as the percentage change in quantity supplied divided by the percentage
change in price.
• As the case with price elasticity of demand, we can measure the price elasticity of
supply using point and arc elasticity methods.
• However, a simple and most commonly used method is point method.
• The point price elasticity of supply can be calculated as the ratio of proportionate
change in quantity supplied of a commodity to a given proportionate change in
its price.
• Thus, the formula for measuring price elasticity of supply is:

• Like elasticity of demand, price elasticity of supply can be elastic, inelastic, unitary
elastic, perfectly elastic or perfectly inelastic.
• The supply is elastic when a small change on price leads to great change in
supply.
• It is inelastic or less elastic when a great change in price induces only a slight
change in supply.
• If the supply is perfectly inelastic, it will be represented by a vertical line shown as
below.
• If supply is perfectly elastic it will be represented by a horizontal straight line as in
second diagram.
Market equilibrium
• Having seen the demand and supply side of the market, now let‘s bring demand
and supply together so as to see how the market price of a product is
determined.
• Market equilibrium occurs when market demand equals market supply.
• In the above graph, any price greater than P will lead to market surplus.
• As the price of the commodity increases, consumers demand less of the product.
• On the other hand, as the price of increases, producers supply more of the good.
• Therefore, if price increases to P1 the market will have a surplus of HJ.
• If the price decreases to P2 buyers demand to buy more and suppliers prefer to
decrease their supply leading to shortage in the market which is equal to GF.
Effects of shift in demand and
supply on equilibrium
• Given demand and supply the equilibrium price and quantity are stable.
• However, when these market forces change what will happen to the equilibrium
price and quantity?
• Changes in demand and supply bring about changes in the equilibrium price level
and the equilibrium quantity.
• when demand changes and supply remains constant
• Factors such as changes in income, tastes, and prices of related goods will lead to
a change in demand.
• The figure below shows the effects of a change in demand and the resultant
equilibrium price and quantity.
• DD is the demand curve and SS is the supply curve.
• DD and SS curves intersect at point E and the quantity demanded and supplied is
OM at OP equilibrium price.
• Given the supply, if the demand increases the demand curve will shift upward to
the right.
• Due to a change in demand, the demand curve D1D1 intersects SS supply curve at
point E1.
• The equilibrium price increases from OP to OP1 and the equilibrium quantity from
OM to OM1.
• On the other hand, if demand falls, the demand curve shifts downwards to the
left.
• Due to a change in demand, the curve D2D2 intersects the supply curve SS at point
E2.
• The equilibrium price decreases from OP to OP2 and the equilibrium quantity
decreases from OM to OM2.
• Supply being given, a decrease in demand reduces both the equilibrium price and
the quantity and vice versa.
• When supply changes and demand remains constant
• Changes in supply are brought by changes in technical knowledge and factor
prices. The following graph explains the effects of changes in supply.
• SS and DD intersect at point E, where supply and demand are equal at OM
quantity at OP equilibrium price.
• Given the demand, if the supply increases, the supply curve shifts to the right
(S1S1).
• The new supply curve, which intersects DD curve at E1, reduces the equilibrium
price from OP to OP1 and increases the equilibrium quantity from OM to OM1.
• On the contrary, when the supply falls, the supply curve moves to the left (S 2S2)
and intersects the DD curve at point E2 raising the equilibrium price from OP to
OP2 and reducing the equilibrium quantity from OM to OM2.
Effects of combined changes in
demand and supply
• When both demand and supply increase, the quantity of the product will increase
definitely.
• But it is not certain whether the price will rise or fall.
• If an increase in demand is more than an increase in supply, then the price goes
up.
• On the other hand, if an increase in supply is more than an increase in demand,
the price falls but the quantity increases.
• If the increase in demand and supply is same, then the price remains the same.
• When demand and supply decline, the quantity decreases.
• But the change in price will depend upon the relative fall in demand and supply.
• When the fall in demand is more than the fall in supply, the price will decrease.
• On the other hand, when the fall in supply is more than the fall in demand, the
price will rise.
• If both demand and supply decline in the same ratio, there is no change in the
equilibrium price, but the quantity decreases.
Review questions
• Distinguish between the following:
• Normal goods and inferior goods
• Complementary goods and substitute goods
• Market demand and individual demand
• Individual supply and market supply
• Excess demand and excess supply
• 1. Why does the quantity of salt demanded tend to be unresponsive to changes
in its price?
• 2. Why is the quantity of education demanded in private universities much more
responsive than salt is to changes in price?
• 3. To get the market demand curve for a product, why do we add individual
demand curves horizontally rather than vertically?
• 4. The market for lemon has 10 potential consumers, each having an individual
demand curve P = 101 - 10Qi, where P is price in dollars per cup and Qi is the
number of cups demanded per week by the ith consumer. Find the market
demand curve using algebra. Draw an individual demand curve and the market
demand curve. What is the quantity demanded by each consumer and in the
market as a whole when lemon is priced at P = $1/cup?
• 5. The demand for tickets to an Ethiopian Camparada film is given by D(p)=
200,000 - 10,000 p, where p is the price of tickets. If the price of tickets is 12 birr,
calculate price elasticity of demand for tickets and draw the demand curve.
• 6. Given market demand Qd = 50 - P, and market supply P = Qs + 5
• Find the market equilibrium price and quantity?
• What would be the state of the market if market price was fixed at Birr 25 per
unit? (Birr is the official currency of Ethiopia. It is abbreviated as ETB and is
issued by the National Bank of Ethiopia.)
• Calculate and interpret price elasticity of demand at the equilibrium point.