CHAPTER ONE

INTRODUCTION TO ECONOMIC ANALYSIS

Contents
1.1. Introduction
1.2. Some Basic Definitions
1.3. Opportunity Cost
1.4. Microeconomics Vs Macroeconomics
1.5. Positive Vs Normative Analysis
1.6. Deductive Vs Inductive Method
1.7. Rational Behavior
1.8. Marginal Analysis of Rational Behavior

1.0 Aims and Objectives

This unit aims at providing the various methods of economic systems.
After reading this unit, you should be able to:
 Define what economics is.
 identify the concepts of scarcity and opportunity cost.
 Discuss major branches of economics inquiry: microeconomics, macroeconomics,
positive analysis, and normative analysis.

1.1 Introduction
Dear student! The course microeconomics contains the prime principles that economics
must lay up on. In this unit, the writer has made efforts to explain the basics of
microeconomics. Economics is more or less taken as a science because it depends on the
collection of real data, detail analysis of problems under consideration, and solving of
problem with the help of its basic principles. Those things make economics partially a
science send its roots deeper into quantitative analysis of prevailing problems by comparing
it to the past. So Microeconomics enables you to acquire the brief understanding of such
concepts at the firm and/or household level.

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1.2. Some Basic Definitions
Before defining economics, we need to know what constitutes the economy. The economy is
the mechanism through which the use of labor, land structure, vehicles, equipment, and
natural resources are organized to satisfy the desires of those who live in the society. The
rules, institutions, and traditions used to coordinate economic activity differ considerably
among nations, but all societies must deal with similar economic issues.

The discipline of economics is concerned with the use of available productive resources in a
society to satisfy what often are conflicting desires and demands. In economics, we are
concerned with choice: with evaluating and selecting among alternatives, realizing that each
time we make a choice, we also forgo an opportunity. One goal of this book is to help you to
develop an understanding of the issues of scarcity and choice within the context of the way
modern economies function. The economy is a dynamic, constantly changing mechanism.
Natural resources, the supply of workers, managers, innovators, equipment, structures, and
the amount of technical know-how available to produce useful goods and services are all in
some way limited. The wants we seek to satisfy, however, seem unlimited. We all have
biological needs for minimum amount of foods, clothing, and other basic goods, but few of
us are content with minimum amount of these items. We want amenities, comfort, and
luxuries.

Scarcity is the imbalance between our desires and the means of satisfying those desires. The
problem of scarcity is faced by rich as well as poor societies. We can probably agree that
even the vast wealth of the United States is inadequate to satisfy all of our desires. Scarcity is
the fundamental economic problem. The importance of scarcity as a unifying topic in
economics is highlighted by the fact that many economists would define their discipline in
the following way:

Economics is the study of how human beings make choices to use scarce resources as they
seek to satisfy their seemingly unlimited wants.

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1.3. Opportunity Cost
When scarcity exists, we know we must sacrifice something of value to obtain more of any
scarce good or service. The limited availability of resources such as land, skilled labor,
structures, and equipment with in a nation over a year mean that the more resources are used
for one purpose, the less there will be available for other purposes. The opportunity cost of
choosing to use resources for one purpose is the sacrifices of the next best alternative for the
use of those resources. For example, if your next best alternative to studying for an hour is an
hour of swimming, then the opportunity cost of studying is the hour of swimming that you
sacrifice when you choose to study. If you are considering the choice between a bicycle and
a new speakers for your stereo and each costs Br.200, then the opportunity cost of choosing
to buy the bike is the speaker, and vice versa.

Concept Check
1. What constitutes the economy?
2. What is the discipline of economics?
3. Define scarcity and opportunity cost, and explain the opportunity cost of your
decision to attend college.

1.4. Microeconomics Vs Macroeconomics

Economic analysis is divided into two main branches: microeconomics and macroeconomics.

In microeconomics, we take a close-up view of the economy by concentrating on the choices

made by individual participants in the economy such as consumers, workers, business
managers, and investors.

In macroeconomics, we look at the economy from a broader perspective by considering its

overall performance and the way various sectors of the economy relate to one another. We
gauge the performance of the economy by the total value of annual production, the capacity
of the economy to provide jobs, the changes in purchasing power of money, and the growth
of employment and output.

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Microeconomics
In microeconomics, we analyze how individuals choose among various courses of action by
weighing the benefits and costs of alternatives available to them. In microeconomics
analysis, we place special emphasis on the role of prices in business and personal decisions.
A major goal is to understand how the prices of particular goods and services are determined
and how prices influence decisions. Because of its preoccupation with prices and trading of
goods and services, microeconomics is sometimes called price theory.

In microeconomics, we study the actions of individuals as they buy and sell in market
transactions. As you know, some services such as education and police protection are
provided by government agencies rather than being sold in markets. What are the advantages
and disadvantages of alternatives to markets as a means of accomplishing the basic tasks of
the economy? What role does government play in the economy? How do political choices
influence the functions and performances of the economy? We will examine each of these
important questions as we learn to look at the economy from the micro perspective. You will
find that microeconomic analysis provides a useful point of view about human behavior that
will give you insight into important social and political issues.

Macroeconomics
In macroeconomics, we study changes in total national production and constitution, average
of the prices of broad groups of goods and services, and employment of workers in the
economy. Macroeconomics seeks to explain the causes of economic fluctuations and to
suggest policies that will make the fluctuations less abrupt, with the aim of preventing
excessive unemployment and rapid price increase.

In macroeconomics, we place special emphasis on understanding the causes of

unemployment and inflation. The unemployment rate is the number of jobless workers who
are actively looking for work or who have been laid-off from a job, expressed as a percentage
of the total labor force. Unemployment is often a major issue in congressional and
presidential elections. In fact, the federal government is required by law to pursue policies
that seek to keep unemployment from becoming excessively high. If such policies are to
succeed, the individuals who develop them must have a keen understanding of how the
economy works.

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Inflation is another highly charged political issue. Inflation is a general yearly increase in
the average level of prices for a broad spectrum of goods and services. Inflation erodes the
purchasing power of money. It can create economic instability in a nation by harming the
competitiveness of firms seeking to sell products in foreign markets and by distorting
economic choice as people try to unload money today that they think will be worth less
tomorrow. During the late 1970’s inflation was a severely disrupting influence in the US
economy, rising to double-digit levels along with escalating interest rate. Macroeconomics
seeks to understand the causes of inflation and to help government authorities pursue policies
aimed at keeping the inflation rate low and within predictable bounds. Stable and predictable
prices facilitate planning and reduce the uncertainty associated with market transactions.

In studying aggregate production in the economy and its fluctuations, macroeconomists seek
to uncover the basic influences that cause national production to increase. The key to
prosperity in an economy is steady growth in national output. When growth in a nation’s
output exceeds its growth in population, the output per person in the economy will grow, thus
improving the well-being of the population on average.

Concept Check
1. Describe the focus of microeconomic analysis.
2. What economic issues are the focuses of macroeconomics?

1.5. Positive Analysis Vs Normative Analysis

In the field of economics, we are concerned with more than understanding how the economy
functions. We also look at ways of improving the outcomes that emerge as the economy
accomplishes its tasks of producing and distributing goods and services. The operation of the
economy is not flawless, nor does it please all of us. As individuals, we differ in our opinions
about the goals for which resources in the economy should be used. We also disagree about
the appropriate nature and extent of government involvement in the economy, and through
political channels, we express our views about which groups government should help.
Because we understand the concept of opportunity cost, we know that a government action
that benefits one group inevitably imposes a cost on another group.

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Positive Analysis
In evaluating economic policies, we must understand the basic functioning of the economy
before we can predict the impact of such policies on the economy. Positive analysis of
changes in economic policy or conditions seeks to forecast the impact of the changes on
observable items like production, sales, prices, and personal incomes. It then tries to
determine who gains and who loses because of the changes. Positive analysis makes
statements of the “if . . . then” type that can be supported or rejected by empirical evidence.
An example of positive statement is: “if electronics import quotas are imposed, then the price
of compact discs will increase.” Another positive statement is: “if the federal government
deficit is reduced, then interest rates will fall.” We can support or reject these statements by
observing whether evidence exists that changes in prices, incomes, or interest rates actually
do occur directly as a result of the policy changes. Because no one completely understands
how the economy works, economists often disagree about actual cause-and-effect
relationships. These disagreements must be resolved by examining the facts, using statistical
methods to test the relationships.

Normative Analysis
Positive analysis cannot be used to evaluate an outcome. For example, positive analysis of
government welfare programs might look at the impact of such programs on the incentives of
recipients to work and on national production without trying to determine whether the
programs are good or bad. To evaluate the performance of an economy, we must establish
criteria or norms against which we will compare actual outcomes.

We use normative analysis to evaluate the desirability of alternative outcomes according to

underlying values judgments about what is good or bad. An example of a normative
statement is “Families of four with income below $15000 per year should be exempted from
federal income taxes.” This statement presents a point of view about what a policy should
accomplish. Another normative statement is: “tariffs and other restrictions that impede free
international trade should be eliminated.”

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The normative approach used by many economists is based on an underlying value judgment
that evaluates well-being in a nation only in terms of well-being of individuals. The
normative approach makes recommendations regarding what ought to be. It is used to
prescribe changes in policy and the use of productive capacity in an economy as well as to
evaluate performance.

1.6. Deductive Vs Inductive Method

Economists use two methods of analysis. Many professionals in other disciplines use these
two methods, too. These are:
I) Deductive Method and
II) Inductive Method

Deductive Method
Deduction means the process of drawing generalizations based on some assumptions and
observation. The generalization is to be drawn on the very limited observation that could not
be powerful to represent the whole. Most deductively drawn conclusions are applicable to
specific areas and situations. It had been used for long periods alone before the Historical
school had come. The classical and neo-classical economists widely used this method. Under
this method, we proceed from general to particular.

For example,
 All human beings are rational.
 John is a human being.
 John is rational.

This method is called hypothetical because some of the assumptions may not correspond to
all facts. A hypothesis in economics may study the causal relationship among various
variables that affect the particular situation. It is also called ‘abstract’ because the problem is
simplified, removing all irrelevant facts.

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The deductive process as used by economists follows a number of steps: identification of the
problem, building up of hypothesis, collection of data, and development and verification of
theories. The first step of deduction is screening of the problem; then the task is to take
certain assumptions on the framework of which some definite conclusions can be drawn. For
example, consider the law of demand that says as the price of the product goes on decreasing;
the quantity to be consumed by the buyer becomes larger. From this general truth we can
have a conclusion in the light of deductive reasoning. The law states that lowering the price
of the good successively, higher would be the frequency of the buyer to purchase the good. In
other words, as the price of the product decreases, the real income of the consumer could
obtain value to acquire more and more of the good. We can now draw a new conclusion that
the fluctuation of income may push the consumer to change his/her decision of buying the
good. The next step in deductive analysis is derivation of hypothesis. These hypotheses
may/may not be true. It is just subjective prediction of the relationship of variables. The last
task is verification of the theory. Verification is done based on experience of facts through
empiricism by means of statistical studies.

The deductive method has several advantages as its use is very simple affair and it does not
require elaborate experimentation. This method results in accuracy and exactness in
generalization as this method invariably makes use of logic and mathematics. At the same
time this method suffers from certain disadvantages.

Disadvantages
1. The generalizations arrived at because of deductive reasoning can be true only if the
assumptions upon which they are based hold true.
2. If the economists were to confine themselves exclusively to the method of abstraction,
there is a danger of their efforts resulting in the production of wasteful intellectual
exercises.
3. This method proves particularly dangerous when universal validity is claimed for
economic generalizations on the basis of deductive reasoning

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Inductive Method
This is also known as empirical or historical method. It was strongly advocated by
economists belonging to the Historical School. This technique is a practical approach to the
problems of economic science. It reduces the gap between theory and practice. It proceeds
from the particular to the general.

1.7. Rational Behavior

A key component of any economic model is the assumption it makes about the way people
behave. We use behavioral assumptions to establish the motivation of individuals so that we
can understand cause-and effect relationships among economic variables. For example, it is
typically assumed that the owners of business firms seek to maximize their annual profit
from the sale of a product. Once we make this assumption, we can use a model to trace out
the impact of a change in an economic variable such as the wages paid to the firm’s
employees on the quantity of a product the seller is willing to sell. It is also commonly
assumed that consumers act to obtain the most possible satisfaction from purchasing goods
and services. We can use the assumption of maximization of satisfaction to examine how
changes in such economic variables as the price of one item affects the quantity buyers are
willing and able to pay for.

When you seek to gain by choosing to undertake actions for which the extra benefit exceeds
the associated extra cost, you are engaging in rational behavior. For example, you will be
considered rational if you choose to take additional courses each semester as long as the extra
benefit that you associate with those courses exceeds the extra cost you incur when you take
them. If you take courses to the point at which the last course costs you more than the benefit
it provides you, you would be considered irrational.

1.8. Marginal Analysis of Rational Behavior

Marginal analysis is a step-by-step way of analyzing how people engaging in rational
behavior make choices. Marginal analysis of your decision to buy orange would look at the
benefit and costs associated with your purchase of each extra orange starting from zero.

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If the additional benefit you obtain from another unit of an item exceeds its price, you will be
better off buying the item rather than keeping your money to spend on something else. The
Birr value you place on the satisfaction you obtain form another unit of an item is its
marginal benefit to you. The marginal benefit of an item in Birr represents the maximum
sum of money you are willing and able to give up to obtain one more unit of the item without
becoming worse off or better off by doing so. The marginal cost of an item is the sacrifice
you must make to obtain each extra unit. The marginal cost of buying another unit of an item
is what you forgo to obtain one more unit. If you choose to buy bread that costs 1Br, you
forgo the opportunity to use that sum to purchase another item. Because of this as a rational
person, you will always decide to purchase an additional unit of any good or service if its
marginal benefit exceeds its marginal cost. By doing so, you can obtain net gains from
buying extra units of the good or service. A net gain is possible when the marginal benefit of
the good exceeds the marginal cost.

Using Marginal Analysis

To understand the decisions made by rational persons, we need to take the following steps:
1. determine how a person evaluates the benefit and cost of the activity, and how
marginal benefit and marginal cost are likely to change as more or less of an activity
undertaken over a given period.
2. figure out how changes in the economy or other factors (such as changes in prices)
change the marginal benefit and marginal cost associated with various quantities.
Analyzing the impact of changes in economic conditions on marginal benefits and
marginal costs of transactions allows a model based on rational behavior to develop
hypotheses about how changes in economic conditions affect choices and the
magnitude of economic variables.

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Summary
Economics is concerned with the use of available productive resources to satisfy the desires
and demands of those in a society. Scarcity is the imbalance between the desires of members
of a society and the means of satisfying those desires. Scarcity is the fundamental economic
problem. The opportunity cost of choosing to use resources for one purpose is the sacrifice
of the next best alternative for the use of those resources. There are two main branches of
economics: microeconomics and macroeconomics. Microeconomics views the economy
from the perspective of its individual participants. Because of its emphasis on the role of
prices in business and personal decisions, microeconomics is sometimes called price theory.
Macroeconomics considers the overall performance of the economy and the way its various
sectors relate to one another. Macroeconomics places special emphasis on understanding the
causes of unemployment and inflation. Positive analysis seeks to predict the impact of
changes in economic policy on observable items like production and income, and then tries
to determine who gains and who loses because of the changes. Positive analysis makes
statements of the “if . . . then” type. Normative analysis evaluates the desirability of
alternative outcomes according to underlying value judgments about what is good or bad.
Normative statements present a point of view about what an economic policy should
accomplish.

Summary questions
1. What are the basic characteristics of rational individuals?
_________________________________________________________________
2. What is economics in your own words?
_________________________________________________________________
3. Explain the concept of marginal cost and marginal benefit.
_________________________________________________________________
4. What makes scarcity the center of economics?
_________________________________________________________________
5. Explain the two branches of economics in relation to your daily life.
__________________________________________________________________

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 CHAPTER TWO
UTILITY ANALYSIS
Contents
2.1. Introduction
2.2. Approaches to Utility Analysis
2.3. The Cardinal Utility Theory
2.4. Equilibrium of the Consumer
2.5. Law of Diminishing Marginal Utility
2.6. The Consumer’s Surplus
2.7. Indifference Curve Analysis
2.8. Budget line
2.9. Consumer’s Equilibrium for Purchases
2.10. Consumer’s Equilibrium
2.11. Income and Substitution Effect
2.12. The Diamond Water Paradox
2.13. Deriving Demand Curves

2.0 Aims and Objectives

The unit discusses the approaches to utility analysis and presents the meaning and law of
diminishing marginal utility. The unit also presents the meaning of consumer surplus.
After reading this unit, you will be able to:
 distinguish between cardinal and ordinal approaches to utility analysis;
 explain the law of diminishing marginal utility and its limitations;
 recognize consumer surplus.

2.1 Introduction
All human beings live in this world just for the sake of their satisfaction. Why they work
hard, collect large amounts of money, kill other people, etc. is just to fulfill their want not to
be hurt. But the economic concern is why people buy goods and services, since consumers
satisfy their wants through the consumption of goods and services. Goods are visible things

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that have the ability to satisfy a need. This satisfying ability of goods is called by many
economists “utility”. Utility is defined as the satisfaction one can drive from the consumption
of goods. For example, utility of money is the satisfaction obtained from not the possession
but from the goods and services that the money is able to buy. Utility is subjective by its
nature in a sense that we can not measure how much satisfaction a person has derived from
the consumption of a good. In other words, like height or weight we cannot give exact values
to satisfactions. Utility has a changing tendency even to one person at different times in
different places. A particular type of good will have differing amounts of utility depending
on the amount consumed. For example, an individual’s satisfaction varies when he consumes
the first and the last units in a successive consumption of a good. Satisfaction from the
consumption at the time of hunger is higher than it is on another day. Thus, the utility of a
particular good will vary as the quantity consumed varies. Therefore, each unit of a particular
commodity will be distinct from another unit.

2.2 Approaches To Utility Analysis

There are two polarized approaches to the measure and comparison of utility. They are:
(1) Cardinalist Approach, and
(2) Ordinalist Approach.

Even if we mention the two approaches, the cardinal measure of utility has no use in the
today’s modernized economics.

There were a number of economists that believed utility can be measured in monetary terms
or in simple numbers. In their assertion, utility can be measured in subjective units called
‘Utils’. This theory is called the Cardinal Approach.

On the other hand, the Ordinal Theory assumed that utility is not measurable but is possible
to rank. According to this theory, the consumer can put his/her satisfaction in an orderly
manner rather than assigning cardinal values.

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2.3 The Cardinal Utility Theory
Basic Assumptions of utility Theory
a) Rationality of Consumers: the consumer tries to maximize his utility subject to the
undergoing constraints.
b) Measurability of Utility: The utility of each commodity is measurable. The units used to
measure utility are utils. The utility can also be measured by the price that
the consumer is willing to pay for another unit of the commodity.
c) Constant Marginal Utility of Money: This assumption is essential if the monetary unit is
used as the measure of utility. The essential feature of a standard unit of
measurement is that it must be constant.
d) Diminishing Marginal Utility: The law states that as one goes on consuming more units
of a commodity, the utility of the commodity will increase for some time
and then diminishes.
e) Utility is Additive: The total utility (TU) a consumer obtains from consuming batches of
goods is a function of the number of goods and services consumed. The total utility
gained from the consumption of bundles of goods can be calculated through a simple
aggregation. Assuming that utility is measurable, total utility is the sum total of utilities
from the whole goods and services. When a consumer consumes x number of goods and
services, his total utility would be:
U = f (x1, x2…, xn)
Marginal utility is the amount of satisfaction that could be derived from each additional unit
of commodities consumed. Marginal utility (MU) is concerns itself with additional
consumption and satisfaction, keeping other things equal.
Mathematically;
MU= ∆TU
∆Q
Where, ∆TU and ∆Q are the changes in total utility and quantities consumed respectively.

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Equilibrium of the Consumer
The consumer’s utility maximization issue is dealt with in the light of his/her goods acquiring
potential. A person without money cannot be considered as consumer; so analysis of the
consumer’s utility maximization is based on the available money at hand. A consumer with
limited money might need different goods and services but his purchase primarily focuses on
those goods that give higher satisfaction. Therefore, consumers equilibrium is reached when
the additional utilities derived become equal to the price paid for the good.

Assume a world of one commodity(Y) and a consumer with limited money income. This
consumer has two choices regarding his money. One is to buy and consume the commodity
and the other is just to put the money at home. When the consumer decides to consume,
he/she must decide in such a way that the satisfaction brought by each additionally bought
quantities must be equal with the pain felt in paying the value (price).

MUx = Px
Where MUX is marginal utility of good, x and Px is price of good x.
If the marginal utility of ‘X’ is grater than its price, the consumer can increase his welfare by
purchasing more units of ‘X’. Similarly, if the marginal utility of ‘X’ is less than its price, the
consumer can increase his or her total satisfaction by cutting down the quantity of ‘X’ and by
keeping more of his income unspent. Hence, he attains the maximization of his utility when
MUx = Px.

Concept check
1. What are the criteria to be fulfilled for a consumer to be in equilibrium?
_________________________________________________________________
2. What are the units used for measurement of utility in Cardinalist view?
_________________________________________________________________
3. Explain equilibrium of the Cardinalist theory.
__________________________________________________________________
4. What does the rationality of consumers refer?
__________________________________________________________________
5. Discuss the shortcomings of this theory.
___________________________________________________________________________________________________

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2.4 Law of Diminishing Marginal Utility
This is one of the important laws in consumption theory. According to this law, as more and
more units of a commodity are consumed, the consumer cannot derive the same level of
additional satisfaction as the previous in a given period of time. In other words, the
difference between the marginal utility of successive units is negative.
The above law can be explained with the help of a table.
Table-2.1: Total and Marginal Utilities (in units)
Number of Total Marginal
bread Utility Utility
1 50 50
2 90 40
3 120 30
4 140 20
5 150 10
6 150 0

From Table 2.1 above, even if the total utility of the good is increasing, we can also note
aside the fall in magnitude of marginal utility. It is clear that as the consumer goes on eating
bread, the addition to marginal utility goes on decreasing and finally becomes zero. It means
that it is of no use to consume units in addition of this level. But if we look at it more
carefully, we will notice that although the total utility does increase, it increases only at a
diminishing rate. In the table, when the consumer eats the successive loaves of banana, the
marginal utility goes decreasing by 10. As marginal utility is the slope of total utility, when
marginal utility becomes zero, total utility would be at its maximum and its negativity makes
total utility to decrease. Marginal utility which is the slope of total utility measures the
responsiveness of total utility to the change in quantities consumed. As an alternative, total
utility can be calculated by the simple addition of the given marginal utilities.

2.5 The Consumer’s Surplus

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The Consumer’s Surplus is the difference between what a consumer pays for some goods or
services and what he would have been willing to pay. Some times we will be prepared to pay
much more for a commodity than we actually pay. The price a consumer pays for a good,
therefore, is the measure of the marginal utility. The total Consumer’s Surplus is then
calculated as the total sum of surplus enjoyed above the market price. Consumers’ Surplus =
Total utility – Total amount spent

U Graphically, the Consumers’

Surplus is the area under the
A1 P11 demand curve but above the market
price (△uA1P11).
P
A P 1

U
1
X
O M 1
M
Fig. 2.1
Goods

At the market price A1, the consumer buys M1 amount of the good and pays an amount equal
to A1OM1. But he has assumed to pay prices that are higher than the prevailing market prices.
Although the consumer would be willing to pay different prices for different levels of
quantities, the price in the market is lower than all he assumed. His actual expenditure is now
less than he would be willing to pay for the acquisition of the amount ‘M1’. The consumer
assumed to pay an amount equal to the area UOM 1.This difference is called the Consumer’s
Surplus and it is represented by the area of the UA1P11 (UOM1- A1OM1).
Concept check
1. What would happen to Consumer’s Surplus when the demand curve for a product is
horizontal?
2. What is the relationship between slope of the demand curve and Consumer’s Surplus?
3. Discuss the situations that allow the presence of LDMU.

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2.6 Indifference Curve Analysis
2.6.1 Introduction to ordinal utility approach
In the forgoing unit, we studied that utility can be measured in monetary terms or units called
utils. However, the modern economists found a new means of understanding the utility
concept. This approach believes that objective measure of utility is impossible, that we can
only give ranking instead. In the ordinal approach, the consumer need not assign specific
amounts to the utility which he derives from the consumption of a good or combination of
goods. He will simply compare the different utilities or satisfaction in the sense that one level
of satisfaction is equal to, lower than, or higher than another. In this theory everyone can put
his preference of goods but cannot specify by how much one good is preferred to the other.
For example, we have four goods A, B, C and D; letting a person put his preference in order,
he puts A first, C second, then D and at last B. However, if we let him show how strongly he
prefers A to C, then he can do nothing to tell precisely in quantitative terms.

2.6. 2 Indifference curves

Indifference curve is a locus of points that reflect the same level of satisfaction that can be
derived from a combination of two or more goods. Indifference curves are drawn based on
the amount of income on hand. It shows the combination of goods, between which the
consumer is indifferent. Along a single indifferent curve, moving up or down has no effect
on the level of satisfaction. The only change is the proportion of goods to be consumed.
Moving up along the indifference curve allows the consumer to buy more of the good, which
is on the Y-axis while the good in the X-axis is being reduced.

Characteristics of Indifference Curves

1. Negatively sloped (also called the marginal rate of substitution): This is due to the trade
off between the two goods to be portrayed. Along the indifference curve, an increase in
the consumption of one good is at the cost of the other. It would mean that whenever we
need to buy more of one good, we are required to forego the other because of the
constrained income.

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2. Indifference curves do not cross and intersect each other: There is only a single
indifference curve for a combination of two goods at a given income level. So the utility
level reflected by that curve belongs to the curve alone. If another line crosses or touches
this curve, the two indifference curves could produce the same level of satisfaction,
irrespective of the income levels. In other words, the consumer can receive equal
satisfaction from either with smaller or larger combinations.
3. Indifference curves are all over the commodity combination space.
4. The further the indifference curve from the origin, the higher the satisfaction it bears
would be. A higher indifference curve represents a higher level of satisfaction than the
indifference curve at a lower level.
5. Indifference curves are convex to the origin.
6. Indifference curves should not touch either of the axes.

Nevertheless, there are cases in which indifference curves may have characteristics out of
this.
 Indifference curves may not be convex to the origin when the two goods under
consideration are perfect substitutes. In such a case, the indifference curves would
have a linear graph sloping downward to show a unit increase in one good leads
us to a unit decrease in another.
 Indifference curves would have a right angle shape when the two goods are
perfect complements and when the marginal rate of substitution becomes zero.

Assumptions behind Indifference Curve Analysis

1. Consumers may consume more of one and less of the other. This is true when they
possess more of one than the other.
2. Let us assume three combinations of goods, A, B and C. If A is preferred to B and B
is preferred to C, then by the law of transitivity, A must be preferred to C.
3. In a convex indifference curve, as we go from left to right in the X-Y plane, the
number of units of commodity Y sacrifices for commodity X becomes lower.

19
2.7. Budget Line or Price Line
This is an important concept in the study of consumers equibrium with the indifference
curve. Budget line is also called budget constraint. It is so because the consumer cannot make
a choice beyond that point. Budget line represents the various combinations of goods that a
consumer can buy by his limited money income. Budget lines are downward sloping.
Combinations out of the budget line are unattainable. The slope represents how many of one
good is given up to add more of the other. Budget line has a tendency to shift
correspondingly to the right or to the left with the increase or decrease in income. However,
the flactuation in price of the goods splits the line from the bottom or top and causes the
slope of the budget line to change.

The consumer has the discreation with existing realities to make efficacious decisions. His
satisfaction could be maximized only if he makes a decision that assumes the indifference
curve to be on the budget line(tangent). The consumer can only buy a combination of goods
that are on or within the budget line alone. Combinations out of the area under the budget
line are not in our choice because we are constrained not to go beyond the line by the limited
money.

Therefore, the consumer with a given income under given market conditions will have
different alternatives of consumption along the budget line.

Consequently, attainment of equilibrium is after a detailed analysis of both the budget line
and the indifference curve. In the event of the equilibrium settlement, the indifference curve
should make a tangent line on the budget line from outside.

Assumptions on the Equilibrium

The following assumptions explain the consumers’ equilibrium:
a) the amount of money allotted to the two goods is limited.
b) prices for goods are fixed for a given period.
c) goods are homogeneous and divisible.
d) rationality of consumers, i.e., the consumer maximizes his or her satisfaction with
given income and prices of goods.

20
Conditions
The consumer is in equilibrium when he maximizes his utility, given his income and the
market prices. This means the budget line makes a contact to the furthest possible
indifference curve. There are two conditions for the consumer to be in equilibrium:
1. Equity between marginal rate of substitution and the price ratio of the two goods.
This is necessary but not a sufficient condition for equilibrium.
MUx Px
=
MRSxy = MUy Py
2. Convexity of the indifference curve to the origin.

Graphical Presentation
The budget line represented by line AB shows the different combinations of the two goods
that the consumer can buy depending on his income. Given the indifference map of the
consumer and his budget line, the equilibrium is defined by the point of tangency of the
budget line with the highest possible indifference curve. At the point of tangency the slope of
the budget line (Px/Py) should be equal with the indifference curves (MRSxy = MUx/My).
Y
A

P
'Y' Goods

IC4
IC3

G IC2
H
IC1

'X' Goods X

Figure 2.6: Equilibrium

point

21
From the above figure, indifference curve IC4 is not our business. All points under the budget
line can be attained but do not maximize satisfaction. Take point G that lies on the budget
line AB, but the indifference curve, which passes through G lies on lower position near to the
origin IC2 and therefore will yield less satisfaction than P. By the same notion, all points
except point P are rejected to be taken as utility maximizing, since they lie on lower
indifference curves. Points on the budget line do not guarantee us to take it as equilibrium. It
is only on the point of tangency that we find the marginal rate of substitution and the price
ratio of the two goods is equal.

2.8. Consumer Equilibrium for Purchases: the Equi-marginal Principle

As a consumer, you have limited income available to spend on the goods that provide you
with utility. Your problem is to allocate your income (say per month) among the items you
want. The opportunity cost of spending some of your income on any one good is the forgone
opportunity to spend the income on the next best alternative.
Each time you buy more of an item you simultaneously obtain extra utility, which is the
marginal utility of the item, and sacrifice the opportunity to purchase other goods. Assuming
you can buy as much of an item as you want at the market price, the sum of expenditure on
other goods you sacrifice for each unit of a particular good is constant. For example, if
orange and banana both cost Br.1, you will have to give up one orange each time you buy
another banana. However, the marginal utility of banana will decline as you buy more per
month. The marginal utility per Birr of banana will therefore be less as you buy more units
per month.

As a rational consumer, you presumably seek to obtain the greatest possible utility from
spending your limited monthly income. You will gain utility each month by consuming more
orange if your marginal utility per dollar of orange exceeds your marginal utility per Birr of
banana. For example, if your units of marginal utility per Birr are 5 for orange and 3 for
banana, it is easy to see that you can enjoy a gain in utility by consuming more orange
instead of banana. If you choose not to buy a banana so you can buy another orange, you
forgo the opportunity of getting 3 units of utility for your Birr. Instead, you enjoy 5 units of

22
utility from spending the Birr on the orange. Your net gain from using the Birr to consume
the orange instead of the banana is 2 units of utility.

We can generalize this principle: As long as the marginal utility per Birr is not the same for
all goods consumed, the consumer can gain by reallocating income to buy more of the goods
that have higher marginal utility per Birr than others do. Of course, when you consume more
goods with high marginal utility per Birr, the marginal utility per Birr of those goods
declines. Consuming fewer goods with low marginal utility per Birr increases their marginal
utility per Birr. Adjusting marginal utility per Birr in this way by controlling the purchase of
particular goods enables you to maximize your satisfaction from spending your income.

Consumer equilibrium is attained when a consumer purchases goods (say weekly) until the
marginal utility per Birr is the same for all goods consumed. In general, the marginal utility
per Birr for any good can be obtained by dividing the marginal utility the consumer places on
the good by the price of the good. For example, if the marginal utility of a sweatshirt is
Br.25, its marginal utility per Birr is 2. The conditions for consumer’s equilibrium can
therefore be expressed as:

MUA = MUB = MUC, and so on for all goods.

PA PB PC
In this formula, MU is the marginal utility of the good indicated by the subscript and P is the
price of the good indicated by the subscript. The equation illustrates the equimarginal
principle for consumer purchases, which states that to maximize utility, consumers must
equalize the marginal utility per Birr spent on each good.

23
Concept check
1. State the reason behind the downward sloping of budget line.
_______________________________________________________________
2. Describe the characteristics of indifference curve.
_______________________________________________________________
3. Define the budget line and its characteristics.
_______________________________________________________________
4. Why don’t we use points on the indifference curve as equilibrium?
______________________________________________________

2.9. Consumer’s Equilibrium

As a consumer, you are assumed to choose the quantities of X and Y that maximize your
utility given your budget constraints. The economic variables the model seeks to explain are
the quantities of good X and Y you choose to buy over a given period.

In the box below a typical consumer’s indifference map is superimposed on the same set of
axes as that consumer’s budget line. Let us say you are this typical consumer. We can now
use the model to determine your choice of weekly consumption of apples and bananas. The
quantities chosen represent your equilibrium market basket. We can view this equilibrium
basket as maximizing your utility level subject to the constraint that you can spend no more
than the available income per time period. This gives your most preferred weekly purchases
of good X and Y given income and the prices of the two goods.

24
 Y

U1

8 A

E
4

2 B

1 3 4 X
Figure 2.7: Equilibrium
Look first at a point like A corresponding to a market basket of one unit of good X (apple)
and eight units of good Y (bananas) per week. This basket of goods gives you a utility level
of U1. Similarly, the market basket corresponding to point B where Qx = 4 and Qy = 2 also
gives you a utility level of U1.

But neither point A nor point B can be equilibrium. By moving along the budget line from A
to the market basket represented by point E, you can increase your utility by moving to
higher indifference curves. You do this by substituting good X for good Y in your weekly
market basket. Keep in mind that even though they have not been drawn, there is an
indifference curve going through each and every point on the budget line. Similarly, by
moving toward point E from point B, you become better off.

You achieve the maximum utility from your budget when you consume the combination of
goods corresponding to the point where the budget line touches the highest possible
indifference curve. The combination of good X and Y corresponding to this market basket,
Qx* = 3, Qy* = 4, is your equilibrium market basket of goods. No other combination will give
you more utility or satisfaction given your available income. The consumer equilibrium
represents that combination of goods purchased that maximizes utility subject to the budget
constraint.

25
2.10. Income and Substitution Effects

Income Effect
Another concept associated with indifference curves is the income effect. We have been
assuming a person with a give level of income to maximize his or her utility, but what would
happen if the income changes. This change in income brings change in the consumption level
of the person. So far the shift in the budget line is parallel, it lefts the slope unchanged,
assuming prices to be constant. The new budget line represents combination of goods that
include larger stock of goods than the previous with the new income level. Thus, the income
effect means the change in consumer’s purchases of the goods because of change in his
Y
income.

L3
COMMODITY 'X'
IC3
ICC

L2
IC2

L1
IC1

Fig. 2.2: Income Consumption Curve

S
R
Q
P1

P2

P3

Y 'Y'
COMMONDIT

In the above figure, the initial equilibrium is at point Q taking L 1P1 be the original budget
O
line. If the income of the consumer increases, he would be able to purchase larger quantities
of both the goods. Because of a change in income, the price line will shift upwards to the
right and will be parallel to the price line P 1L1. With further rise in income, the price line
shifts to P3L3 and the consumer is at equilibrium at S. The line drew connecting the

26
equilibrium points as the budget line shifts due to the increase in income is called income
consumption curve. Income consumption curve is thus the locus of points of consumer
equilibrium at various levels of consumer’s incomes, holding prices to be equal.

The shape of the curve depends on the consumer’s preference or type of the good. If the
proportion of goods in all successive indifference curves is equal, then ICC will be linear
otherwise not. A non-linear ICC looks either increasing (sloping up) or decreasing (slopes
down). If the ICC makes approach to one of the goods, that good is superior, keeping the
slope positive. The negative and positive slopes indicates that the goods normality and
inferiority, respectively.
ICC2

ICC1
Good 'Y'

ICC3

O
Goo

Good
'Y'
ds

‘X’
Figure 2.3: Slope of ICC
Substitution Effect
We have seen the effect of a change in income while the price is constant, to shift the budget
line up parallel. But what would happen if the price changes? A change in price leads us only
for the rotation of the price line. Substitution effect is inclination of buyer to one good as a
result of an increase in the price of the other. With a change in price, commodities having
constant price would be consumed more than those with increasing price.

27
With the given income and prices, the consumer is in equilibrium at point D on the
indifference curve, purchasing OA of commodity Y and OW of commodity X. Suppose
the price of commodity X rises, the price line shift to PL 1. With this rise in price, the
consumer’s real income or purchasing power would diminish. The loss in real income
induces consumers to go for another alternative, which is the consumption of less of that
good. This shift of the consumer from its previous consumption level is called
substitution effect.

P
Goods 'Y'

N1 Q

A D
N

T IC

M1

O
P
W M(L1)
B L
L1 Goods
L 'X'

Fig. 2.4: Substitution effect

Since the income level is still the same there will be change in the slope of the price line. The
change appears while the price line rotates toward left from the side of good X. This shows
that more of good Y is now consumed while the consumption of good X is reduced. At the
new budget line the consumer is able to buy only OM amount of good X or OP amount of
good Y. When some money income is taken away, the price line is shifted to a new position
AB parallel to PP which means that the reduction of consumer’s income by the amount PA
(in terms of Y) or L1B (in terms of X) has been made to keep him on the same indifference
curve. The consumer would therefore rearrange his purchases of X and Y and will substitute
X for Y since X is now relatively cheaper and Y is now relatively dearer. Thus in order to

28
buy more of X he moves on the same indifference curve from point Q to point T. Thus,
increase in the purchase of commodity X by MM1 and the decrease in the purchase of
commodity Y by NN1 is due to the change only in the relative prices of commodity x and y,
since the effect due to the gain in real income has been wiped out by making a simultaneous
reduction in consumer’s income. Therefore movement form Q to T represents the
substitution effect. Substitution effect on commodity X is the increase in its quantity
purchased by MM1 and substitution effect on Y is the fall in the quantity purchased by NN 1.
In short, the substitution effect implies that a change on the real income of a consumer due to
a change in the price is compensated by a corresponding change in money income but the
relatively cheaper commodity is bought in the place of the dearer one.
This effect shows the reaction of the consumer and
Price Effect
measures the full effect of the change in the price of
Y the commodity on the quantity purchased with given
B
money income.

To begin with, the consumer is at equilibrium at

COMMODITY

point Q on budget line AB. With the fall in the price

of X, the budget line shifts to the right BA1 and the
Q consumer can now buy OA1 of X and OB of Y. A
Q1
'Y'

Q2 PCC further fall in price of X will shift the budget line to

BA2 and so on.
A A1 A2
O

Commodity ‘X’

Figure 2.5: Price effect

By joining Q, Q1 and Q2 we got a curve called the price consumption curve. The price
consumption curve shows the price effect.

29
Concept check
1. Define the income and substitution effect.
2. Define the income consumption curve.

2.11 The Diamond Water Paradox

Have you ever noticed that some items of great value, like air and water, are free while
apparently useless items like diamond jewelry can be sold at astronomically high prices? The
paradox of value is that people are willing to give up zero or very small amounts of money to
obtain certain items that provide them great total benefit. For example, the total benefit that
obtained from one gallon of drinking water per day is great because we cannot survive
without water each day. The total benefit of diamonds, however, is likely to be lower because
we can survive without diamonds.

The key to unraveling this apparent paradox is to look at the marginal benefit you or any
person receives from these two goods. Water is very abundant in most regions. This means
that at the current quantity available, the marginal benefit you receive falls to a level close to
zero. However, diamonds are not very abundant in most relative to the desire for them. Given
the availability of diamonds, most of us have so few that the gem’s marginal benefit remains
quite high. Your willingness to give up more money for one more diamond per year than for
one more gallon of water per year is therefore rooted in the fact that diamond are scarce than
water.

You can see this in the graph. Graph A shows the marginal benefit you receive from water.
Given the amount of water you already have available, represented by the vertical line, the
marginal benefit of water is close to zero. Graph B shows the marginal benefit of diamonds
that the maximum amount of money you will give up for one diamond is less than the
amount you would give up for water if only one gallon of water were in fact available. Given
the number of diamonds you currently have, you would be willing to give up more for
diamond than for an extra gallon of water. This is why sellers of diamonds can get higher
prices for their goods than can sellers of drinking water. Given the quantities actually
available, the marginal benefit of diamonds exceeds the marginal benefit of water

30
Price Price
SS SS

DDS DDS
S S
Gallons of water A Carats of diamond B
for most of us. This holds even though the total benefit we obtain from water exceeds the
total benefit we obtain from diamonds.

2.12 Deriving Demand Curves

2.12.1 The demand curve for an individual consumer

Now we can explain the law of demand using the theory of consumer choice. Concentrate on
your demand for any particular good. The demand curve is a relationship between the price
of the good and the quantity you will purchase at various prices, other things being equal.
The theory of consumer behavior argues that over any period, a person will buy any given
good in amount that cause the marginal benefit to fall to the price. The demand curve
represents a relationship between the marginal benefit of a good and the quantity consumed,
other things being equal. In other words, we can think of the marginal benefit curve for a
good as the consumer’s demand curve. You can therefore think of points on your own
demand curve for a good as representing the maximum sum of money you will give up for
various available amounts of an item. Now you can see the importance of the law of
diminishing marginal utility for demand theory. The maximum price that you will pay for a
good will decline as you consume more of it, because the marginal utility of the good
declines as you buy more. The law of demand is therefore rooted in the law of diminishing
marginal utility. As price declines, you buy more of the good so that the marginal benefit you
receive from the good declines to equal the new lower price. The law of demand is, in fact,
based on the idea that as consumers we seek to maximize the satisfaction, or total net benefit,

31
we receive from exchanging our money for goods. You buy more of a good when its price
falls because the lower price allows additional net benefit. Through increased consumption,
that was not previously possible.

2.12.2 Deriving Market Demand Curve from Individual

Demand Curves
Market demand for consumer’s products is of great interest to business firms and investors.
Ultimately, the success or failure of businesses depends on their ability to satisfy consumer
demands. Astute investors anticipate changes in market demand for products and profit by
doing so. A successful marketing and sales program for any business is based on
comprehensive studies of the demand for the product. Predicting the pattern and level of
consumers demand is a prerequisite to forecasting business conditions.

A market demand curve shows the relationship between the price of a product and the total
quantity demanded by all consumers willing and able to purchase the product at each price,
other things being equal. We derive a marker demand curve from individual demand curves
for a given product by adding the quantities demanded by each buyer in the market at each
possible price. Because, as we have just proved, individual demand curves are downward
sloping, market demand curves will also be downward sloping.

32
Summary
Preferences represent a person’s likes and dislikes. Utility is a concept that can be used to
gauge preferences. Utility measures a person’s intensity of desire for goods and services.
Higher-utility alternatives are preferred to ones that provide less utility. Utility is a subjective
concept. Total utility measures the total satisfaction obtained from a certain quantity of a
good consumed over a given period. The marginal utility of a good is the extra utility
obtained from unit of the good. The law of diminishing marginal utility is a great principle
that states that the marginal utility obtained from an item to decline as more is consumed
over a given period. The equimarginal principle expresses the conditions for consumer
equilibrium by indicating that the marginal utility of each good divided by its respective price
must be the same for all goods. The demand curve of an individual consumer for a good is
generally downward sloping because the marginal benefit of the good tends to decline as
more is consumed. When the price of a good falls, a consumer buys more of the good until
the marginal benefit falls to the new lower price. The income effect of a price change is the
change in purchases of the good resulting only form the change in purchasing power of
money income caused by the price change. The substitution effect of a price change is the
change in purchases of a good resulting only from the change in the relative price of a good.
A market demand curve is obtained by adding quantities demanded for all consumers at each
possible price. Market demand curves slope downward because individual demand curves
slope downward and because, at lower prices, more consumers are willing and able to buy.
The law of demand is firmly based on the notion that people maximize the benefit they
obtain from purchasing goods and services.

33
Questions
1. Explain the law of diminishing marginal utility.
_____________________________________________________________________
_____________________________________________________________________
2. What is consumer’s surplus?
_____________________________________________________________________
_____________________________________________________________________
3. How does the utility of a certain quantity of a good differ from its marginal utility?
How are the concepts of total and marginal benefit related to those of total and
marginal utility?
____________________________________________________________________
____________________________________________________________________
4. Explain why you as a consumer consider both the prices and marginal utilities of all
goods in making your choices. What is the equimarginal principle, and how is it
relevant to consumer equilibrium.
_____________________________________________________________________
_____________________________________________________________________
5. What must you as a consumer do to maximize your net benefit from purchasing
goods?
_____________________________________________________________________
_____________________________________________________________________

34
 CHAPTER THREE
THEORY OF DEMAND AND SUPPLY

Contents
 Meaning of Demand
 Types of Demand
 Law of Demand
 Demand Schedule and Curve
 Individual Demand and Market Demand
 Determinants of Demand
 Elasticity of Demand
 Meaning of Supply
 Types of Supply
 Supply Schedule and Supply Curve
 Law of Supply
 Individual Supply and Market Supply
 Determinants of Supply
 Elasticity of Supply

3.0 Aims and Objectives

Dear student! This unit discusses the meaning of demand, types of demand, law of demand
and exceptions to the law of demand.
By the end of the unit, you should be able to:
 understand the meaning of demand;
 list out the types of demand;
 explain the law of demand;
 define the concept of elasticity
 clearly identify the meaning of supply
 describe the types of supply, the law of supply, equilibrium of the market

35
3.1 Demand

3.1.1. Introduction
Dear student! There are two main role-playing entities in an economic system: buyers and
seller. The first group is responsible for the demand for goods and services and the second
group provides the supply of those goods. Demand as used in economics is not necessarily
the same as want, need or desire. But it is more than this. As we have learnt, people normally
want many things. However, their resources are usually not sufficient to satisfy all wants.
More specifically, consumers have enough money to buy only a few of the thing they want.
Our concern here is with the part of their wants that can afford to satisfy by paying money in
exchange for goods and services.

3.1.2. Meaning
Demand is a wide concept in economics without which nothing can be done. Demand
implies more than a mere desire to purchase a commodity. Demand is desire or wants which
is supported by the willingness and ability, on the part of the consumer, to pay a price for
acquiring the commodity required for satisfying the want. In fact, to distinguish demand from
want, need or desire, it is more fully referred to as effective demand.

The demand, or effective demand, for a commodity is the quantities of the good or service
which consumes are able to purchase at a given price over a period of time. There are two
basic types of demand. One is individual demand; the other is aggregate or market demand.
Individual demand refers to the quantity of a commodity which a particular consumer will by
at a given price. Market demand on the other hand refers to the quantity of a commodity
which all consumers will buy at a given price. Therefore, aggregate demand is the sum of the
demands by individual consumers for the commodity.

3.1.3. Types of demand

Joint demand: complementary or joint demand occurs when two or more commodities are
required to be used or consumed together. Usual examples are tea and sugar; motor vehicle
and petrol; pen and paper etc. If two goods are in joint demand, the desire to consume one
will initiate the demand for the other.

36
1. Derived demand: there are goods which do not give satisfaction by them selves. These
goods can get want satisfying power when they are converted to other types of goods.
Thus, the demand for such goods is called derived demand. The demand for money falls
in these goods category, because the satisfaction that we derive from money is not with
its possession but with its power to buy goods and services. Demand for all factors of
production is therefore referred to as derived demand. The demand for them is derived
from, or depends on, the demand for the final products which they help to produce.
2. Competitive demand: when two or more commodities compete against each other for
the consumer’s income, they are said to be in competitive demand. In a more technical
word, called substitute demand. It is in cost of the other that one commodity is
consumed. Examples include tea and coffee, Pepsi and Coca Cola, etc.

3.1.4. The law of demand

Demand is defined generally above as a relationship between quantity and price. Now, what
can we say about this relationship? More specifically, how can we describe the relationship
between quantity and price which represents demand? From our daily observation, it is
generally true that more of a good is consumed when its price seems low. But this
assumption may not hold true for some exceptional goods, called Giffen goods which violate
the law of demand.

The law states that consumers will buy more of a commodity at lower price and fewer at
higher prices, all other things being equal. In other words, this law is in most cases valid if
all other things (like income, taste, price of other goods, etc) that may affect the consumer’s
preference, keep unchanged.

3.1.5. Demand schedule and curve

The relationship between the quantity of a commodity and its price which the law of demand
describes is more easily illustrated with the help of a demand schedule or a demand curve.
Suppose individual A is a consumer who wants to by banana in a market. If we observe his
decisions closely, we can record the quantity of banana which he is willing to buy at different
prices that several banana sellers may demand. If he behaves in accordance with the law of

37
demand, we would expect him to buy more oranges when the unit price becomes low and
fewer oranges at higher unit prices. Thus, we may find that perhaps when the price is one
Birr per unit, he wants to buy twenty oranges, whereas he may be willing to buy only one
orange when the price rises to 60 Br per unit.
Table 4.1 Hasan’s individual demand schedule

Quantity Demanded Price of Banana (in Br. Per unit)

20 1
17 5
13 10
10 20
6 30
4 40
2 50
1 60

This demand schedule shows that as the price per unit rises from 1Br. to 60Br. The quantity
of bananas demanded falls from twenty units to one. The association of an increase in price
with a decrease in quantity demanded persists throughout the schedule. For instance, when
the price rises from 5Br to 20Br, the quantity demanded falls from seventeen to ten.
Similarly, two bananas are demanded when the price per unit is 50Br, but the quantity
demanded increases to six when the price decreases to 30Br. This demand schedule clearly
illustrates the law of demand. Hasan is probably not the only buyer of banana in the market.
There may be hundreds and thousands of consumers of banana. The sum of the quantities
demanded by all consumers at each of the different prices gives the market demand schedule.

The relation between the price and quantity demanded of a commodity can also be shown on
a diagram called the demand curve. In other words, the information, which is used to derive
the tabular presentation called the demand schedule, can also be used to derive the demand

38
curve. In building up the diagram called the demand curve, two axes are used, one vertical
and the other horizontal. The vertical axis used to measure prices while quantities are
measure along the horizontal axis.

The following figure contains the demand curve labeled DD. This demand curve has one
particular important feature. It slopes downward from left to right. This feature indicates that
more units to the commodity are demanded at a lower price than at a higher. This important
feature, which embodies the law of demand, is common to most demand curves. Thus even
if the demand curve is really a straight line, it remains consistent with the law of demand as
long as it slopes downward from left to right.

D
5
60

5
0
3
0
1
01
D

1 2 6 1 20 Q
Figure 3.1: Demand curve 3

What we have described

1 above is a normal demand curve that follows the law of demand.
But there are also2cases to violate the law of demand. The basic characteristic of the unusual
demand curve is that they slope upward from left to right. This reversal of the basic law of
demand may be true for the following types of commodities:
 Article of ostentation: This is category of commodities which are bought at a higher
price so that their possession may impress others. For these commodities, the quantity
demanded tends to increase as the price rises. E.g. jeweler materials

39
 Commodities whose prices are expected to rise: People may, for various reasons, expect
the price of a commodity to rise in the future. Hence, they may buy more of the
commodity now, even at a higher price to escape from future hardships.
 Inferior goods: families with low income spend a large part of their income on essential
goods. This does not generally mean they do not consume non-essential goods. In case of
lower prices of these inferior goods, these people use to consume more from inferior
goods and less portion from non-essentials. But as the price of these basic foods rise, just
for the sake of adjustment, they ignore the non-basic items and use more of the essential
ones.
 Rare commodities: these are unique commodities as old works like paintings.

3.1.6. Factors determining shift of demand

There are two types of shift in demand. One is the shift which occurs on a given demand
schedule or curve. This is often referred to as changes in quantity demanded. The other kind
of shift in demand occurs as a change of the whole demand schedule or curve. It is also
called a change in demand. Illustrative examples of both types are given in figure below. In
the first figure, we have an illustration of change in quantity demanded. This occurs as a
movement along a given demand curve. Thus, when the price falls from P 1 to P2, quantity
demanded increases from Q1 to Q2. Hence, the change in quantity demanded is caused by an
opposite change in the price of the commodity. In other words, change in quantity demanded
reflects the buyers’ reaction to change in price. The factor, which is responsible for the
change in quantity demanded of a commodity, is the price of that commodity.

The next figure represents a complete shift in the demand from its original position DD 1 to a
new one represented by the curve labeled DD2. Because of the outward shift in demand
curve, more of the commodity could be consumed at every price than ever before. Thus, the
consumer can access more quantities of the good at the previous price. Several factors are
responsible for the shift of the demand curve from its original position. These are:
Consumers’ Income
One of the most important factors affecting demand is the income of consumers. What makes
our daily life severe is absence or shortage of income that is why most people gone out of

40
their home for beggary. No one in this world likes to live as dogs but his/her failure to get
money. The higher the income, the greater is the demand for most commodities. In the
opposite, poorer people consume less of commodities (except inferior). The distribution of
income among the population of consumers also plays an important role. The sizes of
consumers’ income and its distribution have significant implications for the demand for
various commodities.

Price of Other Goods

The prices of other goods influence the demand for a particular commodity in two basic
ways. If two goods are substitutes, the rise in price of one of the two goods, leads to an
increase in the demand for the other good. For example, Pepsi and Coca Cola are to some
extent substitutes. Now if the price of Pepsi goes up, consumers will shift for Coca Cola. On
the other hand, if the two goods are complementary, the existence of one necessitates the
other, and an increase in the price of one good would lead us to forego the other. Examples of
complementary goods are vehicle and petrol, pen and paper, tea and sugar, etc. An increase
in the price of motor vehicle will tend to reduce the demand for motor vehicle. This will in
turn reduce the demand for petrol even though its own price may not have risen.

Consumers’ Taste
Consumers’ taste and current fashion also influence the demand for various goods. Fashion is
particularly important for wear. The coming up of new companies with new fashion wear,
pushes the existing companies with old fashions to go out of the market. The demand for
such new-fashioned goods increase and the demand for others may fall as a result. With
respect to taste and fashion aspect, advertising plays a great role to influence the demand.

Number of Consumers
Other things being constant, the number of consumers in the market determines the demand
for a product or service. The larger the number of consumer who wants a particular

41
commodity, the larger is the demand for the commodity likely to be. In addition to this, the
age, sex etc proportion of the population has some sort of influence. For instance, if most of
the consumers are females, then the kinds of goods that will be in high demand are those that
appeal to the female.

The weather
The seasonal fluctuation of weather causes a change in the demand structure of the product.
In most countries, for example, umbrella and rain coat are in high demand during rainy
season. Thus, changes in the weather have some impact on the demand for some types of
commodities.
Concept check
1. What is demand?
________________________________________________________________________
2. Can we consider wants as demand?
________________________________________________________________________
3. List examples of goods that violate the law of demand.
________________________________________________________________________

3.1.7. Price elasticity of demand

Price elasticity of demand is a number representing the percentage change in quantity
demanded resulting from each 1% change in the price of the good. This number is used to
gauge the sensitivity of quantity demanded of a good to percentage change in the price of that
good. Price elasticity is calculated by dividing the percentage change in quantity demanded
to a good by the percentage change in the price that caused it, other things being equal:

Price elasticity of demand = %change in quantity demanded/%change in price

For example, suppose the price of cars went up by 1% this year and the resulting decline in
cars purchases was 2%. The price elasticity of demand would be

42
 -2%/1% = -2
Notice that price elasticity of demand is a number without units of measurement because it is
obtained by dividing two percentage changes.
In categorizing price demand as more or less elastic, it is convenient to ignore the minus sign
in front of the number measuring elasticity of demand. The larger the absolute value of the
price elasticity of demand, the more elastic the demand.

An elastic demand prevails is the price elasticity of demand for a good turns out to be a
number that exceeds 1, ignoring the minus sign. For example, if the number that measures
the price elasticity of demand for fur coats is -5, the demand for coats would be elastic. If the
price elasticity of demand for sweatshirts is -2, their demand would also be elastic. However,
note that the demand for fur coats would be more elastic than the corresponding demand for
sweatshirts.

A good has an elastic demand if its price elasticity of demand is a number equal to or greater
than zero but less than 1, ignoring the minus sign. The smaller the number after the minus
sign, the more inelastic the demand for the good would be. For example, the demand for milk
would be categorized as inelastic if its price elasticity of demand were -0.8 because 0.8 is less
than 1.

Finally, a good has a unit elastic demand if the number that measures its price elasticity of
demand is exactly equal to 1 when the minus sign is ignored. If the demand for a good is unit
elastic, the percentage change in its quantity demanded caused by a price change will equal
the percentage change price, again ignoring the direction of change.

Calculating Price Elasticity of Demand from Two Points on a Demand Curve

We can use the concept of price elasticity of demand together with the demand curve to reach
some interesting conclusion. Suppose the unit price of T-shirt is 1Br at equilibrium where
20,000 units are sold. This corresponds to point A on the demand curve. Now suppose, as a
result of a decrease in the supply, the price of T-shirt increases to 1.10Br and the quantity
demanded falls to 15,000 per week as the equilibrium moves from point A to point B on the

43
demand curve. To calculate the price elasticity of demand from the data, we follow these
steps.
1. Calculate the change in price (∆P) and the change in quantity demanded (∆Q). In this
case the change in price is ∆P = 10c and the resulting change in quantity demanded is
∆Q = -5,000.
2. Calculate the percentage change in price and quantity caused by the decrease in supply.
The percentage change in price and quantity can therefore be calculated as
%∆P = ∆P × 100% = 9.5%
½(P1+P2)
%∆Q = ∆ Q × 100% = -28.6%
½(Q1+Q2)
3. Divide the percentage change in quantity demanded by the percentage change in price
to get the price elasticity of demand:
Price elasticity of demand = -28.6%/9.5% = -3.01
Because the number after the minus sign exceeds 1, the demand for T-shirts can be
categorized as elastic.
Price elasticity of demand = ∆Q/ (Q1 + Q2)
New
∆P/ (P1 + P2) supply
P Initial
supply
B
1.10
A
1

.30 F
.20 E
Demand

1500020000 55000 (60000 Q

)
Figure 3.3: Elasticity of Demand
If you use elasticity estimates to make forecasts, heed this warning: if the demand curve for
your product is linear, like the one drawn in the graph above, then price elasticity of demand

44
will change as price changes. When using past data based on previous price changes, be very
careful to calculate price elasticity of demand for your product. Assuming that the demand
curve for your product is linear, the demand for your product will tend to be more elastic at
higher prices than at lower prices. You can check this by comparing elasticity values for the
shift of equilibrium from point E to point F and the previous value.

Perfectly Inelastic and Perfectly Elastic Demand Curves

Suppose the price elasticity of demand for a product were always zero, no matter what the
price. What would its demand curve look? If the price elasticity of demand is zero, the
percentage change in quantity of the good demanded will always be zero no matter what the
price or how much the price changes. For this to be the case, the quantity demanded of the
good would have to be completely insensitive to change in price. A demand curve that
corresponds to such a situation is drawn in the next graph.

Perfectly
P inelastic P
Demand

Perfectly
P*
elastic
Demand

0 Q 0 Q
Q*

Figure 3.4: Perfectly elastic and inelastic demand curves

An infinitely elastic demand curve would prevail for a product that had a great many perfect
substitutes. In fact, such a demand curve can be regarded as existing for a particular seller in
a competitive market. The curve for an infinitely elastic demand is flat. An almost flat

45
downward sloping demand curve implies that the minutest change in the price of a good will
result in an infinite change in quantity demanded. The graph is labeled above.

Determinants of Price Elasticity of Demand

There are a number of factors that can influence the price elasticity of demand for an item.
These factors include:
1. The availability of substitutes. Remember that a substitute for a good is one that serves
the same general purpose. In general, the more and better substitutes that exist for an
item, the more elastic its demand.
2. Time. In general, demand tends to become more elastic with time because we fine more
substitutes for goods over longer periods. Over long periods we also have more time to
adjust our consumption patterns in response to price change, which also contributes to a
more elastic demand over long periods.
3. The proportion of income consumers spend on the good. As consumers we tend to spend
high proportions of out income on housing and cars. A 10% increase in the price of these
goods is likely to reduce substantially our ability to buy these items and result in sharp
percentage declines in quantity demanded. The goods on which we spend large
percentages of our income are likely to be less elastic.

Other Demand Elasticity Measures

In addition to price elasticity of demand, the income elasticity of demand and the cross-
elasticity of demand provide useful information. Income elasticity of demand is a number
that measures the sensitivity of consumer’s purchases to given percentage change in income.
The cross-elasticity of demand is a number used to measure the sensitivity of consumer’s
purchases of one good to percentage changes in the price of the substitute or complement
goods.

3.1.7.1 Income elasticity of demand

Income elasticity of demand measures the percentage change in the number of units of a
good consumers demand, other things being equal, resulting from each 1% change in income.

46
We can calculate income elasticity by dividing the percentage change in quantity of a good
purchased by a corresponding percentage change in income, assuming that only income and
no other demand determinant changes.
Income elasticity of demand = %change in quantity demanded/%change in income

For example, an income elasticity of 3 for foreign travel means that a 1% increase in income
will result in a 3% increase in consumer trips overseas.

Income elasticity of demand for a good may be positive or negative. A positive income
elasticity of demand implies that increase in income (other things being equal) is associated
with increase in the quantity of a good purchased. Goods that have positive income elasticity
of demand are called normal goods. A good whose income elasticity is greater than 1 is
sometimes called a luxury good.

A negative income elasticity of demand implies an inverse relationship between income and
the amount of a good purchased. Goods with negative income elasticity are those that
consumers will eventually stop buying as their income increases. Goods that have negative
income elasticity of demand are called inferior goods. These are goods we tend to consume
less of as our income increases. You would expect such goods as poor cuts of meat, second-
hand clothing, and used furniture to have negative income elasticity of demand.

3.1.7.2 Cross-elasticity of demand

Another useful price elasticity concept is the cross-elasticity of demand, which measures the
sensitivity of purchases of one good to change in the price of another good. For example, the
cross-elasticity of demand for coffee with respect to the price of tea would measure the
percentage change in purchases of coffee resulting from a 1% change in the price of tea,
other things being equal. Cross-elasticity of demand between the demand for a good X and
the price of some other good, Y, is:

Cross-elasticity of demand = (% change in quantity of X) / (% change in the price of Y)

Cross-elasticity of demand may be positive or negative. A positive cross-elasticity of demand
implies that the two goods are substitutes. Whenever the price of one good changes, other

47
things being constant, the demand for the other moves in the same direction. This means that
a price increase for one of the goods leads to an increase in the amounts purchased of the
other. However, the cross-elasticity of demand for unrelated goods like ice cream and
typewriters is likely to be zero. Goods that are complements have negative cross-elasticity of
demand. Tea and sugar are complements. An increase in the price of sugar is likely to
decrease the demand for tea.

Concept Check
1. How is price elasticity of demand calculated? If the price elasticity of demand for ice
cream is equal to -0.8, calculate the effect of a 10% decrease in the price of ice cream on
the quantity demanded.
________________________________________________________________________
________________________________________________________________________
2. Under what conditions is demand for a good categorized as elastic?
________________________________________________________________________
________________________________________________________________________
3. The slope of the demand curve for cassette tapes is -2 at all points. Will its price elasticity
also be constant at all points?
________________________________________________________________________
________________________________________________________________________

3.2. Supply
In addition to buyers, sellers constitute the second group of participants in market
transaction. We have described the behavior of buyers in the last chapter. Hence, the focus of
this chapter is a description of the behavior of sellers who provide the supply of
commodities. Supply means the quantity of a commodity that a seller is willing and able to
offer for sale. The decision of seller to sell more or less depends on the price level of the
product. The seller offers large amount of his produce when the price of the product is
higher. However, if the price goes down, he will be unwilling to sell and will offer less to
sell. Hence, supply varies with a change in price.

What is meant by the supply of a commodity is the quantity of it which producers or sellers
willingly offer for sale at a given price. Supply is therefore not the same thing as the total

48
stock of the commodity in existence. Supply refers only to the portion of total stock which is
offered for sale at a price.

3.2.1. The law of supply

As in the case of demand, general observations of the behavior of producers and sellers have
led to the formulation of the law of supply. This law states that, in general, suppliers are
normally willing to offer more quantities of a commodity for sale at higher prices than at
lower ones. In other words, the law says that the higher the price, the greater will be the
quantities made available for sale; and the lower the price, the smaller will be the supply.

3.2.2. Supply schedule and supply curve

In accordance with the law of supply, producers would be willing to offer more of a
commodity for sale as the price of the commodity increases. If we can observe the behavior
of sellers or persuade them to indicate the quantities of a given commodity which they would
be willing to offer for sale at different prices, we can construct a supply schedule. This
supply schedule is a table which shows the quantities that would be offered for sale at
different prices.

Supply schedule:

Quantity supplied Price per unit (in Birr)

200 17
185 16
170 15
160 14
142 13
20 12
100 11
80 10

This table shows that while sellers would offer 200 units of a commodity for sale when the
price was seventeen Birr per unit, they would offer 160 units for sale if the price fell to
fourteen Birr per unit; and if the price fell even lower to say, ten Birr per unit, they would
offer only 80 units.

49
Clearly, this supply schedule is in accordance with the law of supply since it shows that more
is offered for sale at higher than at lower prices. We can easily derive a supply curve from
the supply schedule given on the table. If, using a suitable graph paper, we represent quantity
on the horizontal axis and price on the vertical one, the pair of observations on quantity and
price can be plotted on a graph to form the supply curve.

S
5

4
Price

1
S
0
50 200 300 400 X

Supply curves

There are three types of supply curves. The supply curve, which is derived from individual
supply schedule, is called an individual supply curve. However, the supply curve, derived
from an aggregate or market supply schedule is referred to as an aggregate or market supply
curve. The aggregate supply curve represents the sum of many individual supply curves. It
indicates the quantity of a commodity which is offered for sale by all sellers at different
prices.

Finally, there is the joint supply curve. This term is used in a situation where one commodity
is produced, as a by-product, in the process of producing another commodity. Familiar
examples of this include wool and mutton which are produced jointly by the sheep; beef and
milk produced jointly by the cow.
A normal supply curve, as represented in the above figure, slopes upward from the left to the
right. Like the normal supply schedule, the upward slope of this curve implies that producers
and sellers would offer more quantities of a commodity for sale at higher prices and less at
lower ones. The supply curve is thus in conformity with the law of supply.

50
However, there are several exceptions to this rule. In other words, some supply curves have
shapes which violate the law of supply. These are referred to as exceptional supply curve. Let
us examine two examples of such curves. To start with, it is possible to have a commodity
which is fixed in supply, or a rare product whose supply cannot be increased, at least within a
short period. In such a case, supply of the commodity is said to be fixed and its supply curve
appears as a vertical straight line as in the figure below.

In this case, the quantity supplied does not respond to the increases in price.

Price

SS

Quantity
Figure 3.3: Inelastic supply curve

Our second example represents the exceptional case where a portion of the supply curve
slopes backward from left to the right, indicating that a smaller quantity of the commodity
would be offered for sale at a higher than at a lower price. This example is usually identified
with supply of labor curve. This curve may have a backward-bending slope in certain portion
of it because, beyond a particular wage rate, people may wish to work for shorter hours and
spend more of their time on leisure activities.

Price
SS

51
 Quantity
Figure 3.4: Backward bending Supply curve

3.2.3. Factors affecting shift in supply

There are two types of shifts in supply. One type corresponds to a movement up or down to a
given supply curve. The other type of shift is a complete displacement or bodily movement
of the whole supply curve.

When the price of a commodity rises, producers tend to increase the quantity of it which they
offer for sale. This response of producers and sellers is a movement along a particular supply
curve. This movement represents a change in quantity supplied in response to a
corresponding change in the commodity’s own price. Hence, a change in quantity supplied is
caused by the change in the price of the commodity. An illustrative example is given in the
next figure. In this figure we can see that as price increases from P 1 to P2, there is a
movement along the same supply curves (SS) so that quantity supplied increasing from Q 1 to
Q2.

P
SS

52

Q
A bodily shift or complete displacement of the entire supply curve is referred to as a change
in supply.

We have stated above that the commodity’s own price is the factor which cause changes in
quantity supplied. Several other factors are responsible for changes in supply. These are as
identified and described below. Q
Figure 3.5: Shift of supply curve
SS1
SS

Price of Other Goods

P

Producers must determine the commodities they wish to produce. Among the important
factors that they have to consider before making their decisions are the prices of all
commodities that they could produce. Thus, a farmer may examine the prices of Teff, maize,
orange, and banana before deciding which to plant on his farm. Hence, if he finds that the
price of orange is very high and is likely to remain so for quite a while, he may be induced to
abandon the production of Teff in favor of orange. In other words, producers tend to switch
away from commodities whose prices are low and towards those with high prices.

Cost of Production

53
As we saw in the previous chapter, resources are used to produce commodities. These
resources have costs. The cost of production is therefore another import factor which
influences changes in supply. If the cost of production is high, producers tend to supply less
but would be willing to supply more if the cost of production decreases.

Technical Progress
In every community, new inventions, innovations, and better ways of doing things are
constantly emerging. The new machines and new techniques help to increase the supply of
various commodities by reducing the cost of production. To the extent that they result in the
emergence of new products, they may also cause an increase in the supply of the new
products in addition to a decrease in the supply of some existing commodities.

Number of producers
In most cases, it can be said that the larger the number of producers of a particular
commodity, the greater will be the supply of the commodity. Thus, a product which is
becoming more and more popular with producers is likely to increase in supply. However,
the product, which more and more producers are abandoning, can be expected to decrease in
supply.

Climate and weather

The output of most agricultural products depends on the environment. The weather, climate
and soil conditions of a given region determine which crops can be grown successfully in the
region. The seasonal weather pattern also determines the period of the year when the supply
of particular commodities can be large or small. For instance, oranges and mangos are
abundantly available during certain parts of the year, but quite scarce at other times. The
weather factor is, understandably, not as important for the supply of factory-produced goods.

3.2.4. Elasticity of supply

The elasticity of supply is very similar to the concept of elasticity of demand which we
discussed in the previous section. In relation to supply, elasticity indicates the responsiveness

54
of producers or suppliers to price changes. As before, we will discuss various aspects of this
concept below.

Definition and Measurement

The elasticity of supply can be defined as the percentage change in quantity supplied
resulting from a one percent change in price. The formula for calculating the coefficient of
the elasticity of supply (Es) is similar to that used for computing the demand elasticity
coefficient. In effect, if the quantity supplied changes by 20% when price changes by 15%,
then the supply elasticity coefficient is:
Es = 20% = 0.8
15%
Supply is elastic when the coefficient Es is greater than one. In this case, the percentage
change in quantity supplied is greater than the corresponding change in price. It is unit elastic
when Es equals one; and it is inelastic when Es is less than one. The five different supply
elasticity ranges are from negative infinite to positive infinite.
Mathematically,

Es = Change in amount supplied ¿ Change in price

Original amount supplied Original price

ΔQ ΔP
÷
= Q P
Where 'Q' refers o the quantity supplied and 'p' to the price and Δ represents change. The

supply is elastic when with a small change on price there is 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, a vertical line will represent it shown as below. In addition,
perfectly elastic supply curve is depicted by a horizontal supply curve.

Perfectly inelastic or zero Infinite elasticity

elasticity perfection elastic
Y Y

S 55
P

Price
X X
O
O
Supply
Supply

Figure 3.6: Elasticity of supply

Concept check
1. Explain supply, supply curve and law of supply.
______________________________________________________________________
______________________________________________________________________
2. Describe the determinants of supply.
_______________________________________________________________________
_____________________________________________________________________
3. Discuss the relationship between slope of the supply curve and elasticity of the supply.
________________________________________________________________________
________________________________________________________________________
4. Briefly explain the cases when supply may exhibit unusual curves.
________________________________________________________________________
________________________________________________________________________

3.3. Market Equilibrium Price and Quantity

Equilibrium prevails when economic forces balance so that economic variables neither
increase nor decrease. Market equilibrium is attained when the price of a good adjusts so that

56
the quantity buyers are willing and able to buy at that price is just equal to the quantity sellers
are willing and able to supply. When market equilibrium is attained, forces of demand and
supply balance so that there is no tendency for the market price or quantity to change over a
given period. The equilibrium price acts to ration the good so that everyone who is willing
and able to buy the good will find it available. Similarly, at the equilibrium price, everyone
who wants to sell the good will be able to do so successfully. For example, equilibrium in the
personal stereo market requires that the price of personal stereo be such that the quantity
demanded equals the quantity supplied over a period. When quantity demanded equals
quantity supplied in a market, the market is said to clear.

A shortage exists in a market if the quantity demanded exceeds the quantity supplied of a
good over a given period. For example, there will be a monthly shortage of compact disc
players if at the current market price the monthly number of players that sellers are willing
and able to make available falls short of the monthly number that buyers are willing and able
to purchase.

A surplus exists in a market if the quantity supplied exceeds the quantity demanded of a
good over a given period. These would be a monthly surplus of gasoline if the monthly
quantity supplied by sellers exceeds the monthly quantity demanded by buyers at a certain
price. At the market equilibrium price of the good there can be neither surpluses nor shortage
in the market over any given period. When a market clears, the good is rationed in the sense
that there are neither surpluses nor shortage over a period.

3.4. The Impact of Changes in Demand on Market Equilibrium

Changes in either demand or supply can change market equilibrium prices and quantities.
You can now begin to use supply and demand analysis to make forecasts about what will
happed to prices and quantities sold in response to these shifts in demand and supply.

Change in demand affects market equilibrium. For example, suppose there is a decrease in
demand for eggs because of concern about the high cholesterol content of eggs and its effect
on health. In fact, in recent years this concern is likely to have contributed to a decrease in

57
 P
SS

P1 E1
P2 E2
DD
DD1a decrease in the demand for egg means an inward shift of
the demand for egg. Recall that
the entire demand curve.
Q
Q3 Q2Q1
Figure 3.7: The effect of shift in demand on the equilibrium P & Q

The graph shows the impact of a decrease in demand for eggs on the egg market. As the
demand curve shifts inward, the old price of Br1 and quantity of 5000 dozen eggs per week,
corresponding to point E1 in the graph, no longer represent the market equilibrium. To see
why this is so, move along the dotted horizontal line drawn from the point corresponding to
Br.1 on the vertical axis. The quantity demanded at that point along the new demand curve is
now 3000 dozen eggs per week. The quantity supplied at that price would still be 5000 dozen
eggs because there has been no change in supply. If the price remained at Br.1, there would
be a weekly surplus of 2000 dozen eggs. The market attains a new equilibrium in response to
the decrease in demand as price declines to eliminate the surplus. The new market
equilibrium corresponds to point E2, at which the new demand curve intersects the supply
curve. The price corresponding to that point is 75cent per dozen. At the lower price, the
quantity supplied by sellers declines to 4000 dozen per week, which exactly equals the
quantity demanded by buyers along the new demand curve at that price.

The decrease in demand, other things remaining constant, sets up the following chain of
events in the market: First, the price declines as a surplus develops at the original price.
Second, sellers respond to the decrease in price by decreasing the quantity supplied. Finally,

58
as the quantity supplied declines, a new equilibrium is attained at a price for which quantity
demanded on the new demand curve equals quantity supplied on the existing supply curve.
Notice that sellers do not respond directly to the decrease in demand. Instead, they respond to
the decline in price caused by the decrease in demand. This illustrates the role of prices as a
signal through which buyers communicate a change in their desires to sellers.

The chain of reasoning for an increase in demand is exactly the reverse. Suppose an increase
in income causes an increase in the demand for stereo speakers. An increase in demand is a
shift of the entire demand curve outward. The next graph shows that an increase in demand
for speakers will increase the market equilibrium price. As the price increases, there is a
corresponding increase in quantity supplied until quantity demanded, on the new demand
curve, once again equals quantity supplied. In the graph, the initial equilibrium corresponds
to point E1, at which the price of a standard-quality speaker is Br.100, and 10000 speakers are
sold per month at that price. After the increase in demand the new equilibrium corresponding
to point E2, at which the price is Br.125 per speaker and the quantity supplied is 12000 per
month. The increase in price is a signal that induces sellers to increase the quantity supplied.

P
SS

P1
P
DD1
DD
Q Q1 Q
Figure 3.8: Outward shift of demand curve

3.5. The Impact of Change in Supply on Market Equilibrium

Remember that a change in supply is a shift of the entire supply curve for a good caused by a
change in some influence other than the price of the good. For example, an increase in the
price of chicken feed is likely to decrease the supply of eggs. The graph drew below shows

59
how a decrease in supply will affect market equilibrium. Assume that the initial market
equilibrium, corresponding to point E1 on the graph, is once again a price of Br.1 per dozen
and those 5000 dozen eggs are sold per week at that price. As the supply curve shifts inward,
the initial price can no longer result in equilibrium. This is because the quantity supplied at
that price along the new supply curve is now only 3000 dozen per week. Because there has
been no change in demand, the quantity demanded at that price would still be 5000 dozen per
week. There would therefore be a weekly shortage of eggs on the market if the price

Figure 3.9: Effect of supply shift on equilibrium price and quantity

remained at Br.1 per dozen. Competition among buyers eliminates the shortage and raises the
price. As price increases, quantity demanded declines until it equals quantity supplied. The
new market equilibrium corresponds to point E 2, at which market price is Br.1.25 per dozen
and quantity sold is 4000 dozen per week. This is the point at which the new supply curve
intersects the original demand curve. Note that buyers do not respond directly to the decrease
insupply. Instead, they respond to the increase in market price caused by the decrease in

Q
supply. Once again, you can see how price serves as a device for communication between
SS
buyers and sellers. Buyers are motivated to reduce the quantity demanded in response to the

DD
SS1

higher price caused by the decrease in supply.

Q1 Q
P1
P

The reasoning is similar for an increase in supply. For example, in recent years
improvements in technology have served to increase the supply of television sets. A number
of years ago the equilibrium price for a standard 14-inch color TV was about Br.3000. As
advances in technology increased supply, there was downward pressure on the price of TVs.

60
The graph shows the impact of the increase in supply on the market equilibrium. Start out
once again at point E1, at which the original demand curve intersects the original supply
curve. At that point, the market price of TVs is Br.3000 and the quantity sold per year is 4
million. The increase in supply means that the original supply curve shifts outward. The new
market equilibrium now corresponds to point E2, at which the new supply curve intersects the
original demand curve. If market price remained at Br.3000 per set, there would be an annual
surplus of TVs on the shelves of retailers. The price must fall to clear the market. The new
equilibrium price is now Br.2000 per TV. Quantity demanded at that price is 5 million TVs
per year, which exactly equals the quantity sellers, are willing to supply at that price along
the new supply curve. An improvement in technology therefore tends to lower the market
price of a good and increase the quantity demanded.

Summary
Markets are arrangements through which buyers and sellers can communicate and conduct
transactions to enjoy mutual gain. In a free and competitive market there are large number of
rival buyers and sellers, no one of which can influence the price of the product traded. There

61
are no restrictions on who can buy and sell. Supply and demand analysis explains how prices
are established in the competitive market and how those prices affect the quantities traded.
The law of demand states that, in general, other things being constant, there is a negative
relationship between the price of a good and the willingness and ability of buyers to purchase
the good. Demand curve illustrates the relationship between price and quantity demanded.
The law of supply states that, in general, other things being equal, there is a positive
relationship between price and the amount of good sellers are willing and able to make
available. Market equilibrium is attained when the price of a good adjusts so that the quantity
demanded equals the quantity supplied. If price exceeds the market equilibrium level, a
surplus will prevail. If price is below the market equilibrium, a shortage will prevail.
Surpluses put downward pressure on prices, while shortages put upward pressure on prices.
Changes in demand or supply result a new market equilibrium price and quantity
combination. A change in demand affects market price. A change in market price affects the
gains from selling the good and causes sellers to respond by adjusting the quantity they
supply. A change in supply also affects market equilibrium price. The resulting change in
price affects the personal possible gain from purchasing the good and therefore causes buyers
to respond by adjusting quantity demanded.

Questions
1. What do you mean by demand?
________________________________________________________________________
________________________________________________________________________

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2. What are the determinants of demand?
________________________________________________________________________
________________________________________________________________________

3. Explain the law of demand.

________________________________________________________________________
________________________________________________________________________
4. What are examples of goods that are exceptional to the law of demand?
________________________________________________________________________
________________________________________________________________________

CHAPTER FOUR
PRODUCTION, COST AND REVENUE

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Contents
4.1 Introduction
4.2 The Concept of Production Function
4.3 Production Function for a Single Product
4.4 The Law of Variable Proportion
4.5 Summary
4.6 Answers to Check Your Progress
4.7 Model Examination Questions
4.8 References

4.0 Aims and Objectives

This unit aims at discussing the meaning of production, production function and the law of
variable proportions.
By the end of the unit, you will be able to:
 tell the meaning of production
 explain the production functions
 identify the law of variable proportions.

4.1 Introduction
Dear Student! Individuals in a community have many wants which they would like to
satisfy. These wants are usually satisfied by the use of goods and services. The goods and
services must, of course, be produced before they can be used to satisfy human wants. But
the production of these goods and services require the use of other goods. These goods and
services are called raw materials or intermediate goods. Production is an activity whether
physical or mental which is directed to the satisfaction of other people’s wants through
exchange. Thus, production refers to all economic activities which result in the creation of
goods and services. In other words, production is the process of making or communicating
goods as well as the process of providing or rendering service with the goal of exchange.
Thus, the farmer who grows corn on his farm is engaged in act of production. Similarly, the
factory worker who helps to make a new car is engaged in the process of production. But we

64
do not mean to imply, by these example, that production is limited to the farm or the factory.
The person who moves or transports the farmer’s produce from his farm to the market takes
part in the production process. In the same way, the market woman who sells the farmer’s
corn to the housewife provides a service which is an important part of the process of
production. Therefore, we can say that production is not complete until the commodities
produced have reached the final consumers that satisfied some wants. In its complete sense,
production is the transformation of materials from less useful into forms that are more useful.
This transformation involves the following aspects.
1. Changing or modifying the form of a commodity at any stage from the raw material to the
finished product. For example, the farmer grows corn or wheat which is changed to flour
by the miller. The baker in turn changes the flour into bread. Each process involves a
transformation of the commodity from the less useful raw material form to the more
useful finished product form.
2. Changing the situation or location of a commodity. We illustrate this by continuing with
our previous example. The bread has been baked and is in the baker’s shop. But it is not
mean that all those who need bread also know where the baker’s shop is. Thus, it may be
necessary to transfer or move the bread from the baker’s shop to the market. This change
of location makes the commodity more useful because delivery makes it readily available
to move people.
3. Changing the position of a good in time. This means storing or keeping a good until it is
required. Let us illustrate this with the case of a farmer who produces Teff. After his Teff
is harvested, the farmer may store some of his produces in a barn and sell the rest. The
part kept in a barn may then be used for consumption over time in the future.
4. Provision of services which facilitate the exchange of goods and services. This aspect of
production involves banking, insurance, retailing, transport and communication services.
In essence, these services make it easier for the producer to contact the consumer so that
the process of exchange can be arranged as quickly as possible.
Essentials of production
I. To undertake the production process there should be materials and activities
necessary for the production.

65
 II. The final destiny of the out put need to be consumers in a sense that people that did
not participate in the production process.
III. Those who did not participate in the production can access the product only through
exchange.
We have defined production as the creation of goods and services or the transformation of
materials from less useful to more useful forms. This creation or transformation is
economically useful only to the extent that it helps to satisfy some human wants. Thus, the
primary aim of all productive activities is to make available goods and services which can be
used to satisfy human wants. This is the sense in which consumption is the final aim of
production.

4.2 Factors of Production

To satisfy its wants, a community needs goods and services which result from the process of
production. What determines the level of production or output of commodities in any country
is the quality and quantity of resources. These resources are called factors of production. The
resources are inputs without which production can never be undertaken. The resources
appear in many different forms. But they are usually classified into four broad categories.
These are land, labor, capital and entrepreneurship.

Land
Land includes all forms of natural resources. In addition to earth’s soil, land covers, other
natural resources such as mineral wealth (in the form of coal, tin, petroleum, iron ore, gold
deposits, etc.) as well as forest and climate resources. From this, we can say that it is
impossible to produce without land. Land is a gift of nature; it is not created through man’s
effort. But it is not productive when taken by itself. It needs some sort of help from other
inputs.

Labor
Human effort, called labor, is a necessary and an important part of any economic activity
which is directed towards producing goods and services. We can distinguish two different

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types of labor. A man who cut a tree in the school field uses an aspect of human effort. The
person who teaches economics in the class uses another aspect of human effort. The tree
cutter effort, which needs strength and very less mental power, is considered as manual
labor. The teacher on the other hand depends on his mental ability rather than physical
strength and his effort is called mental labor. Unlike land, the quantity of labor is not fixed.
It depends on the country’s population size, especially, the proportion of that population
which is engaged in productive activity. The quality of labor refers to its efficiency and
productivity.

Capital
The combination of land and labor would not yield much in terms of the production of goods
and services in the absence of raw materials, factory buildings, tools and machinery, as well
as fuel. These resources are called capital. These manufactured assets are used in further
production of goods and services. Capital supplements and makes the other factor of
production more efficient. The addition of capital to other factors of production increases the
level of production. For instance, the farmer who changes his implement from hoe and
cutlass to a tractor can plough more land and produce more. It is useful to recognize several
types of capital. In doing this, we can classify in to two way. Firstly, there are some forms of
capital which we can refer to as fixed capital. This category of capital is durable and does not
change in process of production. It is used up gradually over a relatively long period until it
is eventually scrapped or replaced. Some examples of this are factory buildings, equipment,
and machinery. The other type of capital, which is with in the framework of this two-way
classification, is known as circulating or working capital. This includes only those elements
of capital which are immediately used up in the process of production or transformation into
finished product. The clearest examples of this are raw materials, seeds, semi finished goods,
and fuel. The second form of classification makes a distinction between social and private
capital. Social capital consists of assets that belong to the community and the private capital,
as the name indicates, is capital holdings of producers.
Entrepreneurs
Production requires some kind of organization. There is the need to combine the first three
factors- land, labor and capital- in a best, effective and efficient way. Entrepreneur refers the

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function which includes the organization, planning, management and the bearing of the
general uncertainties that arise from production. From the definition of entrepreneurship
given above, it can be said that entrepreneur is the person who initiates, organizes, controls,
and directs the process of production. It also assumes the risks associated in the production.
More specifically, an entrepreneur is the person who makes the following decisions:

1. What commodities are to be produced, and the quantity of each:

_______________________________________________________________________
_______________________________________________________________________
2. What type of production unit, or what size of organization is required;
________________________________________________________________________
________________________________________________________________________
3. Where to produce:
________________________________________________________________________
________________________________________________________________________

4. How to produce:
________________________________________________________________________
________________________________________________________________________
5. How to distribute the output:
_______________________________________________________________________
________________________________________________________________________

4.3 Concept of Production Function

Production function describes the technical relationship between inputs and outputs. In other
words, production function shows the maximum output that can be obtained from a given set
of input such as land, labor, capital and entrepreneur.
Symbolically, we can put as follows
Q= f (La, Lb, K, E,)
The production function includes the variables that have direct or indirect influence on the
production process. It expresses the functional relationship between quantities of inputs and
outputs; this is called the production function. This can also be expressed in mathematical
equation form in which output is the dependent variable and inputs are the independent

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variables. Every manufacturing firm has its own production function, which is determined by
the state of the technical knowledge and managerial ability of that firm.

Assumptions
a) It is always related to a specified period.
b) Technical knowledge is assumed constant.
c) The firm in question will use the best and the most efficient technique available.
d) The factors of production are divisible into variable units.

4.4. Periods of Production

The short run is a period of production during which some inputs cannot be variable. A
variable input is one whose quantity can be changed. For example, because managers can
hire more or fewer workers to produce compact discs in a factory, labor is a variable input. A
fixed input is one whose quantity cannot be changed over the short run. For example, if a
factory has a certain number of machines occupying a specified amount of floor space are a
fixed input.

The short run can be best thought of as a period of production during which the firm is
confined to a given plant. It has some flexibility to vary input use within that plant, but it
cannot vary all inputs simultaneously. Typically, labor inputs are more variable in the short
run than are capital inputs, such as structures. A firm can work a factory around the clock in
periods of peak demand by using both day-shift and night-shift workers. However, it takes
more time than is available in the short run to increase the plant size by building additions to
existing facilities or constructing new facilities. In effect, in the short run there is a limit to
production because there is only limited plant capacity available.

A long run is a period of production long enough that managers have time to vary all the
inputs used to produce a good. In the long run there are no fixed inputs. It is clear that
producers have more flexibility in the long run than they do in the short run.

The actual period of time encompassing the long run is likely to vary from one industry to
another. For example, the owner of a hot-dog stand might be able to increase all of its inputs

69
in a month. However, an oil company could take years to increase the capital inputs, such as
refineries, required to produce more output. We can think of the long run as a planning
period in which managers contemplate future changes in the use of currently fixed inputs.
For example, in the long run the manager of a waterbed factory can consider expanding by
acquiring more floor space and machinery. The distinction between short-run and long run
production periods is not based on periods they are implementing. Rather it is based on the
difference between fixed and variable inputs. The classification of periods in to short run and
long run differs as we go from one industry to the other. The length of short run may be
influenced by technical and economic factors.
Concept check
1. What are the constituting parts of production?
______________________________________________________________________
2. Is a person who grows orange and consumes himself producing?
______________________________________________________________________
3. What is the difference between labor and entrepreneur?
______________________________________________________________________
4. Discuss the concept of production periods- short run and long run.
______________________________________________________________________

4.5 The Law of Diminishing Returns

The law of diminishing returns is a summery of what happened to output in relation to the
variable factor when this factor is combined with a fixed factor or several fixed factors.
Specifically, the law states that if the amount of one or more factors used in a given
production process is fixed, and increasing amount of other (variable) factors are combined
with the fixed factors, then the successive additions to total output which may rise at first will
eventually diminish. In the same way, the average output per unit of the variable input will
also eventually decline.
Thus, the law permits two opposite reactions. There may be increasing returns in the early
stages because of increasing the amount of the variable factor, but eventually, diminishing
returns will gradually take over. There is a simple explanation for these contradictory effects.
It is obvious that at very low levels of use of the variable factor, its efficiency or productivity
will be low since it has to be spread too thinly across the factor. Therefore, further increase of

70
the variable factor is beneficial. For example, one farmer who tries to cultivate 1,000 hectares
of farmland with his hoe cannot do much. Additional help in the form of more men is likely
to increase total output as well as labor productivity. This does not, however, change the
conclusion that sooner or later, as more and more men (in this case labor is the variable
factor) are added to the fixed input (i.e., land, and capital), the productivity of the variable
factor begins to fall because of overcrowding and the consequent inefficient use of the
variable input. People produce less, on the average, because they are now getting in each
other’s way.
A few numerical examples will perhaps illustrate the law of diminishing returns more clearly.
To start with, let us suppose that a farmer wants to grow teff on a plot of land whose size is
fixed. He also has a fixed quantity of equipment and tools.

Diminishing returns to labor

Units of Fixed amount Fixed Total Additions Average output
labor of labor capital output to output per unit of labor
1 1 2 1 -- 1
2 1 2 6 5 3
3 1 2 14 8 4&2/3
4 1 2 24 10 6
5 1 2 35 11 7
6 1 2 48 13 8
7 1 2 58 10 8&2/7
8 1 2 64 6 8
9 1 2 67 3 7&4/5
10 1 2 67 0 6&7/10
But he can vary the amount of labor he combines with the other fixed factors. How will the
crop yield vary with the amount of labor he employs? One possible outcome is shown on the
table. Three important relations are worth noting. First, we can see that total output increases
with increasing amount of the variable factor, labor. This trend is sustained until nine units of
labor have been used. Thus, when nine units of labor are employed, total output reaches its
maximum figure of sixty-seven. The use of the tenth unit of labor leaves this figure
unchanged.

71
But it is the next two relations which the law of diminishing returns summarizes. The second
relation, in particular, associates additions to total output with charges in the units of labor.
This relationship is referred to as the marginal physical productivity of labor.

The relationship shows two trends. First, addition to output increases with increases in labor
units. This goes on until the sixth unit of labor is employed. Then, the second trend takes
over; addition to total output falls consistently as more and more units of labor are added. It
eventually reaches zero, implying that the tenth labor unit contributes nothing to total output.
The declining portion of this relationship demonstrates the law of diminishing returns.

The third relationship, which is the average output per unit of labor, conveys the same
message as the second. Average productivity first rises, reaches a maximum, and eventually
declines as more and more of the variable input is used. This example should not be
interpreted to mean that the law of diminishing returns is unique to labor as a variable factor.

Total, Average and Marginal Products

Total Product: this the total output produced through the application or employment of the
available inputs.
Average Product: it is the ratio of the total output produced per a given period of time and
the variable factor employed in its production. Average product is used to measure how
productive are the variable factors employed, labor, capital, etc. Productivity is a measure of
the efficiency of factors.
Marginal Product: is the measure of an increase in output due to a unit increase in the
variable factor, keeping other factors constant.

4.6. Production Relationships

Production is the process of using the services of labor and equipment together with other
inputs to make goods and services available. Inputs are the labor, capital, land, natural
resource and entrepreneurship that are combined to produce any output. The relationship
between any combination of input services and the maximum output obtained from that
combination is described by a production function. Production functions are defined for a

72
given technology. An improvement in technology increases the maximum output obtained
from any combination of inputs and therefore results in a new production function.

Total Product Curve and the Marginal Product Curve

A total product curve describes how output varies in the short run as more of any one input is
used together with fixed amount of other inputs under current technology. Points on a total
product curve give the output that is obtained, given current technology, from any quantity of
the variable input used with the fixed input

Total product of a variable input, such as labor service, is the amount of output produced
over any given period when that input is used along with other fixed inputs. The first column
of the table shows the number of workers employed per week in your factory. The second
column shows the greatest possible output that can be produced with that number of workers,
assuming nothing else is varied when more workers are employed.

The marginal product of an input is the increase in output from one more unit of that input
when the quantity of all other inputs is unchanged. The marginal product of labor (MP L) is 7
pairs of shoes per week when you hire 1 worker because production increases from zero to 7
units when you hire the first worker. The marginal product of labor when you hire 2 workers
per week is 18 – 7 = 11 pairs of shoes per week. In other words, by hiring a second worker
your firm adds 11 units of output to its weekly production.

Number of workers TPL MPL APL

employed per week
0 0 - -
1 7 7 7
2 18 11 9
3 33 15 11
4 46 13 11.5
5 55 9 11
6 60 5 10

73
 7 63 3 9
8 63 0 7
9 54 -9 6
10 40 -14 4

MP
TP
AP

0
L

Graph A
Graph B

Figure 4.1: Relationship between TP, AP and MP

Graph A plots the data for the total product curve of labor from the table. The vertical axis
corresponds to the total output of running shoes per week. The horizontal axis shows the
number of workers hired per week. A smooth curve is drawn through the point showing the
pattern of variation in weekly output as labor input is increased while all other inputs are held
constant. Notice how production initially increases at an increasing rate as the curve becomes
steeper, up to the point at which 3 workers are hired per week. When more than 3 workers
per week are hired, the rate of increase in output decreases. You can see this in the fact that
the curve becomes flatter as more workers are hired. Eventually, when 8 workers are hired,
the rate of increase in the output is zero. At this point the total product curve is at a
minimum. This implies that there is a maximum amount of weekly output you can squeeze
out of your plant. Thereafter, hiring additional workers would actually decrease output. This
is shown in the dotted portion of the total product curve. As a manager who seeks to
maximize profits, you will never operate your plant in the dawn-ward sloping portion of the

74
total product curve. If you did so, you would be paying additional workers to decrease total
production. This implies higher cost and less output to sell, and therefore less revenue. The
increase in costs and decrease in revenue would both act to reduce your profit.

Graph B plots the marginal product of labor from the data in the table above. You will notice
that marginal product increases at faster and then decreases. You can also see that when
marginal product is decreasing, the rate of increase in total product is declining. This is
because the marginal product of labor is the slope of the total product curve. Marginal
product (MP) is:
MPL = △TP/△L
Where △TP is the change in the total product of labor and △L is the increase in the number
of workers hired per week. When the marginal product of labor is zero, total product is at its
maximum value per week. This is because at the point at which MP L is zero, hiring another
worker does not add to the production anymore, and hiring still one more worker would
begin to reduce output. When marginal product is negative, additional workers decrease
weekly production.

The Relationship between Average Product and Marginal Product of Labor

Graph B plots the average product of labor on the same set of axes as the marginal product of
labor. You will notice that when the marginal product exceeds the average product, the
average product increases. This is because the marginal product is the last number added into
compute the average product. When the marginal product exceeds the average product, the
average product has to go up. A good way to understand this is to think about your average
of test grades at any point. Until the end of the semester, your average changes each time you
take another test. The grade in each extra test is your marginal grade. Suppose you have an
80 average on the first two tests. What happens to your average if you have an 85 on the third
test? Your average must increase because the last number, your grade on the third test,
exceeds your previous average. By the same token, your average will fall if you get a grade
of less than 80 on the last test.

4.6.1. Stages of production

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Stage 1: this range of production reveals the increase of both of the average and marginal
products, but the increase in marginal product is more pronounced than the increase
in average product. This stage covers the area from the origin to the point where the
average and marginal products get equal. In this stage, addition of a variable input
produces a higher increase in total product. Average product gets its maximum in
this stage. The point as which average product gets higher is called point of
diminishing returns. Because before this point marginal product is above average
product, but from this point on wards the average product will dominate, showing
that every addition in the variable factor will produce a smaller output than the
previous employment. Stage 1 is not the efficient stage of production.

TP
MP
AP

TP

II
I III

76
AP

0 L
 Figure 4.2: Stages of production

Stage 2: this stage extends from the maximum point of average product curve to the point
where the marginal product curve becomes zero. Up to the point where marginal
product reaches its maximum, addition of a variable input induces the total product
to increase at an increasing rate. This is the stage of increasing returns to variable
factors. However, after that point total product increases at a decreasing rate. Stage
2 is also called as the stage of diminishing returns to the variable input. The ending
boundary of this stage demarcates the maximum point of total product. When
marginal product equals to zero, total product reaches its maximum.
Stage 3: marginal product gets negative in this stage and the total product falls. This stage
has nothing relevance to the efficient decision of firms because this is the stage of
negative returns to variable factors. In here, employment of additional inputs could
never produce an increase in total output.

Therefore, the efficient point in the production process must be stage 2.

As we have learnt in previous topics, the production of any commodity requires the use, in
appropriate proportions, of many types of resources. These resources have been referred to as
factors of production or inputs.

A producer who wishes to make use of resources for production purposes must, of course,
pay for them. The payments which have to be made for factor inputs in order to secure their
use in any productive activity are called costs of production.

Concept check

77
1. How could marginal product be the slope of total product curve?
_____________________________________________________________________
2. What will happen to total product when marginal product get zero?
______________________________________________________________________
3. Why don’t we advice firms to increase profit by producing more rather than following the
marginal analysis.

_______________________________________________________________

4.7. Types of Costs

There are two principal ways of classifying production costs. The first method groups costs
into two categories. These are (a) explicit costs, and (b) implicit costs. Explicit costs
represent payments made to acquire purchased inputs. Example of such costs include wages
paid to hired labor, payments made for rented buildings, costs of purchased raw materials,
fuel and power. Thus, explicit costs are payments made by the entrepreneur or producer to
other people whose resources are used in the entrepreneur’s productive activity.

Implicit costs are usually less obvious. They represent payments which should be made for
services provided directly by the producer or entrepreneur himself. For instance, the owner of
a small bookshop may operate his business with the help of only paid shop assistant. This
means that he not only owns the shop, but he also contributes his labor time as the manager.
The payment which he should make to himself as manager is an implicit cost; whereas the
salary he pays to his shop assistant is an explicit cost. Furthermore, if he does not own the
room which he uses as a shop, he has to pay rent for the space. This is an explicit cost.
However, if he owns the building itself, then the payment for the rent should be made to
himself as an implicit cost. Similarly, the maize farmer who provides most of the labor time
required on his farm should pay himself the implicit cost of this labor time.

The second classification method groups costs of production into two other categories. These
are (a) fixed costs, and (b) variable costs. This classification corresponds to the two
categories of factors of production, which we have discussed in a previous section.
According to this classification, there are two classes of inputs-fixed inputs and variable

78
inputs. Fixed costs represent payments made for the use of fixed factors of production, while
variable costs are the amount of money spent on the use of variable factor inputs. Fixed costs
are, therefore, costs which do not change with the level of output or size of production. For
instance, let us suppose that we have a vehicle assembly plant. This plant, with its factory
building and installed machinery, has the capacity to turn out 200 cars per day. What
happened to the costs of production if the plant can only operate at half capacity and thus
produce 100 cars per day? Fixed costs, which include rent paid on space, interest on loans,
depreciation reserve for machinery, and management expenses, will remain the same.

In comparison, variable costs change with the level of output. They increase as output level
rises; they fall with decrease in output level, and they cease when production ceases. In the
vehicle assembly plant example described above, variable costs would include wages for
direct labor and payments for power, fuel, and raw materials. These costs go up as output
increases because in order to produce more cars, more labor, raw materials and fuel have to
be used. Hence, variable costs will increase as size of production grows.

In fact, it is sometimes difficult to make clear-cut distinction between fixed and variable
costs, except we relate these costs to time. Whether factors are fixed or variable in quantity
has something to do with time. In particular, economists identify two time periods within
which factors can be described as fixed or variable. For example, the long run is defined as
the period of time during which a production unit or firm can vary the quantity of any of its
inputs. As against this, the short run is the period of time during which some factors of
production (e.g., factory buildings and machinery) in use remain fixed in quantity.

Hence, fixed costs represent payments for all factors whose quantities remain fixed in the
short run. Similarly, variable costs are payments for factors whose quantities can be changed
even in the short run. In the long run, the quantity of any input can be changed. Therefore, all
costs are variable in the long run.

It is important, finally, not to confuse the two forms of classification described above. In
other words the distinction between fixed and variable costs is not necessarily the same as

79
that between implicit and explicit costs. A variable cost can be either explicit, implicit or
even a combination of both. The same is true in the case of a fixed cost.

4.7.1. Economic cost vs. accounting cost

Economic cost is the monetary value of all inputs used in a particular activity or enterprise
over a given period, say a year. The idea behind economic cost is that the sum of Birr
representing the value of resources used must accurately reflect the opportunity cost of those
resources. Remember, the opportunity cost of a resource used in a particular activity is its
value in its next best use. When firms hire or purchase inputs in market, the market price in
most cases reflects the value of those resources to other. Owners of firms give up funds to
buy these resources; and if they are rational, they consider the opportunity cost of not using
those funds in their next best uses.

Costs as measured by accountants do not include the opportunity cost of inputs supplied by a
firm’s owners. Accounting cost measures the explicit costs of operating a business. Explicit
costs do not include the value of non-purchased inputs. Accounting cost provides valuable
information. Those who own business, however, are aware of the shortcomings of this
measure and actually base their decisions on economic cost, including implicit costs, to
accurately measure their opportunity costs.

4.7.2. Average cost (Ac)

Average cost is total cost divided by the number of units of output produced over a given
period. It is also called average total cost. Managers often refer to average cost as their unit
cost:
AC= TC/Q
Average variable cost (AVC) is total variable cost divided be the number of units of output
produced over a given period.
AVC = VC/Q

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Average fixed cost (AFC) is total fixed cost divided by the number of units of output
produced over a given period.
AFC = FC/Q
It is easy to show that average cost is the sum of average variable cost and average fixed cost.
Remember that total cost is the sum of variable cost and fixed cost. It follows that:
TC/Q = VC/Q + FC/Q
Because dividing both sides of an equation by the same variable does not disturb the equality.
The first term of the equation just given is AC. The two terms on the other side of the equal
sign are AVC and AFC, respectively. It follows that:
AC = AVC + AFC

4.7.3. Marginal cost

Marginal cost (MC) is the extra cost of producing one more unit of output. There is no
accounting concept that parallels marginal cost. However, all good business managers have
an idea of their marginal cost and use their estimates of marginal cost of production to make
decisions.

We can calculate marginal cost from the data in the box below. As is common in many
businesses, the data show increases in weekly output associated with additional workers
rather than increase in cost for each unit of output. However, we can approximate marginal
cost from the data by recalling that marginal cost can be thought of as the change in cost
associated with any given change in output. Marginal cost for the batch of output associated
with each extra worker can be calculated from the following formula:
MC = △TC/△Q
Where △TC is the change in total cost associated with any given change in weekly output,
△Q.

The table in below calculates marginal cost from the data on total cost and output. The
second column shows the change in total cost associated with each change in output as more
workers are hired. For example, the change in total cost when the first worker is hired is
△TC = Br. 1300 – 1000 = Br.300. The change in output is △Q = 7-0 = 7. Marginal cost for
the batch of shoes produced by the first worker is therefore approximated as Br. 300/7 =
Br.42.86. Notice that marginal cost depends only on changes in variable cost. Because fixed

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cost does not change as output changes, fixed cost does not influence marginal cost. Marginal
cost is influenced by only variable cost. For example, here fixed cost is Br.1000. As output
increases, fixed cost remains Br.1000. Only labor cost, which is the variable cost, increase as
output increases.

Marginal cost decreases at first and then increases. The eventually increasing marginal cost
of output reflects the law of diminishing marginal returns. As more of the variable input is
hired, the extra output obtained eventually becomes smaller and smaller.

Calculate marginal cost

Output Change in total cost Change in output Marginal cost

7 1300-1000=300 7 42.86
18 300 11 27.27
33 300 15 20
46 300 13 23.08
55 300 9 33.33
60 300 5 60
63 300 3 100
Relationship between the Total Cost Curve and the Total Product Curve

It is now possible to derive a total cost curve from your running-shoe firm, whose total
product curve was drawn in the previous graph, by making a few simplified assumptions.
First, let us assume your firm uses two inputs in the short run: labor, a variable input and
capital, a fixed input. Lumped into capital are the services of all machines, structures and
land, the inventory of materials the firm keeps on hand, and any other equipment. Assume
that the monthly cost of all capital is 1000Br. This is your firm’s monthly fixed cost.

The only variable input is labor services. Assume that as the firm’s manager you can hire all
the workers you desire at the going market wage of Br.300 a week. It is now possible for us
to use the data on production in the table to calculate the firm’s total cost and show how that
cost varies with output in the short run. The table shows how costs vary with output as your
firm produces more by hiring more workers.

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 Labor used Total output Fixed cost Variable cost Total cost
0 0 1000 0 1000
1 7 1000 300 1300
2 18 1000 600 1600
3 33 1000 900 1900
4 46 1000 1200 2200
5 55 1000 1500 2500
6 60 1000 1800 2800
7 63 1000 2100 3100
8 63 1000 2400 3400
9 54 1000 2700 3700
10 50 1000 3000 4000

The next graph plots the data for variable cost. The vertical axis measures the variable cost,
while the horizontal axis measures the corresponding weekly output of running shoes. It is
easy to show how the variable cost curve is related to the total product curve drawn before.
The total product curve shows how output varies with the number of workers hired per week
and reflects the law of diminishing marginal returns. The variable cost curve shows the
relationship between labor cost and output produced. Because the weekly wage does not
change as more workers are hired, the variable cost curve reflects the way output varies with
labor input. The shape of the variable cost curve mirrors the shape of the total product curve.
To prove this to you, turn the book so that the next graph is on its side and hold it up to a
mirror. You will see that the shape of the variable cost curve looked at in this way parallels
that of the total product curve drawn previously, except it does not include the variable cost
levels corresponding to points at which the marginal production of labor would be negative.

C
VC

63 Q 83
Figure 4.3: Variable cost curve
 Notice in the first table that the maximum possible output of running shoes in your factory is
63 pairs per week. Accordingly, if you tried to hire more labor to produce more than 63 pairs
per week, variable cost would increase but output could not increase. As a manager who
seeks to maximize profit, you will not hire more labor if you can not increase saleable output
by doing so. Therefore the variable cost curve in the previous graph is extended upward after
your firm reaches a weekly output of 63 pairs of shoes.

Isocosts /Isoclines
An isocost refers to various combinations of factors that can be hired with given outlay and
available input prices. It can also be expressed as the price ratio of the two factors. The slope
of an isocost is given by -P L/Pk where PL refers to the price of labor and P k to the price of
capital. Since the slope of iso-cost curves is negative, we find the negative sign before the
price ratio.
Capital

Y
10
If the firm spent all of its outlay
8 on capital, it could purchase total

6 outlay equal to 10 units of capital.

If the firm spent all of its total
4
outlay on labor, it could purchase
2 X
total outlay of 100 units of labor.
O
20 40 60 80 100
Labor

The firm can purchase any combination of labor and capital shown on its isocost line. If the
farmer uses labor-intensive technology, his most outlay would be on labor than on capital.
Unlike the isoquant and the indifference curves, the isocost curves are linear.

84
4.8. Economies of Scale
Economies of scale (sometimes called increasing returns to scale or economies of mass
production) are reductions in unit costs resulting from increased size of operations. The scale
of a firm’s operation increases as a firm becomes bigger by operating out of larger plants.
Economies of scale can be the result of increases in the productivity of inputs caused by
increased specialization and division of labor as the firm builds more or bigger factories. This
is quite common, particularly as a firm initially expands production. With only one worker
and one machine, there is little opportunity to allocate specialized tasks to labor. When there
are two workers and two machines, one worker can specialize in machine operations and the
other can specialize in hand-finished operations.

Economies of scale also results from the fact that a larger scale of operations does not require
a proportionate increase in all inputs. For example, to double his grazing area, a farmer does
not have to double the amount of fencing. This is because the perimeter of his farm does not
double when its area doubles.

Finally, economies of scale can result from shifting in the method of production as a firm
expands productive capacity in the long run. Expanding operations also permits use of more
sophisticated machinery and allows workers to specialize in certain tasks. Some production
processes are not feasible to use when firms are small. However, as a firm grows in the long
run its greater productive capacity makes it economical to use new production processes that
are too expensive to use when output is low. Typically a firm shifts to a more capital-
intensive (meaning more equipment per worker) production process as it expands. The use of
more capital per worker increases labor productivity and helps reduce cost per unit of output.

Finally, a firm may be able to purchase certain inputs at lower prices per unit when it buys in
greater volume. This helps reduce average cost of production.

Economies of scale are eventually exhausted in the long run. As a firm becomes large, it is
likely to encounter diseconomies of scale (also called decreasing returns to scale), which are
increases in average costs of operation resulting from problems in managing large-scale set

85
in or the reason for their occurrence. However, as a firm expands, communication between
managers and workers often is impaired. Workers sometimes shirk their duties, and the firm
can become more difficult to manage. However, the level of managerial skill varies from
firm to firm, and it is not at all certain that diseconomies of scale will occur in all enterprises.

Most businesses are likely to enjoy a fairly long range of output for which average costs
neither increase nor decrease in the long run. Constant returns to scale prevail when
economies of scale no longer exist and when average costs do not increase as a result of
diseconomies of scale in the long run. If constant returns to scale prevails at all possible
outputs in the long run, the long run average cost curve would be a horizontal line. If
constant returns to scale prevailed from zero output on, large-scale firms would have no cost
advantage over small-scale firms.
4.9. Revenue Analysis
The concept of revenue is necessary to understand the notion of equilibrium of a firm.
Revenue is the total sale of a firm’s output for monetary values. This concept has different
forms, Total revenue, marginal revenue and average revenue.

4.9.1. Types of Revenues

 Total Revenue (TR)

Total revenue is the amount of money that a firm receives for the offer of goods and services
in the market. It is directly the opposite of the total cost, in a sense that total revenue is
receiving money while total cost is the money outlay.

A firm’s total revenue can be calculated as the quantity of goods sold multiplied by the price.
The total revenue includes the product of the quantity sold and the price.
Total revenue = total quantity sold × unit price

 Average Revenue (AR)

Average revenue is used as price in a perfectly competitive market. This can be found by the
ratio of the firm’s total revenue and the number of goods sold.

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 Total Re venue
AR = Output sold
AR = P×Q
Q
Since the Q can be cancelled, the equation remains with AR = P

 Marginal Revenue
Marginal revenue is the extra money received by selling one more additional unit of the
commodity. It is an addition to the total revenue of a firm as new additional units are sold. By
selling an additional unit, a firm earns additional revenue that adds to the total revenue and
this addition to revenue is called marginal revenue.
It is given in the form,
MR= △TR/△Q
4.10. Isoquant Analysis of Production
Iso-quant (iso-product): a locus of points joining the various combinations of labor and
capital which yield the same level of output. This concept is as the same as the indifference
curve analysis of consumer’s utility. Iso-quant slopes down from the left to the right, which
indicates the trade off between the two factor inputs. Iso-quant may exhibit different shapes
depending on the substitutability and complementarities between the two inputs. The perfect
substitutability between the two factors is revealed by a linear iso-quant curve. As discussed
in the previous unit, a combination of labor and capital as two inputs for providing output of
a certain commodity may involve different methods of production. The choice of any
technique depends on various economic factors; through technical efficiency is another
guiding factor. In this regard, the concept of iso-quant is important for understanding the
process of production. An iso-quant is “the locus of all technical efficient methods, or all the
combinations of factors of production for providing a given level of output”.

Y
Linear Isoquant - This isoquant assumes
substitutability of factors of production.
87
Capit

A the linearity of the curve does not

al

guarantee us the perfect substitutability of

 O substitutability depends on the slope of
Labor
the curve.

Capital
O

Y
A
Labor

A needs the additional employment of labor

for the increased production.

the supply of one. Every addition of capital

addition of the other input as we increase
This production technique requires an
substitutability of the factor of productions.
strict
Input-output Iso-quants – This assumes
complimentarily
that

Y
Smooth Convex Isoquant – In this type
Capital

is

of isoquant, capital and labor are

substitutes but this substitutability does
zero

not continue all across the iso-quant

curve. As we go through the iso-quant
A down from left to right, the
88
substitutability diminishes; usage of
X
capital would have more return than
Labor labor.
 Figure 4.4: Isoquant curves

An isoquant shows the different combinations of labor and capital with which a firm can
produce a specific quantity of output. A higher isoquant refers to a greater quantity of both
output and input levels and a lower one to smaller quantity.

Properties of Iso-quant
Iso-quant is negatively sloped: the slope negativity is a normal indicator of the
substitutability of the two factors. Iso-quant could not have positive slopes since a positively
sloped iso-quant indicates an increase of inputs while the output is kept constant.

No intersection between iso-quants: an intersection between two iso-quants indicates that two
different combinations of inputs can produce the same level of output. The same combination
cannot be both less and more productive at the same time. Hence, two iso-quants cannot
intersect each other.
The further an Iso-quant is from the origin, the higher would be its output.
Iso-quants are drawn at every point in the capital labor plane.
No iso-quant can touch either of the axes. If an iso-quant touches either of the axes, it means
that the commodity can be produced by using either of the factors alone.

Iso-quants are oval shaped.

Iso-quants are convex to the origin.

Concept Check
1. What are the different types of costs?
____________________________________________________________________

89
 2. What is the source of revenue for a producing firm?
_____________________________________________________________________
3. Explain the concept of economies of scale.
_____________________________________________________________________
4. Describe the different characteristics of isoquant?
_____________________________________________________________________

4.11. Marginal Rate of Technical Substitution (MRTS)

The marginal rate of technical substitution is a measure of the sacrifice one factor for the
addition of the other. The marginal rate of technical substitution or the marginal rate of
substitution (MRS) refers to the rate at which one factor is changed for the other factor to
remain in the same output level. The MRS is equal to the marginal product ratio of labor and
capital. As the firm moves down on an isoquant, the MRS declines. For example, the MRTS
of x to y is the amount by which y can be forgone per unit of increase of x for maintaining a
constant level of output.

Consider the following graph on an isoquant which defines the combination of x and y used
in the production of Q.

We can see from the figure that quantity of y decreased from OK1 to OK2 and quantity of x
increased from OL1 to OL2. The rate at which y is substituted by x would be the ratio of
changes in quantities of these units. Thus, MRTS is the ratio of the two changes in the
factors.
MRTS = (OK1-OK2) / (OL2-OL1)
The result would have negative sign, which is an indication of the negative slope of the
isoquant curve. Therefore, the slope of the iso-quant curve is MRTS.

Y
The slope of the line through the origin
Capital

K1 representing the particular process

Q1
measures the factor intensity of any
Q2
x process. The factor intensity is the
capital-labor ratio. Labor 90
L1 L2 X

Figure 4.5: MRTS

 O
In the above figure, process Q1, is more capital intensive than process Q2. Because the capital
proportion in the production process is larger than the labor.
K1 K2
L1 > L2

The upper part of the isoquant includes more capital-intensive process. The lower part of the
isoquant includes more labor-intensive techniques.
Concept check

4.12. Fixed Proportion Production Function

Iso-quants are normally curves that show different combination of factors which produce the
same level of output. But there are also cases by which factors lack substitutability. In such a
case, factors can be productive if and only if they are attached with other factor(s) unless
their marginal product will be zero. There would be no possibility of input substitution and
the iso-quant would be at right angle shape. There would be no tendency for production to
increase unless we increase the two inputs in the same proportion.

4.13. Producer’s Equilibrium

Behind the survival objective of firms, they may assume to maximize output or minimize
costs, at a given output level. Based the above thinking, a producer is in equilibrium when it
achieves its objective. A producer is in equilibrium when he maximizes output for his given
total outlay or when he minimizes his cost, subject to a fixed level of output. This means the
producer is in equilibrium when he reaches the highest iso-quant, given the iso-cost.
Equilibrium of the firm is defined at a point where the iso-quant makes a tangency with the
iso-cost curve. Tangent curves have always-equal slope at the point of tangency. Thus, the
two curves, iso-quant and iso-cost, have equal slope at their tangency. At equilibrium,
MRTSLK = -PL/PK, where MRTSLK is the slope of the iso-quant curve and PL/PK is the slope of
the iso-cost curve.

91
 MP L PL MP L MP K
= or =
MP K PK PL Pk

Minimum Cost Input Combination

A tangency of the isoquant and an isocost line implies that the slope of the isoquant equals
the slope of the isocost line at that point. Because the slope of the isoquant is MRTSLK and the
slope of the isocost line is – PL/PK, the condition for minimizing the cost of producing a given
output can be written as:
PL = MRTSLK
PK
This equation shows that, least costly production method is influenced by the prices of
variable inputs and by the marginal rate of technical substitution between variable inputs.
The marginal rate of technical substitution associated with any given input combination on
an iso-quant depends on technology. However, you are free to substitute inputs for each other
given technology by varying production methods until input use is adjusted to meet the above
condition. The actual production method you choose depends on both input prices and
technology affecting the marginal rate of technical substitution. Changes in technology
change the shape of the iso-quants and cause movement to a new least costly production
method.

Given the same technology available to two nations, you would not expect to see capital-
intensive methods used to produce goods and services in nations where labor is cheap
relative to capital, as is the case in China. On the other hand, in the United States labor is
expensive while capital equipment is relatively abundant. It is therefore not surprising to see
highly mechanized apparel manufacturers in the United States, while in China the same
clothes are produced with less capital-intensive techniques- even though both nations have
access to the same technology.

Note that changes in the prices of labor or capital will change the slope of the iso-cost lines.
When this occurs, assuming no change in technology affecting the shape of the iso-quant,
managers will respond by adjusting their production method until the iso-quant is just tangent

92
to one of the new iso-cost lines. For example, if the price of the machine rental in China were
to decrease relative to the price of labor, China would become more capital intensive.

4.14. Production Possibility Curve

You will see the problem of scarcity more dearly with the aid of a simple model whose
purpose is to examine the relationship between the production of goods and services and the
availability and use of resources. In the analysis we make the following assumptions.
1. The quantity and quality of economic resources available for use during the year are
fixed. There is a given amount of labor, land, capital, natural resources, and
entrepreneurial ability available for use during the year. This limits the extent to
which our desires for goods and services can be satisfied during the year.
2. There are two broad classes of outputs we can produce with available economic
resources over the year: food and clothing. We make the assumption of only two
products to simplify the analysis while showing the basic tradeoffs we must consider
while coping with the problem of scarcity.
3. Some inputs are better adapted to the production of one good than to the production
of the other. A pickup truck can as easily be used to transport materials needed to
produce clothing as to transport materials needed to produce food. However, a loom
that is used to weave cloth is virtually useless in the production of food. The loom
might be dismantled and its parts used in agriculture machinery, but it is much
productive when used intact to manufacture clothing. Similarly, some workers have
skills that are better adapted to one use than the other. Transferring a skilled tailor
from clothing to food production will cause a greater loss in output of clothing than
when a truck driver’s labor is transferred from delivering clothing to delivering food.
Transferring the labor of an experienced farmer from agricultural to clothing
production, results in a greater loss in food output than does transferring the labor of a
crop picker. The more specialized a worker, the higher the opportunity cost of
transferring him or her to an area out of that specialty.
4. Technology is fixed and does not advance during the year. In general, advances in
technology take more than 1 year to develop. In assuming fixed technology, we are

93
 implying that the productiveness of inputs does not change during the year as a result
of improving knowledge or technical advances.
Given available resources, their quality, and current technology, there is a limited amount of
any one good that can be produced in an economy given the output of other goods. A
production possibilities curve shows this graphically. The curve shows the maximum
possible output of one good that can be produced with available resources given the output of
the alternative good over a period. A production possibilities curve for good and clothing
shows the maximum number of garments that can be produced each year given each possible
level of food production. The curve shows the options available to produce various
combinations of goods and services under current technology during a year, assuming the
resources are fully utilized.
4.15. Expansion Path
Expansion path shows how the use of inputs by a producer will vary as the firm expands its
production. Assuming that the producer minimizes the cost of producing any given output,
we can derive the expansion path by connecting points of tangency of isoquants and iso-cost
lines. Such an expansion path is illustrated in the box.
Only a few iso-quants have been and labeled according to the amounts of monthly output to
which they correspond. The minimum possible cost of producing each output is given by the
tangency of each iso-quant and iso-cost line. Points on the variable cost curve can be derived
simply by plotting the month cost of each output level. Each point on the variable cost curve
gives the minimum cost of producing that output given the prices and technology.

Machine hours
B
Q2
12

10

8
Q3
QII2
Q1
O
80 100 120
Labor hours
94

: An expansion path
Notice how the expansion path drawn in the Box bends upward as output is increased by
moving to higher and higher iso-quants. This shape of the expansion path implies that the
ratio of labor to capital would be constant only in the case of a straight-line expansion path.
The expansion path shown in the above box is quite realistic for most enterprises in the long
run because production methods often become more capital intensive as an enterprise grows.
This is because, as firms become larger, they tend to become more mechanized by increasing
the ratio of machine hours to labor hours used to produce any given amount of output.
Concept check
1. What is defined by the intersection point of marginal cost and marginal revenue
_______________________________________________________________________
2. What does production possibility curve defines?
________________________________________________________________________
3. How firms achieve long run economies of scale while we are talking about the law of
diminishing marginal returns?
________________________________________________________________________

95
Summary
Production is the process of transforming inputs from less useful to more useful type. The
transformation requires some inputs such as land, labor, capital and entrepreneur, which are
under the category of factors of production. These factors of production has nothing
importance without one another. Production can be undertaken in different forms just to
satisfy different wants. These can be through form utility, time utility, place utility, etc. The
end aim of production is consumption. Factors are divided in to two broad categories, fixed
and variable. Fixed inputs are inputs whose quantity cannot be increased in a given period.
However, variable inputs can be increased at any time. There are three production stages,
stage 1, stage 2, and stage 3. The difference between these production stages is due to the
increase and fall of both the average and marginal products. The first stage is characterized
by increasing total output at an increasing rate. The second stage exhibits an increasing total
output at decreasing rate. However, total output falls in the third stage. Law of diminishing
returns to scale states that if increasing amount of a variable factor is applied with some fixed
factor, the amount added to the total product by each additional unit of the variable factor,
which is the marginal product, will eventually decline with the increasing quantity of the
variable input. Returns to scale is the relationship between variable inputs and total output.
Iso-quants are locus of points that join points of similar output level. Iso-quants have many
characteristics such as negatively sloped, never cross each other, are drawn everywhere in the

96
capital-labor coordinate plane, each iso-quant is oval shaped, etc. the various combinations of
two inputs- capital and labor- a firm can purchase given a total outlay and input prices of the
firm is called iso-cost curves. The firm’s equilibrium is at the point where the slope of iso-
quant curve equals the slope of the iso-cost curve. Expansion path is a line that joins points of
equilibrium as the firm increases his outlay, while input prices are constant.

Questions
1. What is production?
____________________________________________________________________
2. What is production function?
____________________________________________________________________
3. Explain the law of variable properties.
____________________________________________________________________
4. What are factors of production?
___________________________________________________________________
5. Describe the periods of production.
____________________________________________________________________
6. What is MRTS?
____________________________________________________________________
7. List at least three examples of explicit costs.

_____________________________________________________________________

97
 CHAPTER FIVE

PERFECT COMPETITION

Contents
5.1. Introduction
5.2. Perfect Competition
5.3. Demand for a Competitive Firm
5.4. Price Variation due to Change in Output
5.5. Using Marginal Analysis to Choose the Profit Maximizing Output
5.6. Profit Maximization
5.7. The Decision to Shutdown in the Short Run
5.8. The Competitive Firm's Short Run Supply Curve
5.9. Long Run Competitive Equilibrium

5.0 Aims and Objectives

After reading this chapter, you should be able to:
☞ explain the concept of perfect competition in markets

98
 ☞ explain why the demand curve for the product of a competitive firm is perfectly
elastic at the market equilibrium price.
☞ explain how the total profit a competitive firm can earn over a period varies with
the output actually sold given the market price of the product.
☞ show how a supply curve can be derived for a competitive firm that maximizes
profit from selling a single product and how the market supply curve can be
derived from the supply curves of individual firms in an industry.

5.1. Introduction
Dear Student! There are four types of market structures. These are perfect competition,
monopoly, monopolistic competition and oligopoly. Perfectly competitive markets are
market structures through which many sellers and many buyers can participate To develop a
theory of supply, we begin by making a number of simplifying assumptions. Although these
assumptions may seem quite unrealistic to you, they allows us to develop a model that
uncovers the basic forces that underlie supply by profit-maximizing firms in markets. In this
instance, as is the case for all economic models, you will find that unrealistic assumptions
will yield useful insights into the way the economy actually functions. The purpose of the
model we will develop in the chapter is to allow us to use marginal analysis to explain how
quantity supplied to a market in the short run is related to the price of a product, assuming
that sellers maximize profit.

5.2. Perfect Competition

The theory of supply is based on the simplifying assumption of “perfect” competition in a
market for a product. A perfectly competitive market exists when the following conditions
prevail:
1. There are many sellers in the market. In a perfectly competitive market, the number
of sellers usually exceeds 100 and is often in the thousands.
2. The products sold in the market are homogeneous, which means that the product of
each seller is identical to that of other sellers. A homogeneous product is one that is
standardized. Grade A eggs are an example. Buyers view the product sold by any one
seller in the market as a perfect substitute for that of any other seller.

99
 3. Each firm has a very small market share of total sales. Market share is the percentage
of total sales over any period accounted for by a single seller. Generally, in a
perfectly competitive market, no seller has a market share exceeding 1%.
4. No seller in the market regards competing sellers as a threat to its market share. Firms
therefore are unconcerned about their competitors’ marketing or production decision.
5. Information is freely available on price, technology and profit opportunities, and
resources are mobile.
6. There is freedom of entry and exit by sellers of the standardized good. This means
there are no restraints preventing firms from entering the industry, nor there
difficulties involved in ceasing operations.

In a perfectly competitive market, an individual seller cannot influence the market price of its
product. Because each seller’s product is a perfect substitute for that of any other seller on
the market, buyers have no reason to prefer the product of one seller to that of any other. A
firm that tries to charge more than the going market price for its product will lose all its
customers to competing sellers.

In a perfectly competitive market no individual firm can shift the market supply sufficiently
to make the good scares or more abundant. Even if one firm withholds its entire production
from the market, this will not cause the good to become scarcer and therefore will not result
in an increase in the market price. If the firm floods the market with its output, the good will
not become sufficiently more abundant to result in downward pressure on market price. This
means that no seller in the market can affect the price of the product by offering to sell either
more or less.

A competitive firm is one that sells its product in a perfectly competitive market. A
competitive firm is characterized as a “price taker” because it can only react to the market
price and cannot by itself cause the market price to go up or down. In a perfectly competitive
market the number of sellers is responsive to the profitability of the selling the industry’s
product. Free entry and mobility of resources ensure that the number of sellers, and therefore
market supply, will increase when it is profitable to sell the product in the market.

100
5.3. Demand for a Competitive Firm
The market demand curves for the product sold by a competitive industry composed of many
firms selling a homogeneous product is down ward sloping. Market price is determined by
demand and supply in the competitive market, in which prices adjust until quantity demanded
by the many buyers equals quantity supplied by the many sellers.

For example, suppose firms in a segment of the furniture industry produce standard-sized
futon (you know-those comfortable, economical couch substitutes that are a basic in Japanese
decor). Assume there are 1000 firms in the industry and consumers regard the product of any
one firm as a perfect substitute for that of any other. The market in which these firms sell
their futons is perfectly competitive, and each firm can be considered a price taker. Each
individual firm in the industry is very small and operates out of a very small plant in which it
can produce small number of futons each day.

In box 1, A shows how the market price is determined by supply and demand and how this
influences the demand as seen by any single competitive firm in the industry. The market
demand and supply curves for the futon intersect at point E. The corresponding market
equilibrium price is 150Br. per futon, and the equilibrium quantity sold per day at the price is
8000.

The graph labeled B shows the demand curve as seen by any firm in the industry. This
demand curve is a horizontal line. We can easily understand the reason for this by
considering the short run productive capacity of each firm in the industry. Suppose each firm
can produce no more than 5 futons per day in it’s existing plant. The most any one can add to
(or subtract from) market supply is therefore 15 units per day. Even if any one firm adds or
subtracts this maximum amount, the shift in the supply curve will be imperceptible. There
would therefore be no perceptible effect on market price. To see this, go to A in box 1 and
note how removing 15 futons per day from the market quantity supplied of 8000 at the
Br.150 price will not noticeably change the quantity supplied. No firm has the capacity to
make the good appreciably more abundant or scarce. This means that any firm can sell all it
wants at the market equilibrium price. This being the case, there is no incentive to sell at any

101
price lower than the market price. A firm that lowers its price will not be able to sell more
than it would otherwise. The decrease in price would therefore lower revenue but have no
effect on the quantity of futons sold and the cost of production selling at a price below the
market equilibrium price would therefore decrease a firm’s profit.

P P
SS

E
DD

Q Q
market price
The standardized and
product the
sold by demand for output
any one competitive ofisaa perfect substitute for that of
firm
any other competing seller. The horizontal demand curve of each firm in a competitive
Competitive Firm
industry is perfectly elastic at the market price.

5.4. Price Variation due to Change in Output

Profit can be calculated as the difference between total revenue (TR) and total cost (TC) per
sales period:
Profit = TR - TC

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Total revenue is the price (P) of the good sold multiplied by the amount produced (Q). The
total cost of production includes all implicit costs. This means that profit is measured as
economic profit.
The price is beyond the influence of a competitive firm. Therefore, the only way a
competitive firm can influence its revenues is by varying the amount it produces. However,
as output changes, so does cost. The current market price of standard-size futons is Br.150.
Total revenue per unit of a good sold is called the average revenue of the good.
Average revenue = Total revenue
Q

Where, Q is output.

Because total revenue is P × Q, it follows that:

Average revenue = PQ = P
Q
Therefore, average revenue, or revenue per unit, is the price of a product.
The table in Box 2 provides hypothetical data on output, revenue, cost, and profits for a
typical futon producer selling in a competitive market. We assume the firm has fixed costs of
Br.100 per day and the pattern of variation of short run costs reflects the law of diminishing
marginal returns.

Graph A in Box 2 plots total revenue and total cost for the data in Box 2 and shows profits
graphically as the difference between the two curves. Graph B plots daily profit. Total
revenue increases by Br.150 each time an extra futon is sold. The graph of total revenue is
therefore a straight line through the origin of the two axes with a slope of 150 because the
change in total revenue (△TR) is always Br.150 when another futon is sold. The total cost
curve has the shape typically assumed to exist in the short run. Its shape reflects the law of
diminishing marginal returns. The vertical distance between the total revenue and total cost
curve gives profit at each level of production. This difference is plotted directly below the
total revenue and total cost curves.

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You will notice that at low levels of output, the futon factory would lose money. If it were to
produce nothing, its losses would be equal to fixed costs. As production begins, profits
increase, eventually reaching a maximum level. Maximum possible daily profits are earned
when the firm sells eight futons per day. If the firm were to produce more than eight futons
per day, profits would steadily decline and eventually become negative again.

5.5. Using Marginal Analysis to Choose the Profit-Maximizing Output

The Theory of Short Run Supply: Marginal Revenue, Marginal Cost, and Marginal
Profit
Marginal Revenue: The extra revenue obtained from selling an additional unit of a good is
called the marginal revenue (MR) of output. We can compute marginal revenue for any
given output by calculating the change in total revenue (△TR) associated with any given
change in output sold (△Q):
MR = △TR/△Q
Because a competitive firm can sell all the output it wishes at the market price, it is easy to
show that its marginal revenue will always equal the price of its product and therefore equal
its average revenue. For example, if futon producers can sell all the futons they wish at the
market price of Br.150, the extra revenue they will take in for amount the firm sells, the
marginal revenue of selling an additional futon would be its price. Because price is also
average revenue, this means that for a competitive firm, P = AR = MR. It follows that the
additional gain, or marginal revenue, a competitive firm enjoys from selling output is
measures by the market price of its product. In this case, the marginal revenue is always
Br.150.

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The table in Box 3 shows daily output, total revenue, and marginal revenue Br.150. You can
now convince yourself that marginal revenue equals price by observing that total revenue
increases by Br.150 each time an additional futon is sold.

Marginal Cost: Marginal Cost is the extra cost of selling an additional unit of a good. In the
table Box 4, the marginal cost is obtained by calculating the extra cost associated with each
extra futon produced and shipped. Notice how marginal cost decreases at first but then
steadily increases as the firm approaches its short run capacity output of 15 futons per day.
This pattern of variation in marginal cost reflects the law of diminishing marginal returns as
the firm tries to produce more in the short run.

In choosing the profit-maximizing output, managers can be thought of as comparing the

marginal cost with the marginal revenue for each extra futon sold. When marginal revenue
exceeds marginal cost, selling an additional futon will increase profits. The marginal cost
influences the willingness of firms to sell more. When marginal revenue falls short of
marginal cost, sale of an additional futon will decrease profits.

Marginal Profit: Marginal profit is the change in profit fro selling an additional unit of a
good, represents the difference between the marginal revenue from the unit and its marginal
cost. The marginal profit represents the net gain to the firm of making an additional futon
available. When the marginal profit is positive, the firm adds to total profit by selling more
futons. When the marginal profit is negative, the firm will reduce its profits by selling more
futons.

Box 2. Output, Total Revenue, and Marginal Revenue for a competitive firm

Daily output Total Revenue Marginal Revenue

0 0 -
1 150 150
2 300 150
3 450 150
4 600 150
5 750 150

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 6 900 150
7 1050 150
8 1200 150
9 1350 150
10 1500 150
11 1650 150
12 1800 150
13 1950 150
14 2100 150
15 2250 150

Box 3. Marginal Cost Calculated from Total Cost for a Competitive Firm
Daily Output Total Cost Marginal Cost
0 100 --
1 160 60
2 200 40
3 230 30
4 270 40
5 320 50
6 390 70
7 490 100
8 635 145
9 815 180
10 1,015 200
11 1,245 230
12 1,495 250
13 1,775 280
14 2,095 320
15 2,495 400

5.6. Profit Maximization: Choosing the Output

The table in Box 5, which is based on the data in previous tables, shows how marginal
revenue, marginal cost, and marginal profit vary, as more output is made available for sale.
The next to last column of the table calculates marginal profit from the following formula:
Marginal profit = MR - MC
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A firm maximizes profits by continuing to produce up to the point at which marginal revenue
just equals marginal cost. The condition for maximum profit is therefore
MR = MC
Whenever marginal revenue exceeds marginal cost, producing more will result in extra
revenue that exceeds the extra cost. This will cause increases in profit, and marginal profit
will be positive. Whenever marginal cost exceeds marginal revenue, the extra output will
cost more than the revenue it brings in and profit will fall. Marginal profit in this case would
be negative. Marginal analysis therefore shows that a firm can continue to increase profits up
to the point at which marginal revenue equals marginal cost.

Daily Output Marginal Marginal Cost Marginal Total Profit

Revenue profit
0 -- -- -- -100
1 150 60 90 -10
2 150 40 110 100
3 150 30 120 220
4 150 40 110 330
5 150 50 100 430
6 150 70 80 510
7 150 100 50 560
8 150 145 5 565
9 150 180 -30 535
10 150 200 -50 485
11 150 230 -80 405
12 150 250 -100 305
13 150 280 -130 175
14 150 320 -170 5
15 150 400 -245 -245

Because price (P) is equal to marginal revenue for a competitive firm, maximum profit for
such firms occur when output has been adjusted to the point at which:
P = MC
The equilibrium output of a profit maximizing competitive firm is therefore attained when
the firm produces enough to adjust marginal cost to the point at which it rises to equal the
price of the product. Any output below this level will mean that the firm can increase profits

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by more. Any output greater than that corresponding to the point at which marginal cost
equals the price of the product implies that the firm can increase profits by producing less.

The table in Box 4 shows that the futon factory can continue to increase profits by producing
more futons until it produces eight futons per day. Up to that point, the Br150 marginal
revenue form selling futons exceeds the marginal cost of making those futons available. If
the firm produces a ninth futon per day, its marginal cost would rise to Br.180. This would
exceed the marginal revenue of Br.150 that could be obtained from selling that futon. The
firm would therefore reduce its profits by selling the ninth futon. The last column of the table
shows that profit would fall from the maximum of Br.565 per day to Br.535 per day if the
firm were to produce and sell a ninth futon. Notice how the firm’s choice of output depends
on both the market price of futons and the way the marginal cost of making futons available
to buyers varies as more futons are actually produced.

In Box 5, A shows the Futon Factory’s choice of the profit maximizing output. Along the
competitive firm’s demand curve, P = MR = 150Br. The marginal cost curve intersects the
firm’s demand curve at point B. Equilibrium output corresponding to that level of marginal
cost is eight futons per day. If the firm were to produce one unit, more than eight futons per
day, marginal cost would exceed marginal revenue and profit would decline.

C
P MC
AC

C
P

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Profi
t
 Q

Profit Maximization by a Competitive firm

Q

In Box 6, B shows the profit curve based on the data in Box 2. Notice how maximum profit
is achieved at exactly the point at which eight futons per day are produced. Output has been
increased just to the point at which marginal cost equals the market price for this output
level.
5.7. The Decision to Shutdown in the Short Run
As long as the market price exceeds the minimum possible average variable cost of
production, the Futon Factory will continue to operate at a loss in the short run rather than
shut down. To see this, recall that the vertical distance between the AC and AVC curves is
average fixed cost (AFC). Therefore, at an output of four futons per day, fixed cost can be
represented by the rectangle AFCD in Box 8. The height of this rectangle is AFC, while its
length is the equilibrium quantity of output (Q). By shutting down, your firm would generate
no revenue to offset its fixed costs. Short run losses would therefore be equal to fixed costs if
the firm ceases operations.

By continuing to operate, the Futon Factory loses the amount of money represented by the
area ABED in Box 8. The distance DE represents (AC – P), the daily loss per unit of output.
The distance BE is the output. Multiplying these two distances gives total losses. As long as
price is greater than the average variable cost at the output for which MR = MC, the loss
from remaining in business will be less than fixed cost, which is the short run loss incurred
by shutting down. When price has fallen to a level below that which just allows the firm to
cover its minimum possible average variable cost, the firm is at the shutdown point. When
price has fallen to minimum possible average variable cost, the loss per unit is equal to
average fixed cost. The loss from continuing to operate will exactly equal fixed cost. In Box
9, the loss per futon is equal to the distance DC, which also represents average fixed cost. It

109
follows that losses from remaining in operation exactly equal fixed cost of Br.100 per day,
which is represented by the area AFCD in Box 9.

AC
MC AC
MC
AVC AVC

P*
P = MR

0 Q*

. The Shutdown Point

Q
If price were to fall below the minimum possible AVC, losses from remaining in operation
would exceed fixed cost and the Futon Factory would cease operating. At any price below
minimum possible AVC, the loss per unit (AC – P) would exceed average fixed cost. This is
because of the vertical distance between AC and AVC.

5.8. The Competitive Firm’s Short Run Supply Curve

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As you know, a supply curve shows a relationship between price and quantity supplied. A
competitive firm always adjusts output until price is equal to marginal cost to maximize
profit. The marginal cost curve therefore gives the relationship between price and quantity
supplied by the competitive firm. Price must exceed minimum possible average variable cost
of production; otherwise, the firm will cease operations. Quantity supplied by the firm at any
price below minimum possible AVC will be zero. The competitive firm’s short run supply
curve is therefore that portion of its marginal cost curve above the minimum point of its
average variable cost curve.

5.9. Long Run Competitive Equilibrium

In the short run, a firm is confronted to a fixed size. Managers of a single-production firm
can adjust production in the plant to achieve the goal of maximum profit. However, the
plant’s limited capacity eventually causes average and marginal costs to increase sharply as
the firm tries to produce more and more. In the long run, the firm’s managers have the
flexibility to build larger or additional plants if they can increase their profits by doing so.
However, the opportunity to earn profits lures new firms into the market in the long run.
Similarly, firms will tend to leave the industry in the long run if losses prevail.

A long run competitive equilibrium exists in an industry when there is no tendency for firms
to enter or leave the industry or to expand or contract the scale of their operations. New firms
will enter the industry if profits are possible, and existing firms will leave the industry if they
cannot cover their opportunity costs. Similarly, firms will tend to expand if they can increase
their profits by doing so. All opportunities to earn profits or eliminate losses must be
exhausted for an industry to attain a long run competitive equilibrium. Profits must therefore
be zero for an industry to be in equilibrium. When economic profits are zero, firms just cover
their explicit and implicit costs, and there is no tendency for any sellers to enter or leave the
market. When sellers cover their opportunity cost, they cannot earn more in their next best
alternative. They therefore have no incentive to leave the market. For the same reason, new

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sellers will not enter the market because they cannot earn more than they currently enjoy in
their existing enterprise.

Summary
Competitive firms react to prices. A competitive firm is a price taker in the sense that it
considers the price of its output as beyond its influence. A perfectly competitive market
consists of many sellers and buyers. Each seller has a small market share and sells a
standardized product also sold by its many competing sellers in the market. Information is
freely available in such a market, and both buyers and sellers can freely exit or enter the
market as they choose. The demand curve for the output of a perfectly competitive firm is
infinitely elastic at the market price of the product. However, the demand curve for the
product of the industry to which the competitive firm belongs is downward sloping. Profit in
the short run tends to increase and then decrease as a firm produces and sells more of its
product. At very low and very high levels of output in the short run, profit is likely to be
negative. If a firm were to cease operating in the short run, its losses would be equal to its
fixed costs. Marginal revenue is the extra revenue obtained from selling an additional unit of
output. If a seller can sell all it wishes at the market price, as is the case for a competitive
firm, marginal revenue is equal to price. Another term for price is average revenue, which is
total revenue divided by the quantity of output sold. A firm can increase total profit by
selling more as long as marginal cost does not exceed marginal revenue. Marginal profit is
zero when marginal revenue just equals marginal cost. At the point at which marginal

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revenue equals marginal cost, profit is at a maximum because additional sales would
decrease profit. The equilibrium output of a profit maximizing competitive firm corresponds
to the output for which marginal revenue equals marginal cost. A profit-maximizing firm will
operate at a loss in the short run as long as the market price exceeds the minimum possible
average variable cost. However, when price falls below minimum possible average variable
cost, the firm will cease operating because at so low a price its losses would exceed its fixed
costs at the output for which marginal revenue equals marginal cost. The firm is just at the
shutdown point when price equals the minimum possible average variable cost of production.

The firms supply curve is the portion of its marginal cost curve lying above its average
variable cost curve. Short run supply curves tens to be upward sloping because the marginal
cost of production tends to increase, as more goods are made available for sale in markets.
Short run market supply is obtained by adding the quantities supplied by all sellers in the
market at various prices. Changes in the prices of variable inputs will shift marginal cost
curves and will therefore results in changes in supply in the short run. However, because
changes in the prices of fixed inputs do not affect variable costs, they result in no shift in
marginal cost curves and therefore no changes in supply in the short run.

Evaluation Questions
1. The market equilibrium price of wheat is currently Br.2.50 a bushel. Assuming the wheat
is produced by firms in a perfectly competitive industry, draw the industry demand and
supply curves. Draw the demand curve for the wheat produced by a single wheat
producer and explain how it differs from the industry demand curve.
2. Suppose the marginal cost of producing wheat for a farmer is Br.1 per bushel when 10
acres are planted. The farmer wants to maximize profits from selling wheat this season.
Assuming that the market price is expected to be Br.2.50 per bushel; would you advise
the farmer to plant more wheat this season? Explain your answer.
3. Assuming that marginal cost, eventually increases, as more is produced in the short run,
show that profit is at a maximum when marginal revenue is just equal to marginal cost.
Why will marginal profit equal zero when profits are at a maximum? Explain why
marginal revenue equals the price of the product sold by a competitive firm.

113
4. Draw the demand curve for the output of a single-product competitive firm and explain
why it differs from the industry demand curve. Explain why the competitive firm is a
price taker.
5. Draw a curve to show how total revenue will change as a competitive firm sells more
output.

CHAPTER SIX
IMPERFECT COMPETITION
Contents
6.1 Monopoly
6.2 How Monopoly Is Maintained
6.3 The Demand for a Monopolist’s Product
6.4 The Monopolist Marginal Revenue
6.5 Profit Maximization by Monopoly Firm
6.6 Monopoly Supply
6.7 Price Discrimination
6.8 Monopolistic Competition
6.9 Equilibrium of the Firm
6.10 Oligopoly
6.11 Barrier to Entry

6.0 Aims and Objectives

After reading this chapter, you should be able to:

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  explain the concept of monopoly.
 show how the demand curve for a product sold by a monopolist firm.
 show how the marginal revenue from a monopolist’s output is less than the price the
monopolist charges for its product.
 explain the concept of monopolistic competition.
 explain the concept of oligopoly.

6.1. Monopoly
A pure monopoly occurs when there is a single seller of a product that has no close
substitutes. Buyers who want to consume the product of a monopoly firm have only one
source of supply for that particular good. As you know, perfect competition is characterized
by the inability of individual sellers to control price. No individual firm produces a large
enough share of the total market supply affect price. Monopoly, on the contrary, is
characterized by concentration of supply in the hands of the owners of a single firm.

In actuality, it is rare for a national or world market to have only one seller. A firm has
monopoly power if it can influence the market price of its product by making more or less of
it available to buyers. Although pure monopoly is very rare, monopoly power is quite
common.

Local monopolies are more common than national monopolies, and single sellers serve local
markets often. However, few if any products have no substitutes. A local electric power
company may be the sole seller of electricity in an area, but electricity in its multitude of uses
does have substitutes. When the price of electricity rises, there is a decline in the quantity
demanded for its use as a means of heating. Natural gases and oil furnaces are good

115
substitutes for electric heat. Similarly, the Ethiopian postal agency is the sole supplier of
letter delivery. However, telecommunication, including electronic transmission of messages,
is a substitute for the mail service.

6.2. How Monopoly Is Maintained: Barriers to Entry

Barrier to Entry is a constraint that prevents additional sellers from entering a monopoly
firm’s market. If free entry were possible in monopolist markets, economic profits earned by
monopoly firms would attract new sellers. Supply would increase, as would the number of
sellers. The monopolist control over price would eventually disappear as the market became
competitive. The major barriers to entry are as follows:

6.2.1. Government Franchises and Licenses

Some barriers to entry are the result of government policies that grant single-seller status to
firms. For example, local governments commonly give the right to install cable television
systems to a single firm. Governments typically establish monopolies for the rights to sell
transportation and communication services, electric power, water and sewer service.

6.2.2. Patents and Copyrights

Patents and copyrights are other government-supported barriers to entry. They give creator of
new products and works of literature, art, and music exclusive rights to sell or license the use
of their inventions and creators. Patents and copyrights provide monopoly protection for only
a specified number of years. After the patent expires, the barrier to entry is removed. The
idea behind patents and copyrights is to encourage firms and individuals to innovate and
produce new products. This is done by guaranteeing exclusive rights to the profits from new
ideas to their originators through establishment of monopoly supply for limited periods.

6.2.3. Ownership of the Entire Supply of a Resource

A monopoly can also be maintained as a result of ownership of the entire source of supply of
a particular input. Unique ability or knowledge can also create a monopoly. Talented singers,

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artists, athletes, and the cream of the crop of any profession have monopolies on the use of
their services. Firms with secret processes or technologies have monopolies if other firms
cannot duplicate the techniques.

6.2.4. Cost Advantage of Large Scale Operations and the Emergence

of Monopoly
Monopolies might also arise naturally out of cost or technological advantages associated with
large-scale production or marketing of products. Economies of scale are cost savings that
result from large-scale production. These cost saving favor the establishment of monopolies
because bigger firms in industries for which economies of scale prevail can product at lower
average cost than smaller competitors.

If firms can continually reduce average costs of production and profit by expanding in the
long run, one firm will eventually emerge as the dominant supplier. Perfect competition
would require many small firms with small market shares. If perfect competition existed
initially, it would end soon as existing firms would merge or one firm would purchase their
assets and consolidate them. To achieve lower average costs, one firm must dominate. Once
it dominates, new firms cannot enter because they would be too small initially to achieve the
low average costs the dominant firm enjoys by virtue of producing the entire market supply
in very large plants.

6.2.5. Natural Monopoly

The term natural monopoly is sometimes used to describe a situation in which a firm
emerges as a single seller in a market because e of cost or technological advantages
contributing to lower average costs of production. Competition among firms in such an
industry results in one large firm supplying the entire market demand at lower cost than two
or more smaller firms. A natural monopoly can produce the entire quantity demanded by
buyers at any price at lower average cost than would be possible for each firm in the industry
if more than one firm existed. For example, a local electric company might be regarded as a
natural monopoly firm if the average cost of producing the quantity of electricity currently
demanded would be higher if more than one firm sold this product.

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6.3. The Demand for a Monopolist’s Product
A common mistake made by people who criticize monopoly is to assume that the demand for
a monopolist’s product is perfectly inelastic. This assumption is without foundation. In fact,
as you will see shortly, a monopolist seeking to maximize profits will try to avoid serving
markets in which demand is inelastic! Consumers always have the alternative of doing
without a monopolist’s product when its price is increased. For example, if your local electric
monopoly raises its price, you and other consumers can cut down on your use of electricity.
You might use your air conditioners less or be more careful about turning out lights when
leaving a room.

If there were only one seller of automobile in the Ethiopia, we would still react by buying
more cars when the monopoly seller lowered prices, and buying fewer when prices increased.
The managers of a monopoly firm take this fact into account when deciding in their price.
They know that the amount they will sell depends on the price they choose. Because there is
only one seller in a pure monopoly market, there is no distinction between the market
demand curve and the demand curve for the firm’s product. The output of a pure monopoly
firm is the downward-sloping market demand curve that would be faced by an entire
competitive industry. For this reason, the monopolist’s pricing decision is inseparable from
the decision about how much to offer for sale. The higher the price it sets, the lower the
quantity it will sell.

6.4. The Monopolist’s Marginal Revenue

For a competitive firm, marginal revenue is the same as price. For example, if many rival
firms in a competitive market sell bread, each individual seller can sell as much as it wishes
each day without reducing price. If the price of bread is 2Br a loaf, any one firm will take in
an extra 2Br each time it sells an additional loaf. A monopolist, on the other hand, must
decrease the price of the product to sell more. This follows from the fact that the demand
curve for a monopolist’s product is downward sloping. The marginal revenue of additional
sales by a monopolist is always less than the price. Thus, the slope of the monopolist
marginal revenue curve is negative.

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 Price

Demand Deman
d
MR
0 Q

Figure 6.1: Monopolists demand and marginal revenue curve

6.5. Profit Maximization by Monopoly Firm

A competitive firm, which cannot influence the price of its product, maximizes profit by
merely adjusting the amount it produces at the market until marginal revenue equals marginal
cost. Although a monopoly seller can influence the market price of its product, the principle
of profit maximization is the same for a monopolist as for a competitive firm. Maximization
of profits implies that marginal revenue must equal marginal cost at the output produced.

119
However, the marginal revenue of additional output for a monopolist is less than the price at
which that output is sold.

MC
P * AC

P1
E*
D
D
MR
Q* Q

Figure 6.2: Equilibrium of the

firm
Also, notice that it is not in the interest of a monopoly firm to charge the highest possible
price. The monopolist that maximizes profits realizes it loses sales by increasing price and
considers this in making its price decisions. Monopoly firms maximize profits by always
setting price to achieve the output over any period for which marginal revenue equals
marginal cost.

6.6. Monopoly Supply

A supply curve shows a relationship between price and quantity supplied by a firm or an
industry. Competitive firms simply react to prices. A monopolist, however, is a price maker.

120
It chooses the price that maximizes its profits and lets consumers decide how much to buy at
that price. A monopoly firm does not react to a price.

A monopoly firm decides how much to produce based on information it has on the demand
for its product. Given this information, it prices its product so that marginal revenue equals
marginal cost.

Even though a monopoly firm has an upward-sloping marginal cost curve at any point in
time, it does not necessarily increase quantity supplied when the demand for its product
increases. Sometimes a monopoly firm reacts to an increase in demand by raising the price of
its product rather than increasing quantity supplied! The change in quantity supplied by a
monopoly firm depends on the shift in its marginal revenue curve when demand increases.
For example, if the demand for a monopolist’s product increases, the monopolist might find
it can increase profits more by raising price rather than increasing the quantity supplied. In
deciding how to respond to an increase in demand, the monopolist examines the way the
price elasticity of demand has changed to figure the new marginal revenue associated with
each possible output. It then adjusts price to maximize profit given the new marginal revenue
curve by choosing the price that allows sale of the output for which under the new demand
MR=MC.

6.7. Price Discrimination

In some cases, a profit-maximizing firm can charge different prices for the same good or
service to different buyers. When this is the case, some lucky consumers will be able to
purchase the monopolist’s product at a price that is just equal to the marginal cost of the
good. The practice of selling a certain product of given quality and cost per un it at different
prices to different buyers is called price discrimination. Price discrimination is often
practiced by public utilities, which charge higher rates to businesses than they do to
household users. Many drugstores, restaurants, and movie theatres offer discounts to senior
citizen. Airlines are notorious price discriminators, as shown by the multitude of fares
available for similar seats on a given flight.
To engage in price discrimination a seller must meet the following conditions:

121
 1. The seller must be able to control the price of its product. A monopoly firm can
engage in price discrimination because it can control prices.
2. The product that will be sold at more than one price must not be resalable. It is not
possible to charge different prices to different buyers if the good is resalable.
Individuals who buy it at low prices could resell it to people who would pay higher
prices. Eventually such a process would lead to the establishment of a single price in
the market.
3. The seller must be able to determine how willingness and ability to pay vary among
prospective buyers. Price discrimination will result in some people paying more and
some paying less than would be the case is one price were announced for the product.
The seller must be able to distinguish among buyers in a way that allow it to charge
higher prices only to buyers whose marginal benefit for the good would exceed the
single price.
Monopolists engage in price discrimination when they can increase their profit by doing so.

Summary
A pure monopoly is a single seller of a product that has no close substitutes. In a market in
which a profitable monopoly firm sells a product, a barrier to entry must exist to prevent
additional sellers form entering to compete for sales. Monopolies often arise as a result of
cost or technological advantages that ate not enjoyed by smaller firms. A natural monopoly
firm is one that attains its position as a single seller in a market by virtue of cost advantages.
A monopolist demand curve is the market demand curve. Monopolists can sell more by
lowering prices. Similarly, when they increase the price of their product they can expect to
sell less. Unlike a perfectly competitive firm, a monopolist cannot sell all it wishes at a given
price. Marginal revenue is the extra revenue a monopolist receives for selling additional
output. For any amount sold, the marginal revenue received by a monopolist is less than the
price it receives for the product. The price set by a profit-maximizing monopoly firm exceeds
the marginal cost and minimum possible average cost of the product in the long run.
Monopolists sometimes find it advantageous to engage in price discrimination by selling the
same product at different prices to different buyers, even though the cost per unit is the same.

Questions
1. Under what circumstances would a seller enjoy a pure monopoly in a market?
_________________________________________________________________________

122
2. How is the marginal revenue form a monopolist’s sales calculated?
_________________________________________________________________________
3. Explain why the price a monopolists set for its product will exceed the marginal cost of
making the profit maximizing output available.
________________________________________________________________________
4. What would happen to prices and output made available to buyers in a market if a
perfectly competitive industry were monopolized through a merger of all sellers?
________________________________________________________________________
5. What is price discrimination?
________________________________________________________________________
6. When does a monopoly firm engage in price discrimination?
________________________________________________________________________

6.8. Monopolistic Competition

Monopolistic competition exists when many sellers compete to sell a different product in a
market in which entry of new sellers is possible. In a monopolistically competitive market:
1. There is relatively large number of firms, each satisfying a small but not microscopic
share of the market demand for a similar but not identical product. The market share
of each rival firm is generally larger than that which would prevail under perfect
competition. Each firm in the industry has a market share of over 1% of the total sales
over any period, but it is unlikely that any one firm satisfies more than 10% of market
demand.
2. The product of each firm selling in the market is not a perfect substitute for that sold
by competing firms. Each seller’s product has unique qualities or characteristics that
cause some buyers to prefer it to products of competing firms.
3. Firms in the industry do not consider the reaction of their rivals when choosing their
products prices or annual sales target.
4. Relative freedom of entry by new firms exists in monopolistically competitive
market.
5. Neither the opportunity nor the incentive exists for firms in the industry to cooperate
in ways that decreases competition.

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6.9. Equilibrium of the Firm
The demand curve for a monopolistically competitive firm is downward sloping this means
that marginal revenue is less than price for any given output, as is the case for a pure
monopoly. The demand for any particular firm’s product tends to be quite elastic, but it is not
perfectly elastic, as is the case for a perfectly competitive firm. The demand for the output of
a monopolistically competitive firm is more elastic than that for a monopoly firm. This is
because many very good substitutes, sold by many rival firms, exist for the product sold by
any one firm in the industry. It is important, however, to understand why the firm’s demand
curve is downward sloping despite the fact that there are many competing firms. An example
will help illustrate this point. Suppose you run a small firm that produces fashionable
women’s dresses. Your product is differentiated from those of your competitors by your
unique styling and detailing. You have a clientele of devoted customer who go into many
retail outlets and ask for your brand of dresses. However, you also compete with many other
producers of similar but not identical dresses.

Because your product is differentiated from those of the competitors, you can raise the rice of
your dresses without losing all of your customers. Depending on the price elasticity of
demand for your product, however, you can expect to lose some customers when you raise
your prices. By the same token, you can expect to attract more customers when you lower
your prices.

Demand and marginal revenue for your dresses also depends on the prices set by competing
firms in your product group. Of rival firms were to reduce their prices, you would not be able
to sell as many dresses at your set prices as you would have otherwise. The reverse would be
true if competitors raise their prices. In the following analysis, we concentrate on the decision
of a single firm. The prices of other firms are beyond the control or influence of any one
firm.

The short run equilibrium of the firm facing monopolistic competition is illustrated in figure.
Assuming that you seek to maximize profits from annual sales of dresses, the short run
equilibrium output is the one for which marginal revenue equals marginal cost. This is

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 exactly the same way a monopolist chooses its price and output. The marginal cost curve
intersects the marginal revenue curve at an annual output of 10,000 dresses. To sell this
quantity you must set a price of Br100 per dress. Any price lower than this would result in an
annual quantity demanded greater than 10,000. Similarly, a higher price would result in a
quantity demanded that falls short of the profit-maximizing output of 10,000 dresses per
year. As you can see in the figure, the average cost of dresses when you sell 10,000-pre year
is Br80. At the Br100 price. Therefore, you earn a profit equal to Br20 per dress. Total profit
from the 10,000 dresses sold per year is Br200,000, which is represented by the shaded area
in the graph. If you enjoyed a pure monopoly in the production of these dresses, a barrier to
entry in the market would prevent additional sellers from competing with you. Under
monopolistic competition, however, your handsome profits are likely to disappear in the long
run. To find out why, we have to show how entry of new firms as sellers in the market affects
demand for your dresses.

P
The firm maximizes profit by

MC selecting the output for which

AC marginal revenue equals marginal
P* cost.
P

DD

0 Q∗ Q

Figure 6.3: Equilibrium of the firm under monopolistically competitive market

6.10. Oligopoly
Oligopoly is a market structure in which a few sellers dominate the sales of a product and
where entry of new sellers is difficult or impossible. Te product sold by oligopolistic firms

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can be either differentiated or standardized. Oligopolistic markets typically are characterized
by high market concentration.

6.10.1. Characteristics of Oligopolistic Markets

1. Only a few firms supply the entire market with a product that may be standardized or
differentiated.
2. At least some of the firms in the oligopolistic industry have large market shares and
thus can influence the price of the product.
3. Firms in the industry are aware of their interdependence and always consider the
reaction of their rivals when selecting prices, output goals, advertising budgets, and
any other business policy.
6.10.2. Other Oligopoly Models
Cartel is a group of firms acting together to coordinate output decisions and control prices as
if they were a single monopoly. There are many other possible outcomes in oligopolistic
markets. Each outcome depends on how firms regard their rivals, on their willingness to
collude with their rivals, and on the penalties they might pay for illegal collusion.

Price leadership under these circumstances one dominant firm in the industry sets its price to
maximize its own profits and other firms simply follow its lead by setting exactly the same
price. The dominant firm is called the price leader.

6.11. Barriers to Entry and Cost Advantages: How Oligopolies Arise and
Are Maintained
In many cases, oligopolies are protected by barriers to entry similar to those we discussed for
monopoly firms. Oligopolies sometimes arise because of inherent cost or technological
advantages associated with large-scale production. In such cases, a few firms can supply the
entire market output at lower long run average cost than can many firms. In such an industry,
small firms would eventually merge with rivals to achieve the lower average costs associated
with large factories. Alternatively, a few firms would buy out existing small firms and
combine their assets into large factories.

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Summary
Under imperfect competition, there are rival sellers, each of which has some measure of
control over the price of the product it sells.

Monopolistic competition exists when many rival sellers compete to sell a differentiated
product in a market in which there is free entry of new sellers. The product each firm sells is
a close but not perfect substitute for the products of competing firms. The demand curve for
the product of a monopolistically competitive firm slopes downward. The price of the
product exceeds the marginal revenue of any given quantity. The firm maximizes profits by
selecting the output for which marginal revenue equals marginal cost.

Because free entry is possible in a monopolistically competitive market, prices in such

markets tend to decrease when it is possible for new entrants to earn profits. In equilibrium,
the demand curve for a firm’s product tends to be tangent to its average cost curve. Entry of
new firms continues until economic profits fall to zero.

Oligopoly is a market structure in which a few sellers dominate the sales of a product and
where entry of new sellers is difficult or impossible. Firms in oligopolistic markets also are
likely to be close to average costs when the market is contestable. A contestable market is
one in which ease of entry and exit attracts new firms when price are high enough to permit

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profits. Cartel is a group of firms acting together to coordinate output decisions and control
price as if they were a single monopoly. In an oligopolistic market, one firm might emerge as
a price leader. This firm sets prices to maximize profit, and other firms also set that price.

Questions
1. Under what conditions would a market be regarded as monopolistically competitive?
_____________________________________________________________________
2. What are the characteristics of oligopoly market?
_____________________________________________________________________
3. What is oligopolistic market structure?
_____________________________________________________________________
4. Explain the concept of price leadership.
_____________________________________________________________________

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