CHAPTER- ONE

1. Introduction
1.1 Definition of Economics

Brain storming: define economics? And what is the deference between micro and macro economics?

Two fundamental facts, which constitute the economizing problem, provide the
foundation for the field of economics. These are:
1) Unlimited human wants and
2) Limited resources
Material wants - the desires of consumers to obtain and use various goods and services
that provide utility (satisfaction or pleasure) - cannot be completely satisfied. This is
because:
a) Wants are recurring in nature - even if some wants are satisfied for a while, they
will reappear at some intervals.
b) Wants multiply endlessly over time - as soon as one want is satisfied, another want
begins to be felt.
On the other hand, resources - the means of producing goods and services - are

limited.

Economics: is a branch of social science that study about our behavior in producing, distributing and
consuming material goods and services in a world of scarce resources. Because wants exceed the resource
available to satisfy them, the fundamental economic problem is scarcity. Economics is also defined as the
study of how people make choice to cope with scarcity.

1.2. Uses of economics

 Economics helps in studying the behavior of human being in production, distribution and
consumption of material goods and services in a world of scarce to allocate resources.
 It also important for the society to allocate the scarce resources wisely and then to satisfy the
unlimited human wants.
 Our understanding of economic principles can be applied in resolving or alleviating specific
economic problems and the realization of society’s economic goals.

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  Helps you managing your business. As economics deals with price, cost, profit, market, production,
saving, investment, supply, demand, elasticity and many other similar issues quite in making business
decisions.

1.3. Scope and methods of economic analysis

Scope

The most fundamental fact of economics is that people must make choices. This fact
applies to societies (or nations) as well as individuals. In other words, the core issues of
scarcity, choice, allocation, economic systems, and growth can be studied from either
a micro or a macro perspective.
 Micro economics: is a branch of economics that study about individual decisions making units such
as consumers, resources owners and business firms. Micro economics we examine the “trees” not the”
forest”.
 Macro economics: is a branch of economics that considers the overall/aggregate performance of the
economy with respect to total (national, regional production, consumption, employment, general price
level, investment, etc. It investigate how the economy as a whole works. Example: national GNP,
inflation, unemployment, etc

Economics is concerned both with the analysis of facts (or statements) - “what is” and
with value judgments - “what should be”.
 Positive economics: is that part of economic science which deals with specific
statements that are capable of verification, by reference to the facts about
economic behavior. That is, it is concerned with describing and analyzing the
economy as it is.
Example: - increasing the money supply will lead to higher prices.
- 20% of the labor force in Ethiopia is unemployed.
 Normative economics: is that part of economic science which involves
someone’s value judgments about what the economy should be like or what
particular policy action should be recommended to solve economic problems
based on a given economic generalization or relationship.
Example: the government should reduce the tax rate in order to initiate private
investment.
Methods
In deriving economic principles, which are useful in the formulation of policies designed
to solve economic problems, one may move from descriptive or empirical economics to
theoretical economics - inductive method or the other way round - deductive method.
Inductive (empirical) method: is the process of deriving principles or theory (a general
explanation applicable to a wide range of particular circumstances) from facts. It
moves from facts to theories, from particular to general.
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Deductive (hypothetical) method: is the process of beginning at the level of theory and
proceeding to the verification or rejection of this theory (rather a hypothesis) by an
appeal to facts. It moves from general to particular.

1.4. Scarcity, choice, opportunity cost and production possibilities frontier

Economists use the concept of production possibilities frontier (PPF) to illustrate the
concepts of scarcity, choice, opportunity costs and the law of increasing costs.
Definition: The production possibilities frontier (PPF) represents the
combinations of goods that can be produced when the factors of production are used
to their full potential.
Alternatively, it shows the maximum possible output of a pair of goods or services that
can be produced with available resources and technology over a given period of time.
Simplifying assumptions in using PPF for our Illustrations:
1) Fixed Resources: The quantity & quality of economic resources available for use
are constant for a short period of time; but they can be shifted or reallocated among
different uses in the long run.
2) Fixed Technology: Technology doesn't change over the course of our analysis
(over a very short period of time)
3) Only two products in the economy: i.e., suppose that our economy is producing
just two products: Food & clothing.
4) Efficiency: The economy is operating at full employment & achieving productive
efficiency.
􀂙 Full-employment means full utilization of resources, or no waste or mismanagement
of resources.

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􀂙 Productive efficiency occurs when society cannot produce more of one good without
cutting back on another good.
Now given the above assumptions, we can begin our study of food and clothing with
the numerical example of the table below.

Production Possibilities of Food & Clothing

Combination Food (in ton) Clothing (in meter)
A 18 0
B 17 1
C 15 2
D 12 3
E 7 4
F 0 5

Here the economy has limited resources that can be used for food or clothing, food
clothing trade-off.
Suppose that our economy threw all its resources in to producing the food item, and
then it will produce no clothing and the maximum of 18 tons of food with the existing
technology & resources (point A in the table). At the other extreme (point F) all the
society's resources had instead been devoted to the production of clothing. In this
case, only five units of clothing could be produced if we are willing to produce no food.
At point C, 2 units of clothing are produced; the maximum number of tons of food that
can be produced is therefore 15. Each intermediate point between A & F represents a
different combination of food & clothing that are produced using the given resources &
technology.

18 A

17 B

15 C

12 D

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 G = unattainable

H= attainable

7 E

0 1 2 3 4 5 clothing

Production Possibilities Frontier (Graphical Depiction of PPF)

-The Frontier (curve) shows the menu of choice along which society can choose to
substitute clothing for food or vice versa, assuming a given state of technology & a
given total amount of resources.
-Points outside the frontier (such as point G) are impossible or unattainable (under the
given assumptions)
-Any point inside the curve, such as H, indicates that resources are unemployed, or not
used in the best possible way, hence though attainable not efficient.
-Each point on the PPF represents some maximum output. That is, all points on the PPF

are efficient.
Efficiency
An economy operates on its PPF only when it uses its resources with maximum
efficiency. If the economy produces output combinations that lie on the PPF, the
economy is efficient.
Definition: Efficiency occurs when the economy is using its resources so well
that producing more of one good result in less of other goods, i.e. no resources are
being wasted.
Note that the employment of all available resources is insufficient to achieve efficiency.
Full production must also be realized. Full production implies two kinds of efficiency:
allocative efficiency & productive efficiency. Allocative efficiency means that resources
are being devoted to those combinations of goods & services most wanted by society.

In addition, productive efficiency is realized when the desired goods & services are
produced in the least costly ways. Thus, full production means producing the "right
goods" (allocative efficiency) in the "right way" (productive efficiency). Being on the
PPF means that producing more of one good inevitably implies sacrificing other goods,
i.e., substitution is the law of life in a full-employment economy & PPF depicts the
menu of society's choice.
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The PPF can help to introduce many of the most basic concepts of economics:
- It shows the outer limit of combination of producible goods & services in a given time
period with the available resources. Scarcity is a fact. Scarcity: is the imbalance between
human wants and the means of satisfying those wants (desires) or resources.

- Scarcity of resources is implicit in that all combinations of output lying outside PPF are
unattainable.

- It illustrates the combinations of goods that can be produced when resources are fully
utilized. Thus, it shows economic choices open to society.
- It is also used in illustrating the three basic economic problems (what, how & for
whom).
- Opportunity costs are always there - we obtain additional quantities of any desired
good by reducing the potential production of another good.
- Its concavity reveals the law of increasing costs.
Economic Growth and the PPF
Economic growth occurs when the economy expands its outputs of goods and services. Economic growth is
an expansion of the PPF outward and to the right. The PPF can expand for two reasons:
a) When capital, labor or any resource(s) of the economy expand(s). This type of growth is extensive growth.
It is the result of the expansion of the economy's resources.
b) When the efficiency of the use of productive resources improve. This type of growth is intensive growth.
Intensive economic growth is the result of the more efficient use of available resources. The sources of
intensive economic growth are improvement in technology, better management techniques, & the creation of
better legal & economic institutions.
- Intensive growth occurs when society learns how to get more output from the same inputs: Technological
progress also shifts the PPF outward. Technical progress & increase in productive factors (land, labor, and
capital) have different effects on the PPF. Technical progress may affect only one industry where as labor,
capital & land can be used across all industries. The figure below shows a technical advance in wheat
production without a corresponding change is the productivity of car production.
Technical progress in wheat production
Wheat

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 O F car

If a higher yielding strain of wheat is discovered, a larger quantity can be produced with the same resources.
Since this wheat production will not influence car production, the PPF will rotate from AF to BF. Here the
PPF shifts upward but not to the right.

Opportunity Costs
We know that resources are scarce which forced us to make choices among competing ends. However,
whenever we make choices among competing ends, we must sacrifice valuable alternatives. The value of
such a sacrifice is an opportunity cost.
Definition: The opportunity cost of any decision is the foregone (sacrificed) values of the next best
alternative that is not chosen. Economic decisions are based on opportunity costs. Before signing a contract to
work for commercial banks, workers must consider the other employment opportunities that they are passing
up. People with saving must weigh the various alternatives before they commit their funds to a particular
investment, such as certificate of deposit, stocks or bonds.
Every choice involved in the allocation of scarce resources has a positive opportunity cost. Free goods have
an opportunity cost of zero. The concept of opportunity cost can be illustrated using the alternative PPF.
Consider food-clothing trade-off in the tables below.

1.5. Basic Economic Problems(questions)

The basic problems of the economy are closely related /associated/ with the central
problem of endless wants and virtually limited resources. That is, whatever the nature
of the economic system, all types of economies have been faced with certain common
economic problems which arises due to shortage of available means to satisfy endless
human wants & aspirations.
These basic problems are:
i) What to produce & how much to produce,
ii) How to produce,
iii) For whom to produce.

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The problem of 'what to produce' is the problem of choice between commodities.
This problem arises mainly for two reasons:
a) Scarcity of resources does not permit production of all the goods & services that
people would like to consume.
b) All the goods & services are not equally valued in terms of their utility by the
consumers. The objective is to satisfy maximum needs of maximum number of people.
The question of "how much to produce" is the problem of determining the quantities
of each commodity & service to be produced.
The problem 'how to produce' is the problem of choice of technology. Here the
problem is how to determine an optimum combination of inputs (say labour & capital)
that is used in the production of goods or services. By whom & with what resources
and in what technological manner are goods & services to be produced is the how to
produce problem. Different techniques of production can be used to produce goods and services. Even if
resources are generally scarce, some resources may be relatively abundant than others in a country. For
instance, in Ethiopia labor is relatively abundant than capital. If the country uses more of labor and less of
capital it minimizes cost of production.
The problem of "for whom" goods shall be produced is the problem of how is the
national product to be divided among different individuals and families-i.e, who is to
enjoy & get the benefit of the nation's goods & services?
1.6. Economic systems

The basic economic problems (what, how & for whom to produce) faced by every
society are universal. However, the solutions vary from place to place, because of
differences in the economic system of the world. Here economic system (economy)
implies the set of organizational arrangements & institutions that are established to
solve the economic problem.
In general, economies of the world differ essentially on two grounds:
* Ownership of means of production, &
* The method by which economic activities are organized.
Based on the above two factors, we can identify 4 types of economic systems. They are:
1. Free enterprise (market) economy or capitalist economy
2. The command (government controlled) economy or socialism.
3. Mixed (Hybrid) economy, and
4. Traditional (customary) economy.
How the basic economic problems could be solved under different alternative economic
systems?
1. Pure Capitalism (Market Economy). It is characterized by:
- Private ownership of means of production.
- Private gains are the main motivating forces.
- Both consumers & firms enjoy the freedom of choice.
- Free competition that probably leads to increased efficiency.
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- Least government interference.
In such a system, the three fundamental problems are answered as follows. Business
enterprises produce those commodities that give the highest profit (the what), by the
techniques of production that are least costly (the how), and incomes are distributed
based on the ownership of factors of production (the for whom).
In a market, everything has a price. Prices perform two functions: one, prices serve as
signals for the producers to decide 'what to produce' & for the consumers to decide
'what to consume'. Second, prices force the demand & supply conditions to adjust
themselves to the prevailing prices. Thus, in a market economy "what things will be
produced" is determined by the dollar votes of consumers - every day decisions of
consumers to purchase one good instead of another, i.e., the demand. Firms are lured
(attracted) into production of goods in high demand by the high profits there. "How
things produced" is determined by the competition among different producers. The
best way for firms to meet price competition & maximize profit is to keep costs at a
minimum by adopting the most efficient methods of production. “For whom” to
produce is also solved by market mechanism. The simple market rule is produce for
those who have ability & willingness to pay. The problem is determined by supply
&demand in the markets for factors of production (labor, capital, land, etc.). Factor
markets determine factor prices (wages rates, rents, profits, etc). The sum of all the
revenues from factors yields people's incomes. The distribution of this income among
the population is thus determined by the amounts of factors (person hours, acres of
land, etc) owned and the prices of factors.
2. Command Economy
Features: means of production are owned by the society or by the state in the name
of the community; social welfare is the guiding factor; freedom of choice for the
consumer is curbed to what society can afford for all; and the role of market forces &
competition is eliminated by law. In this case, the dictator (or more likely a planning
committee appointed by the dictator or the party) makes all decisions about
production & distribution.
3. Mixed Economy.
Both private and public sectors co-exist in this economy. In a mixed economy, the
government (through taxes, subsidies, etc.) modifies and in some instances (through
direct controls) replaces the operation of the market (price) mechanism in its function
of what to produce. The operation of the price mechanism in solving the 'how to
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produce' problem is also modified & sometimes replaced by a government action. Both
private & public sectors exist simultaneously. In the name of equity & fairness,
governments usually modify the workings of the price mechanism by taking from the
rich (through taxation) & redistributing to the poor (through subsidies & welfare
payments). They also raise taxes in order to provide 'public goods', such as education,
law & order, and defenses.
4. Traditional Economy
Features: production method, exchange & distribution are all sanctioned by customs;
technological changes & innovations are constrained by tradition; economic activities
are secondary to religious & cultural values. The basic questions are answered by
tradition/long staining rules of behaviors.
1.6. Decision making units and the circular flow model
Decision Making Units
There are three decision-making units in an economy:
1) Households,
2) Firms/Business organizations, and
3) Government.
Household is defined as all the people who live in one roof & make financial decisions
jointly. The members of a household are often referred to as consumers because they
buy and consume most of the consumption goods & services. Principal ownership of
resources is what characterizes the household. Households make consistent decisions
as though they were composed of a single individual i.e., economists avoid internal
conflicts among household members in the case of resource usage.
Firm is the economic unit that employs resources to produce goods & services. They
sell their product to households, other firms & government. Firms also make a
consistent decision as though they were composed of a single individual i.e., informal
conflict is avoided.
Government: includes all Ministries, Government Agencies and other government
organizations. It also comprises government at different levels like Federal, State &
Local Government. It is an important unit that corrects the market mechanism when
there is a failure.
The Circular Flow Model
Definition: The Circular flow model implies a complex interrelated web of decision
making and economic activity. The interaction between consumers & producers takes
place in two different markets called:
1. Factor market – in which services of resources are sold, or
2. Goods market – in which goods & services produced by firms are sold.
In general, in the circular flow of output and income in the capitalist economy, we have
two markets-resource & product markets, and two economic participants – households
and firms.

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Note: 1) The prices paid for the uses of inputs (L, K, etc) are determined in the
resource market (shown in the upper loop). Business enterprises are on the demand
side & households are on the supply side of this market.
2) The prices of finished goods & services are determined in the goods market
represented in the lower loop of the diagram. Households are on the demand side &
business enterprises are on the supply side of this market.
In the nutshell, households (as resource owners) sell their resources to firms and (as
consumers) spend the income received in buying goods & services. Business
enterprises must buy resources in order to produce goods and services. Firms also sell
their finished products to households in exchange for consumption expenditures, which
businesses view it as receipts (revenue). Thus, the net effect is a counterclockwise real
flow of economic resources & finished goods & services, and a clockwise money flow
of income and consumption expenditures. These flows are simultaneous and repetitive.
Drawbacks:
􀂾 It does not show transactions within the household and the firm sector.
􀂾 Economic role of government is not mentioned.
􀂾 It assumes that households spend all their income and, hence the flows of income &
expenditure are equal in volume

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 The Circular Flow Model with Government Intervention

CHAPTER – TWO

THEORY OF DEMAND AND SUPPLY

2.1. Theory of demand

Demand is defined as an individual’s willingness and ability to buy or purchase goods

and services at different levels of price during a particular time, ceteris paribus. Ceteris
paribus is a Latin term meaning “other things being equal”. Otherwise it becomes
difficult to establish the effect of one factor on anther (if other things change).
2.1.1. Demand function, demand schedule and demand curve

A demand schedule is a tabular representation of a series of prices of a commodity and

the corresponding quantity demanded. The graphic representation of the individual’s
demand schedule gives us his/her demand curve. The demand schedule or function
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shows the relationship between various possible prices of a product and the quantities,
which consumers will purchase at each of these prices.
Demand curve: A demand curve conveys the same information as the demand schedule. But it shows
the information graphically rather than in tabular form.

The individual demand schedule

0 1 2 3 4 5
Px (price of x
Qx(quantity 5 4 3 2 1 0
of x)
Demand curve: is a graphical depiction of a demand schedule. It can be obtained by
plotting the demand schedule on a graph

The demand function: the demand function shows the relationship between the demand and the factors
affecting it.
Px
5
4
3
2 Demand curve
1
0
1 2 3 4 5 Qx
The demand curve shows that, at a particular point in time, the individual is willing to
buy a certain unit of X over the period of time specified.

The demand function: the demand function shows the relationship between the demand and the factors
affecting it.

Dx=f ( p x , p y , p z ,)

Where Dx stands for the demand of the commodity X

Px, Py, Pz shows the price of commodity X, Y, Z the price other substitutes and other complements goods
respectively.
The law of demand: The law of demand state that other things being equal, at higher price consumers will
purchase less of a commodity and at a lower price, consumer will purchase more of it.

The law implies that the quantity demanded and price changes are inversely
(negatively) related, ceteris paribus.
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2.1.2. Determinants of demand
The demand curve shows what would happen to the quantity demanded if only the
good’s own price were to change. But good’s own price is not the only determinant of
demand; other factors can play an important role. These factors include:
a) The prices of related goods (Po)
b) Consumer income (I)
c) Consumer preferences (tastes) (T),
d) The number of potential buyers,
e) Expectations,
A. Prices of Related Goods: goods can be related to each other as either substitutes or
complements. Substitute goods are goods that serve the same purpose implying
that the demand for one and the price of the other move in the same direction.
Two goods are substitutes if the demand for one rises/falls when the price of the
other rises/falls. E.g.Tea and Coffee. Complement goods are goods used
together. These goods are “go together” goods. e.g. car and gasoline, Tea and
Lemon, etc. Thus, two goods are complements if the demand for one falls when
the price of the other increases.
B. Income: as our income rises, we spend more on normal goods and services. But as
income increases, we spend less on inferior goods. Thus, as income changes,
demand also changes. A normal/superior good is one for which demand
increases when income increases, holding all prices constant. An inferior good is
one, for which demand falls as income increases, holding all prices constant.
C. Preferences: is what people like and dislike without regard to budgetary
considerations. Preferences and budgetary considerations determine demand.
Thus, as preferences change, demand changes.
D. The Number of Potential Buyers: If more buyers enter the market, the market demand
will rise, and vice versa.
E. Expectations: The mere expectation of an increase in a good’s price can induce us
to buy more of it (today). Similarly, we can postpone the purchase of things that
are expected to get cheaper. It is also true for income expectation, which results in change
in demand.
2.1.3. Elasticity of Demand
Elasticity of demand

Elasticity of demand is the measure of responsiveness of demand for a commodity to the changes in any of its
determinants, such as price of the commodity, price of related goods, and consumers’ income. Accordingly,
there are three basic elastic ties:
1. Price elasticity of demand,
2. Cross-price elasticity of demand &
3. Income elasticity of demand

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1. Price elasticity of demand is a measure of the degree of responsiveness (or sensitiveness)
of consumers to a change in price of the commodity itself. More exactly, it may be
defined as the ratio of the percentage change in quantity demanded to the percentage
change in price. In other words, the price elasticity of demand (ep) is the percentage
change in the quantity demanded divided by the percentage change in price.
Economists measure the degree of elasticity or inelasticity by the elasticity coefficient
(ep), which is given as follows:
% ∆ Qd ∆X/X
ep = ep = (-)
%∆ p ∆ p/ P
The price elasticity of is always negative

Example: calculate the prices elasticity of demand for good X when price from 20 birr to 20.5 and quantity
demanded changes from 300 units to 290 per month. Using these figures we can calculate the point elasticity
as follows:

Solution: E = ¿ = 1.32

Interpretation a 1% increased in the price leads to 1.32% decrease in quantity demand of good X.

Degrees of price elasticity demand

Price elasticity can range between a value of zero and infinity. The value of one and infinity are case special
cases. In general, elasticity will be either less or greater one.
Inelastic demand (<1): a given percentage change in price leads to a small percentage change in demand.
Elastic demand (> 1): a given percentage change in price leads to a large percentage change in demand.
Perfectly inelastic (=0): a given percentage change in price leads percentage change in demand.
Unit elastic (= 1): a percentage change in price leads percentage change in demand.
Perfectly elastic (= infinity): any increase in price leads to quantity demanded.
2. Income elasticity of demand

Income elasticity of demand measures the percentage change in the quantity demanded with respect to the
percentage change in consumer’s income ceteris paribus. It can be calculated using the following formula:

% change∈quantity demanded
Ei = % change∈the incoe of theconsumer

Income elasticity can be either positive (normal goods) or negative (inferior goods).

Ranges and meanings of income elasticity

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  If 0 < ei <1(income elasticity is between 0 and 1). Then quantity demanded rises by a smaller
percentage than income implying that consumers do not spend much of any increase in income on
this particular good; these goods are often called necessities
 If ei > 1; then quantity demanded rises by large percentage than income implying that quantity
demanded is quite responsive to change in income. These goods are called luxury goods.
 If ei < 1. Quantity demanded of the product changes in opposite direction as income changes. For
example, if there is an increase in income, quantity demanded for a good declines. A negative
income elasticity coefficient designates an inferior good.

If income elasticity is The good is

Negative Inferior
Positive( < 1) Normal and necessity
Positive( > 1) normal and luxury
2. Cross elasticity of demand

Is the relation between percentages in quantity demanded of a good to the percentage in the price of related
good? The cross elasticity of demand between good X and Y:
% ∈quantiy demanded of Y
Eyx¿ % change∈ price of X

The value of coefficient Description Type of good

Positive(Exy>0) Quantity demanded of W changes in Substitute
the same direction as change in price
of Z
Negative (Exy <0) Quantity demanded of W changes in Complementary
the opposite direction as change in
price of Z
Zero or near to zero (Exy =0) We would not expect a change in the Independent
price of b to have any impact on the
purchase of the firm

Example: assume the price of coffee increases from 2 birr to 3 birr as a result demand of tea per day keeping
price of tea constant. Find cross elasticity of tea to coffee?
3−2
Etc =
3−2
=1

2.2. Theory of supply

2.2.1. Supply function, supply schedule and supply curve

What is the supply of a commodity?

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Possible answer: it refers to the amount of goods which producers are willing and able to offer for sale at a
particular time at a various corresponding price.

In a market economy, while buyers of a product constitute the demand side of the
market, sellers of that product make supply side of the market.
• Supply may be defined as a schedule, an equation or a curve which shows the
various amounts of a product which a producer (firm) is willing and able to produce and
make available for sale in the market over specific time period, at given prices, ceteris
paribus.
• The quantity supplied of a good or service is the amount offered for sale at a given
price, holding other factors constant.
The law of supply
The law of supply can be stated as ‘the quantity supplied of a product increases with
the increase in its price and decreases with decrease in its price, other things
remaining constant”. It implies that the quantity supplied of a commodity and its price
are positively related, which holds under the assumption that “other things remaining
constant”(costs of production, technology, price of related goods, and weather and
climate for agricultural products, etc. held constant).
Supply function: Is a statement that states the relationship between the quantity supplied
(as dependent variable) and its determinants (say price, as independent variable).
Suppose that a single producer’s supply function for commodity X is given as: Qsx=
10Px, ceteris paribus.
Supply schedule: is a tabular presentation of the (law of) supply. By substituting various
“relevant” prices of X into the above supply equation, we get the producer’s supply
schedule shown below:
Px (in birr) 0 1 2 3 4 5
Qsx 0 10 20 30 40 50

Supply curve; is a graphical depiction of the supply schedule plotting each pair of values
from the supply schedule in table above on a graph and joining the resulting points we
get the producer’s supply curve, as below:

5 supply curve
4
3
17
 2
1
0
10 20 30 40 50

It will be immediately noted that the supply schedule the supply curve above show a
direct relationship between price and quantity supplied. This particular relationship is
called the law of supply. It simply tells us that producers are willing to produce and
offer for sale more of their products at a higher price.
2.2.2. Determinants of Supply
In constructing a supply curve, the economist’s assumption is that price is the most
significant determinant of the quantity supplied of any product. But factors other than
the good’s own price can change the relationship between price and quantity supplied.
These other factors include:
􀂾 The prices of other goods
􀂾 The prices of relevant factors
􀂾 The techniques of production (technology)
􀂾 The number of sellers in the market
􀂾 Taxes and subsidies, and
􀂾 Price expectations
Change (Shift) in Supply
A change in any one or more of the basic non-price determinants of supply will cause
the supply curve for product to shift to either the right or the left.
• An increase in supply of commodity X; the decision of producers to sell more of X at
each possible price can be caused by:
􀂃 Technological improvement
􀂃 A decrease in resource prices
􀂃 Subsidies
􀂃 A decrease in the price of other goods, say Y-a good which competes for resources,
and
􀂃 Expectations: expected price increases may induce firms to expand production
immediately, causing supply to increase
Conversely, a decrease in the supply of commodity X can be caused by changes in
non-price factors (listed above) in the opposite direction.
In general, an increase and a decrease in the supply of goods, X, can be illustrated by
an upward and downward shift in the supply curve respectively.

PX S2
S0
B S1

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 A

O OX

A shift to the left, S 0 to S2 , indicates, a decrease in supply: suppliers are offering less at
each price. A shift to the right from S 0 to S1, designates an increase in supply:
producers are now offering more of X at each possible price.
Change in Quantity Supplied
A change in quantity supplied refers to the movement from one point to another point
on a given stable supply curve. The cause of such a movement is a change in the price
of the specific product under consideration. The movement from A to B on S 0 of figure
above represents “change in quantity supplied”.
2.2.3. Elasticity of supply
Elasticity is a measure of responsiveness of one variable to another.
Elasticity of supply
- Is the measure of responsiveness of the quantity supplied of a good to the change in its determinant.
The formula of supply elasticity is given as:
% change∈quantity supplied
Es =
% change∈its determinant
Note that formula for measuring elasticity of supply is the same as that of measuring the elasticity of demand.
Elasticity of supply is always positive and varies between 0 and infinity.
2.3. Market equilibrium
The word equilibrium means a state of balance. In the context of price determination, equilibrium refers to a
situation in which the quantity demanded of equals the quantity supplied of the commodity. It refers to the
balance between opposite force of demand and supply and termed as market equilibrium.

Equilibrium price: it is the price at which the quantity demanded of a commodity equal with quantity
supplied.

Equilibrium quantity: it is the amount that is bout and sold at equilibrium price

Example let there is 5000 identical buyers of a commodity X in a market with ban individual demand
function of
Dx = 8 - Px, and 1000 identical sellers of commodity X with an individual supply function of S x = 20Px,
where Dx, Sx and Px are quantity demanded, supplied and price of commodity X
Then calculate equilibrium price and quantity

Solution
Market demand function = number of buyer * individual demand function
19
 = 5000 (8 - Px)
= 40000 - 5000 Px
Market supply function = number of sellers * individual supply function
=1000(20Px)
= 20000 Px
At equilibrium Dx = Sx
40000 - 5000 Px = 20000 Px
Px = 1.6
Qx = 32000units

The intersection of the down sloping demand curve & the up sloping supply curve
indicates the equilibrium price and quantity.
CHAPTER THREE: THEORY OF CONSUMERS’ BEHAVIOUR

3. Theory of Consumers’ Behavior

3.1. Consumer preferences

Preferences indicate how we as consumers would rank different commodity bundles in all conceivable
situations. A simple criterion for evaluating consumer preferences is to use the utility of various commodity
bundles.
3.2. The concept of utility

Utility is a numerical ranking of a consumer's preferences among different commodity

bundles. It measures the rank order of different satisfactions rather than the
magnitude of those satisfactions (modern economic theory).
Some Basic concepts of utility are:-
 Consumer: - A decision making unit (an individual or household) who uses or consumers a commodity or service.
 Relative of utility: The utility of a commodity is subjective to a person’s need.

3.3. Approaches of measuring Utility

There are mainly two kinds of measurements of utility implemented by economists:

- Cardinal approaches and
- Ordinal approaches.

20
3.3.1. Cardinal approaches

This approach is also known as the Traditional theory of consumer behavior

3.1.1. Assumptions
o A consumer has full information relevant to his consumption.
o Rationality of consumer: the main objective of the consumer is maximized his/her satisfaction
given his/her limited budget /income. Thus in order to maximize his /her, satisfaction
consumer has a rational.
o A consumer has limited income.
o Utility is cardinally measurable.
o Marginal utility of money is constant.
o Diminishing marginal utility: the utility derived from each successive units of a diminish. .
Cardinal approaches argued that utility can be measured. I.e. utile
3.3.1.2. Total and marginal utility
In this approach, total utility (U) is the sum of utilities obtained by consuming the various units of goods and
services. Total utility can be calculated as:
U= U1+U2+U3……UN
Example: suppose a consumer’s utility function for good a and good b is U( Qa, Qb)= 3Qa + 2Qb .in this case
the market basket consisting of 4 units of good a and 6 units of good b generates a utility of:
U (Qa, Qb) =3Qa+2Qb
= 3*4+2*6 =24
Marginal utility (MU) is the additional satisfaction received over a given period by consuming one more
unit of good. Marginal utility can be calculated as:
dTU
MU =
dQ
Example: given: U(X ½ Y1/2, find MUX and MUY?
Solution: MUX = du/dx = ½ X1/2-1 Y1/2
= ½ X1/2 Y1/2
= ½*1/X1/2 Y1/2
= Y1/2/ 2* X1/2
1/2-1 1/2
MUY = du/dy =1/2 Y X
= ½ Y-1/2 X 1/2
= ½*1/Y1/2 X1/2
= X1/2/ 2* Y1/2

Example2. Given U =3x2 -6x3

Mux = 6x-18x2
3.3.1.3. Law of diminishing marginal utility (LDMU)

The Law of Diminishing Marginal Utility: The law states that as Quantity consumed of a commodity
increases over a unit of time, the utility derived by the consumer from successive units declines.
Tabular and Graphical presentation:

21
 Hamburger consumed per meal Total utility(TU) Marginal utility(MU)
0 0 -
1 10 10
2 18 8
3 24 6
4 28 4
5 30 2
6 30 0
7 28 -2

Graphically;
Total utility
TU

Quantity

Marginal utility

MU

22
As more of a product is consumed:
 Total utility increase at a diminishing rate, reaches a maximum, and then declines.
 Marginal utility, by definition reflects the change in total utility. Therefore, marginal utility diminishes
with increased consumption becomes zero, where total utility is at its maximum, and is negative when
total utility decline.
 Total utility is maximized when marginal utility is zero. Consuming the seventh meal would create dis
–utility as total utility falls (marginal becomes negative).
3.3.1.4. Equilibrium of the consumer

The objective of a rational consumer is to maximize the TU, or satisfaction derived from
spending his/her income. This objective is reached (or said to be in equilibrium), when
the consumer spends his/her income in such a way that the utility or satisfaction of the
dollar spent on the various goods is the same.i.e. the MU per unit of price for each
commodity must be equal. Mathematically,
Mux = MUy = … = Mun
, subject to the constraint
Px Py Pn
PxQx + PyQy + …+QnPn = M ( M = individual's money income).

3.3.2. The ordinal utility approach

Ordinal utility – is not quantity or a numerical value, it is only an expression of the consumer’s preference for one
commodity over another

3.3.2.1. Assumptions of ordinal utility approach

 The consumers are rational. The aim at maximizing their satisfaction or utility given their income and
market price.
 Utility is ordinal. i.e utility is not absolutely measurable. Consumers are required only to order or rank
their preference for various bundles of commodities.
 Diminishing marginal rate of substitution (MRS) is the rate which a consumer is willing to substitute
one commodity(x) for another consumer commodity (y) so that his total satisfaction remain the same.
 Transitivity and consistency of choice.
 Transitivity: If A>B, and B>C, then A>C
 Consistency: If A>B, in one period, then B is not greater than/equal to A
in another period.
 Consumers always prefer a large quantity of all the goods.

3.3.2.2. Indifference curve and map

Definition: An indifference curve is the locus of points, each representing a different combination of two
goods, which yield the same utility or level of satisfaction to the consumer so that he is indifferent between
any two combinations of goods when it comes to making a choice between them. It is also called iso–utility
curve or equal utility curve.
Tabular and Graphical representation indifference curve and indifference map

Combination Food(F) Cloth(C)

A 1 15
23
 B 2 10
C 3 6
D 4 3
E 5 1

Graphically: cloth

15 A

10 B

6 C

3 D

1 E IC

1 2 3 4 5 food

3.3.2.3. Properties of indifference curves

 Indifference Curves have negative slope or they are down ward sloping. This denotes that if the
quantity of Y decrease, the quantity of X must increase if the consumer is to stay on the same
satisfaction level.
 Indifference Curve’s are convex to the origin. This shows that MRS declines as an individual
consumer more as long the Indifference Curves.
 Indifference Curves do not intersect each other if two indifference Curves intersects it would violate
consistency or the transitivity assumption of consumer’s preference.
Y

A B IC1

C IC2
X

A and B is equally satisfied, because It lies the same indifference curve, A and C also equally
satisfied. by transitivity assumption of consumer preference if A>B, B>C, then, A>C, but in this case
A=B, B=C,A=C, the consumer is indifferent between B and C but this violate more prefer than to less,
because B contains more units of Y than C.
 Upper /higher indifference Curves represents a higher level of satisfaction than lower one.
24
 In the below figure, IC3 represents higher satisfaction than IC2.

Indifference map: is a set of indifference curve.

IC3

Indifference map

IC2

IC1

3.3.2.4. The marginal rate of substitution (MRS)

It is the rate at which one commodity can be substituted for another, the level of satisfaction remaining the same. It is
also the ratio of quantities of X and Y required to replace one another under the condition that total utility remains the
same.

Marginal Rate of Substitution between two commodities is the ratio of the marginal utilities of the two
MUx
commodities. i.e MRSxy =
MUy

Example: consumer use two consumption bundles X and Y and have the following cobb-douglas utility
function. U (X, Y) = X1/2 Y1/2 find the slope of an indifference curve?

MUx du du
Solution: MRSXY = , Mux = and MUy =
MUy dx dy

Y
MRSXY =
X

The law of diminishing marginal rate of substitution

The law states an observed behavioral rule that when a consumer substitutes one commodity (say X) for another
commodity (say Y), the marginal rate of substitution decreases as the stock of X increases and that of Y decreases.
Reason for diminishing MRS

 Since additional utility derived from one more additional unit of a commodity declines. The
consumer’s marginal utility of X (MUx) decreases as her consumes more of it as a result he wants to
forgone less of Y.

25
  Commodities are imperfect substitutes for each other.

3.3.2.5. The budget line or the price line

The budget line: shows all the various combinations of any two products, which can be
purchased, given the prices of the products & the consumer's money income.
Assuming a two-commodity model, the income constraint may be expressed as: P xQx
+PyQy = I ---- Budget constraint Solving for Q y from the above equation we get a budget
equation: Qy = I/ Py – (Px/ Py )Qx
􀃆 Budget equation
An easier method of deriving the budget line is to find the point on Y-axis (assuming Q x
= 0) & the point on X-axis (assuming Q y = 0). This is indicated by point I/P y on the Y
axis and I/Px on the x-axis.

The slope of the budget line is the ratio of the two prices: Px/Py. Whenever there is
change in income and price the budget line will be affected. When income increases
the budget line will shift to upward; and decrease in income will shift the budget line to
the left but remains parallel to the original one. And the effect of change in price is to
rotate the budget line to the left or the right.

3.3.2.6. Equilibrium of the consumer

26
The consumer is in equilibrium (maximizes utility) when, given his/her budget line, the
person reaches the highest possible indifference curve. This optimal consumption
combination occurs at the point where the budget line is tangent to the highest
attainable IC. Thus, at this point (tangency point), the slope of an IC (MRSxy) is equal
to the slope of the budget line ( Px/Py).

Effect of Change in Prices on Consumer Equilibrium

Ceteris paribus, when there is a decrease or increase in the price of one commodity the
budget line rotates outward or inward. That means, the slope of the budget line
depends on the relative prices.When the price of the commodity changes, the slope of
the budget line changes, which changes the conditions of consumer's equilibrium. A
rational consumer adjusts his consumption basket to the change in relative prices with
a view to maximizing his satisfaction under the new price conditions. The change in
consumption basket is called price-effect. The total price effect may be stated as the
change in consumption basket resulting from the change in price.
Let us illustrate effect of change in prices: Suppose the price of X falls, while
consumer's taste & income and price of Y remains constant. To represent this, one foot
of the budget line is moved to the right by a distance proportionate to the fall in price.
Chapter four

Theory of Production and cost

4.1. Production, input and production period

What is production and production function?

Production is the process of converting economic resources (inputs) into consumable

forms (goods and services).
The term production function refers to the physical relationships between a firm’s inputs or resources and its
output of goods and services per unit of time leaving price’s aside.

Factors of production: is a good or service which is required for production. there are four factors of
production; i.e land, labor, capital and enterpreureship.
27
Before discussing the above two production periods, we should say something about the two types of inputs,
namely fixed input and variable input.

Fixed input: is one which is used in a fixed quantity for a certain level of output i.e quantity doesn’t
change with the change in put. Example, building and machining

Variable input: is one whose quantity changes with the change in output. example, labor

Corresponding to fixed and variable input economists use two production periods.

a. Short run – refers to a period of time in which the supply of certain inputs is fixed or inelastic, the
production of a commodity can be increased only by increasing amount of variable input.

b. Long run - refers to a period of time in which the supply of all inputs is elastic but not long enough to
permit change in technology. Production of a commodity can be increased by employing more of both
inputs.
4.1. 1. Production Function with one variable input (short –run production function)

Short run production: is a production with only one variable input i.e. Labor

Total, marginal and average product

Total physical product (TP) – is the total output produced using inputs over a given period of time.

Average product (AP) – is calculated by dividing total output (Q) by the total variables input.

Q Q
AP= , for example AP L= Where Q – output, FV- variable factor, L- labor
FV L

Marginal product (MP) – is the marginal addition to total output due to marginal addition to a variable
input.
Q Q
MP= , for example MP L=
Fv L
No of labor TP(Q) APL(Q/L) Q
MPL( )
L
0 0 - -
1 10 10 10
2 30 15 20
3 60 20 30
4 80 20 20

28
Example:-Consider the following short- run production function; Q=6L2-0.4 L3

a. Determine the MPL function?

b. Determine the APL function?
c. Find the value of L (labor) the maximum output?
d. Find the value of L (labor) at which its average product takes on maximum values?

4.1. 1. 1The three stages of production

Production stage: There are three stages in the short –run production on period.

Stage1
 Stage of increasing returns
 MP>AP,AP is rising
 TP is increasing at increasing rate
Stage2
 Stage of diminishing returns
 MP<AP,AP is decreasing
 TP is increasing at decreasing rate

Stage3
 Stage of negative returns
 TP starts to decline
MP of variable factor is negative.

I II III
TPL

APL

MPL
29
4.1. 2. Production Function with two Variables input (long –run production function)

ISO-Quant Curves

Definition –An iso –quant is a curve that shows all the combinations of inputs that yield the same level of output “iso”
means equal and “quant” means quantity so an iso-quant represents a constant quantity of output.

Combination of labor and capital Units of labor (L) Units of capital (K) Out put of cloth (meter)

A 5 9 100

B 10 6 100

C 15 4 100

D 20 2 100

The combinations A, B, C, D shows the possibility of producing 100 meters of cloth by applying various combinations
of labor and capital

Iso –quant curve: is the graphic representation of an iso product schedule

Iso –quant map: is a sat of iso quant that shows the maximum attainable out put from any given combination of input

10 A

6 B

4 C IQ=300

3 D IQ=200

IQ=100

5 10 15 20

Properties of iso-quants

1. Iso-quants have a negative slope:-substitutability of inputs

30
2. Iso-quants are convex to the origin: due to diminishing rate of MRTS
3. Iso- quants cannot intersect or be tangent to each other-
4. Upper iso-quants represent higher output: an upper iso-quant always means a higher level of output because any
point on it (within the economic region) indicates a larger input combination than a lower iso-quant, with either
higher level of capital or labor or both.

Marginal rate of technical substitution (MRTS)

MRTS is the rate at which one input can be substituted for another input without changing the level of output. In
mathematical terms;
−K MP L
MRTS L , K = = slope of iso-quant, MRTS and Marginal products MRTSLK =
L MP K

* Law of diminishing MRTS – along the iso-quant curve MRTS continuously declines, hence making the curve
convex to the origin.
4.1.3. Laws of Returns
The laws of return associated with two variable inputs are called laws of returns to scale.

Laws of Returns to Scale /Long Run/

Here we will discuss the input – output relationship under the condition that all inputs (labor and capital) are changed
proportionately and simultaneously. As a result the scale of production i.e. size of firms changes.
 The law of increasing returns to scale
Occurs if the increase in output is more than proportional to the increase in inputs this situation might arise
from possibility of specialization and division of labor. Example; if the inputs are increased by 10% outputs
will increase by 15%.
 The law of constant returns to scales
Occurs when the increase in output is equals to proportional to the increase in inputs. The reason for this
might be perfectly divisibility of factors of production. Example; if the inputs are doubled, the output also
doubled.
 The law of decreasing returns to scale
Occurs if the increase in output is less than proportional to the increase in inputs this situation might arise
from managerial inefficiency. Example; if the inputs are increased by 10% outputs will increase by 5%.
Numerical example:
Given the production function Q = L2K3; where L is labor and K is capital and Q is output. Does this show
constant, increasing or decreasing return to scale?
Q = L2K3, increased both inputs by M, we gate
Q= (ML) 2 * (MK)3
31
 = M2L2*M3K3
= M2M3*L2K3
= M5L2K3 . this means the increase in both inputs by M results the output to increase by M5
Theory of Cost

4.2 .cost related concepts

• Production and cost are interrelated. Production without cost is impossible and cost without
production is economically meaningless.

• Cost: is a monetary value paid for factors of production.

• Price: is the payment made for final goods and services.

4.2.1. Types of costs

I. Actual (Accounting) cost: are costs which are actually incurred by the firm for factors of production
like labor, capital, raw materials, buildings and equipments etc. They are an actual out of pocket
payments. Accountants take into account only the payment made by the producer to the outside
supplier of inputs.
II. Economic cost: Economists take into account both explicit and implicit costs.
 Explicit costs: these are an actual out of pocket payment. They include wages and salaries, price of raw
materials, amounts paid on fuel, advertisement, taxes etc.
 Implicit costs: are the costs of self owned inputs. Self owned input includes the amount of money that
the entrepreneur could have earned if he had invested his money and sold his own services and other
factors. For example the owner of the company may be the manager of that company. The cost of his
managerial skill is included in implicit cost. Implicit costs – are implied value of the entrepreneur’s
own resources and services. In other words, implicit costs are costs which self owned and self –
employed resources could have earned in their best alternative use.
III. Opportunity cost: is the value of the next best alternative when choice is made. For instance the
opportunity cost of a medical doctor who is deciding to open his own clinic is the amount of money
which is forgone if he is employed in governmental hospitals.
Private, external and social costs
IV. Private costs are those costs which are incurred by all individuals on the purchase of goods and
services from the market.
V. External cost – are those costs incurred on the surrounding society, like drainage system and also the
disutility created through air, water and noise pollution.

32
VI. Social cost – implies the cost which a society bears on account of production of a commodity. As a
result a true cost to the society must include all costs, regardless of the persons on whom it’s impact
falls and its incidence as to who bear them.
Social Cost = 1 May 2015private Cost + external Cost

4.2.2. The theory of costs in the short –run and long- run

4.2.2.1. Short run cost of production

In short run there are two broad cost categories. These are:

Fixed costs: they are independent of the level of output and the firm will incur such costs even if he stops
production temporarily.

Variable costs: dependent on the level of output and vary with the change in output.

Total, average and marginal costs

Total cost (TC): refers to the cost of the total resources used in production.

TC=TFC+TVC…………… (1)

Average cost (AC): is the cost per unit of output.

AC=TC/Q………………….. (2)

Average variable cost (AVC) =TVC/Q…… (3)

Average fixed cost (AFC) =TFC/Q………… (4)

Marginal cost (MC): Is an additional cost incurred to produce one more unit of the product.
MC=dTC/dQ

Total variable cost (TVC): are costs which are incurred on the employment of variable factors of
production.

Total fixed costs (TFC) are costs which do not change over a certain level of output.

• TC=TVC+TFC, AC=AVC+AFC and MC=dTC/dQ

Labor(L) Output(Q) TFC TVC TC AFC AVC AC MC

0 0 50 0 50 - - - -
1 10 50 20 70 5 2 7 2

33
 2 15 50 40 90 3.3 2.66 6 4
3 18 50 60 110 2.7 3.33 6.11 6.3
4 20 50 80 130 2.5 4 6.5 10
5 27 50 100 150 1.8 3.7 5.55 2,8
6 35 50 120 170 1.4 3.4 4.85 2.5
7 42 50 140 190 1.19 3.33 4.5 2.85

 TFC: is remaining fixed irrespective of the level of output.

 TVC: starts at the origin implying that when the output is zero total variable cost is also zero. It slopes
upward showing that when the out level is increasing total variable cost also rises.

Graphically short run average and marginal cost curves can be shown as follows:

34
 Figure 4.2 short run average and marginal cost curve

They have u-shaped pattern.

Numerical example

Suppose the total cost function for the production of cloth is given as follows

TC=100+50Q-12Q2+Q3 Where TC= total cost and Q=output then

1. Determine

Total fixed cost function (TFC)

Total variable cost function (TVC)

Average variable cost function (AVC)

Marginal cost function (MC)

2. Calculate total costs, AC, AVC and MC when the firm produces 10 units of output

3. Calculate the level of output in which AVC is minimum?

4. Calculate the level of output in which MC is minimum?

Solution

a. TFC=100

b. TFC=50Q-12Q2+Q3

c. AVC=50-12Q+Q2

d. MC==50-24Q+3Q2

2. TC=100+50(10)-12(10)2+(10)3 =400

3. Q=6 at which AVC is minimum.

4. Q=4 in which MC becomes minimum.

Chapter five

Market Structure and Decision of the Firm

35
Definition: Market is defined as the contact between seller and buyer in which transaction (sale and
purchase) is made. There are three major bases for classifying markets. These are:

 The number of firms in the market

 The nature of the product( homogeneous or heterogeneous)
 The nature of entry (free entry or entry barrier)

5.1. Perfect competitive market

-is a market which is characterized by the following features:

 Large number of buyers and sellers: there are large number of buyers and sellers in the market any single
seller or buyer can not influence the market price.
 Homogenous or identical product: in perfectly competitive market any of the producers produces
identical product.
 Perfect information (knowledge): in perfectly competitive market structure the seller and buyer have
perfect information on price of the product and quality of the product.
 Free entry and exit: perfectly competitive firm has complete freedom of entry and exit.
 There is no government intervention.

5.1. 1. Short run equilibrium of the firm and industry under PCM

5.1.1. 1Short run equilibrium of the competitive firm

Revenue functions of the firm

Revenue: is an income earned by the seller after the sale of a certain unit of the product.
Total Revenue: refers to the total earning by the seller from the sale of the whole (total output).
TR=PQ
Average revenue: an earning received by the seller from the sale of each output.
AR=TR/Q but TR=PQ AR=PQ/Q=P therefore AR=P
In perfectly competitive market structure AR=P=MR
Marginal Revenue: is an extra unit of revenue that the firm produces one more unit the output.
MR = dTR/dQ = dP.Q/dQ, MR = p
Two approaches of profit maximization under perfect competitive market structure:
i. Total approach (Π= TR-TC)
According to this approach the profit maximizing level of output is that:

36
Maximize the excess of TR over TC
Minimize the excess of TC over TR

ii. Marginal approaches (MR = MC)

In marginal approach to select the level of output that maximizes profit two conditions must be fulfilled:

1st order condition (necessary condition)

37
 dΠ/dQ = 0 d(TR-TC)/dQ=0,MR-MC=0 MR=MC

2nd order condition (sufficient condition)

dΠ2 /dQ2 < 0, dTR2 /d2Q – dTC2/d2Q <0 i.e slope of MR must less than slope of MC

For perfectly competitive market slope of MR is zero.

Generally at a profit maximizing level of output the MC curve cuts the MR from below:

The demand curve for perfectly competitive firm is perfectly elastic or horizontal line since price is
constant each firm is price taker.

The firm cannot maximize his/her profit by producing Q1 unit of output because 2 nd order condition is not
fulfilled. Even if at point “K” 1st order condition is fulfilled i.e MR = MC, 2nd order condition is not
fulfilled MC does not cut MR curve from below.

Categories of short run Equilibrium of a firm

When a firm is operating in a perfectly competitive market it will earn profit or loss depending on the revenue
and cost conditions.

Super normal profit(Economic profit) or abnormal profit: it occurs when P>AC

Normal profit :it occurs when price=AC

38
Below normal profit(Loss): this is when price<AC

Shut down point: when P<minimum AVC

Numerical example

A firm producing cloth is operating in a perfectly competitive market. The firms total cost function is given
as:

TC=400+200Q-10Q2+Q3 if the current market price is birr 200 per cloth,

Should a firm produce at this price in the short run?

If the market price is birr 150 per cloth what will total profit/loss be in the firm producing ten units of
output? Should the firm produce at this price?

If the market price is greater than birr 250 should the firm produce in the short run?

Solution

The firm should continue production in the short run if price 200 is greater than the minimum average
variable cost.

The minimum average variable cost can be calculated as first let us determine AVC,

AVC=TVC/Q, AVC=200-10Q+Q2

FOC: AVC’=0, dAVC/dQ=-10+2Q=0, Q=5

AVC=200-10(5)+(5)2=175 , Then P> The minimum AVC so the firm should continue production.
Because the firm covers its variable cost of production

Short Run equilibrium of the industry

We have already discussed the equilibrium of the firm in the short run to complete the discussion on short
– run price and output determination we discuss now the short run equilibrium of the industry.

An industry is in equilibrium in the short run when market is cleared at a given price i.e. when the total
supply of the industry equals the total demand for its product, the prices at which market is cleared is
equilibrium price. When an industry reaches at its equilibrium, there is no tendency to expand or to
contract the output.

39
 In short – run equilibrium of the industry, some individual firms may make pure profit, some normal
profits and some may make even losses depending on their cost and revenue conditions

Short run supply curve of the competitive industry is the horizontal summation of the short run
competitive firm.

5.1. 2. Long run equilibrium of the firm and industry under PCM

Long run equilibrium of the firm

In the long run the firm will earn only normal profit in pcm.

Because the short run abnormal profit is avoid by new entering firms

In the long run the firm will not incur a loss. Because if the firm is incurring a loss he will be leave out the
market. The firm in a perfectly competitive market will be in its long run equilibrium when:
P=AR=LMC=LAC=MR

Graphically the long run equilibrium of the firm can be shown as follows:

Figure
5.8 long run equilibrium of the firm under pcm
In the above figure we can infer that the firms long run equilibrium is not established at price op1becuase
P>AC. The firm is at its long run equilibrium at op2 because at this level of price P=AR=LMC=LAC MR.
Long run equilibrium of the industry
In the long run equilibrium of the industry all firms in the industry should be in the long run equilibrium
when P=LMC.
In short the long run equilibrium of the competitive industry is Qd=Qs or
P=LMC=min LAC
5.2. Pure Monopoly Market Structure
5.2.1. Introduction

40
Monopoly is a market structure where there is only one firm that produces and sells a particular
commodity or service and there are no close substitutes available. Since the monopoly is the seller in the
market, the industry is a single firm industry and it has no direct competitors.

Characterstics of monopoly markets

a. There is only one seller so that there is no distinction between firm and industry.
b. The product is unique and there is no close substitute
c. The monopolist can exercise control over the price. The monopoly firm is therefore a price maker.
d. The existence of barriers to entry in to the market. No other firm can supply the product because of
legal, geographical or technological restriction.
e. There may or may not be advertisement.
5.3. Source and kinds of monopoly

Dear students think of any monopoly firm in our country and try to analyze the reason why the firm maintains
its monopoly power. There are many factors that create monopoly and help the monopolists to maintain
monopoly power. Some of the factors will be discussed below.
1. Ownership of strategic or key inputs.
A firm may own or control the entire supply of a raw material required for the production of a commodity.
Such firms are not willing to sell the raw materials to another firm. For example, until the second world war,
the aluminum Company of America (Aloca) controlled practically the entire supply of Bauxite(the basic raw
material necessary for the production of aluminum), giving it almost a complete monopoly in the production
of aluminum in the united states. To come to our country, Ambo Mineral Water can be taken as an example.
Ambo mineral water has monopolized the natural mineral water.
2. Exclusive knowledge of production technique. Most of the beverage (soft drink) companies such as Coca
Cola Company have maintained monopoly power over supply of their product partly due to exclusive
knowledge of the ingredient chemicals required for the production of their product.
3. Patents and copyright Patents and copyrights are government supported barriers to entry. Patents are
granted by the government for 17 years as an incentive to investors. Authors of books, artistic works (such as
cassette, video, etc) are the best examples of such monopoly.
4. Government Franchise and License Another cause for the emergence of monopoly is government
franchise. Franchise is a promise by the government for a firm to prohibit the establishment of another firm
(by another person) that produces the same product or offers the same service as the original one. For
example, when the first Bank in Ethiopia, Abyssinia Bank was established, Emperor Minilik has promised
for the Egyptian firms (the owner of the Bank) that they will monopolize the Banking service in Ethiopia for

41
 50 years. Postal service in Ethiopia, Ethiopian television, telecommunication service in Ethiopian etc, are
other examples of monopoly.
5. Economies of scale may operate (i.e. the long run average cost may fall)
Another cause for the emergence of monopoly is economies of scale in production. A firm is said to have
economies of scale if its long run average cost is declining. In such a situation, when the incumbent firm
observes that new firms are entering into the market, it will produce large amount of output to minimize its
unit cost of production and will charge a lower price than the new firms to deter entry. Such a monopoly is
called natural monopoly. Aside from the few cases of monopoly mentioned above, pure monopoly is rare and
most governments discourage pure monopoly because monopoly is deemed to create inefficiency. For
example, had it been the case that the telecommunication services are not monopolized in our country, their
prices would have been lower. But through pure monopoly is rare, the pure monopoly model is useful for
analyzing situations that approach pure monopoly and for other types of imperfectly competitive markets (i.e.
monopolistic competition and oligopoly)
5.2.2. Short run equilibrium under pure monopoly

Demand curve under monopoly

In the previous unit, we have seen that the perfectly competitive firm is a price taker and faces a demand curve that
is horizontal or infinitely elastic at the price (determined by the intersection of the industry or market demand and
supply) of the commodity. But, remember that the market demand curve is down ward sloping. However, a
monopolist firm is at the same time the industry and thus, it faces the negatively sloped market (industry) demand
curve for the commodity. In other words, because a monopolist is the sole seller of a commodity, it faces a down
ward sloping demand curve. This means, to sell more units of the commodity, the monopolist must lower the
commodity price

Conversely, if the monopolist decides to raise the price of the product, it will reduce the quantity of supply without
worrying about the competitors, who by charging lower prices would capture a large share of the market
(customers) at the expense of him. So the monopolist can manipulate the price of its commodity by changing the
quantity of supply. To sell more units of the commodity, the monopolist will charge lower price and vise versa.
Hence, the demand curve facing the monopolist is negatively sloped, showing the inverse relationship between
market price and quantity demanded.

P1

42
 P2

DD
Q

Q1 Q2

Fig.6.1 the demand curve facing the monopolist firm is down wards sloping.

At price p1, the firm sells only Q1 outputs. To sell more units the firm should reduce the price .
Mathematically, assuming that the demand curve is linear, it can be written in the following form.

5.2.2.1. Profit maximization in the short run

We examine the determination of equilibrium price and output by a monopolist in the short run. We will also
show that a monopolist, like a perfectly competitive firm, can incur losses in the short run. Finally, we
demonstrate that, unlike the case of the perfectly competitive firm, the monopolist‘s short run supply curve
cannot be derived from its short run marginal cost curve (the supply curve of the monopolist is
indeterminate). To start with, it was discussed in the last chapter that in a perfectly competitive market price
is given and profit maximization involves only looking for the profit maximizing unit of output, given the
market price. But, under monopoly, the firm is a price maker and has a power to alter the level of output.
Thus, profit maximization under monopoly involves determination of the price and output combination that
yields the firm the maximum possible profit.
Price and output combination that maximizes the monopolist profit can be determined in the similar fashion
as that of the perfectly competitive firm. That is, price- output combination that yields the monopolist the
maximum profit can be determined in two ways:
1. Total approach

2. Marginal approach

1. Total approach
In this approach the profit maximizing unit of output is defined as that level of output where the positive
difference between TR and TC is maximal or the negative difference between TR and TC is minima. The
equilibrium price can be determined by dividing the w let us see the two approaches one by one.
TR corresponding to the equilibrium output level to the equilibrium output. The following figure tells more about
this approach.

43
Fig 6.3 Short –run equilibrium of the monopolist Total approach: The TR of the monopolist has an inverse U
shape because the monopolist must lower the commodity price to sell additional units. The STC has the usual
shape. The total profit is maximized at Q2, where the positive difference between the TR and STC is the
greatest. Profit is negative for output levels below Q1 and above Q .In this approach the profit maximizing
price is given by the ratio of TR* to Q2.

2. Marginal approach
In this approach the profit maximizing level of output is that level of out put at which marginal cost curve
cuts the marginal revenue curve from below. The equilibrium (profit maximum) price is the price
corresponding to the equilibrium price from the demand curve. Consider the following figure:

Fig. 6.4 Short- run equilibrium of the monopolist: marginal approach. Equilibrium output is Q2, where
MC and MR curves intersect each other and MC curve is up ward sloping. Equilibrium price is the

44
 price corresponding to the equilibrium quantity, Q2 (i.e. p2).

Note that, a monopolist charges a price which exceeds the MC of production, unlike the case of the perfectly
competitive firm. Now, how can we be sure that Q2 is the profit maximizing unit of out put? To answer this
question, note that in the total approach the level of profit at a given level of output is the vertical distance
between the TR and TC (i.e, Π = TR - TC.) In the marginal approach, however, the level of profit at a given
level of output is not the distance between the MR and MC curves. Rather it is the area between marginal
revenue and marginal cost curves starting from the origin up to the given level of output.

Mathematically, the profit maximizing condition of MR = MC and MC is increasing can be shown as follows.
Π = TR – TC
dπ dπ dTR dTC
Π is maximized when = 0, that is = - =0
dQ dQ dQ dQ

MR- MC = 0

MR= MC ----------------------------first order condition

The Second order condition of profit maximization is:

d2 π
That is , <0
dQ 2

d 2 π d 2 TR d 2 TC
= - <0
dQ 2 dQ2 dQ 2

dMR dMC d 2 TR dTR/Q dMR

- < 0 (Because =d( )= and the same for MC
dQ dQ dQ2 dQ dQ

Slope of MR- slope of MC<0

45
Slope of MC > slope of MR ------- the second order condition

5.3. Monopolistic Competitive Market Structure

5.3.1. Features of monopolistic competition

A monopolistically competitive market combines the characteristics of competitive and monopoly markets.
Specifically, the following are some of the basic assumptions (features) of a monopolistic competition
market.

i. Product differentiation is the major characteristic of monopolistically competitive market structure.

ii. There is a large number of sellers and buyers in market:-
iii. There is free entry and exit of firms in the market
iv. The goal of the firm is profit maximization both in the short run and long run:-
v. The prices of factors of production (labor, capital, etc) and technology are given
vi. No collusion
5.3.2. Product Differentiation, demand curve and cost

Product differentiation refers to imperfect substitutability across varieties of products.

Product differentiation in the monopolistically competitive market may be based up on certain characteristics
of the product itself. Product differentiation intended to distinguish the product of one producer from that of
the other producer in the industry.

The effect of product differentiation is that the producers have some discretion in the determination of the
price. Monopolistic competitive firm is not a price taker, but has some monopoly power which he can exploit.
Therefore, demand of a product in this market is determined not only by the price policy of the firm, but also
by the style of the product, the services associated with it, and the selling activities of the firms. Thus, the
demand curve will shift if:

 The style or the selling strategy of the firm changes

 Competitors change their price, output, services or selling policies
 Tastes, incomes, prices or selling polices of products from other industries change

The Demand Curve

46
Product differentiation gives rise to a negatively sloping demand curve for the product of the individual firm.
That means, since each firm produces a differentiated product, it holds the monopoly power over its own
products and the firm has some power to influence the market price of its products. As a result, the demand
curve for a product of a firm is downward (or negatively) sloping.

The demand is determined not only by the price policy of the firm but also by the style of the product and
other services. Two important policy variables in the theory of the firm are the product itself and selling
activities. Thus the dd curve will shift if all other things (other than the firm's price of its product) are
changed. Variables other than firm's price can be style, quality, design, advertising, etc. They are called
product and selling activities.

All cost curves short- run average variable cost (AVC), average cost (AC),marginal cost (MC) and long- run
total average cost (LAC) of a firm are U- shaped, implying that there is only a single level of output which
can be optimally produced and economies and diseconomies of scales. So the shapes of costs are the same in
all perfectly competitive, monopoly, and monopolistically competitive markets.

5.3.3. The Concept of Industry and Product "Group”

An industry under perfectly competitive market is defined as a group of firms that produce homogenous
products. However, this definition cannot be applied in the case of differentiated products. In the case of
homogeneity of products, it is possible to add them horizontally and get the market demand and supply of the
products. But here, in the case of monopolistic competition, products cannot be added to get the market
demand and supply. For this reason, it is very important to redefine the industry for analytical purpose.

In monopolistic industry (product group); is firms producing very closely related products which should be
both technological and economic substitute. e.g different brands of soaps.

5.3.3.1. Equilibrium Conditions in Monopolistically Competitive Market

This section tries to analyze how a firm in monopolistically competitive market arrives at its equilibrium in
the short and long run. This equilibrium analysis is very important to determine the optimum or profit
maximizing level of output and price. Further, we will compare the equilibrium conditions of both
monopolistically competitive and perfectly competitive firms

Short run equilibrium

As with the monopoly under monopolistic competition the firm faces a downward sloping demand curve and
thus it has some control over its output price. That is a monopolistically competitive firms demand curve is
not perfectly elastic as it in perfect competition. Certainly it is so much more elastic than the demand curve

47
for a monopoly firm. The rule of determining profit maximizing level of output is the same in all market
structures, i.e., producing the output at which marginal revenue (MR) is equal to marginal cost (MC) and at
that point MC must be rising. MR is the slope of total revenue.

5.4. Oligopoly market structure

Introduction

So far we have examined three types of market structures: Perfectly competitive, pure monopoly, and
monopolistically competitive. This oligopoly is the fourth type of market structure. Oligopoly is a form of
market structure in which a few sellers sell homogeneous or differentiated products. The essence of
oligopoly is recognized interdependence among firms. Coca-Cola considers the actions and likely future
responses of Pepsi when it makes its decisions (whether concerning product design, price advertising, or other
factors).

In Ethiopia, for instance, there are two Soft Drink Companies: MOHA which produces Pepsi and Mirinda
and East African Bottling that produces Coca-Cola and Fanta. In the U.S.A examples of Oligopolistic
industries include automobiles, Computers, Steel, etc.

Characteristics of Oligopoly Market

1. Interdependence: The firms under oligopoly are interdependent in making decision. They are
interdependent because the number of competition is few and any change in price & product etc by an firm
will have a direct influence on the fortune of its rivals, which in turn retaliate by changing their price and
output. Thus under oligopoly a firm not only considers the market demand for its product but also the
reactions of other firms in the industry. No firm can fail to take into account the reaction of other firms to its
price and output policies. There is, therefore, a good deal of interdependences of the firm under oligopoly.

2. Keen (or intense) competition between firms: The number of firms is small enough that each seller takes
into account the actions of other firms in its pricing and output decisions. In other words, each firm keeps a
close watch on the activities of the rival firms and prepares itself with a number of aggressive and defensive
marketing strategies.

3. Importance of advertising and selling costs: The firms under oligopolistic market employ aggressive
and defensive weapons to gain a greater share in the market and to maximise sale. In view of this firms have
to incur a great deal on advertisement and other measures of sale promotion. Thus advertising and selling cost
play a great role in the oligopolistic market structure. Under perfect competition and monopoly expenditure

48
on advertisement and other measures is unnecessary. But such expenditure is the life-blood of an oligopolistic
firm.

4. Group behaviour: Another important feature of oligopoly is the analysis -of group behaviour. In case
of perfect competition, monopoly and monopolistic competition, the business firms are assumed to behave in
such a way as to maximize their profits. The profit-maximizing behaviour on this part may not be valid. The
firms under oligopoly are interdependent as they are in a group.

5. Indeterminateness of demand curve: This characteristic is the direct result of the interdependence
characteristic of an oligopolistic firm. Mutual interdependence creates uncertainty for all the firms. No firm
can predict the consequence of its price-output policy. Under oligopoly a firm cannot assume that its rivals
will keep their price unchanged if he makes charge in its own price. As a result, the demand curve facing an
oligopolistic firm losses its determinateness.

The demand curve as is well known, relates to the various quantities of the product that could be sold at
different levels of prices when the quantity to be sold is itself unknown and uncertain the demand curve can't
be definite and determinate.

6. Elements of monopoly: There exist some elements of monopoly under oligopolistic situation. Under
oligopoly with product differentiation each firm controls a large part of the market by producing
differentiated product. In such a case it acts in its sphere as a monopolist in lining price and output.

7. Price rigidity: Under oligopoly there is the existence price rigidity. Prices lend to be rigid and sticky. If
any firm makes a price-cut it is immediately retaliated by the rival firms by the same practice of price-cut.
There occurs a price-war in the oligopolistic condition. Hence under oligopoly no firm resorts to price-cut
without making price-output decision with other rival firms. The net result will be price -finite or price-
rigidity in the oligopolistic condition.
8. Barrier to entry: in oligopoly market firms are small enough in number implies there is barrier for new
firms to enter into the market. Some common barriers to entry are economies of scale, patent rights, and
control over important inputs by existing firms.
5.4.1. Non- Collusive Oligopoly
Oligopoly firms may cooperate (collude) or may not cooperate (no- collusion) in some activities with
respect to their businesses depending on their interest and agreement. If firms do not cooperate, their
decision-making process is analyzed using the non- collusive model.

5.4.2. Collusive Oligopoly

Sometimes firms form collusion each other in many actions to avoid uncertainty or competition among
themselves. This collusion helps the oligopolistic firms to act like a monopoly. The two main types of
collusion are, cartels and price leadership.

49
 Chapter Six

Fundamental Concepts of Macro Economics

VI.1. fundamental concern of macro economics

Macro economics: is a branch of economics, it deals with the economy in large phenomenal at
national level.
 It concerns with unemployment, inflation, investment, consumption and so on related to economic
performance in aggregate level.
 Macroeconomics is a policy-oriented part of economics. The subject matter of macro-economics includes
factors that determines both the level of macroeconomic variables such as: total output, aggregate price
level, employment and unemployment, interest rates, wage rates and foreign exchange rates and how the
variables are change over time.
 Macroeconomics is concerned with the behavior of the economy as a whole- with booms and recessions,
the economy’s total output of goods and services and the growth of output, the rate of inflation and
unemployment, the balance of payments, and exchange rates.
 Macroeconomics focuses on the economic behavior and policies that affect consumption and investment,
trade balance, the determinants of changes in wages and prices, monetary and fiscal policies, the money
stock, government budget, interest rate, and national debt.
 In macroeconomics, we do two things. First, we seek to understand the economic functioning of the world
we live in; and, second, we ask if we can do anything to improve the performance of the economy. That
is, we are concerned with both explanation and policy prescriptions.

Evolution and growth of macroeconomics

Let us now see different school of thought in macroeconomics:
 Classical 1776 – 1870. In this period the distinction between micro and macro was not clear. The
ruling principle was the invisible hand coined by Alfred Marshall.
 Neo classical 1870 – 1936. Basically the neoclassical school is not different from the classical school.
The main distinction is the tool of analysis, such as the marginal analysis.
 Keynesian 1936 – 1970s. The main thesis of the Keynesian stream is that the economy is subjected to
failure so that it may not achieve full employment level. Thus, government intervention is inevitable.
 1970s – Present. There is no dominant school of thought of ma fundamental concern of macro
economy.
AIM OF MACRO ECONOMICS
 Full employment
 Stabilization of price level
 Economic growth
 Redistribution of income
 Satisfactory balance of payment

POLICY INSTRUMENTS
The major macro- economic objective of every country is to achieve high economic
growth, full employment and stability in price levels. So in order to stabilize the

50
business cycle we need policy instruments. The major stabilization policy instruments
are:
i. Fiscal Policy
ii. Monetary policy
I. Fiscal policy: this is related to government expenditure and tax. There are two types
of fiscal policies:
a) Expansionary fiscal policy: it is a tax-cut and/or rise in government
expenditure aimed at increasing aggregate demand.
b) Contractionary fiscal policy: this is a policy aimed at decreasing aggregate
demand by increasing tax and/or reducing government expenditure.
II. Monetary: it is the control of money supply and interest rate by the central bank.
This policy is mainly used to stabilize the rate of inflation and unemployment. Monetary
policy can be tight (contrationary) or expansionary. An expansionary monetary policy is
policy to increase money supply and /or to reduce the interest rate. Contractionary
monetary policy involves a reduction in the growth of money supply and /or increase in
interest rate.

6.2 problems of macro economics

UNEMPLOYMENT
Whenever we are talking about unemployment, we are talking about the idleness of
economic resources. But most of the time unemployment is mainly related to labor.
Unemployment is defined as a state of affairs where there is a large number of able
bodied persons of working age who are willing to work but cannot find job at the
current wage rate. People who are working under their full capacity are called
underemployed.
There are three main types of unemployment:
I. Frictional Unemployment: this type of unemployment is very common
even if the economy is at full employment. It occurs when there is a continual
mount of workers between jobs, i.e. workers that have voluntarily dropped
their previous jobs and are searching for new and better jobs or looking for
employment for the first time. The unique feature of this type of
unemployment is that the economy is capable of absorbing the unemployed
persons.
II. Structural Unemployment: this is because of the mismatch between the workers skills &
experience and the skills required by the employers who are hiring the workers.
It also occurs because of the mismatch between the location of job vacancies of the expanding industries and
location of job vacation of the unemployed workers.
III. Cyclical Unemployment: occurs when there are fewer vacancies than the unemployed. This mainly
occurs in the recession phase of the business cycle. The main cause is low level of aggregate demand, i.e. the
community is not capable of absorbing goods &services produced by all workers

51
Hence the first two types of unemployment consist of what we call it the natural rate of unemployment which
is unavoidable from the economy. So, full employment is achieved despite the existence of natural rate of
unemployment when cyclical unemployment is zero. So it doesn’t mean zero lever of unemployment.
Generally: Unemployed: A person who is willing to have a job and seeking it but couldn’t find the job.

Employed: A person who have a job and actively participate at a paid job.

Having the concept unemployment now let us discuss how the rate of unemployment is measured. Then
unemployment rate is the statistic that measures the percentage of those people wanting to work who do
not have jobs.

Numberofunemployed
UnemploymentRate= ×100
Labourforce

where the labor force usually includes those people aged between 15 and 64 and are
willing to and capable of work.

The labour force is defined as the sum of the employed and unemployed, and the unemployment rate is defined as
the percentage of the labour force that is unemployed.

LabourForce=NumberofEmployed+NumberofUnemployed

A related statistics is the Labour-force-participation Rate, the percentage of the adult population that is in the
labour force:
LabourForce
Labour−ForceParticiaptionRate= ×100
AdultPopulation

Illustration

Spouses the Statistical Authority in Ethiopia have the following result from the census taken in 1994. The
number of unemployed is 45 billion, employed 20 billion and adult population 50 million.Find
1. Unemployment Rate
2. Labour-Force Participation rate

Solution
To find the unemployment rate first we need to have the Labour Force;

Labour Force= Unemployed + Employed

= 45 billion + 20 Billion
= 65 billion

Then;
Numberofunemployed
UnemploymentRate= ×100
Labourforce

45 billion
UnemploymentRate= ×100=0. 6923 %
65 billion

Labour-Force participation rate can be also calculated as follows:

52
 LabourForce
Labour−ForceParticiaptionRate= ×100
AdultPopulation

65 billion
Labour−ForceParticiaptionRate= ×100=1 . 3 %
50 billion
INFLATION
Inflation is a situation in which the general price lever is rising. Inflation does not mean
that the price of all goods/services have increased rather some specific prices may be
relatively constant, but in general there is a percentage change in a price index such
as consumer price index (CPI).
That is,
CPIcurrentyear−CPIofpreviousyear
therateof inf lationn= ×100
CPIofpreviousyear
It the rate of inflation is positive, that will be inflation and if it is negative, it will be
deflation.

Chapter seven
The national income and product accounts
National income accounting concepts have been designed to measure the overall
production performance of the economy. By comparing the national income accounts
over a period of time, we can plot the long-run course that the economy has been
following; the growth or stagnation of the economy will show up in the national income
accounts. It also provides a basis for the formulation & application of public policies
designed to improve the performance of the economy.
It is generally agreed that the best available indicator of an economy’s health (well
being) is its total annual output of goods & services, or the economy’s aggregate
output. The basic social accounting measures of the total output of goods & services
are Gross Domestic Product (GDP) and Gross National Product (GNP).
Definition: GDP is defined as the total market value of all final goods and services
produced in the territories (within the boundary) of the economy in a given year.
GNP is defined as the total monetary value of final goods & services produced by citizens of
the country in a given year. Thus, GDP and GNP are related as follows:
GNP = GDP + Net Factor Income (NFI)
But NFI =

{Factors incomegenerated
¿
citizens living abroad ¿−factors income flowingout by foreigners living ∈host contry ¿ ¿ ¿

53
GDP is a monetary measure that includes only the market value of final goods &
services and ignores transactions involving intermediate goods (in order to avoid
double counting). To avoid double counting national income accountants are careful to
calculate only the value added by each firm.
Value added is the market value of a firm’s output less the value of the inputs, which it
has purchased from others.
GDP also excludes two non-productive transactions i.e.,
1) Purely financial transactions, which include:
- Public transfer payments because recipients make
- Private transfer payments no contribution to current
- Buying & selling of securities production in return for them

2) Second hand sales because such sales either reflect no current production, or they
involve double counting.
How Can GDP Be Measured? Three approaches:
1. Product (Output) Approach or Value Added Approach:
In this method, GDP can be obtained either by taking the market value of final goods &
services or by taking the value added at each stage of production. Consider the
hypothetical data below:
Stage of production Sale value of product Value added
Firm A: sheep ranch $60 $60
Firm B: wool processor 100 40
Firm C: suit manufacturer 125 25
Firm D: cloth whole seller 175 50
Firm E: cloth retailer 250 75
Total sale value 710
Value added 250

Thus, by calculating and summing the values added by all firms (sectors) in the
economy, we can determine the GDP, that is, market value of total output.
2. The Expenditure Approach to GDP
All final goods produced in an economy are purchased either by the three domestic
sectors: households, government and business enterprises or by foreign nations. Thus,
to determine GDP through this approach, one must add up all types of spending on
finished goods & services by these sectors. That is;
GDP = Personal consumption expenditure (C) by households + Gross private domestic investment (I)
by businesses + Government purchases of goods & services (G) by Government + Net exports
(export - import) (Xn) by foreign sector.

 Personal consumption expenditure (C) entails expenditures by households on durable consumer goods,
non-durable consumer goods & consumer expenditures for services.
 Gross investment (I) (purchase of machinery & equipment, all construction, and changes in inventories)
includes replacement & added investment i.e., replacement investment implies depreciation (capital used
up), D, and added investment that is known as net investment (In). Thus, I=D+ In. The relationship
between gross investment & depreciation provides a good indicator of whether our economy is
expanding, static or declining.
*When gross investment (I) exceeds depreciation (D) i.e., positive net investment (In>0), the economy is
expanding (since its productive capacity or stock of capital goods is growing.)
54
* A stationary or static economy reflects the situation in which I and D are equal (or In =0).
*The unhappy case of declining economy arises whenever I is less than D, i.e., when the economy uses up
more capital in a year than it manages to produce.
 Gov’t expenditures (G) include all government (federal state and local) spending on the finished
products of businesses & all direct purchases of resources by government.
 Net exports (Xn): is the amount by which foreign spending on domestic goods and services (Exports =X)
exceeds domestic spending on foreign goods & services (import = M). It can be positive or negative.
GDP = C + I + G +Xn
3. Income Approach
This year’s GDP can also be determined (other than by adding up all that is spent to
buy this year’s total output) by summing up all the incomes derived from the
production of this year’s total output.
It measures GDP in terms of income earned. It is the sum of all incomes received from
all factors of production that contribute to the production process. The main income
categories are:
a) Compensation of employees: This comprises wages & salaries paid by
governments and businesses = W + S
b) Rents (r): Consists of income payments received by households& businesses, which
supply property resources.
c) Interests (i): comprise items such as the interest payments households receive on
saving deposits, certificate of deposits (CDs) and corporate bonds.
d) Proprietor’s Income or profit (ΠP) - is net income of sole proprietorships and
partnerships (or income of unincorporated businesses).
e) Corporate Profits (ΠC) - may be divided into three:
- They may be collected as corporate income taxes
- They may be distributed as dividends (to stockholders)
- They may be retained as undistributed corporate profits. (i.e. corporate II = corporate
income tax + dividend + undistributed corporate profits).
Note: Total Profits (Π) =Πp +Πc
Adding employee compensation, rents, interests, Πp & Πc, we get a country’s
National Income (NI) less NFI.
f) Indirect Business Taxes (IBT): Which firms treat as costs of production & therefore
add to the prices of the products they sell. E.g. Sales tax, excise tax, business property
tax, license fee.
g) Consumption of fixed capital (depreciation-D): the annual charge, which estimates
the amount of capital equipment used up in each year’s production, is called
Depreciation.
Therefore, GDP = (W+S) +r + i + II+ D+ IBT

Other Social Accounts

1) GNP=GDP+NFI
2) Net National Product (NNP): Is GNP adjusted for depreciation changes. It is
derived by subtracting the capital consumption allowance, which measures
replacement investment, from GNP. That is,
NNP = GNP- D
3) National Income (NI): Measures the income earned by resource suppliers for their
contributions of land, labor, capital, and entrepreneurial ability, which go into the

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 year’s net production. The only component of NNP that does not reflect the current
productive contributions of economic resources is IBT. Thus,
NI = NNP- NIBT

4) Personal Income (PI): it is income received by households.

PI = NI (income earned)
-Social security contribution are not actually
- Corporate income taxes received by hhs &
- Undisturbed corporate profits should be deducted.
+ Transfer payments --- is received but not currently earned.
5) Disposable income (DI): Is simply personal income less personal taxes (PT).
DI = PI - PT

Do you know the difference between real and Nominal GDP?

Nominal versus Real GDP

Nominal GDP: Represents the market value of all final goods at current prices. But
the value of different years’ GDPs can be usefully compared only if the value of money
(price) itself doesn’t change. Thus, to compare GDPs of different periods (or to see
differences in production activity) Nominal GDP must be adjusted for price level
changes.
Definition: Nominal (Current Birr) GDP measures each year’s output valued in terms
of the prices prevailing in that year. Real (constant-Birr) GDP measures each
year’s output in terms of the prices, which prevailed in a selected base year. Inflation
(or deflation) complicates GDP because GDP is a price time’s quantity figure. The
change in either the quantity of output or the level of prices will affect the size of GDP
since GDP equals the sum of P iQi. But it is the quantity of goods & services produced &
distributed to households which affects their standard of living, not the price. E.g. the
bread selling for Br. 2 in 1998 yields the same satisfaction, as an identical bread of
1960 that is sold for 50 cents, not four times as much satisfaction, as the nominal
value might imply. Therefore, Nominal GDP can be adjusted by using a price index.
Price Index: Measures the combined price of a particular collection of goods &
services in a specific period relative to the combined price of an identical group of
goods & services in a reference period. That is:

the price of market baskett ∈ specific year

GDP Deflator = price Index in a given year = x 100
price of the same market basket ∈base year

Thus,
nominalGDP NGDP
Real GDP = =
price index PI

GDP AND WELFARE

GDP has some limitations in gauging the social well being of the people in a nation.
This is mainly because:
A) Non- market transactions are not included: non –monetary economies will be under
estimated.
B) It doesn’t include the underground economy
C) It ignores the quality aspect of goods & services.
D) It does not consider the cost of environmental damage, among others.
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 Chapter Eight
Consumption, Saving and Investment
8.1. Consumption and saving
In the previous chapter we have seen that the level of national income in an economy depends up on
consumption expenditure, investment and government expenditure. Now let us introduce you some points
about consumption functions and theories of consumption.

What is consumption?

Definition: The term consumption means the use of a good rather than the expenditure on the good in any
one period. Consumption expenditure on the other hand is the expenditure on consumer goods in a given
period.

In a simple language, all unconsumed disposable income (Income after tax) is known as Savings.

C= a + bYd

The above equation implies consumption is an increasing function of income. Note that a saving function is
directly related to the consumption function. With an increase in the disposable income of an economy, the
personal savings of the recipients of this income and hence the aggregate savings of the economy also grow.

 The proportion of each increment in the level of disposable income that will be saved is the Marginal
Propensity to Save (MPS). That is MPS is the increment to saving per unit increase in disposable
income.
 Likewise, the value of the increment to consumer expenditure per unit increment to income is termed
the Marginal Propensity to Consume (MPC).
 Thus, the MPS plus the MPC must be one (MPC + MPS = 1)
You should note that the consumer expenditure is the largest component of aggregate demand. This is why
consumption plays a central role in the macroeconomics

What factor affect or influence the level of consumer expenditure?

John Maynard Keynes believes that the level of consumer expenditure was stable function of disposable
income (Yd). Keynes did not deny that variable other than income affect consumption, but he believed that
income was the dominant factor determining consumption. The specific from of the consumption-income
relationship, i.e. the consumption function, proposed by Keynes was as follows:

C= a + bYD where; a and b are constants

YD is disposable income

As can be seen from the above Keynesian function, when disposable income (Y D) is zero, then the value of
consumption function will be equal to the intercept term a (autonomous consumption). Thus, as such, a can be
thought of as a measure of the effect on consumption of variables other than income, variables not explicitly
included in this simple model (e.g., dis saiving, borrowing, etc). The parameter b (which is the slope of the
function) gives the increase in consumer expenditure per unit increase in disposable income .

ΔC
Thus in notation, b= ΔYd where; the Greek letter delta Δ , indicate the Change in the variable it precedes.

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 Thus, b is the marginal propensity to consume (MPC)

The Keynesian assumption is that consumption will increase with an increase in disposable income (b¿ 0) but
that the increase in consumption will be less than the increase in disposable income (b¿ 1).Thus, Keynesians
assume that b is between 0 and 1. I.e., 0≤b≤1 . From the definition of National income we know that
Y¿ C +S +T  Aggregate supply
YD¿ Y –T ¿ C +S
This implies that disposable income is, by definition, consumption plus saving. I.e., YD= C +S
Now we can replace C by a +bYD. Then we can get:
YD= a +bYD +S
 S= YD - a – bYD
 S= -a + (1-b) YD
Note that if a one-unit increase in disposable income leads to an increase of b units in consumption, then the
remainder of the one unit increase, i.e., (1-b), is the increase in savings:
ΔC
Therefore, ΔYd = 1- b
This increment to savings per unit increase in disposable income (1 –b) is the marginal propensity to save
(MPS). Note also that the MPS and the MPC add up to one. This is because the one unit increment in
disposable income is divided in to consumption and savings.

8.2. Investment and its determinant

Investment is expenditure on capital goods – for example, new machines, offices, new
technology. Investment is a component of Aggregate Demand (AD) and also influences the capital stock and
productive capacity of the economy (long-run aggregate supply)
Investment consists of goods bought for future use. Investment is also divided into
three subcategories: business fixed investment, residential fixed investment, and
inventory investment. Business fixed investment is the purchase of new plant and
equipment by firms. Residential investment is the purchase of new housing by
households and landlords. Inventory investment is the increase in firms’ inventories of
goods (if inventories are falling, inventory investment is negative.
Investment levels are influenced by:

1. Interest rates (the cost of borrowing)

2. Economic growth (changes in demand)
3. Confidence/expectations
4. Technological developments (productivity of capital)
5. Availability of finance from banks.
6. Others (depreciation, wage costs, inflation, government policy)

1. Interest rates
Investment is financed either out of current saving or borrowing. High interest rate makes it more
expensive to borrow. High interest rate also give a better rate of return from keeping money in

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 bank .with higher interest rate, investment has higher opportunity cost because you lose out the
interest payment.
Interest rate

5% marginal efficiency of capital

2%

80 100 quantity of investment

2. Economic growth

Firms invest to meet future demand. If demand is falling, then firms will cut back on investment. If economic
prospects improve, then firms will increase investment as they expect future demand to rise. There is strong
empirical evidence that investment is cyclical. In a recession, investment falls, and recover with economic
growth. Accelerator theory The accelerator theory states that investment depends on the rate of change of
economic growth. In other words, if the rate of economic growth increases from 1.5% a year to 2.5% a year,
then this increase in the growth rate will cause an increase in investment spending as the economy is on an
up-turn. The accelerator theory states that investment is dependent on economic cycle.

3. Confidence

Investment is riskier than saving. Firms will only invest if they are confident about future costs, demand and
economic prospects. Keynes referred to the ‘animal spirits’ of businessmen as a key determinant of
investment. Keynes noted that confidence that wasn’t always rational. Confidence will be affected by
economic growth and interest rates, but also the general economic and political climate. If there is uncertainty
(e.g. political turmoil) then firms may cut back on investment decisions as they wait to see how event unfold.

Evaluation – Confidence is often driven by economic growth and changes in the rate of economic growth. It
is another factor that makes investment cyclical in nature.

4. Inflation

In the long-term, inflation rates can have an influence on investment. High and variable inflation tends to
create more uncertainty and confusion, with uncertainties over the cost of investment. If inflation is high and
volatile, firms will be uncertain at the final cost of the investment, they may also fear high inflation could lead
to economic uncertainty and future downturn. Countries with a prolonged period of low and stable inflation
have often experienced higher rates of investment.

Evaluation – if low inflation is caused by a fall in demand and economic growth – then this low inflation will
not, of itself, be sufficient to boost investment. The ideal is low inflationary and sustainable growth.

5. Productivity of capital

Long-term changes in technology can influence the attractiveness of investment. In the late nineteenth
century, new technology such as Bessemer steel and improved steam engines meant firms had a strong
incentive to invest in this new technology because it was much more efficient than previous technology. If
there is a slowdown in the rate of technological progress, firms will cut back investment as there are lower
returns on the investment.

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 7. Availability of finance

In the credit crunch of 2008, many banks were short of liquidity so had to cut back lending. Banks were very
reluctant to lend to firms for investment. Therefore despite record low-interest rates, firms were unable to
borrow for investment – despite firms wishing to do that.

Another factor that can influence investment in the long-term is the level of savings. A high level of savings
enables more resources to be used for investment. With high deposits – banks are able to lend more out. If the
level of savings in the economy falls, then it limits the amounts of funds that can be channelled into
investment.

7. Wage costs

If wage costs are rising rapidly, it may create an incentive for a firm to try and boost labour productivity,
through investing in capital stock. In a period of low wage growth, firms may be more inclined to use more
labour intensive production methods.

8. Depreciation

Not all investment is driven by the economic cycle. Some investment is necessary to replace worn out or
outdated equipment. Also, investment may be required for the standard growth of a firm. In a recession,
investment will fall sharply, but not completely – firms may continue with projects already started, and after a
time, they may have to invest on less ambitious projects. Also, even in recessions, some firms may wish to
invest or startup.

9. Public sector investment

The majority of investment is driven by the private sector. But, investment also includes public sector
investment – government spending on infrastructure, schools, hospitals and transport.

10. Government policies

Some government regulations can make investment more difficult. For example, strict planning legislation
can discourage investment. On the other hand, government subsidies/tax breaks can encourage investment. In
China and Korea, the government has often implicitly guaranteed – supported the cost of investment. This has
led to greater investment – though it can also affect the quality of investment as there is less incentive to make
sure the investment has a strong rate of return.

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