CHAPTER ONE

INTRODUCTION

1.1. Definition of economics

Two fundamental facts together provide a foundation for economics:

 Society’s economic wants, i.e. the economic wants of its citizens and institutions, are virtually
unlimited and instable.
 Economic resources, the means of producing goods and services are limited or scarce.

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

Human wants are not only numerous but also expand and diversify through time. Therefore, human
wants are unlimited. Anything natural or manmade that can be used in production of goods and
services is called resource. Thus, economic resources are the means to produce goods and services.
Examples are various types of labor, oil deposits, minerals, building, communication, facilities etc.
All these resources are scarce or limited in supply.

Economics is thus a social science concerned with the problem of using scarce resources to attain the
maximum fulfillment of society’s unlimited wants. Economics is concerned with “doing the best with
what we have”. It serves as a bridge between unlimited wants and limited resources.

1.2. Classification of economics

From the point of view of elements of analysis, economics has two major branches: microeconomics
and macroeconomics. Microeconomics deals with behaviors of individual economic units such as
consumers, producers, business firms and other economic decision making units. On the other hand,
macroeconomics is concerned with macro issues/aggregate issues/ high level issues. In other words,
macroeconomics deals with aggregate units of national economy such as national output or Gross
National Product (GDP), general price level, inflation and national employment.
Table 1. Comparison between Macroeconomics and Microeconomics
Macroeconomics Microeconomics
National economy Households’ and/or firms’ economic behavior
General price level Price of individual items or firms
Consumer price index (CPI) Price of a consumption good
Inflation An increase in price of a commodity
National output or GDP Output of a factory or a firm
National wage rate Wage rate in an enterprise
National Investment Investment of individual firm
National Consumption Consumption of households or individuals
Government expenditure Firm’s expense or households’ expenses

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1.3. The use of graphs and equations

Economists most often use graphs and equations to illustrate their models. By using graphs and
equations, economic relationships can be easily represented.

A graph is a visual representation of the relationship between variables. Graphs serve two purposes.
First, when developing economic theories, graphs offer a way to visually express ideas that might be
less clear if described with equations or words. Second, when analyzing economic data, graphs
provide a way of finding how variables are in fact related in the world. Whether we are working with
theory or with data, graphs provide a lens through which a recognizable forest emerges from a
multitude of trees.
Numerical information can be expressed graphically in many ways, just as a thought can be
expressed in words in many ways. A good writer chooses words that will make an argument clear, a
description pleasing, or a scene dramatic. An effective economist chooses the type of graph that best
suits the purpose at hand. Table 2 is a hypothetical illustration showing the relationship between
income and consumption for the economy as a whole. Without even studying economics, it is
intuitively expected that people would buy more goods and services when their incomes go up. Thus,
as Table 2 indicates total consumption in the economy increases as total income increases. The
information in Table 2 is expressed graphically in Figure 1.
Table 2. The relationship between income and consumption

Income per Week Consumption per Week Point

$0 $ 50 a
100 100 b
200 150 c
300 200 d
400 250 e
The line in Figure 1 slopes upward to the right, so it depicts a direct relationship between income and
consumption. By a direct relationship (positive relationship) we mean that two variables change in
the same direction. An increase in consumption is associated with an increase in income; a decrease
in consumption accompanies a decrease in income. In contrast, two sets of data are inversely related
(inverse or negative relationship) when they change in opposite directions. For instance, when ticket
price decreases, attendance increases.
Figure 1. The direct relationship between consumption and income.

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Lines can be described in terms of their slopes. The slope of a straight line is the ration of the vertical
change to the horizontal change between any two points of the line. Between point b and point c in
Figure 1 the rise or vertical change is +$50 and the run or horizontal change is +$100. Therefore:
Vertical change  50
Slope    0. 5
Horizontal change  100
If the vertical intercept and slope of a line are known, it can be described in equation form. In its
general form, the equation of a straight line is
y  a  bx , where a = vertical intercept and b = slope of the line
For our income-consumption example, the equation is given as:
y  50  0.5 x
This equation allows us to determine the amount of consumption at any specific level of income.

1.4. The production possibility frontiers, efficiency and opportunity cost

Most economic models are built using the tools of mathematics. The production possibilities frontier
is one of the simplest of such models.

Although real economies produce thousands of goods and services, let’s imagine an economy that
produces only two goods—cars and computers. Together the car industry and the computer industry
use all of the economy’s factors of production. The production possibilities frontier is a graph that
shows the various combinations of output—in this case, cars and computers—that the economy can
possibly produce given the available factors of production and the available production technology
that firms can use to turn these factors into output.

Figure 2 is an example of a production possibilities frontier. In this economy, if all resources were
used in the car industry, the economy would produce 1,000 cars and no computers. If all resources
were used in the computer industry, the economy would produce 3,000 computers and no cars. The
two end points of the production possibilities frontier represent these extreme possibilities. If the
economy were to divide its resources between the two industries, it could produce 700 cars and 2,000
computers, shown in the figure by point A. By contrast, the outcome at point D is not possible
because resources are scarce: The economy does not have enough of the factors of production to
support that level of output. In other words, the economy can produce at any point on or inside the
production possibilities frontier, but it cannot produce at points outside the frontier.

Figure 2. The production possibilities frontier

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An outcome is said to be efficient if the economy is getting all it can from the scarce resources it has
available. Points on (rather than inside) the production possibilities frontier represent efficient levels
of production. When the economy is producing at such a point, say point A, there is no way to
produce more of one good without producing less of the other. Point B represents an inefficient
outcome. For some reason, perhaps widespread unemployment, the economy is producing less than it
could from the resources it has available: It is producing only 300 cars and 1,000 computers. If the
source of the inefficiency were eliminated, the economy could move from point B to point A,
increasing production of both cars (to 700) and computers (to 2,000).

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

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

Notice that the production possibilities frontier in Figure 2 is bowed outward. This means that the
opportunity cost of cars in terms of computers depends on how much of each good the economy is
producing. When the economy is using most of its resources to make cars, the production possibilities
frontier is quite steep. Because even workers and machines best suited to making computers are being
used to make cars, the economy gets a substantial increase in the number of computers for each car it
gives up. By contrast, when the economy is using most of its resources to make computers, the
production possibilities frontier is quite flat. In this case, the resources best suited to making
computers are already in the computer industry, and each car the economy gives up yields only a
small increase in the number of computers.

Figure 3. A shift in production possibility frontier

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The production possibilities frontier shows the tradeoff between the production of different goods at a
given time, but the tradeoff can change over time. For example, if a technological advance in the
computer industry raises the number of computers that a worker can produce per week, the economy
can make more computers for any given number of cars. As a result, the production possibilities
frontier shifts outward, as in Figure 3. Because of this economic growth, society might move
production from point A to point E, enjoying more computers and more cars.

1.5. The basic economic problems

The science of economics is used to make decision with the help of economic principles. There are
three basic economic problems that any economic unit needs to answer:
a. What to produce: The answer to this question may help determine which product is profitable
for producers in terms of revenue or profit.

b. How to produce: the answer to this question may help determine what production method or
technique to use and what input to use. For instance the decision may be about identifying the
best combinations of inputs or raw materials.

c. For whom to produce: This question helps us to identify potential customers.

1.6. Economic systems

Every society needs to develop an economic system, a particular set of institutional arrangements and
a coordinating mechanism, to respond to the economizing problem. There are two general types of
economic systems: the market system and the command system.

The market system

The private ownership of resources and the use of markets and prices to coordinate and direct
economic activity characterize the market system, or capitalism. In that system each participant acts
in his or her own self-interest; each individual or business seeks to maximize its satisfaction or profit
through its own decisions regarding consumption or production. The system allows for the private
ownership of capital, communicates through prices, and coordinates economic activity through
markets. Goods and services are produced and resources are supplied by whoever is willing and able
to do so. The result is competition among independently acting buyers and sellers of each product and
resource.

In pure capitalism or laissez faire capitalism government’s role would be limited to protecting private
property and establishing an environment appropriate to the operation of the market system. The term
“laissez faire” means “let it be”, i.e. keep government from interfering with the economy. The idea is
that such interference will disturb the efficient working of the market system.

The command system

The alternative to the market system is the command system, also known as socialism or
communism. In that system, the government owns most property resources and economic decision
making occurs through a central economic plan. A central planning board appointed by the
government makes nearly all the major decisions concerning the use of resources, the composition
and distribution of output, and the organization of production. The government owns most of the
business firms, which produce according to government directives. A central planning board

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determines production goals for each enterprise and specifies the amount of resources to be allocated
to each enterprise so that it can reach its production goals. The division of output between capital and
consumer goods is centrally decided, and capital goods are allocated among industries on the basis of
the central planning board’s long-term priorities.

1.7. Decision-making units and the circular flow of economic activities

The economy consists of millions of people engaged in many activities—buying, selling, working,
hiring, manufacturing, and so on. To understand how the economy works, we must find some way to
simplify our thinking about all these activities. In other words, we need a model that explains, in
general terms, how the economy is organized and how participants in the economy interact with one
another.

Figure 4 presents a visual model of the economy, called a circular-flow diagram. In this model, the
economy has two types of decision makers—households and firms. Firms produce goods and
services using inputs, such as labor, land, and capital (buildings and machines). These inputs are
called the factors of production. Households own the factors of production and consume all the goods
and services that the firms produce.

Figure 4. The circular flow

Households and firms interact in two types of markets. In the markets for goods and services,
households are buyers and firms are sellers. In particular, households buy the output of goods and
services that firms produce. In the markets for the factors of production, households are sellers and
firms are buyers. In these markets, households provide firms the inputs that the firms use to produce
goods and services. The circular-flow diagram offers a simple way of organizing all the economic
transactions that occur between households and firms in the economy.

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The inner loop of the circular-flow diagram represents the flows of goods and services between
households and firms. The households sell the use of their labor, land, and capital to the firms in the
markets for the factors of production. The firms then use these factors to produce goods and services,
which in turn are sold to households in the markets for goods and services. Hence, the factors of
production flow from households to firms, and goods and services flow from firms to households.

The outer loop of the circular-flow diagram represents the corresponding flow of dollars. The
households spend money to buy goods and services from the firms. The firms use some of the
revenue from these sales to pay for the factors of circular-flow diagram a visual model of the
economy that shows how dollars flow through markets among households and firms production, such
as the wages of their workers. What’s left is the profit of the firm owners, who themselves are
members of households. Hence, spending on goods and services flows from households to firms; and
income in the form of wages, rent, and profit flows from firms to households.

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 CHAPTER TWO

2.1. DEMAND AND SUPPLY

One of the best ways to appreciate the relevance of economics is to begin with the basics of supply
and demand. Supply-demand analysis is a fundamental and powerful tool that can be applied to a
wide variety of interesting and important problems. This chapter introduces the theory of supply and
demand. It considers how buyers and sellers behave and interact with one another. It shows how
supply and demand determine prices in a market economy and how prices, in turn, allocate the
economy’s scarce resources.

2.1.1. DEMAND
Demand refers to the different units of a good or service that an individual is willing and able to
purchase at alternative prices during a given period of time. We say “willing and able” because
willingness alone is not effective in the market. You may be willing to buy a digital camera, but if
that willingness is not backed by the necessary dollars (Birr), it will not be effective and, therefore,
will not be reflected in the market. To be meaningful, the quantities demanded at each price must
relate to a specific period- a day, a week, a month. Table 2.1. is a hypothetical demand schedule for a
single consumer purchasing ice-cream cones per month at different prices of ice cream. If ice cream
is free, our consumer eats 12 cones. At $0.50 per cone, the consumer buys 10 cones. As the price
rises further, he/she buys fewer and fewer cones. When the price reaches $3.00, the consumer doesn’t
buy any ice cream at all.

Table 2.1
DEMAND SCHEDULE. The demand
schedule shows the quantity demanded at
each price.

Figure 2.1
DEMAND CURVE, which graphs the
demand schedule in Table 1, shows how the
quantity demanded of the good changes as its
price varies.

Figure 2.1 graphs the numbers in Table 2.1 By convention, the price of ice cream is on the vertical
axis, and the quantity of ice cream demanded is on the horizontal axis. The downward-sloping line
relating price and quantity demanded is called the demand curve.
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2.1.1.1. Law of Demand

A fundamental characteristic of demand is this: All else equal, as price falls, the quantity demanded
rises, and as price rises, the quantity demanded falls. In short, there is a negative or inverse
relationship between price and quantity demanded. Economists call this inverse relationship the law
of demand.
The other things equal assumption is critical here. Many factors other than the price of the product
being considered affect the amount purchased. The quantity of Nikes purchased will depend not only
on the price of Nikes but also on the prices of such substitutes as Reeboks, Adidas, and Filas. The
other things that are held constant include individuals’ tastes, Income, prices of other goods, and even
the weather.

2.1.1.2.Market Demand Versus Individual Demand

Normally, economists talk about market demand curves rather that individual demand curves. A
market demand curves are what most firms are interested in. Firms don’t care whether individual A
or individual B buys their goods; they only care that someone buys their goods. Market demand is the
sum of all individual demand for a particular good or service.

Table 2.2
Individual and market demand
schedule.

Figure 2.2
Market demand as the sum of
individual demand.

Figure 2.2 shows the demand curves that correspond to the demand schedule. Assuming that
Catherine and Nicholas are the only consumers of ice-cream, the market demand is the sum of the
two individual demands. Notice that the individual demand curves are summed horizontally to obtain
the market demand curve.

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2.1.1.3.Shift in Demand Versus Movement Along a Demand Curve

To distinguish between the effects of price and the effects of other factors on how much of a good is
demanded, economists have developed the following precise terminologies;

 Demand refers to a schedule of quantities of a good that will be bought per unit of time at
various prices, other things constant.
 Quantity demanded refers to a specific amount that will be demanded per unit of time at a
specific price, other things constant.

In graphical terms, the term demand refers to the entire demand curve. Demand tells how much of a
good will be bought at various prices. Quantity demanded tells how much of a good will be bought at
a specific price; it refers to a point on a demand curve. The terminology allows as distinguishing
between changes in quantity demanded and shift in demand. A change in quantity demanded refers to
the effect of a price change on the quantity demanded. It refers to a movement along a demand curve.
A shift in demand refers to the effect of anything other than price on demand.

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2.1.1.4.Shift Factors of Demand

Shift factors of demand are factors that cause shifts in the demand curve. Important shift factors of
demand include:

A. Income: - For most products, a rise in income causes an increase in demand. As individuals’
income rises, they can afford more of the goods they want, such as steaks, computers, or clothing.
These are normal goods. For other goods, called inferior goods, an increase in income reduces
demand. Examples are used cloths and third-hand cars, because the higher incomes enable
consumers to buy new versions of those products.

B. Price of Related Goods: - A change in the price of a related good may either increase or decrease
the demand for a product, depending on whether the related good is a substitute or a complement:
 A substitute good is one that can be used in place of another good. Beef and Chicken, Jeans
and Khakis, Tea and Coffee are examples of substitutes. When two goods are substitutes, the
price of one and the demand for the other move in the same direction.
 A complement good is one that is used together with another good. Gasoline and Car, movies
and popcorn, cameras and film are examples of complements. When two goods are
complements the price of one good and the demand for the other good move in opposite
direction.

C. Tastes: - A favorable change in consumer tastes for a product – a change that makes the product
more desirable – means that more of it will be demanded at each price. Demand will increase; the
demand curve will shift rightward. An unfavorable change in consumer preferences will decrease
demand, shift the demand curve to the left.

D. Expectations: - Finally, expectations will also affect demand. Expectations can cover a lot. A
newly formed expectation of higher future prices may cause consumers to buy now in order to
“beat” the anticipated price rises, thus increasing current demand. Similarly, a change in
expectations concerning future income may promote consumers to change their current spending.
For example, first-round NFL draft choices may splurge on new luxury cars in anticipation of a
lucrative professional football contract.

E. Number of Buyers: - An increase in the number of buyer in a market increases demand. A

decrease in the number of buyers in a market decreases demand. For example, the baby boom
after the Second World War increased demand for diapers, baby lotion, and the service of
obstetricians. When the baby boomers reached their twenties in the 1970s, the demand for
housing increased. Conversely, the aging of the baby in the 1980s and 1990s was a factor for the
demand of housing in those decades.

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2.1.2. SUPPLY

Supply refers to the different units of a good or service that a producer is willing and able to sell at
alternative prices during a given period of time. Supply can be represented using tables or/and graphs.
Table 2.3 represents a hypothetical supply schedule for a single producer of ice-cream. It shows the
quantities of ice-cream that will be supplied at various prices, other things equal. The supply curve is
the graphical representation of the relationship between price and quantity supplied. A supply curve
is shown graphically in Figure 2.3.

Table 2.3
The supply schedule shows the
quantity supplied at each price

Figure 2.3
Supply curve, which graphs the
supply schedule in Table 2.3, shows
how the quantity supplied of the
good changes as its price varies.
Because a higher price increases the
quantity supplied, the supply curve
slopes upward.

2.1.2.1.The Law of Supply

There’s a law of supply that corresponds to the law of demand. The law of supply states that, quantity
supplied of a good is directly related to that good’s price, other things constant. As price rises, the
quantity supplied rises; as price falls, the quantity supplied falls.

2.1.2.2.Market supply versus Individual supply

Just as market demand is the sum of the demands of all buyers, market supply is the sum of the
supplies of all sellers. Table 2.4 shows the supply schedules for two ice-cream producers—Ben and
Jerry. At any price, Ben’s supply schedule tells us the quantity of ice cream Ben supplies, and Jerry’s
supply schedule tells us the quantity of ice cream Jerry supplies. The market supply is the sum of the
two individual supplies.

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 Table 2.4
The quantity supplied in a market is the
sum of the quantity supplied by all the
sellers.

Figure 2.4
The market supply curve is found by
adding horizontally the individual supply
curves.

Figure 2.4 shows the supply curves that correspond to the supply schedules in Table 2.4. As with
demand curves, we sum the individual supply curves horizontally to obtain the market supply curve.
That is, to find the total quantity supplied at any price, we add the individual quantities found on the
horizontal axis of the individual supply curves. The market supply curve shows how the total quantity
supplied varies as the price of the good varies.

2.1.2.3.Shift is Supply Versus Movements Along a Supply Curve

The same distinctions in terms made for demand apply to supply.

 Supply refers to a schedule of quantities a seller is willing to sell per unit of time at various
prices, other things constant.
 Quantity supplied refers to a specific amount that will be supplied at a specific price.

In graphical terms, supply refers to the entire supply curve because a supply curve tells us how much
will be offered for sale at various prices. “Quantity supplied” refers to a point on a supply curve.

The second distinction that is important to make is between the effects of a change in price and the
effects of shift factors on how much a good is supplied. Changes in price causes changes in quantity
supplied; such changes are represented by a movement along a supply curve. If the amount supplied
is affected by anything other than price, that is, by a shift factor of supply, there will be a shift in
supply.

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 Figure 6
Shift in the supply curve.

2.1.2.4.Shift Factors of Supply

Other factors besides price that affect how much will be supplied include the price of inputs used in
production, technology, taxes and subsidies and number of sellers.

A. Price of Inputs: - The price of inputs used in production process determines the costs of
production incurred by firms. A higher price raise production costs, squeeze profits, and lowers
the incentive to supply. Therefore, supply falls when the price of inputs rises. If costs rise
substantially, a firm might even shut down.

B. Technology: - Advance in technology change the production process, reducing the number of
inputs needed to produce a given supply of goods. Thus, a technological advance that reduces the
number of workers will reduce costs of production. A reduction in the costs of production
increases profits and leads suppliers to increase production. Advance in technology increases
supply.
C. Taxes and Subsidies: - Taxes on suppliers increase the cost of production by requiring a firm to
pay the government a portion of the income form products or services sold. Because taxes
increase the cost of production, profit declines and suppliers will reduce supply. The opposite is
true for subsidies. Subsidies to suppliers are payments by the government to produce goods; thus,
they reduce the cost of production. Subsidies increase supply. Taxes on suppliers reduce supply.
D. Number of sellers: - Other things equal, the larger the number of suppliers, the greater the market
supply. As more firms enter an industry, the supply curve shifts to the right. Conversely, the
smaller the number of firms in the industry, the less the market supply. This means that as firms
leave an industry, the supply curve shifts to the left.

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2.1.3. EQUILIBRIUM

Figure 2.5 shows the market supply curve and market demand curve together. Notice that there is one
point at which the supply and demand curves intersect; this point is called the market’s equilibrium.
The price at which these two curves cross is called the equilibrium price, and the quantity is called
the equilibrium quantity. Here the equilibrium price is $2.00 per cone, and the equilibrium quantity
is 7 ice-cream cones.

Figure 2.5
The equilibrium is found where the
supply and demand curves intersect.
At the equilibrium price, the quantity
supplied equals the quantity
demanded. Here the equilibrium price
is $2: At this price, 7 ice-cream cones
are supplied, and 7 ice-cream cones
are demanded.

The dictionary defines the word equilibrium as a situation in which various forces are in balance—
and this also describes a market’s equilibrium. At the equilibrium price, the quantity of the good that
buyers are willing and able to buy exactly balances the quantity that sellers are willing and able to
sell. The equilibrium price is sometimes called the market-clearing price because, at this price,
everyone in the market has been satisfied: Buyers have bought all they want to buy, and sellers have
sold all they want to sell.

Exercise 1: From statistical studies, we know that for 1981 the supply curve for wheat was
approximately as follows:
Supply: QS = 1800 + 240P
Where price is measured in dollars per bushel and quantities are in millions of bushels
per year. These studies also indicate that in 1981 the demand curve for wheat was
Demand: QD = 3550 – 266P
Find the market clearing price and equilibrium quantity of wheat for the year1981.

The actions of buyers and sellers naturally move markets toward the equilibrium of supply and
demand. To see why, consider what happens when the market price is not equal to the equilibrium
price. Suppose first that the market price is above the equilibrium price, as in point (A) of Figure 2.6.
At a price of $2.50 per cone, the quantity of the good supplied (10 cones) exceeds the quantity
demanded (4 cones). There is a surplus of the good: Suppliers are unable to sell all they want at the
going price. When there is a surplus in the ice-cream market, for instance, sellers of ice cream find
their freezers increasingly full of ice cream they would like to sell but cannot. They respond to the
surplus by cutting their prices. Prices continue to fall until the market reaches the equilibrium.

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Suppose now that the market price is below the equilibrium price, as in point (B) of Figure 2.6. In
this case, the price is $1.50 per cone, and the quantity of the good demanded exceeds the quantity
supplied. There is a shortage of the good: Demanders are unable to buy all they want at the going
price. When a shortage occurs in the ice-cream market, for instance, buyers have to wait in long lines
for a chance to buy one of the few cones that are available. With too many buyers chasing too few
goods, sellers can respond to the shortage by raising their prices without losing sales. As prices rise,
the market once again moves toward the equilibrium.

Thus, the activities of the many buyers and sellers automatically push the market price toward the
equilibrium price. Once the market reaches its equilibrium, all buyers and sellers are satisfied, and
there is no upward or downward pressure on
the price.

Figure 2.6
At point (A), there is a surplus. And At point (B),
there is a shortage.

2.1.3.1.Change in Equilibrium

So far we have seen how supply and demand together determine a market’s equilibrium, which in
turn determines the price of the good and the amount of the good that buyers purchase and sellers
produce. Of course, the equilibrium price and quantity depend on the position of the supply and
demand curves. When some event shifts one of these curves, the equilibrium in the market changes.
The analysis of such a change is called comparative statics because it involves comparing two static
situations—an old and a new equilibrium.

When analyzing how some event affects a market, we proceed in three steps. First, we decide
whether the event shifts the supply curve, the demand curve, or in some cases both curves. Second,
we decide whether the curve shifts to the right or to the left. Third, we use the supply-and-demand
diagram to examine how the shift affects the equilibrium price and quantity. The following two
examples explain how the recipe works.

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2.1.3.2.An increase in Demand while Supply Remains Constant

An event that raises quantity demanded at any given price shifts the demand curve to the right. The
equilibrium price and the equilibrium quantity both rise. For example, an abnormally hot summer
causes buyers to demand more ice cream. The demand curve shifts from D1 to D2, which causes the
equilibrium price to rise from
$2.00 to $2.50 and the equilibrium
quantity to rise from 7 to 10 cones.

Figure 9
How an increase in demand affects the
equilibrium.

2.1.3.3.A Decrease in Supply while Demand remains the same

An event that reduces quantity supplied at any given price shifts the supply curve to the left. The
equilibrium price rises, and the equilibrium quantity falls. For example an earthquake causes sellers
to supply less ice cream. The supply curve shifts from S1 to S2, which causes the equilibrium price to
rise from $2.00 to $2.50 and the
equilibrium quantity to fall from
7 to 4 cones.

Figure 10
How a decrease in supply affects
the equilibrium.

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Generally, the following table shows the predicted outcome for any combination of shifts in the two
curves.

Exercise 2: In 1985, the demand curve for wheat was

Demand: QD + 2580 – 194p
The supply curve remained more or less the same as in 1981.

Find the market clearing price and equilibrium quantity for the year 1985.

2.1.4. Elasticity
Elasticity refers to responsiveness; for example, elasticity can be used to describe the responsiveness
of quantity supplied or quantity demanded to price. The most commonly used elasticity concept is
price elasticity of demand and supply.

A. Price elasticity of demand is the percentage change in quantity demanded divided by the
percentage change in price.
Percentage change in quantity demanded
ED 
Percentage change in price
ED can be calculated in terms of the new quantity and price, or with the original quantity and price.
However, different results would then be obtained. To avoid this problem, economists generally
measure ED in terms of the average quantity and the average price, as follows:
Change in quantity demanded Change in price
ED  
Sum of quantites demanded Sum of prices
2 2
Demand curves can be classified according to their elasticity’s. Demand is elastic when the elasticity
is greater than 1, so that quantity moves proportionately more than the price. Demand is inelastic
when the elasticity is less than 1, so that quantity moves proportionately less than the price. If the
elasticity is exactly 1, so that quantity moves the same amount proportionately as price. In the
extreme case of zero elasticity, demand is perfectly inelastic, and the demand curve is vertical. In this
case, regardless of the price, the quantity demanded stays the same. At the opposite extreme, demand
18
is perfectly elastic. This occurs as the price elasticity of demand approaches infinity and the demand
curve becomes horizontal, reflecting the fact that very small changes in the price lead to huge
changes in the quantity demanded.

B. Price Elasticity of Supply is the percentage change in quantity supplied divided by the
percentage change in price.

Percentage change in quantity sup plied

ED 
Percentage change in price

Again the average quantity and price can be used as follows:

Change in quantity sup plied Change in price

ED  
Sum of quantites sup plied Sum of prices
2 2

Supply is said to be elastic if ES > 1, unitary elastic if ES = 1, inelastic if ES < 1, perfectly elastic if E S
= ∞ and perfectly inelastic if ES = 0.

Exercise 2: Plot the graphs of perfectly inelastic and perfectly elastic supply curves.

Exercise 3: Find the price elasticity of demand and supply of wheat for the year 1981 at the
equilibrium price and quantity.

19
2.2.THEORY OF UTILITY AND PREFERENCES

In this chapter and the next, we will see how consumers allocate their incomes and how this
determines the demands for various goods and services. This, in turn, will help us understand how
changes in income and prices affect demands for goods and services and why the demands for some
products are more sensitive than others to price and income changes.

Consumer behavior is best understood in three steps. The first step is to examine consumer
preferences. Specifically, we need a practical way to describe how people might prefer one good to
another. Second, we must account for the fact that consumers face budget constraints-they have
limited incomes that restrict the quantities of goods that they can buy. The third step is to put
consumer preferences and budget constraints together to determine consumer choices. In other words,
given their preferences and limited incomes, what combinations of good will consumers buy to
maximize their satisfaction? We will go through each of these steps in turn.

Economists model people’s preferences using the concepts of Utility, which can be defined as the
satisfaction that a person receives from his or her activities. Utility is a subjective entity and resides
in minds of people. Being subjective it varies with different persons, that is, different persons derive
different amounts of utility from a given good.

There are two approaches to utility analysis:

They are: (1) Cardinal Utility approach and

(2) Ordinal Utility approach

The cardinal approach assumes that utility can be measured. Some economists suggested that utility
could be measured in monetary terms, i.e., by the amount of money the consumer is willing to
sacrifice for another unit of a commodity. Other suggested that utility could be measured in
subjective units called ‘Utils’. This approach suffers from a number of weaknesses. The most
important weakness of this old approach was related to its cardinal measurement of utility.

To overcome this difficulty the modern economists have developed an alternative approach based on
indifference curve analysis. The new indifference curve approach does not deny the existence of
utility but makes use of it in a different way. It states that utility cannot be measured in absolute
terms. Ordinal utility is not a quality or a numerical value. It is only an expression of the consumer’s
preference for one commodity over another or for one basket of goods over another.

The concept of ordinal utility is based on the following assumptions:

a. A consumer has a clear cut preference: It may not be possible for a consumer to express his
utility in quantitative terms. But it is always possible for him to tell which of any two goods he
prefers. For example, an individual may not be able to specify how much utility he derives by
eating a banana. But, he can always tell what he prefers between banana and orange.
b. Preferences have transitive property: In view of (a) the consumer can order all the
commodities he consumes in order of their preference. It expected that consumers would not
make statements about his or her preference that conflict with each other. In other words it is
20
 assumed that preferences are transitive. If a person prefers A to B and B to C, then he prefers A
to C.
c. More is Better: A third assumption we make about preferences is that a person prefers more of
a good to less. That is more of a good is better.

These three assumptions form the basis of consumer theory. They don’t explain consumers’
preferences, but they do impose a degree of rationality and reasonableness on them.

2.2.1. The Indifference Curve

Consumer’s preferences can be shown graphically with the use of indifference curves. An
indifference curve represents all combinations of two goods that provide the same level of utility to a
person. That person is therefore indifferent among the combination of goods represented by the
points on the curve.

Assuming only two goods (food and cloth), figure 1 represents a hypothetical indifference curve and
all points on this curve are equally satisfactory to the consumer. That is, each combination of food
and cloth on the curve yields the same total utility.

Combination Units of Clothing Units of Food

A 16 1
B 10 2 Table 1
D 6 3 An Indifference Schedule
E 4 4
G 3 5

Figure 1
A Consumer’s Indifference
Curve.

2.2.2. Marginal Rate of Substitution

What happens when an individual moves from point A (16 cloths and 1 Food) to point B (10 cloths
and 2 foods)? This person remains equally well-off because the two commodity bundles lie on the
same indifference curve. This person will voluntarily give up 6 clothes for one additional food. The
21
slope of the curve between point A and B is therefore approximately -6. That is, the amount of C
(cloth) declines by six units in response to a one unit increase in F (food). We call the absolute value
of this slope the Marginal Rate of Substitution (MRS). Thus the marginal rate of substitution of F
for C represents the amount of cloth, which the consumer has to give up for the gain of one additional
unit of food so that his level of satisfaction remains the same. Sacrificed
∆ ℎ ℎ( ℎ )
= =
∆ ℎ ( ℎ )

6 − 10
= = |−4| = 4
3−2
4−6
= = |−2| = 2
4−3
3−4
= = |−1| = 1
5−4
2.2.3. Characteristics of the Indifference Curve
Typical indifference curves have the following properties.
A. Indifference curves slope down ward to the right (negative slope): The negative slope of an
indifference curve implies:
i. That the two commodity can be substituted for each other and
ii. That if quantity of one commodity decreases quantity of the other commodity must increase if
the consumer has to stay at the same level of satisfaction.
B. Indifference curves are convex to the origin: The term convex means that the MRS of the
indifference curve diminishes as we move down along the curve. The indifference curve in Figure
1 is convex. Starting with point A and moving to point B, we note that the MRS of food F for
clothing C is 6. However, when starting at point B and moving to D, the MRS falls to 4. Starting at
point D and moving to E, the MRS is 2, and starting at E and moving to G, the MRS is 1. As food
consumption increases, the MRS falls.
C. A higher indifference curve represents a higher level of satisfaction than the lower
indifference curve. In other words, the combinations, which lie on a higher indifference curve,
will be preferred to the combinations, which lie on a
lower indifference curve.

Figure 2
Of the three indifference curves, indifference curve U3
generates the highest level of satisfaction, followed by
indifference curves U2 and U1.

22
D. Indifference curves do not intersect each other: To see why, we will assume the contrary and
see how it violates the assumptions about consumer behavior. Figure 3 shows to indifference
curves, U1 and U2 that intersect at A. Since A and B are both on indifference curve U1, the
consumer must be indifferent between the two market baskets. Both A and D lie on indifference
curve U2 so the consumer must be indifferent between these combinations. As a result, the
consumer must also be indifferent between B and D. But this can’t be true because combination B
must be preferred to D since it contains more of both food and clothing than D. Hence
indifference curves that intersect would contradict our
assumption that more is preferred to less.

Figure 3
If indifference curves U1 and U2 intersected, one of the
assumptions of consumer theory would be violated.

2.2.4. Particular Preferences

Indifference curves might be used to reflect particular types of preferences, Figure 4 shows three
special cases. The shapes of indifference curves can imply different degrees of willingness to
substitute one good for another. To see this, look at the two polar cases illustrated in Figure 3.6.
A. Perfect Substitutes: Figure 4a shows Abebe’s preferences for apple juice and orange juice.
These two goods are perfect substitutes for Abebe, since he is entirely indifferent between having
a glass of one or the other. In this case, the marginal rate of substitution of apple juice for orange
juice is 1; Abebe is always willing to trade a glass of one for a glass of the other. In general, we
say that two goods are perfect substitutes when the marginal rate of substitution of one good for
the other is a constant; that is, the indifference curves that describe the trade-off between the
consumption of the goods are straight lines.

Figure 4
Perfect Substitutes and
Perfect Complements.

23
B. Perfect Complements: Figure 4b illustrates Abeba’s preferences for left shoes and right shoes.
For Abeba, the two goods are perfect complements, since a left shoe will not increase her
satisfaction unless she can obtain the matching right shoe. In this case, the marginal rate of
substitution of left shoes for right shoes is zero whenever there are more right shoes than left
shoes, since Abeba would not give up any left shoes to get additional right shoes.
Correspondingly, the marginal rate of substitution is infinite whenever there are more left shoes
than right, since Abeba will give up all but one of the excess left shoes she has in order to obtain
an additional right shoe. Two goods are perfect complements when the indifference curves for the
goods are shaped as right angles.

2.2.5. The Budget Constraint

An indifference map describes a person’s preferences for various combinations of goods and
services. But preferences do not explain all of consumer behavior. Individual choices are also
affected by budget constraints, which limit people’s ability to consume in light of the prices they
must pay for various goods and services.

2.2.5.1.The Budget Line

To see how a budget constraint limits a consumer’s choices, let’s consider a situation in which a
woman has a fixed amount of income, I, that can be spent on food and clothing. Let F be the amount
of food purchased, and C the amount of clothing. We will denote the prices of the two goods PF and
PC. Then PFF (i.e., price of food times the quantity) is the amount of money spent on food, and PCC is
the amount of money spent on clothing.

The budget line indicates all combinations of F and C for which total money spent is equal to income.
Since there are only two goods, the woman will spend her entire income on food and clothing. As a
result, the combinations of food and clothing that she can buy will all lie on this line:

+ = Equation 1

For example, suppose the consumer has a weekly income of $80, the price of food is $1 per unit, and
the price of clothing is $2 per unit. Table 2 shows various combinations of food and clothing that she
can purchase each week with her $80. If all her budget were allocated to clothing, the most that she
could buy would be 40 units (at a price of $2 per unit), as represented by point A. If she spent all her
budget on food, she could buy 80 units (at $1 per unit), as given by point G. Market baskets B, D, and
E show three additional ways in which $80 could be spent on food and clothing.

Figure 5 shows the budget line associated with the market baskets given in Table 2. Because giving
up a unit of clothing saves $2 and buying a unit of food costs $1, the amount of clothing given up for
food along the budget line must be the same everywhere. As a result, the budget line is a straight line
from point A to point G. In this particular case, the budget line is given by the equation + 2 =
$80.

24
 Points Food (F) Clothing (C) Total Spending
A 0 40 $80
B 20 30 $80 Table 2
D 40 20 $80 Different combinations
E 60 10 $80 that can be purchased.
G 80 0 $80

Figure 5
The consumer’s budget line describes
the combinations of goods that can be
purchased given the consumer’s income
and the prices of the goods.

The intercept of the budget line is

represented by point A. As she moves along the line from point A to G, the consumer spends less on
clothing and more on food. It is easy to see that the extra clothing that must be given up to consume
an additional unit of food is given by the ratio of the price of food to the price of clothing ($1/$2 =
½). Since clothing costs $2 per unit, while food is only $1 per unit, a unit of clothing must be given
up to get 1 unit of food. In figure 5 the slope of the line measures the relative cost of food and
clothing.

Using equation 1, we can see how much of C must be given up to consume more of F by dividing
both sides of the equation by PC and then solving for C:
= ( ⁄ )−( ⁄ ) Equation 2
Equation 2 is the equation for a straight line; it has a vertical intercept of I/PC and a slope
of – ( ).
The slope of the budget line, – ( ), is the negative of the ratio of the prices of the two goods. The
magnitude of the slope tells us the rate at which the two goods can be substituted for each other
without changing the total amount of money spent. The vertical intercept (I/Pc) represents the
maximum amount of C that can be purchased with income I. Finally, the horizontal intercept (I/PF)
tells us how many units of F could be purchased if all income were spent on F.

2.2.5.2. Shifting the Budget Line

We have seen that the budget line depends on income and on the price of the goods P F and PC. Prices
and income often change, however. Let’s see how such changes affect the budget line.

25
Income Changes: From the equation for the straight line, we can see that a change in income alters
the vertical intercept of the budget line but does not change the slope (because the price of neither
good changed). Figure 6 shows that if income is doubled (from $80 to $160), the budget line shifts
outward (form budget line L1 to budget line L2). Note, however, that L2 remains parallel to L1. If she
desires, the consumer now double her purchases of both food and clothing. Likewise, if her income is
cut in half (from $80 to $40), the budget line shifts inward, from L1 to L3.

Figure 6
A change in income (with prices unchanged)
causes the budget line to shift parallel to the
original line (L1).

Price Changes: We can use the equation = ( ⁄ ) − ( ⁄ ) to describe the effects of a change
in price of food on the budget line. Suppose the price of food falls by half, from $1 to $0.50. Then the
vertical intercept of the budget line remains unchanged, but the slope changes from – = -1/2 =
-1/4. In Figure 7 we obtain the new budget line L2 by rotating the original budget line L1 outward,
pivoting from the C-intercept. This rotation makes sense because a person who consumes only
clothing and no food is unaffected by the price change. However, someone who consumes a large
amount of food will have an increase in his purchasing power. The maximum amount of food that
can be purchased has doubled in response to the decline in the price of food. On the other hand, when
the price of food doubles from $1 to $2, the budget line rotates inward to line L3 because the person’s
purchasing power has diminished. Again, a person who consumes only clothing would be unaffected
by the food price increase.

Figure 7
A change in the price of one good (with
income unchanged) causes the budget line to
rotate about one intercept.

26
2.2.6. The Consumer Equilibrium

Given preferences and budget constraints, we can now determine how individual consumers choose
how much of each good to buy. We assume that consumers make this choice in a rational way that
they choose the goods to maximize the satisfaction they can achieve, given the limited budget
available to them.

The way in which a consumer maximizes satisfaction subject to a limited money income is illustrated
in Figure 8. The budget line is LM, and the curves labeled U1, U2 and U3 are a portion of an
individual’s indifference map. Because of the income constraint, the consumer cannot attain a
position on any indifference curve, such as U3, that lies entirely beyond the budget line.

Three attainable bundles on LM are represented by the points Q, P, and R. Each of these, and every
point on the budget line LM, is attainable with the consumer’s limited money income.

Suppose the consumer was located at Q. Let her experimentally move to bundles just to the left and
right of Q. Moving to the left from Q lowers her satisfaction to some indifference curve below U1.
But moving to the right brings the consumer to a higher indifference curve; and continued
experimentation will lead our consumer to move at least as far as P, because each successive
movement to the right brings the consumer to a higher indifference curve.

Similarly, if a consumer was situated at a point such as R, experimentation would lead to a

substitution of cloth for food, there by moving in the direction of P. The consumer would not stop
short of P because each successive substitution of cloth for food brings the consumer to a higher
indifference curve. Hence the position of maximum satisfaction, or the point of consumer
equilibrium, is attained at P; where an indifference curve is tangent to the budget line.

The slope of the budget line is the negative of price ratio, the ratio of price of food to the price of
cloth. On the other hand, the negative of the slope of an indifference curve at any point is called the
marginal rate of substitution. Hence the point of consumer equilibrium satisfies the condition that the
marginal rate of substitution equals the price ratio.

Figure 8
Consumers maximize their
satisfaction at point P. At this point
the budget line and the indifference
curve U2 are tangent. At this point,

27
2.2.7. Change in Money Income

Changes in money income, prices remaining constant, usually result in changes in the quantities of
commodities bought. For most goods, an increase in money income leads to an increase in
consumption, and a decrease in money income leads to a decrease in consumption. To analyze the
effects on consumption of changes in income, we will hold nominal prices constant.

2.2.7.1.The Income Consumption Curve

An increase in money income shifts the budget line upward and to the right, and the movement is a
parallel shift because nominal prices are assumed to be constant. With money income represented by
LM, the consumer comes to equilibrium at point P on indifference curve U1. Now let money income
rise to the level represented by L’M’. The consumer shifts to a new equilibrium at point Q on
indifference curve U2. The consumer has clearly gained. The consumer also gains when money
income shifts to the level corresponding to L”M”. The new equilibrium is at point R on indifference
curve U3.

As income shifts, the point of consumer equilibrium shifts as well. The line connecting the successive
equilibria is called the income consumption curve. This curve shows the equilibrium combination of
food and cloth purchased at various levels of money income, nominal prices remaining constant
throughout.

Figure 9
The income consumption curve is the
locust of points showing the equilibrium
commodity bundles associated with
different levels of money income for
constant prices.

2.2.7.2.Engel Curves

The income consumption curve may be used to derive Engel curves for each commodity. An Engel
curve is a function relating the equilibrium quantity purchased of a commodity to the level of money
income.

The Engel curve that corresponds to the income consumption curve of Figure 9 is shown in Figure
10. There, Food and Income are on the axes rather than Food and Clothing. At point in Figure 19, F1
of Food was consumed and income was I1. Thus, P in Figure 9 corresponds to P in Figure 10.
28
Similarly, at R in figure 9, income was I3 and F3 of Food was consumed. Thus R in Figure 10
corresponds to R in Figure 9. The change from F1 to F3 is the change in consumption of food that
results when income rises from I1 to I3. The Engel curve is formed by connecting the points
generated by repeating the process for all possible levels of money income.

Figure 10
Engel Curve

2.2.8. Changes in Price

In this section we assume that money income and the nominal price of Cloth remain constant while
the price of food falls.

2.2.8.1. The Price Consumption Curve

In Figure 11 the price of food falls from the amount indicated by the slope of the original budget line
LM to the amount indicated by the slope of LM’ and then to the amount represented by LM”.

With the original budget line LM, the consumer reaches equilibrium at point P on indifference curve
I. When the price of food falls, the budget line becomes LM’ and the new equilibrium is attained at Q
on indifference curve II. Finally, when the price falls again, the new equilibrium is point R on
indifference curve III and budget line LM”. The line connecting these successive equilibrium points
is called the price consumption curve.

2.2.8.2. The Demand Curve

The individual consumer’s demand curve for a commodity can be derived from the price
consumption curve. When the price of food is given by the slope of LM in Figure 11, F1 units of food
are purchased. Similarly, when the price of Food falls to the level indicated by the slope of LM’,
quantity purchased increases to F2. Plotting all points obtained and connecting them with a line
generates the consumer demand curve.

29
 Figure 11
The price consumption
curve is the locust of points
showing the equilibrium
points resulting from
variations in the price
ration, money income
remaining constant.

30
2.3.Production

In the production process, firms turn inputs, which are also called factors of production, into outputs
(or products). The relationship between inputs and the resulting output is described by production
function. A production function indicates the output Q that a firm produces for every specified
combination of inputs. For example if we assume that there are only two inputs, labor (L) and capital
(K). We can then write the production function as
Q = F (K, L)
The equation relates the quantity of output to the quantities of the two inputs, capital and labor.

2.3.1. The short run versus the long run

It is important to distinguish between the short and long run when analyzing production. The short
run refers to a period of time in which one or more factors of production cannot be changed. Factors
that cannot be varied over this period are called fixed inputs. A firm’s capital, for example, usually
requires time to change; a new factory must be planned and built, machinery and other equipment
must be ordered and delivered, all of which can take a year or more. The long run is the amount of
time needed to make all inputs variable.

2.3.2. The short run production function

In this case it is assumed that there is only one variable input. In subsequent discussion, this variable
input is usually called “labor”, although any other input could just as well be used. It is also assumed
that this variable input can be combined in different proportions with the fixed variable input to
produce various quantities of output.
Consider the case in which capital is fixed, but labor is variable, so that the firm can produce more
output by increasing it labor input. Imagine, for example, that you are managing a clothing plant.
You have a fixed amount of equipment, but you can hire more labor or less to sew and to run the
machines. You have to decide how much labor to hire and how much clothing to produce. To make
the decision, you will need to know how the amount of output Q increases (if at all), as the input of
labor L increases. Table 2.5 gives this information. The first three columns shows, the amount of
output that can be produced in one month with different amounts of labor, and with capital fixed at
ten units. When labor input is zero, output is also zero. Then output increases as labor is increased up
to an input of eight units. Beyond that point, total output declines: While initially each unit of labor
can take greater and greater advantage of the existing machinery and plant, after a certain point,
additional labor is no longer useful and indeed can be counterproductive. (Five people can run an
assembly line better than two, but ten people may get in each other’s way).

2.3.2.1.Average and Marginal Products

The contribution that labor makes to the production process can be described in terms of the average
and marginal products of labor. The fourth column in Table 2.5 shows the average product of labor
APL, which is the output per unit of labor input. The average product is calculated by dividing the
total output Q by the total input of labor, L. In our example the average product increases initially but
falls when the labor input becomes greater than 4. The fifth column shows the marginal product of
labor MPL. This is the additional output produced as the labor input is increased by one unit. For
31
example, with capital fixed at 10 units, when the labor input increases from 2 to 3, total output
increases from 30 to 60, creating an additional output of 3Q (60 – 30) units. The marginal product of
labor is given as ∆Q/∆L.

Amount of Amount of Average Product Marginal Product

Total Output (Q)
Labor (L) Capital (K) (Q/L) (∆Q/∆L)
0 10 0 -
1 10 10 10 10
2 10 30 15 20
3 10 60 20 30
4 10 80 20 20
5 10 95 19 15
6 10 108 18 13
7 10 112 16 4
8 10 112 14 0
9 10 108 12 -4
10 10 100 10 -8
Table 2.5 Production with one
variable input

Figure 2.7: Production with one

variable input

32
Figure 2.7 plots the information contained in table 2.5. Figure 2.7 (A) shows that output increases
until it reaches the maximum output of 112; there after it diminishes. Figure 2.7 (B) show the average
and marginal product curves. Note that the marginal product is always positive when output is
increasing, and it is negative when output is decreasing.

It is no coincidence that the marginal product curve crosses the horizontal axis of the graph at the
point of maximum total product. This happens because adding a worker to a production line in a
manner that slows up the line and decreases total output implies a negative marginal product for that
worker.

The average product and marginal product curves are closely related. When the marginal product is
greater than the average product, the average product is increasing, as shown between outputs 1 and 4
in Figure 2.7(B). For example, suppose that the only employee of an advertising firm can write 10
advertisements (ads) per day, so that initially 10 is the average product of labor. Now, a more
productive employee is hired who can produce 20 ads per day. The marginal product of labor, 20 ads,
is greater than the average, 10. And because both workers combine to produce 30 ads in two days of
labor, the new average product has increased to 15 ads.

Similarly, when the marginal product is less than the average product, the average product is
decreasing, as shown between outputs 4 and 10 in figure 2.7(B). Because the marginal product is
above the average product when the average product is increasing and below the average product
when the average product is decreasing, it follows that the marginal product must equal the average
product when the average product reaches its maximum. This happens at point E in Figure 2.7(B).

Note the graphical relationship between average and marginal products. At B, the marginal product
of labor (the slope of the tangent to the total product curve at B) is greater than the average product
(dashed line OB). As a result, the average product of labor increases as we move from B to C. At C,
the average and marginal products of labor are equal. Finally, as we move beyond C toward D, the
average marginal product falls below the average product; you can check that the slope of the tangent
to the total product curve at any point between C and D is lower than the slope of the line from the
origin.

2.3.2.2.The Three Stage of Production

Using Figure 2.7, we can identify three stage of production. The first stage corresponds to usage of
the variable input to the left of point C where average product achieves its maximum. Stage II
corresponds to usage of the variable input between point C and point D, where the marginal product
of the variable input is zero. Finally, stage III corresponds to usage of the variable input to the right of
point 6 where the marginal product of this input is negative.

Clearly, the producer would never produce in stage III, since in this stage more output can be
obtained by using less of the variable input. Such inefficiencies in the use of scarce production factors
will always be avoided. In stage I, average product of the variable factor is increasing and is less than
the marginal product. Each additional variable input brings more output than the already employed
33
variable input. Therefore, the firm will not produce in this stage. Efficient production occurs in stage
II.

2.3.3. The Optimal Input Proportions: Two Variable Inputs

Now let’s see a firm’s production technology when it uses two inputs and can vary both of them.
Suppose, for example, that the inputs are labor and capital, and that they are used to produce food.
Table 3.2 tabulates the output achievable for various combinations of inputs.
Labor inputs are listed across the top row, capital inputs down the column on the left. Each entry in
the table is the maximum output that can be produce per time period which each combination of labor
and capital used over that time period. (For example, 4 units of labor per year and 2 units of capital
per year yield 85 units of food per year).
Table 3.2 Production with Two Variable Inputs
Labor Input
Capital Input
1 2 3 4 5
1 20 40 55 65 75
2 40 60 75 85 90
3 55 75 90 100 105
4 65 85 100 110 115
5 75 90 105 115 120

Figure 3.2: The Isoquant Curve

The information contained in table 3.2 can also be represented graphically using isoquants. An
isoquant is a curve that shows all the possible combinations of inputs that yield the same output.
Figure 3.2 shows three isoquans.

For example, isoquant Q1 shows all combinations of labor per year and capital per year that together
yield 55 units of output per year. Two of these points, A and D, correspond to Table 3.2. At A, 1 unit
of labor and 3 units of capital yield 55 units of output; whereas at D, the same output is produced
from 3 units of labor and 1 unit of capital. Isoquant Q2 shows all combinations of inputs that yield 75
units of output and corresponds to the four combinations of labor and capital italicized in the table

34
(e.g., at B, where 2 units of capital and 3 units of labor are combined). Isoquant Q2 lies above and to
the right of Q1 because it takes more labor and/or capital to obtain a higher level of output.

One of the chief features of production under conditions of variable proportions is that different
combinations of inputs can produce a given level of output. In other words, one input can be
substituted for another in such a way as to maintain a constant level of output.
2.3.3.1. Marginal Rate of Technical Substitution
With two inputs that can be varied, a manager will want to consider substituting one input for
another. The slope of each isoquant indicates how the quantity of one input can be traded off against
the quantity of the other, while keeping output constant. When the negative sign is removed, we call
the slope the marginal rate of technical substitution (MRTS). The marginal rate of technical
substitution of labor for capital is the amount by which the input of capital can be reduced when one
extra unit of labor is used, so that output remains constant.
MRTS = - Change in Capital Input/Change in Labor Input
= - ∆K/∆L (for a fixed level of Q)
where ∆K and ∆L are small changes in capital and labor along an isoquant.
In Figure 3.2 the MRTS is equal to 2 when labor increases from 1 unit to 2, and output is fixed at 75.
However, the MRTS falls to 1 when labor is increased from 2 units to 3, and then declines to 2/3 and
to 1/3. Clearly, as more and more labor replaces capital, labor becomes less productive and capital
becomes relatively more productive. So less capital needs to be given up to keep constant the output
from production, and the isoquant becomes flatter. Isoquants are convex (the MRTS diminishes as we
move down along and isoquant.

2.3.3.2. The Isocost Line

An isocost line includes all possible combinations of labor and capital that can be purchased for a
given total cost. The total cost C of producing any particular output is given by the sum of the firm’s
labor cost wL and its capital cost rK:
C = wL + rK
If we rewrite the total cost equation as an equation for a straight line we get:
K = C/r – (w/r)L

Figure 3.3: The Isocost Curve

It follows that the isocost line has a slope of ∆K/∆L = - (w/r), which is the ratio of the wage rate to
the rental cost of capital.

35
2.3.3.3.Maximizing Output for a Given Cost
Suppose at given input price r and w, a producer can spend only C on production. Subject to this cost,
the producer wishes to operate efficiently by producing the maximum attainable output. Thus, among
all input combinations that can be purchased for the fixed amount C, the producer seeks the one that
results in the largest level of output.

Let the given level of cost C be represented by the isocost curve KL in Figure 3.4. The slope of KL is
equal to the ratio of the price per unit of labor to the price per unit of capital. I 1, I2 and I3 are isoquants
representing various levels of output. First, observe that the I 3, level of output is not obtainable
because the available input combinations are limited to those lying on or beneath the isocost curve
KL.
Figure 3.4: Maximizing Output for a Given Cost

Next, the producer could operate at points such as R and S. At

these two points, the inputs combinations required to produce
the I1 level of output are available for a given cost represented by the isocost KL. In this case,
however, output can be increased without incurring additional cost by the selection of a more
appropriate input combination. Indeed, output can be expanded until the I 2 level is reached – the level
at which an isoquant is just tangent to the specified isocuve. The producer reaches equilibrium only
when the marginal rate of technical substitution of labor for capital is equal to the ration of the price
of labor to the price of capital.
2.3.3.4. Minimizing Cost Subject to a Given Output
As an alternative to maximize output for a given cost, an entrepreneur may seek to minimize the cost
of producing a stipulated level of output. The problem is solved graphically in Figure 3.5. The
isoquant I represents the stipulated level of output, while C1, C2, and C3 are isocost curves with the
same slope (input-price ratio).

Figure 3.5: Minimizing Cost subject to a given

output

36
First, notice that the level of cost represented by C1 is not feasible because the I level of output is not
physically producible by any input combination available for this outlay. Next, the I level could be
produced, for example, by the input combinations represented by the points R and S, both at the cost
level C3. But by moving either form R to Q or from S to Q, the entrepreneur can obtain the same
output at lower cost.
In this case also the equilibrium is attained only at point Q where the isoquant is just tangent to an
isocost curve. Thus in equilibrium the marginal rate of technical substitution of labor for capital must
equal the ratio of the price of labor to the price of capital.
2.3.3.5. The Expansion Path
In figure 3.6, each of the points A, B, C, D, and E represents a tangency between an isocost curve and
an isoquant for the firm. The curve which moves upward and to the right from the origin, tracing out
the points of tangency, is the firm’s expansion path. The expansion path describes the combinations
of labor and capital that the firm will choose to minimize costs for every output level. So long as the
use of both, inputs increases as output increases, the curve will look approximately as shown in
Figure 3.6. Thus, the expansion path is a line along which output will expand when factor prices
remain constant.

Figure 3.6: The Expansion Path

2.3.4. Analysis of costs in the short-run

In the short run, some of the firm’s inputs to production are fixed, while others can be varied as the
firm changes its output. Various measures of the cost of production can be distinguished on this basis.

Total Cost (TC): The total cost of production has two components: the fixed cost (FC), which is
borne by the firm whatever level of output it produces, and the variable cost (VC), which varies with
the level of output. Depending on circumstances, fixed cost may include expenditures for plant
maintenance, insurance, and perhaps a minimal number of employees-this cost remains the same no
matter how much the firm produces. Variable cost includes expenditures for wages, salaries, and raw
materials- this cost increases as output increases.

TC = FC + VC

The data in Table 2.6 describe a firm with a fixed cost of $50. Variable cost increases with output, as
does total cost. The total cost is the sum of the fixed cost in column (1) and the variable cost in

37
column (2). From the figures given in columns (1) and (2), a number of additional cost variables can
be defined.

Marginal Cost (MC): is the increase in cost that results from producing one extra unit of output.
Because fixed cost does not change as the firm’s level of output changes, marginal cost is just the
Average Average Average
Rate of Fixed Variable Total Marginal
Fixed Variable Total
Output Cost Cost Cost Cost
Cost Cost Cost
(FC) (VC) (TC) (MC) (AFC) (AVC) (ATC)
0 50 0 50 - - - -
1 50 50 100 50 50 50 100
2 50 78 128 28 25 39 64
3 50 98 148 20 16.7 32.7 49.3
4 50 112 162 14 12.5 28 40.5
5 50 130 180 18 10 26 36
6 50 150 200 20 8.3 25 33.3
7 50 175 225 25 7.1 25 32.1
8 50 204 254 29 6.3 25.5 31.8
9 50 242 292 38 5.6 26.9 32.4
10 50 300 350 58 5 30 35
11 50 385 435 85 4.5 35 39.5
increase in variable cost that results from an extra unit of output. We can therefore write marginal
cost as
MC = ∆TC/∆Q = ∆VC/∆Q

Average cost (ATC): is the cost per unit of output. Average total cost (ATC) is the firm’s total cost
divided by its level of output.
ATC = TC/Q

ATC has two components. Average fixed cost (AFC) is the fixed cost divided by the level of output.
Average Variable Cost (AVC): is variable cost divided by the level of output.

AFC = FC/Q
AVC = VC/Q

Table 2.6 A Firm’s Short run Curves

Figure 2.8 Cost Curves for a Firm

38
 The Shapes of the Cost Curves

Figure 2.8 shows two sets of continuous curves that approximate the cost data in Table 2.6. The fixed
cost, available cost, and total cost curves are shown in Figure 2.8a. Fixed cost FC does not vary with
output and is shown as a horizontal line at $50. Variable cost VC is zero when output is zero, and
then increases continuously as output increases. The total cost curve TC is determined by vertically
adding the fixed cost curve to the variable cost curve. Because fixed cost is constant, the vertical
distance between the two curves is always $50.

Figure 2.8b shows the corresponding set of marginal and average variable cost curve. Since total
fixed cost is $50, the average fixed cost curve AFC falls continuously from $50 toward zero. The
shape of the remaining short-run cost curves is determined by the relationship between the marginal
and average cost curves. Whenever marginal cost lies below average cost, the average cost curve
falls. Whenever marginal cost lies above average cost, the average cost curve rises. And when
average cost is at a minimum, marginal cost equals average cost.

The ATC curve shows the average total cost of production. Since average total cost is the sum of
average variable cost and average fixed cost and the AFC curve declines everywhere, the vertical
distance between the ATC and AVC curves decreases as output increases. The AVC cost curve
achieves its minimum point at a lower output than the ATC curve. This follows because MC = AVC
at its minimum point, and MC = ATC at its minimum point. Since ATC is always greater than AVC
and the marginal cost curve MC is rising, the minimum point of the ATC curve must lie above and to
the right of the minimum point of the AVC curve.

39
2.4. Market Structure

A firm’s decision concerning price and production depends greatly on the character of the industry in
which it is operating. Economist group industries into four distinct market structures: pure
competition, pure monopoly, monopolistic completion, and oligopoly. These four market models
differ in several respects: the number of firms in the industry, whether those firms produce a
standardized product or try to differentiate their products from those of other firms, and how easy or
how difficult it is for firms to enter the industry.

Very briefly the four models are as follows:

a. Pure competition involves a very large number of firms producing a standardized product (that is,
a product identical to that of other producers, such as corn). New firms can enter or exit the
industry very easily.
b. Pure monopoly is a market structure in which one firm is the sole seller of a product or service (for
example, a local electric utility). Since the entry of additional firm is blocked, one firm constitutes
the entire industry. Because the monopolist produces a unique product, it makes no effort to
differentiate its product.
c. Monopolistic competition is characterized by a relatively large number of sellers producing
differentiated products (clothing, furniture, books). There is widespread non price competition, a
selling strategy in which one firm tries to distinguish its product or service from all competing
products on the basis of attributes like design and workmanship (an approach called product
differentiation). Either entry to or exit from monopolistically competitive industries is quite easy.
d. Oligopoly involves only a few sellers of an identical or similar product; consequently, each firm is
affected by the decisions of its rivals and must take those decisions into account in determining its
own price and output.

Market Model
Characteristic Pure Monopolistic Oligopoly Pure Monopoly
Competition Competition
Number of firms A very large no. Many Few One
Type of product Standardized Differentiated Standardized or Unique; no
differentiated close substitutes
Control over None Some, but within Limited by mutual Considerable
price rather narrow limits interdependence;
considerable with
collusion
Condition of Very easy, no Relatively easy Significant obstacles Blocked
entry obstacles
Non price None Considerable Typically a great Mostly public
competition emphasis on deal, particularly relations,
advertising, brand with product advertising
names, trademarks differentiation
Examples Agriculture Retail trade, Steel, automobiles, Local utilities
dresses, shoes farm implements,
many household
appliances
Figure 2.7 characteristics of the Four Basic Market Models

40
2.5.THEORY OF PRICE UNDER PERFECTLY COMPETITIVE MARKET

A cost curve describes the minimum cost at which a firm can produce various amounts of output.
With this knowledge, we can now turn to a fundamental problem faced by every firm: How much
should be produced? In this chapter, we will see how a perfectly competitive firm chooses the level
of output that maximizes its profit.
In perfectly competitive market all firms produce the identical (Homogeneous) product, and each
firm is so small in relation to the industry that its production decisions have no effect on market price.
New firms can easily enter the industry if they perceive a potential for profit, and existing firms can
exit the industry if they start losing money. Both consumers and producers must possess perfect
information about prices if a market is to be perfectly competitive.
The characteristics of large number of sellers and homogeneity of the product imply that the
individual firm in pure completion is a price taker. Its demand curve is infinitely elastic, indication
that the firm can sell any amount of output at the prevailing market price. The demand curve of the
individual firm is also its marginal revenue curve.

Figure 2.5.1:

2.5.1. Short run equilibrium of a firm

In the short run, the rate of output per period of time can be increased or decreased by increasing or
decreasing the use of variable inputs. The individual firm can adjust its rate of output over a wide
range, subject only to the limitations imposed by its fixed inputs. Since each firm adjusts until it
reaches a profit-maximizing rate of output, the market or industry also adjusts until it reaches a point
of short-run equilibrium.
2.5.1.1. The Total Approach
As noted, we assume that each firm adjusts its rate of output so as to maximize the profit obtainable
from its business operation. Since profit is the difference between total revenue and total cost, it is a
maximum for the rate of output that maximizes the excess of revenue over cost.
As shown in figure 2.5.2, there are three different profit regions and profit types. These are
i. The region where the firm gets negative profit/loss/ (i.e. when TR<TC): when the firm produces
and sells 5 and 11 units of output.
ii. The region where the firm gets zero profit (i.e. when TR = TC): when the firm produces and sells
5 and 11 units of output.
iii. The region where the firm gets positive profit (i.e. when TR > TC): when the firm produces and
sells output between 5 and 11 units. Whereas the maximum profit is earned when the firm
produces and sells 9 units of output. Because at this level of output, the difference between total
revenue and total cost will be maximum. This level of output is called optimal output whereas the
output level which makes profit zero is called break even output level.

41
 Figure 2.5.2 Measuring
profit using Total Approach

2.5.1.2. The Marginal Approach

A firm in a perfectly competition attains its profit maximizing equilibrium at the rate of output for
which marginal cost equals price. The theorem follows immediately from the definition of marginal
revenue and marginal cost.
Marginal revenue is the addition to total revenue attributable to the addition of one unit of sales,
while marginal cost is the addition to total cost resulting from the addition of one unit of output. Thus
it should be evident that profit increases when marginal revenue exceeds marginal cost and
diminishes when marginal cost exceeds marginal revenue. Profit must, therefore, attain its maximum
when marginal revenue and marginal cost are equal.

Figure 2.5.3. The equality of Marginal Cost

and Price.

Consider figure 2.5.3. The fundamental proposition is that at market price Op, the firm attains a
profit-maximizing equilibrium at point E, corresponding to the output of Oq units per period of time.
If the rate of output were less than Oq, say Oqe, marginal revenue qeB would exceed marginal cost
qeA. Adding a unit to output and sales would increase total revenue by more than total cost. Profit
would accordingly increase, and it would continue to increase so long as marginal revenue exceeds
marginal cost.

42
On the other hand, suppose the rate of output exceeded Oq, say Oqu. At this point, marginal cost quF
exceeds marginal revenue quc. This unit of output causes total cost to increase by more than total
revenue, thereby reducing profit (or increasing loss). As is evident from the graph, profit must be
reduced by adding a unit of output and sales whenever marginal cost exceeds marginal revenue.

Therefore, since profit increases when marginal revenue exceeds marginal cost and declines when
marginal revenue is less than marginal cost, it must be a maximum when the two are equal.
Furthermore, since price equals marginal revenue for a firm in perfect completion, the following
theorem has been proved. Therefore a firm in a perfectly competitive market attains its short-run,
profit maximizing equilibrium by producing the rate of output for which marginal cost equals the
given, fixed market price of the commodity.

Profit or Loss?
The equality of price and marginal cost guarantees either that profit is a maximum of that loss is a
minimum. Whether a profit is made or a loss is incurred can be determined only by comparing total
revenue to total cost. Since
Profit = Total revenue – Total cost
a loss is incurred whenever
Total revenue < Total cost
Now,
TR = (p) (q)
So profit is positive if
TR > TC
or if
(p)(q) > (AC) (q)
or if
p > AC
So, if price exceeds unit cost, the firm will enjoy a profit in the short run. On the other hand, if unit
cost exceeds price, a loss must be incurred.

Figure 6.4 illustrates this, MC and ATC represent marginal cost and average total cost, respectively.
First, suppose market equilibrium establishes the price OP1 per unit. The demand and marginal
revenue curves for the firm are therefore, given by the horizontal line labeled D1 = MR1. Equilibrium
is attained when output is Oq1 units per period of time. At this rate of output, total revenue (price
times quantity) is given by the area of the rectangle Oq1Cp1. Similarly, total cost (unit cost times
quantity) is the area of Oq1EF. Total revenue exceeds total cost, and profit is represented by the area
of the rectangle CEFp1.

On the other hand, suppose the market price-quantity equilibrium established the price OP2. In that
case the optimum rate of output would be Oq2 units per period of time. Total revenue is the area of
Oq2BP2, while total cost is Oq2 AG. Since total cost exceeds total revenue, a loss is incurred in the
amount represented by the area of p2BAG.

43
 Figure 2.5.4 Profit or loss in the
short run

When demand is D2 = MR2 there is no way the firm can earn a profit. If output were either smaller or
greater than Oq2 units per period of time, the loss would simply be greater. One might therefore ask
why the firm does not go out of business since a loss is incurred at any rate of output.

The basic answer to this question is that a firm incurring a loss will continue to produce in the short
run if, and only if, it loses by producing than by closing the plant entirely. So long as total revenue
exceeds the total variable cost of producing the equilibrium output, a smaller loss is suffered when
production takes place. Figure 2.5.5 is a graphical demonstration of this.

Since our situation only involves a loss situation, the price lines are constructed so as to lie entirely
beneath the average total cost curve. First, suppose market price is Op1, so the firm’s demand-
marginal revenue curve is given by D1 = MR1. Profit maximization (or loss minimization) leads to
producing the output for which marginal cost equals price-production occurs at point B, or at the rate
of Oq1 units per period of time. At this rate of output the firm loses AB dollars per unit produced.
However, at the price Op1 average variable cost is not only covered but there is an excess of BC
dollars per unit. The average cost of the variable inputs is q1C dollars per unit of output. The price
obtained per unit is q1B. The excess of price over average variable cost, BC, can be applied to the
fixed costs. Thus not all of the fixed costs are lost, as would be the case if production were
discontinued. Although a loss is sustained, it is smaller than the loss associated with zero output.

This is not always the case, however. Suppose market price were as low as Op2, so that demand is
given by D2 = MR2. If the firm produced at all, its equilibrium output would be Oq2 units per period
of time. Here, however, the average variable cost of production exceeds price. The firm producing at
this variable costs as well. Thus when price is below average variable cost, the equilibrium output is
zero.

44
 Figure 2.2.5 Ceasing production in the short
run

It is possible to derive the short-run supply curve of an individual firm in a perfectly competitive
market. The process is illustrated in figure 9.6. Panel A of the figure shows the marginal cost curve of
a firm for rates of output greater than that associated with minimum average variable cost. Suppose
market price is Op1. The corresponding equilibrium rate of output is Oq1. Now on Panel B find the
point associated with the coordinates Op1, Oq1. Label this point S1; it is represents the quantity
supplied at price Op1.
Next, suppose price is Op2. The equilibrium output is Oq2. Plot the point associate with the
coordinates Op2, Oq2 on Panel B- it is labeled S2. Similarly, other equilibrium quantities supplied
can be determined by postulating other market prices (for example, price Op3 leads to output Oq3
and point S3 on Panel B). Connecting all of the S points so generated, one obtains the short run
supply curve of the firm, the curve labeled S in panel B. But by construction S curve is precisely the
same as the MC curve. The following is therefore established.
The short-run supply curve of a firm in perfect completion is precisely its marginal cost curve for all
rates of output equal to or greater than the rate of output associated with minimum average variable
cost. For market prices lower than minimum average variable cost, equilibrium quantity supplied is
zero.

45
 CHAPTER THREE

MACROECONOMICS

Why have some countries experienced rapid growth in incomes over the past century while others
stay mired in poverty? Why do some countries have high rates of inflation while others maintain
stable prices? Why do all countries experience recessions and depressions—recurrent periods of
falling incomes and rising unemployment—and how can government policy reduce the frequency
and severity of these episodes? Macroeconomics, the study of the economy as a whole, attempts to
answer these and many related questions.

To appreciate the importance of macroeconomics, you need only read the newspaper or listen to the
news. Every day you can see headlines such as INCOME GROWTH SLOWS and GOVERNMENT
MOVES TO COMBAT INFLATION. Although these macroeconomic events may seem abstract,
they touch all of our lives. Business executives forecasting the demand for their products must guess
how fast consumers’ incomes will grow. Senior citizens living on fixed incomes wonder how fast
prices will rise. Recent college graduates looking for jobs hope that the economy will boom and that
firms will be hiring.

3.1. Measuring the Value of Economic Activity: Gross Domestic Product

Gross domestic product is often considered the best measure of how well the economy is performing.
This statistic is computed every three months by MoFED (Ministry of Finance and Economic
Development) from a large number of primary data sources. The goal of GDP is to summarize in a
single number, the Birr value of economic activity in a given period of time.

There are two ways to view this statistic. One way to view GDP is as the total income of everyone in
the economy. Another way to view GDP is as the total expenditure on the economy’s output of goods
and services. From either viewpoint, it is clear why GDP is a gauge of economic performance. GDP
measures something people care about—their incomes. Similarly, an economy with a large output of
goods and services can better satisfy the demands of households, firms, and the government.

How can GDP measure both the economy’s income and the expenditure on its output? The reason is
that these two quantities are really the same: for the economy as a whole, income must equal
expenditure. That fact, in turn, follows from an even more fundamental one: because every
transaction has both a buyer and a seller, every Birr of expenditure by a buyer must become a Birr of
income to a seller. When Joe paints Jane’s house for Birr 1,000, that Birr 1,000 is income to Joe and
expenditure by Jane. The transaction contributes Birr 1,000 to GDP, regardless of whether we are
adding up all income or adding up all expenditure. To understand the meaning of GDP more fully, we
turn to national income accounting, the accounting system used to measure GDP and many related
statistics.

3.2.1. Income, Expenditure, and the Circular Flow

Imagine an economy that produces a single good (bread) from a single input, labor. Figure 3.1
illustrates all the economic transactions that occur between households and firms in this economy.
The inner loop in Figure 3.1 represents the flows of bread and labor. The households sell their labor
to the firms. The firms use the labor of their workers to produce bread, which the firms in turn sell to
the households. Hence, labor flows from households to firms, and bread flows from firms to
households.

46
The outer loop in Figure 2.1 represents the corresponding flow of dollars. The households buy bread
from the firms. The firms use some of the revenue from these sales to pay the wages of their workers,
and the remainder is the profit belonging to the owners of the firms (who themselves are part of the
household sector). Hence, expenditure on bread flows from households to firms, and income in the
form of wages and profit flows from firms to households.

GDP measures the flow of dollars in this economy. We can compute it in two ways. GDP is the total
income from the production of bread, which equals the sum of wages and profit—the top half of the
circular flow of dollars. GDP is also the total expenditure on purchases of bread—the bottom half of
the circular flow of dollars. To compute GDP, we can look at either the flow of dollars from firms to
households or the flow of dollars from households to firms.

These two ways of computing GDP must be equal because the expenditure of buyers on products is,
by the rules of accounting, income to the sellers of those products. Every transaction that affects
expenditure must affect income, and every transaction that affects income must affect expenditure.
For example, suppose that a firm produces and sells one more loaf of bread to a household. Clearly
this transaction raises total expenditure on bread, but it also has an equal effect on total income. If the
firm produces the extra loaf without hiring any more labor (such as by making the production process
more efficient), then profit increases. If the firm produces the extra loaf by hiring more labor, then
wages increase. In both cases, expenditure and income increase equally.

3.2. Rules for computing GDP

In an economy that produces only bread, we can compute GDP by adding up the total expenditure on
bread. Real economies, however, include the production and sale of a vast number of goods and
services. To compute GDP for such a complex economy, it will be helpful to have a more precise
definition: gross domestic product (GDP) is the market value of all final goods and services
produced within an economy in a given period of time. To see how this definition is applied, let’s
discuss some of the rules that economists follow in constructing this statistic.

Adding products: The Ethiopian economy produces many different goods and services—burgers,
haircuts, chairs, oranges, and so on. GDP combines the value of these goods and services into a single
measure. The diversity of products in the economy complicates the calculation of GDP because
different products have different values.

Suppose, for example, that the economy produces four apples and three oranges. How do we compute
GDP? We could simply add apples and oranges and conclude that GDP equals seven pieces of fruit.
But this makes sense only if we thought apples and oranges had equal value, which is generally not
true. (This would be even clearer if the economy had produced four watermelons and three grapes).

To compute the total value of different goods and services, the national income accounts use market
prices because these prices reflect how much people are willing to pay for a good or service. Thus, if
apples cost Birr 0.50 each and oranges cost Birr 1.00 each, GDP would be

GDP = (Price of Apples * Quantity of Apples) + (Price of Oranges * Quantity of Oranges)

= (Birr 0.50 * 4) + (Birr 1.00 * 3)

= Birr 5.00.

Used Goods: the sale of used goods is not included as part of GDP.
47
Intermediate Goods and Value Added: Many goods are produced in stages: raw materials are
processed into intermediate goods by one firm and then sold to another firm for final processing.
How should we treat such products when computing GDP? For example, suppose a cattle rancher
sells one-quarter pound of meat to McDonald’s for $0.50, and then McDonald’s sells you a
hamburger for $1.50. Should GDP include both the meat and the hamburger (a total of $2.00), or just
the hamburger ($1.50)?

The answer is that GDP includes only the value of final goods. Thus, the hamburger is included in
GDP but the meat is not: GDP increases by $1.50, not by $2.00.The reason is that the value of
intermediate goods is already included as part of the market price of the final goods in which they are
used.To add the intermediate goods to the final goods would be double counting—that is, the meat
would be counted twice. Hence, GDP is the total value of final goods and services produced.

One way to compute the value of all final goods and services is to sum the value added at each stage
of production. The value added of a firm equals the value of the firm’s output less the value of the
intermediate goods that the firm purchases. In the case of the hamburger, the value added of the
rancher is $0.50 (assuming that the rancher bought no intermediate goods), and the value added of
McDonald’s is $1.50 − $0.50, or $1.00.Total value added is $0.50 + $1.00, which equals $1.50. For
the economy as a whole, the sum of all value added must equal the value of all final goods and
services. Hence, GDP is also the total value added of all firms in the economy.

Housing Services and Other Imputations: Although most goods and services are valued at their
market prices when computing GDP, some are not sold in the marketplace and therefore do not have
market prices. If GDP is to include the value of these goods and services, we must use an estimate of
their value. Such an estimate is called an imputed value.

48