Economics

By: Lemma Bali

Semester I, 2024
 Chapter 1: Basics of
Economics

1.1 Definition of economics1.1

1.1 of economics
 OUTLINE

1. Definition of economics
2. The rationales of economics
3. Scope and method of analysis in
economics
4. Scarcity, choice, opportunity cost
and production possibilities frontier
5. Basic Economic problems
6. Economic system
7.
2 Types of goods
 1.1 Foundation of Economics
 The fundamental facts of
economics foundation consist of;
a) Unlimited human wants
• Infinite
• Insatisfiable
b) Limited Resource
 Resources are means of
producing goods and service that
society wants on.
3
 Scarcity:
 is the excess of human wants over
what can actually be produced.
 limited amount of resources
 It is a fundamental problem for
every society
 The decision that can be solve
scarcities are
- what to produce
- how to produce it
- for whom to produce 
5
These decisions involve opportunity
 Resources can be divided in two:
a) Free resource:
- Like breathing air, wind, river
water, and sunlight
- it is gift of nature and no ask of
price( at zero price)
- No opportunity cost( no
scarification)
- Qdd < Qss
b) Scarce resource: limited in supply
o Qdd >Qss
o Positive opportunity cost
4 o They are economic resources factors
Economic resource/ factors of
production/
a) Land- all gifts of nature
 Reward of land is  rent
b) Labor: human resource
skilled labour mental labour reward for
it is salary
unskilled labour physical labour reward
for it is wages.
c) Capital: refers to all manufactured inputs
usable in the production of other goods and
services(sells manufactured input)
 E.g textile machinery: input for textile
factory
6
 To produce textile machinery fabricate
Human capital: skill, talents and
knowledge embodied in people
Is not pure capital but only a type
of labour
Financial capital: stocks, bonds,
paper money
Not directly production (not
directly economic capital)
The reward for it is interest
Real capital: various durable
manufactured types of capital capable
7 of producing other goods and services.
d) Entrepreneurship:
Is a special type of human
expertise with the objective of
making profit (∏) that
organizes and manages factor
of production and takes risk of
making loss(risk takers)
The reward for
entrepreneurship is profit.
8
S/He is innovative, Risk taker
Characteristics of entrepreneurship
Initiative
Decision makers
Risk takers  risks for effort, time,
finance, even life…
Entrepreneurship: organize
factors of production to get output
for maximizing profit
Innovators: ability to create new
type of business after creating new
type of business they may produce
9
new product and new market.
 It1.2 Definition of economics
deals with:
 How societies allocate scarce resources in the
production and distributes of goods and services to
attain the maximum fulfillment of society’s material
wants i.e.  Limited resource and unlimited human
wants.
 Lets look the following ones;
Mankiw’s definition
…is the study of how society manages its scarce
resources
Hedrick’s definition
…is how society chooses to allocate its scarce
resources among competing demands to improve
human welfare
Alternative definitions
10 … what economists do.
 1.3 Scope of economics
• By scope of Economics mean:
o coverage or major areas of
study
• The two main scopes or
branches of economics are:
1. Micro economics – from the
Greece prefix small
2. Macro economics- large
11
 It is the study of the economy in the small
1. Micro economics

It deals with

 Decision making of firms and individuals
 Economic activities of individual consumer and producers
 Specific economic units

 It examines "the individual trees in the forest”

2. Macro economics
It deals with the economics as a whole and its
aggregates and sub aggregates.
 E.g Ethiopia GDP, GNP.
 It study“ the forest but not the individual trees”
GDP is market value of all final goods and
services produced in a country in the a given
12 year.
1.4 Nature of economics
1.4.1 Goals of economics
1. Economic growth : means the production of more
output to increase the living standard of people
Economic development; broader and is social and
economic progress and seek to improve economic
well-being and quality of life for society
It has also multidimensional meaning. Eg. Norway is
number one
 Quantitative: economic growth(GDP);e.g. 10%
 Qualitative: institutional set up, mass part
 e.g. – political participation of people must be developed
 Attitude of human being towards work
 Human resource activity
 Women participation in work
 Development index: income index, educational index(enrolment
13 index, literacy index).
2. Economic security- welfare issue
Provision of welfare; handicapped, disabled
3. Full employment
 All resource would be efficiently utilized
 Not resource would be idle
 Not worker should be involuntary out of work
 No( idle resource, -L, L, K, E fully utilized)

4.Economic efficiency: PPF production

possibility frontiers. To measure the efficiency
5.Price stability
 They should not be fast fluctuation in price (stable)
 Two types of fluctuation
 Inflation;general price increase
 Deflation; general price decrease
15
6. Equity
 Fair distribution of national resource among the
citizens of the nation
 There should not be great poverty gap between
rich and poor.
 They should not be division between people
7. Balance of Trade (BoT)
 Trade deficit: export less than import
 X<M  high need of hard currency
 Trade surplus : export greater than import
 X>M
 Trade balance: export equal to import
 X=M
 As much as possible to try illuminate trade
deficit for development
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Scarcity ,Nature of Choice and Opportunity Cost
What is the crucial ingredient that makes a
problem in economics?
 Scarcity:
Is the central economic problems faced by
all individuals and all societies.
At any time the world can only produce a
limited amount of goods and services
because of the world only has a limited
amount of resources.
It can be product which can be;
o Good - is physical (tangible) things that
satisfies people’s wants and desires such
17
as a car or a hamburger.
 Cont…….
So, scarcity reflects the imbalance between
our wants and the means to satisfy these
want( resources).
The problem of scarcity lies in the inability
of people to produce the quantity and
quality of all goods and services
(resources) that all people want.
 Choice:
 Is the most clear implication of scarcity.
 Because of scarcity or not enough
resources, people need be choice what
should be produce and what should not
18 be produced.
 Cont…….
The society must make choices about :
o What output to produce in what quantities and
what output not to produce
Involves decisions about the kinds and quantities
of goods and services to produce
o How to produce
Requires decisions about what techniques to use
and how economic resources (or factors of
production) are to be combined in producing
output.
 The economic resources used to produce goods
and services include:
 Natural resources-such as land, trees, and minerals.)
 Labor (The mental and physical skills of individuals in a
19 society)
o For whom to produce.
Involves decisions on the distribution of
output among members of a society
Dealing with the above three economic
problems involves choice.
 By deciding which goods and services to
produce, society will choose these at the
expense of others.
 In other words, choice implies cost.
i.e., choice involves sacrifice (give
up).
 This means that when choice is made an
20
 Opportunity Cost
 Is value of the next best alternative
that must be sacrificed or missed
(forgone) in order to obtain one more
unit of a product.
Scarcity choice
opportunity cost.
This relation is known as economics
equation.
The economics equation is clearly
illustrated using the production
21 possibilities curve.
1.5 Efficiency and production possibility frontier (PPF)

 Economics is a science of choice and efficiency.

 In order to understand efficiency we have to achieve two
things
1. full employment
2. full production
 Full employment; all factor of production (L,L,K,E) efficiently
utilized (no idle resource)
Ability and willingness
No labor (worker) should be involuntarily out of work
(unemployed)
 Full production: the full employment of all available resource
is necessary but not sufficient condition to achieve efficiency.
 It can be achieved when all the employed resources (L,L,K,E)
shall be used that they provide the maximum possible
satisfaction of material wants
 Is productive or efficiency in which the goods and services 22
society desires are being produced in the least costly way
 Two types of full production
A. Productive efficiency
o Production of product mix in a least cost way
o Producing goods and service at least cost.
o On the PPF curve, it is impossible to produce
more of one good without producing less of
another or without sacrificing production of
another good.
B. Allocative efficiency
o production of product mix that society wants
most.
o Is an output level where the price equals the
Marginal Cost (MC) of production .
 This is because the price that consumer's are
willing to pay is equivalent to the marginal utility
that they get.
o Is more concerned with the distribution and 23
 Cont’d
Production possibility frontier(PPF)

PPF is a curve or graph that shows the

various combination of goods and service
that can produced in a full employment, full
production economy in which case the
available resources are fixed, and
technology is constant
24
 Production possibility
curve

A Unattainable
Efficient and
attainable
Inefficient and
B
attainable

Where A and B are the products (Let

Banana and Bread).
25
 Assumptions of the PPF model:
1. Two products: economy is assumed to produce only two
products.
2. Fixed resources: The quantity and quality of economic
resources (L,L,K,E) available for use during a certain period are
fixed.
3. Fixed technology: the state of technology-the methods used
to produce goods and services-does not change during specific
(given) period of time.
4. Efficiency: The economy is operating at full employment and
achieving full production.
I.e. No resource must sit idle and the employment of these
resources must provide us the maximum possible output level.
26
 Cont…
5. Possibility of reallocation /shifting of resources:
Thorough of quality and quantity of economic
resources are fixed, with in limits, they can be shifted
or reallocated among different uses.
E.g1 land  factory site–machinery production
 farming- bread production
E.g2 Unskilled laborer can work on a farm, at a
fast-food restaurant or in a gas station.

27
 Production possibility schedule
Example of PPF

28
 Cont’d
The economy has 5 production possibilities
Production possibility:
 A and E unrealistic
 A+A  unrealistic b/c all the economy resources
are devoted only to the production of machine.
E+E  unrealistic b/c all the economy resources
are devoted only to the production of Bread.
 B,C,D realistic because the economy
production mix of capital goods and consumer
goods
29
 Production Possibilities Frontier (Curve)

A
100 n
90 nB
G
70 nC n
Units of
Machine

60
F D
n
40 n

30

nE
10 20 30 40
Bread
30 (N o of Loaves)
 Cont’d
 A society is said to be efficient when it cannot produce
more of one good without producing less of another good.
 ON and WITHIN the PPF:
 The combination is attainable :
-The society can produce of both commodities
 The combination is efficient:
- a society must achieve both full employment
and full production
Ex. If the society wants to produce more bread, say 20
loaves Bread, the society is forced to reduce its
production of machine from 90 to 70. Thus, we say that
the society is efficient at point B (and also at points A, C,
D and E).
 Ex B (10, 90) transfer to C (20, 70) increase the amount
of bread produce, sacrifice machine produce on PPF.
31
 Cont’d
 Inside the PPF
 The combination is inefficient
-There is some idle (unemployed) or unused
resources.
 The combination is attainable
-The economy could produce more of both
commodities
Ex: we can increase bread and machinery
We can decrease bread and machinery
 OUTSIDE the PPF
 Unattainable: we cannot attain with limited factor of
production (with limited technology and fixed resources) 32
It can only be achieved by increases
in resource supply and quality and
technological advance or in general
economic growth.
Ex: Point G
Unattainable: - with fixed resources
- with constant technology
 In the long run:
 When the factor of production increase in quantity
and quality and
 The advancement of technology we can attain
33
outward the PPF.
 Important concept embodied in the PPF or PPC
1. scarcity:
 i.e. society can’t have unlimited amount of output even if it
employees all of resources and utilizes them in the best
possible way.
2. Choice:
 Any movement on the curve indicates the change in choice.
 Choice is indicated in the graph by the movement along the
curve either down ward or in ward.
3. Opportunity Cost:
 when the economy produce on PPF. Production of more of
one goods requires scarifying some of another good.
 The downward( -ve) slope of the PPF implies the idea of
34
opportunity cost .
 Cont‘d
Example, In moving from point B to point C in the
above PPF, 20 units of machine must be given up
(forgone) in order to obtain 10 additional loaves of
bread. Thus, the opportunity cost is given by:
Opp cost = Units given up of one good
Units obtained of another
good
 Numerical example of opportunity cost
Movement from B(10, 90) to C (20, 70)
Opportunity Cost = Sacrifice ( forgone) = 70-90
gain( obtain) 20-10
-20
10
=/-2/= 2 35
 Interpretation
In order to obtain one additional loaf of bread two units of
machines must be sacrificed. In other words the opportunity
cost of obtaining one additional loaf of bread is two unit of
machine(1:2)
4 . Increasing opportunity cost/concavity
 The concavity of the PPF reveals increasing opportunity cost
 The Law of Increasing Opportunity cost indicates the shape of
the PPF is concave or bowed outward.
 This reveals that the slope is increasing in either direction,
which means the amount of one good we have to give up in
order to obtain the other good increases along the curve.
36
 1.6. Economic Growth and the PPF
 Economic growth: is an increase in the real
output level of an economy over time.
 Causes/ingredients of economic growth
Supply factor/ ability to grow
-quantity and quality of economic resources
-stock of real capital
-state of technology
Demand factor-in order to realize its growing
productive potential, a nation must provide
for the full employment of its expanding
supplies of resources. This refers to the
aggregate demand. 37
 Cont‘d
Allocative factor- to achieve its
productive potential, a nation must
provide not only for the full
employment of its resources but also
for full production from them. It refers
to good and effective policy.
Thus, increases in total output level
occurs:
o when there is an increase in the
quantity and /or quality of economic
38
resources such as labor, natural
resources, capital, etc.
 Cont‘d
Changes in ppc

39
 Cont‘d

The increase in total real output

(economic growth).

 Is reflected by the outward

(rightward) shift of the PPF. When
economic growth is realized, the
production possibility frontier
shifts outward to the right (from
PPF1 to PPF2).
40
1.7 Economic problems and Economic system
1.7.1 Three fundamental economic problems
1. What to produce ?
 Sometimes called problem of choice
 such type of question in market
economy( competitive market system) answered by
price system.
i.e by the interaction of dd and ss.
 This refers to the identification of what mix of good
and services to produce over a period of time.

 What collection (kind) of goods and services will mostly

satisfy the needs of its citizens and what quantities the
goods and services to produced
41
 2. How to produce?
 this problem refers to technical and
organizational problem of production.
 Choice of technique of production.

3. For whom to produce?

 Refers to distribution of outputs
 In market economy : Demand and supply
determined by the price system( profit
oriented)
 In central command economy: fair distribution
of output through the country.
42
 1.6.2 Economy system
 In a set of organizational and institutional
arrangements and coordinating mechanism
establishing to answer the three basic economic
question

There are three economic systems

1. Capitalism/ market economy/ sometimes laissez-
faire economy.
2. Command/ socialist/ planned economy
3. Mixed/ hybrid/ realism system.

43
 1. Capitalism

 The three basic economic question are

answered by price system( market
mechanism)

 Adam smith invisible hand theory.

44
 Specific characteristics of capitalism
1. Market determination : price is the main
determinant factor of the market
2. Freedom of enterprises and consumers
sovereignty ( free entry and exit the market.
3. Private ownership of resources
4. Competition and independence
5. Specialization of goods
6. Role of self interest or individual system
7. Profit motive( profit oriented)
8. High inequality( high marginality)

45
 In capitalism system the gap b/n rich and poor
is high. The ownership of the means of
production is falls in the hands of a few
wealthy persons.

2. Command system
 The 3 basic fundamental questions are
answered by central planning Authority( CPA)
appointed by the government.

46
This is a form of economic system in which
means of production except labor are owned by
the state and groups
Both resource allocation and pricing decision is
undertaken by a central planned decision.

47
 Specific characteristics of command system
1. Central planning board determination
2. Restrictive policy ( no freedom of enterprise
and no consumer sovereignty)
3. High government intervention
4. No competition ; due to price is allocated by
the government
5. Public ownership of resources
6. No specialization
7. Role of social interest ( welfare point of view)
8. Social motives
9. Highly equity .

48
 3. Mixed economic system

 “The market needs the state as much as the

state needs” is the base of mixed economy. In
mixed economy, the strong elements of both
capitalism and socialism are hybridized.

 In such a system both government and the

market mechanism answer the fundamental
economic questions.

49
 Market and Gov’t: distribution of income
- provision of market goods

- correcting market failures

- stabilizing the economy

etc..

50
 Chapter Two

Market model
Demand, Supply and
Utility Theories
 Chapter’s Outline
1. Market model
2. Definition, law and determinants
of demand
3. Definition, law and
determinants of supply
4. Market Equilibrium
Determination
5. Measuring Elasticities
6. Examples and Exercises
2
 Market model
A market is an institution or an established
arrangement or place or mechanism, which brings
together buyers (demanders) and sellers
(suppliers) of particular goods or services.
 It is a place where potential buyers and sellers
meet.
Market is an institution arrangement in which a
voluntary exchange is taking place between
buyers and sellers of goods and services in
specific place with a given period of time.

53
Market model deals with the following theories.
Theory of demand – deals with behavior of only
consumers of goods and services.
Theory of supply – deals with behavior of only
suppliers of goods and services.
Theory of equilibrium – deals with interaction
between the behavior of both sellers and
consumers of goods and services.
Theory of elasticity – deals with
response/sensitive of sellers and consumers of
goods and services to policy, environmental,
social, human, and variable(such as prices,
54
income etc) changes.
2. 1. Definition, law and determinants
of demand of agricultural commodities
2.1.1. Definition of demand and Demand
function
 Demand (Dd) in economics has different

meaning as compared to our day-to-day use

(ordinary meaning is want or desire)
 Effective demand: Fulfill the following Criteria
A. Desire (want) to use a Commodity
B. Sufficient money to purchase the commodity
(ability to pay)
C. Willingness to spend money to acquire that
55 Commodity (willingness to buy)
 Demand in economics is defined
as a schedule,
 Which shows the various
amounts of a product which
consumers are willing and able
to purchase at each specific
price in a series of possible
prices during some specified
period of time in a specified
market.
56
Or in shortly it is:
 Important elements from the given
definitions
Purchaser or demander for goods and
services.
Seller or supplier of goods and services.
Products/ goods and services.
Time: there should be specific period of time
Prices specific price.
Willingness and ability.
Because willingness alone is not effective
in the market.
Willingness should be supported by ability
For instance, I may willing to buy a car but
57 my ability may not permit to do so.
 2.1.2 Demand schedule and Curve
Demand schedule :
Is a tabular presentation of the demand for
a commodity.
 It is simply a tabular statement of a
buyer’s plans, or intentions, with respect to
the purchase of a product.
Price per unit Demand
E.g. Hypothetical Quantity Demanded/Week
Schedules for a
(in Birr/unit)
Commodity X (units/week)
1 5
2 3
3 1
The above table in row 1 shows that the buyers in
58 this market demand 5 units of X per week at the
 2.1.3. Demand Curve
 It is a graphic representation of preferences for a
particular good.
In other words, it is the graphic form of the
demand schedule- the quantity on the horizontal
axis and the price on the vertical axis.
The demand curve : Shows an inverse relationship
between product price and quantity demanded.

price

Vertical axis :Price

Horizontal axis: quantity
59
Quantity
 2.2. The Law of Demand
 Keeping all other factors being constant
(ceteris paribus), as price falls, the
corresponding quantity demanded rises,
or as prices increases, the corresponding
quantity demanded falls.
 Qd/P must be negative
 The most important circumstance
affecting the demand for a good is the
price.
 People buy more if the price of a good
60 falls; they will buy less if the prices rise,
 Exceptions to the law of demand
 There is situations when fall in price of a
good actually cases people to by less of it, or
a rise in price causes them to buy more.
 Goods demanded for their price: the
consumer may buy the commodity because it
is expensive, i.e. the price is part of the
attraction of the article and a rise in price may
cause to be it more attractive ‘snob value’.
Ex: Diamond P Qdd
 Expectation of a further change in price:
on a stock exchange market, a rise in the
price of a share often attracts people to buy it
61and vice versa.
 Cont. Exceptions to the law of
demand
Giffen Goods:
Giffen goods are rare forms of inferior goods that
have no ready substitute or alternative.
The only difference between Giffen goods and
traditional inferior goods is that demand for the
former increases even when their prices rise,
regardless of a consumer's income.
If the product is inferior good and if the product
takes major portion of the household income, as the
price of the commodity declined this freed a
proportion of the family income (income effect),
which was immediately spent on other goods, to
vary the diet.
62
E.g. Beans, bread, rice, and potatoes.
 Individual Vs Aggregate (Market) Demand:
 Individual demand is single consumer(demanders)
 The market (aggregate) demand is driven by summing up the demand of all
persons participating in the market for that particular product.
 The market demand schedule can be constructed by adding the quantities
demanded by each consumer at the various possible prices in a given market .
Schedule
Price/kg A B C = Mkt Dd

5 0 0 0 0

4 10 10 10 30
3 15 20 20 55

2 20 30 30 80
1 30 40 40 110

P P p P

+ + =
63
Q Q Q
Q
 Why do the curves slope downward
 Downward sloping demand curve means a rational
consumer will demand more of a commodity when its
price falls. Some of the reasons for the phenomenon
would be:
1. Operation of law of diminishing marginal
utility
U= satisfaction
 Buy something = consume it to get satisfaction.
 Any body scarifies money to get satisfaction .
If scarifies < satisfaction= everybody agree to buy
If scarifies > satisfaction= disagree to buy.
 LDMU: tells that the more a consumer consumes a
commodity the smaller the marginal utility.
Q = Mu
64  Therefore negative slope.
 2. Income effect
 When price of a commodity falls, consumer's real
income rises that is he can now purchase more of
the commodity with the same income
Ex: allocate 120 birr income for buy milk
milk per liters Qdd
2 birr 60 liters
3 40
4 30
3. Substitution effect.
price increase/ decrease= Qdd decrease/increase
Ex= butter and edible oil are substitute good
When price of butter increase and the price of edible
oil constant,
65 the quantity demand for butter will decline.
Or P(butter) decrease when the price of edible oil
constant , the quantity demand for edible oil will
decline.
4. New consumer creating demand.
P = Qdd
eg P( car) = Qdd for car increase
P( car) = Qdd decrease = leave the market.

66
Change in demand and change in
quantity demand
Change in Qdd: This is a movement along the
original demand curve due to change in price.
 Change in quantity demanded refers to
change in the quantity purchased due to
increase or decrease in the price of a product.

Q
67
Change in demand: is the total
change in quantity of the demand
schedule having price constant.
 Change in Dd is due to changes in
various other factors such as change in
income, change in consumer’s tastes
and preference, change in the price of
related goods, while Price factor is kept
constant.
 Increase/decrease in demand refers to
the rise/fall in demand of a product at a
68
given price
 P

D0 D2(increase)
D2 (decrease)

Q
 A decrease in demand shifts a demand
curve to left of the initial and an increase
to the right of the initial.
 It indicated graphically by a shift in Dd
69 curve either to the right or to left of the
 Factors /Determinant/ Influencing
Demand
 Generally, there are two determinants.
1. Own-price determinant /demand mover/ the
price of the product
2 . Non- Own-price determinants /demand
shifters/
1. own- price
Law of demand P and Qdd= -ve slope.
(inverse relation ship).
2. Non- Own-price determinants
1) The income of consumers (level of
income of consumers)
70
The relationship between income and
 Cont
 Generally , for most goods and service as increase
in income(y) (purchasing power) will cause an
increase in demand, such type of goods are normal
goods.
 Y and Dd of normal goods = they have direct
(positive relationship)
 Normal goods divide into luxury goods and necessity
goods.
But as y increase some the level goods and services
whose Dd decrease such type of goods are inferior
goods.
example: Bean Vs meat.
Income of some person increase beyond some level
71the preference (demand) change from bean to meat
so bean is inferior goods for that person.
Dd of inferior goods and
income= -ve ( inverse
relationship)
Note : inferior goods at the very
beginning normal goods, but the
income increase beyond some
level the Dd of inferior good
decrease.
The demand for inferior good is
inversely related to income.
72
 2. Price of other related goods
The effect of the change in the price of other
related goods is dependent on the nature of
the relationships between the goods in
consideration.
 The are two particular interrelationships of
demand which may be quantified,
1. substitutes goods : Where goods are
substitutes one for another
2. complementary goods :Where goods are
complementary.
a) substitutes goods : two goods are
substitutes if they satisfy similar needs or
desires.
73
 With substitutes, the demand for one rises as the
price of the other rises or the demand for one falls as
the price of the other falls,. For example, for many
people butter is a substitute for cooking oil and vice
versa
ex : coca and Pepsi
tea and coffee
 If price of tea increase = demand of coffee increase
Price

Dd coffee 1
Dd coffee 0

74
Q
 b) Complementary goods: are those goods
that are jointly consumed or demanded.
With complements, the demand for one rises
when the price of the other falls and the demand
for one falls as the price of the other rises.
 Thus if two goods are complements, the price of
one good and the demand for the other are
inversely related.
 Ex1: if P of camera increase = Qdd of camera
decrease
if Qdd of camera decrease= demand for
films decrease
Ex2: price of car increase = Qdd of fuel
decrease
75 price of car decrease= Qdd 0f fuel increase
 3.Tastes and preferences
These are usually subjective and changing.
Positive taste and preference favor the
demand for a commodity.
 A change in favor of a good shifts the
demand curve rightward.
A change in preferences away from the
good shifts the demand curve leftward.
Ex : fashion
4. Change in number of buyers
Since the market demand for a good or
service is the sum of all individual
76
demands, an increase in the number of
buyers in a market increases demand.
Increase in the number of buyers could be due to
expansion of markets which could be caused by
expansion the Dd curve.
How number of buyers increase
- Expansion of trade- export to abroad
- Expansion of disorder
- Increase number of population( increase
population growth)
5. Size and composition of population
Composition Age composition
sex composition
77
 Age composition= predominance youth – e.g.
price of
cosmetics
increase
predominance Adult- price
of
normal good
increase
 Sex composition= female( price of female
material increase)
6. Seasonal factors( time)
The demand for many products is influenced by
the season.

78 Example, demand for cloth during holidays;
7. Expectation of consumers about future
income, price and product availability affects
demand.
Current demand depends heavily on long-
term expected income.
Expectation of rise in future income may
initiate consumers to increase their current
spending.
An increase in future price= current Dd for
goods and service increase.
e.g. Teff in December
Future product availability= current Dd for
goods and services decrease.
79
8. Culture: Religious or traditional
forbidden for some products- either
seasonal or permanent.
9. Government influences:
prohibitions or restrictions of some
goods decrease the demand.
10. Distribution of national income.
Equitable( socialist) = Dd( necessity
good) increase Dd( luxury )decrease
Inequitable (capitalist)=Dd(luxury
goods) increase = Dd( necessity)
80
increase.
 2.2 Theory of Supply
Definition, law, Curve and determinants of supply of
agricultural commodities
A. Definition of Supply (Ss)
 Supply can be defined as the quantity that
producers are willing and able to offer for sale
in a given time period.
 In other words, from individual producers point
of view, supply is a schedule which shows the
various amount of the product which a
producer is willing and able to produce and
make available for sale in the market at each
specific price in a serious of possible prices
during some specific time period.
81
 Cont…….
 Supply is the quantities of a product, which
will be supplied at various prices, all other
factors being held constant.
 Like demand, supply is a flow of goods and
services.
Important element in the definition of supply
Willing to produce
Able to produce
Make a product available for sales
Purchaser or Seller of product
Specify period of time
82
specific price
 The Supply Schedule:
Is a tabular presentation of the supply for a product.
It shows a series of alternative price-quantity supplied
combinations.
In other words, it lists the quantities supplied at each
different price, when other non-price factors are held
constant.
Price
E.g. per quintalsupply
Hypothetical (in Birr) Quantity
schedules for commodity X
supplied/week
1 2
2 4
3 6
This shows that an increase in price, the
quantity supplied also increases.
83
 Supply curve
Supply Curve is a graphical representation of price and
quantity supply combinations.
P
Ss

Q
 It is constructed on a two-dimensional graph by
assigning the price on the vertical (Y) axis and the
quantity supplied on the horizontal (X) axis.
 The supply curve has a positive slope showing the
positive or direct relationship between price and the
quantity supplied, holding everything else constant.

84
 Law of Supply
 The law of supply shows the
behavior of suppliers are
receiving the higher the price of
a good, the greater is the
quantity supplied.
 i.e. price and quantity supplied
is directly related.
 As price rises, the corresponding quantity
supplied rises; as price falls, the
85
corresponding quantity supplied also falls.
Why is the Ss curve upward slopping?
(there is direct relationship between
price and Qss).
A. An up-ward slopping curve reflects the
fact that under certain conditions a
higher price is an incentive to producers
to produce more of a good.
B. Some producers employ additional
quantities of factor of production.(L,L,K)
C. High price attracts some producers who
will, otherwise not be interested in
producing the commodity.
86
 Individual versus Aggregate
(Market) Supply
An individual supply curve
represents the price-quantity
combinations for a single seller
(firm).
However, in the real world
markets there are many producers
or suppliers of the same product.
The market supply is simply the
horizontal sum of the individual
87
supply curves.
 Factors Influencing Supply
Two major determinants are stated as follows;
1. Own-price determinant/supply mover/-the price of the
product
2. Non- Own-price determinants/supply shifters/
1. Own-price determinant
 P and Qss have positive relationship movement
along the supply curve is change in Qss
P
Ss

88
Qss
2. Non- Own-price determinants
1. Price of related goods
a. Production substitutes
b. Production Complements
i. Production substitute
 Two products are substitutes in production when an
increase in the price of one product causes a
reduction in the price of the supply of the other
product.
Eg: farmer use the plot of land for production of
barley and wheat
W B W B
Substitute

50% 50% 75% 25%

because price of wheat increase
89
P(wheat) increase= Quantity supply of barley
Unlike Dd, substitution of supply price of one good
inversely relationship of Qss of the other goods.
 Generally if the price of one production substitute
increase, this will decrease the supply of other
substitute.
ii. Production complements:
 Goods that are produced together or jointly, or one
is a by- product of the other product.
 Their production process is inseparable.
 Generally two products are complements in the
production when an increase the price of one
product causes an increase the supply of the other
product.
Eg1: p(beef) increase= Ss (beef) increase
= Ss skin increase
90
so P(beef) increase= Ss skin increase.
 2. Change in price of inputs (factors of
production)
Inputs are the things that are used in
the production of goods and services.
Change in the price of inputs directly
affects the cost of production.
Input costs = cost of production = units
of inputs used X respective prices
Therefore, there is close relationship
between cost of production and supply.
An increase in the price of a factor will

91
increase the cost of production of a firm.
For a particular commodity, when the costs of
production are low, relative to market price, then it
will be profitable for producers to produce a great
amount.
When production costs are varying high relative to
price, producers will produce little (or may stop
producing).
This lowers supply. A decrease in supply is shown
by a shift of supply curve to the left of the original;
where as an increase in supply is shown by shift to
the right.
92
 3. Change in the level of
technology
The state of technology affects the efficiency of
production.
Usually advancement or improvement in technology
allows producers to reduce their cost of production per
unit of output.
This would therefore, have the effect of shifting the supply
curve to the right. However, the effect of technology on
supply tends to be a long-term.
4. Number of Suppliers
The larger the number of suppliers the higher will be the
93
volume of supply, other things being constant.
5. Change in the level of taxes
and subsidies
Taxes are deductions from the profit
of producers or they are additional
costs to producers.
So their effect is similar to increase
in cost of production.
Subsidies, however, are opposite of
taxes.
Subsidies are expense for the
government or society but
94
deductions from the cost of
 6. Nature, especially weather and
pests
Bad weather, pests and disease can
greatly reduce supplies of agricultural
products, while good weather and
absence of pests can greatly assist in
increasing yields and hence supply.
7. Future Expectation of producers
Always producers are expecting a
higher prices for his or her products
with regard to futures.
95
 2. Change in Supply versus Change
in Quantity Supplied
Change in Supply
Change in supply is a total change in the
location of the supply curve.
The change or shift in supply could be an
increase or a decrease.
It is caused by change in any of the non-price
supply shifters or determinants.
An increase is shown using supply curve, by
shift to the right of the initial.
An increase in supply happens when, due to
changes in one or more of the non-price
96
supply shifters, the amount supplied
 Change in quantity supplied
This is movement from one
point to another point on a
stable supply curve (the original
supply curve).

 It is caused by a change in the

price of the specific product
under consideration.
97
 2.3 Market Equilibrium
 Equilibrium is an interaction of Demand and
supply curves.
 The actual quantity that demanders get in
the market and the actual quantity that
producers offer are only determined when the
two actors meet in a market.
 Therefore, we shall now combine our analysis
of demand and supply to show how a
competitive market price is determined.
 The motives of consume and producers are
different in that the consumer wishes to buy
cheaply while the supplier wishes to obtain
98
the highest price possible.
99
Determination of the equilibrium condition
In any market one of the following three conditions
may exist:
1. Equilibrium (balance) Point (Market Clearing
point)
Qss= Qdd at market price
PE= equilibrium price.
QE= equilibrium quantity
 Equilibrium price: is the price at which the wishes
of buyers and sellers coincide or the price that
exists when Qdd equals Qss in a given market at a
specific time period.
 Graphically it is represented by the level of price
that exists at the point of interaction of Dd and Ss
curves.
 It is sometimes is called market- clearing price.
10
0
Equilibrium quantity: it is the
quantity that corresponds the
equilibrium price.
The quantity at which the amount of
good buyers are willing to buy equals
the amount sellers are willing to sale or
provided.

10
1
2. Excess demand (shortage): a condition in
which quantity demanded is greater than
quantity supplied.
When excess demand occurs in an
unregulated market, there is a tendency for
price to rise as demanders bid against each
other for the limited supply.
 There are various problems associated with
shortage economy;
Discrimination-some people will be satisfied
while others will not.
Black market or under economy activities.
There are different solutions for the problems
10
associated with shortage economy;
2

 3. Excess supply (surplus): a condition in which
quantity supplied is greater than quantity
demanded at the current price.
When there is excess supply, price tends to fall as
competing suppliers attempt to sell their product
by lowering the price.
There are many problems associated with
surplus economy;
 Excess production problem/ lots of inventory/
products remain unsold
 Removal or dump of product on the market
 Discourage investor or producers
Solution
 Dealers offers discounts to encourage buyers
10  Government provides subsidy to sellers.
3
 Effect of change in Dd and Ss
on the equilibrium State
Equilibrium price and quantity determined by SS
and Dd any time.
Either Dd or SS or both may change, thus the
10 equilibrium price and quantity also change.
4
 Case I: Change in Demand but Supply being Constant
i. Increase in demand, supply being constant
ii. Decrease in demand, supply being constant
Case II: Change in supply assuming that demand is
constant
i. Increase in supply, demand being constant
ii. Decrease in supply, demand being constant
Case III: When both demand and supply change
(combined effect)
a. Supply and demand change in opposite direction
(in equal or unequal magnitude of change)
 i. When demand increases but supply
decreases
 ii. When demand decreases but supply
increases
10 b. Supply and demand change in the same direction
5
(in equal or unequal magnitude of change)
 2.4 Elasticity
Elasticity is a general concept that can be used to
quantify the response in one variable when
another variable changes.
 It denotes the responsiveness (sensitivity) of one
variable to changes in another.
It is a measure of the responsiveness of a market
to a stimuli (change in a variable)
Types of Elasticity
A. Elasticity of Demand
 It is important to determine how much the amount
demanded will change in response to a change in
one of its determinants.
 Three types of elasticity's of demand
10
6 1. Own-price elasticity of demand
 1. Own Price Elasticity of Demand
Measures how sensitive or responsive consumers
are to a change in the price of the commodity
under consideration other factors held constant.
It is the percent of change in the quantity of a
good demanded that is bring on by a one percent
change in price,
Edp = Percentage change in
quantity demanded
Percentage change in price
Edp =  Q / Qi = % Q
 P /Pi % P
= 1. Pi
10 Slope Qi
7
 = 1 . Pi
Slope Qi
= 1 . Pi
 P Qi
Q
denotes =  Q . Pi
P Qi
Where, Q = Change in quantity
demanded
P = Change in price
Qi = Initial quantity
10
8 Pi = Initial price
 Arc (average) elasticity
Edp = Change in quantity . Average of
prices
Change in price Average of
quantity
Edp =  Q. (Pi + Pf)
 P (Qi + Qf)
Where,  Q = Change in quantity
demanded
 P = Change in price
Qi = Initial quantity
10
9
Qf = Quantity final
Example: Assume that at price of birr 5 per
kg of x, the quantity of x demanded is 12
Kgs; when the price decrease to birr 4 per
kg, the quantity of x demanded increase to
14 Kgs. Then calculate elasticity?
Given
Po =5 birr Qo= 12 kgs
P1= 4 birr Q1= 14 kgs
Ed= Q . Po
P Qo
= 2 .5
1 12
11
0 = 0.83
 Degree of price elasticity of demand
i. perfectly elastic demand( ed= ∞)
 If Qdd keeps on increasing or decreasing
and price remains constant , elasticity of
demand is said to be perfectly elastic.
Consumers will purchase all they can at a
particular price but none of the product at a
higher price (Edp = ).
Here a slight change in price corresponds to
an infinitely large change in quantity.
Quantity demanded is extremely responsive
to even very small changes in price .
The demand curve in this case is a
11 horizontal line.
1
 P constant d

Qo Q1 Q2
Q . Pi = 
P Qi
This indicates one percentage
change in price results in infinite
change in quantity.
11
2
ii. Perfectly inelastic(Edp=0)
Quantity demanded does not change as price
changes.
Quantity demanded is completely
unresponsive to changes in price.
Own-price elasticity of demand (Edp) is zero.
The demand curve in this case is a vertical
line.

p2
P1 Qo
11
3 p0
iii. Unitary elastic: (Edp = 1).
 This is the intermediate case.
In this situation quantity changes by
the same percentage as price, i.e.
both changes in the same proportion.
Ex if a 10% increase in price is
accomplished by a 10% decrease in
qdd. Price elasticity is unitary.
Q . Pi =
1
11
4 P Qi
iv. Elastic: (Edp > 1)
 Quantity of demand is changes by a lager
percentage than price,
i.e. it occurs when some percent change in
price results in a large percentage change
in quantity.
A change in price induces a more than
proportionate change in quantity
demanded.
Consumers are quite responsive to a price
change.
The larger the elasticity, the larger the
11 percentage change in quantity for a given
5
 Q . Pi =>1
P Qi
-20 = /-2/ = 2
10
Most of the time luxury goods are elastic demand
Inelastic demand: (Edp 0< ed< 1).
When a decline in prices brings a smaller
percentage increase in quantity
i.e. quantity of dd changes by a smaller
percentage than price.
 Consumers are less responsive to a price change.
Generally, a change in price causes a less than
proportionate change in quantity consumed.
11
6
Ex : price of x commodity = 7 to 9,  P =
2
Qdd of x commodity = 24 to 20.3,
 Q= /-3.5 /
 Q . Pi =< 1
P Qi
/-3.5 /. 7= 0.6
2 20
Most of the time necessity goods
inelastic demand.
Note: The demand for necessities tends
7 to be inelastic.
11
Exercise one..
1. The price of a stick of cigarettes
increased from 20 cents to 30 cents
per stick.
A smoker who used to smoke 30 sticks of
cigarette per day before the rise in price
now decreased to 27 cigarettes.
Calculate the price elasticity of demand
and indicate the degree of elasticity?

11
8
 2 . Income elasticity of demand
 It relates changes in the quantity
demanded to changes in income.
 It measures the degree of
responsiveness of the quantity
demanded of a product to changes
in income.
In other words, it measures the
responsiveness of consumers to
income changes as the demand
curve shifts from one position to
11
9
 Edy = Percentage change in
quantity demanded
Percentage change in income
Edy =  Q / Qi = % Q
 y /yi % y
=  Q . yi
y Qi
Where,
 Q = Change in quantity demanded
 Y = Change in income
Qi = Initial quantity Qf = Quantity final
Yi = Initial income Yf = Income final
12
0
If demand increases when income
increases, the income elasticity is a
positive number and such goods are
superior or normal goods, (Edy > 0).

If demand decreases with an increase

income, the income elasticity is negative
and such goods are inferior goods, (Edy <
0).

If demand change is the same as income

change, the income elasticity is unit, (Edy
1 =1).
12
 Type of income elasticity
1. High income elasticity
 The percentage change in quantity demanded
of a good is greater than the percentage
change in income.
 when % Qdd > Y
Edy = % Q >1
%y
2. Unitary income elasticity
 Percentage change in quantity demanded of a
good is equal to the percentage change in
income
% Q = %  y
12
2
Edy = % Q = 1
3. Low income elasticity
 The percentage change in quantity demanded
of a good is less than the percentage change in
income
 % Q < %  y
Edy = % Q 0<edy< 1
%y
Saving is behavior show in this type of
elasticity .
4. Zero income elasticity
When change in income doesn’t lead to any
change in quantity demand (whatever the level of
income, the quantity demand remains the same.
The graph of the elasticity is vertical graph.
12
3  Saving is the habit of the person
 Edy = % Q = 0
%y
5. Negative income elasticity
It occurs when the level of income
increase, the quantity demand actually
decrease

12
4
Graphically

Y edy

Qdd
Generally
Normal goods= +ve income elasticity
 Luxury goods= edy> 1
 Necessity goods= 0< edy<1 …..like basic food; water,
12
5 closing and shelter,
 Exercise
1. Consider that the average
monthly income of an
Ethiopian increase from birr
120 to 150. as a result,
average monthly Dd for good x
increase from 20 to 30 units
a) calculate income elasticity
b) identify what type of good is X.
12
6
 3. Cross elasticity of demand
 If two commodities X and Y are either
substitute or complement to each other,
the demand for one of them will be
responsive to changes the price of the
other.
 The extent of this responsiveness is
called cross elasticity of demand
 Edxy = Proportionate change in the quantity
demanded of good X
Proportionate change in the price
of good Y
7 Where, good X and good Y are related
12
Where
 Q x = Change in quantity
demanded of good X
 Py = Change in price good Y
Qxi= Initial quantity of good X
Pyi = Initial price of good Y

If the cross elasticity of Dd is positive

the goods are substitute.
Ex: Quantity demand of Coca-Cola
increase the price of Pepsi increase.
12On the other hand If the cross
8
 Ex: Quantity of film decrease
when the price of camera
increase, (complementary
good)
Exercise
 Suppose the price of Y rises from
8 to 10 birr per Kg and as a
result, the demand for x rises
from 4 to 6 kg. what is the
12
relationship of the two goods?
9
 B . Elasticity of supply
 Is also applicable to measure the behavioral changes of the
supplier/seller/ in response to the changes in the determinants.
 Two types of elasticity's of supply
 Priceelasticity of Supply
 Cross-price elasticity of Supply
I. Price Elasticity of Supply (PES)
 Is the measure of responsiveness of producers in terms of
output to changes in the price of their products.
Essp = Percentage change in quantity supply
Percentage change in price
Essp = Q / Qi = % Q
P /Pi %P
It denotes = Q . Pi
P Qi
 Where, Q = Change in quantity supplied P = Change in
13 pric Qi = Initial quantity
0
Pi = Initial price
E.g. If Esp. is 3, a 5% increase in price will result
in a 15% increase in quantity supplied.
Arc (average) elasticity
Essp= Change in quantity × Average of prices
Change in price Average of quantity
Essp= Q.Pi + Pf
P Qi + Qf
Where, Q = Change in quantity supplied
P = Change in price
Qi = Initial quantity Qf = Quantity
final
Pi = Initial price Pf = Price final
13
1
 Three types of price elasticity of supply
I Elastic-Esp >1, i.e % Qss > % P
 If the percentage rise in quantity supplied is greater than the
percentage rise in price that brought it about.
 That is, when a change in price causes a more than
proportionate change in quantity supplied.
 This means producers are relatively responsive to price
changes.
II. Unitary elastic- Esp equal to one, i.e % Qss = % P
 the percentage increase (change) of quantity supplied is
exactly equal to the percentage increase (change) in price.
III. Inelastic- Esp < 1, % Qss < % P
 If the percentage rise in quantity supplied is less than the
percentage rise in price that brought it about.
 That is, quantity changes by a smaller proportion than price.
 This means producers are relatively insensitive to price
13
2 changes.
 Two extreme cases of elasticity of
supply:
1. Perfectly elastic (Infinitely elastic)
(Esp. =∞)
 Where changes in supply occur with out
any large change in price being
necessary.
 Implies a small change in price changes
quantity supplied by an infinitely large
amount.
 The supply curve for this case is a
horizontal one
2.
13
Perfectly inelastic (Esp. =0)
3
 The Esp. is equal to zero (Where supply
 2. Cross-elasticity of supply
 The percentage change in the supply of one good in
response to a one percent change in the price of
alternative product (a product with in the production
possibility of the producer).
Esxy = % change in quantity supplied of a good “X”
% Change in price of good “Y”
Where ‘X’ and ‘Y’ being production alternatives.
 The value of the Esxy can be negative or
positive
If the value of Esxy is positive, the two products
are complements in production (Complements in
production means the two goods are produced
together.)
If the value of Esxy is negative, the two
products under consideration are production
13
4 substitutes.
Exercise 1
Assume that there are 200
identical buyers of wheat in a
market with an individual Dd
function of Qdd= 8-P. there are also
100 identical sellers of wheat of
wheat with an individual supply
function of Qss=2p, citrus paribus .
Calculate
A) Equilibrium price.
13
5
B) Equilibrium quantity
 Exercise 2
1. Consider the market Dd
function for computer is
represented as Qdd=20000-
0.5P.
A) Calculate the price elasticity of
demand when the price per
unit is birr 10000.
B) Is it elastic or inelastic?
13
6
 Solution 1
Market demand function Qdd= 200(8-p)
Market supply function Qss= 100(2p)
Qdd= Qss
200(8-p)= 100(2p)
1600-200p=200p
1600=400p
P*= 4
Q*= 200(8-p) Q*= 100(2p)
= 200 (8-4) = 100(2 x 4 )
= 200(4) = 100 x 8
= 800 = 800
13
7
 Solution 2
a, edd =  Q . Pi
P Qi
Qdd= 20000-0.5p
derivation ∂Q =  Q = -0.5
∂p p

at Po= 10000
Q0= 20000- 0.5( 10000) = 15000
edd= /-0.5 x 10000 / = /-5 x 10 /
= /-1 /
13
8
15000 10 15
Chapter Three
THE THEORY OF
CONSUMER BEHAVIOR
 Chapter Three
Outlines
1. Consumer preference, Choice and Utility
2. Measuring Utilities
3. The Consumer Budget Line
4. Maximizations of Utilities
 THE THEORY OF CONSUMER BEHAVIOR
3.1. Consumer preference, Choice and Utility
A Consumer is an individual or a household
composed of one or more individuals consuming
a basket of goods and services.
The consumer is the basic economic unit
determining which commodities to purchase and
in what quantities.
Basket of goods and services refers to the
various types but in fixed quantities of
commodities available for consumption.
14
1
 Cont’d
Preference and Utility
 Why do consumers purchase some commodities and
not others?
People have their own unique preferences for certain
commodities over others.
 A consumer’s choice to purchase more or less of a
good or service (or not purchase) depends partly on:
 The ‘taste’ (preference) of the individual
 The relative price (income of the consumers
indicated by the cost of each good or service) of
various commodities available for purchase.
14
2
 Cont’d
 Preference: is the choice among commodities to
satisfy consumer wants.
Commodities are desired because of their ability
to satisfy wants.
Goods and services however differ in their ability
to satisfy a want.
Example: -An individual may prefer coffee to tea.
-Another person still may prefer tea to
coffee.
Both consumers are still deriving some level of

14
satisfaction by consuming the good they choose.
3
 Cont’d
 The power of a good or service that enable it to satisfy
human wants or needs is known as utility.
Utility: is the level of satisfaction that is need by
consuming a commodity or undertaking an activity.
For example:
 Bread has the power to satisfy hungers
 Water satisfy our thirsts
 Books fulfill our desire for knowledge and Skills
 A bed gives us a service for our desire to sleep
All the goods that people hold or consume possess utility.
Thus, utility is the “want satisfying power’’ of a
14
4 commodity.
 Cont…
However, this statement holds true only in relative terms
not in absolute term.
 It is relative to a person’s need.
In other words, whether a commodity possesses utility or
not depends on the person’s need of that commodity.
 All the persons need not derive utility form all
commodities.
For example: Non-smokers do not derive any utility form
cigarettes
-Men do not drive utility by consuming a Modes;
- No one in Ethiopia derives utility from eating dog’s
or donkey’s flesh, etc.
14
5
 Cont…
 The utility of a thing can be different at different
places and time.
Example: during fasting the utility that we derive from
meat is not the same as any time else.
Utility is a purely subjective concept not objective i.e.,
we cannot get the exact measure of utility derived
from consuming a commodity.
 There are two major approaches to the analysis of
consumer behavior.
Cardinal utility Approach (Neo-classical approach)
Ordinal utility approach (Indifference curve
14
6
analysis)
 3.2. Measurements of Utility
The cardinal utility Theory
The cardinal utility approach is based on early psychological
experiments and individual responses to various incentives
that led to the conclusion of quantitative (cardinal)
measurement of utility.
This theory holds that utility can be assigned cardinal
number like, 1,2,3, etc i.e.,
Utils- an util is a cardinal number like 1,2,3 etc simply
attached to utility.
Example:
The first banana consumed might yield 6 utils of satisfaction
and the second banana might yield 10 utils.
 The utility that the consumer derived from consumption of
14
7 the second banana is 4 utils higher than the first banana.
 Assumptions
1) Rationality of consumers: A Consumer has to be rational in the sense
that his/her main objective is to maximize satisfaction.
2) Utility is Cardinally measurable: The Cardinal approach holds that
utility of each commodity is measurable. The most convenient
measure is money.
3) Diminishing marginal utility (DMU): This approach introduces an
important concept called Diminishing Marginal utility. The MU of a
commodity diminishes as the consumer acquires larger quantities of it.
4) Constant MU of money: The essential feature of a standard unit of
measurement is that it must be constant.
5) Limited income: The consumer has limited money to spend on the
goods and services he/she chooses to consume; thus, choice is
expected.
6) The total utility of a basket of goods depends on the quantities of
the individual commodities.
 If there are n commodities in the bundle with quantities,
14
8
 )
Cont’d
 The total utility is
TU=f ( X , X ......X )
1 2 N
Total and Marginal Utility
 Total Utility (TU): Refers to the total amount of satisfaction or
pleasure a person derives from consuming or possessing some
specific quantities of a commodity at a particular time.
 Marginal Utility (MU: Is the additional utility obtained from
consuming an additional unit of a commodity.
 It is the extra unit of satisfaction derived as a result of the
consumption of one more unit of a commodity.
MU = TU i.e. Marginal utility is the slope of the total utility
curve. Q
While total utility generally increases as an individual consumes
more of a commodity, his/her marginal utility declines.
 Total utility comes from all units consumed while marginal utility
14comes only from the last unit consumed.
9
Law of Diminishing Marginal Utility (LDMU)
 States that as the quantity consumed of a commodity
increases per unit of time, the utility derived from
each successive unit decreases, consumption of all
other commodities remaining the same.
The highest utility that an individual can get from
consuming a particular commodity is called the
saturation point.
This point lies at the pick of the Total utility curve or
at the zero point of Marginal utility.
 Consuming more units of a commodity past the
saturation point leads to a decline in total utility.
15
0
 The relationship between total and
marginal utility is shown as following by
schedule and a graph.
The relationship between TU and MU
Units of apples Total Utility in Marginal
Consumed units Per Day Utility in Units
Daily Per Day
1 7 7
2 11 4(11-7)
3 13 2(13-11)
4 14 1(14-13)
5 14 0(14-14)
 Cont’d

15
2
 cont’d
Example: Hypothetical table showing TU and MU of
consuming Oranges ((X)

Units of
Orange (x) 0 1st 2nd 3rd 4th 5th 6th
consumed
TUX 0 util 10 16 20 utils 22 utils 22 utils 20 utils
utils utils
MUX 0 10 6 4 2 0 -2

Formula: TU x =∑MUX

Formula: MUx = TUn –

15
3
TUn-1
15
4
 Cont’d
As an individual consumer consumes more of a good per time
period, the total utility:
 first increase at an increasing rate when the MU is increasing
2nd increases at a decreasing rate when the MU starts to
decrease.
3rd reaches a maximum when the MU is zero; and thereafter
assumes a negative value.
Equilibrium of a consumer
The utility maximizing consumer reaches his/her equilibrium
position when allocation of his expenditure is such that the last
birr spent on each commodity yields the same utility.
In other words, a consumer, to maximize his/her utility, will
choose a market basket where his/her marginal utility of the last
birr spent on all commodities purchased is the same.
15
5
 Cont…
How does a consumer reach equilibrium position?
We know from our assumption that the consumer has
limited income and the utility, which he/she derives from
various commodities, is subject to diminishing returns.
We also know that the MU schedules of various
commodities may not be the same.
Some yield higher utility and others yield lower.
 A rational and utility maximizing consumer consumes
commodities in the order of their utilities by switching the
expenditure from one Commodity to the other in
accordance with their MU till he/she reaches a stage
where MU of each commodity is the same per unit of
expenditure.
15
6
 A case of One commodity (X)
 Since both money income and commodity (X)
generate utility for the consumer, he/she can either
spend his/her money on commodity X or retain it.
a utility maximizing consumer exchanges money
with the commodity.
 Therefore, the utility maximizing consumer reaches
equilibrium level of satisfaction:
When MUX=PX(MUM)
i.e.: MUX/PX(MUm)=1
Because, MUx is subject to DMU while the MUM
remains constant (the constant MUM assumption).
15
7
 The case of two commodities (X&Y)
 If the consumer consumes two commodities (X and
Y) at a time, the equilibrium analysis takes the
comparison between money and the two commodities
consumed.
By making use of similar analysis as in the above one
commodity case:
 MUx= Px(MUm), and thus, MUx/Px(MUm)=1,
and MUy=Py(MUm), and thus, MUy/Py(MUm)= 1
It follows that,
MUx/Px(MUm)=MUy/Py(MUm), but MUm is
constant and can be cancelled out from the above
15 relationship, and it becomes:
8
 Many commodities case (A, B…up to Z)
It follows from the above two-commodity case
that for more than two goods, equilibrium is
achieved when:

Where is the marginal utility of money.

 This means that the consumer reaches his
/her equilibrium when the utility derived
from each Birr spent on all commodities is
15
the same.
9
 2. The ordinal utility Approach (Indifference curve Analysis)
The ordinal utility approach holds that utility cannot be
measured absolutely; only ordering or ranking of preferences
is possible.
Assumptions:
1.Consumers are rational- they aim at maximizing their
satisfaction or utility.
2.Utility is ordinal, i.e. utility is not absolutely (cardinally)
measurable. Consumers are required only to order or rank their
preference for various bundles of commodities.
3.Preferences are complete, i.e. when consumers looked with
any two baskets of goods; a consumer can determine whether
he/she prefers basket A to basket B, B to A, or whether he/she
is indifferent between the two.
By “indifferent” we mean that a person is equally happy with
16
either basket.
0
 Cont…
5. Preferences are consistent or transitive, i.e. if the consumer prefers
market basket A to market basket B, and prefers B to C, then the
consumer also prefers A to C.
6. A commodity is good rather than bad in the sense that consumers
prefer more of a commodity to less.
When we say “Good”, we mean desirable or valuable; Bad represents
things that are not desirable.
 The Ordinalist school postulated that utility is not measurable, but
is an ordinal magnitude:
 The concept of ordinal utility is based relative or subjective
measurement of utility.
 i.e. consumers express their utility by weather the commodity
drives more or less or equal satisfaction when compared to others.
 It is practically possible for the consumers to rank commodities in
16 the order of their preference as 1 st 2nd 3rd and so on.
1
 Indifference Curves
Locus of points representing different bundles of goods,
each of which yields the same level of utility (level of
satisfaction) to the consumer.
It is the locus of points representing market basket among
which the consumer is indifferent (equally happy).
is a concept used to represent an ordinal measure of the
tastes and preferences of the consumer and to show how
he/she maximizes utility in spending income.
 A higher indifference curve refers to a higher level of
satisfaction and a lower indifference curve shows lesser
satisfaction.
The entire set of indifference curves is known as an
indifference map
Negatively sloped and convex
16
2
 Cont’d

 Indifference curves are also called iso-utility curve or

Equal utility curve.
To exemplify the indifference curve, consider a
hypothetical household consuming two commodities, X
(meat) and Y (Potatoes), which are substitutable for each
other to some extent, in consumption.
Assume this household obtains a given level of
satisfaction, in consuming given level (say, 1X and 10Y)
of meat and potatoes per day.
There are so many ways of combining X and Y in
consumption so as to give this same level of satisfaction.
Some four bundles or combinations are given below.
16
3
 Cont’d
Table 2.2 Indifference Schedule
Bundle (Combination) A B C D
1 2 4 7
Meat in kg(X)
10 6 3 1
Potatoes in kg(Y)

16
4
 Cont’d
 By transforming the indifference schedule
into graphical representation, we get an
indifference curve.

16
5
 Cont’d
The number of possible locus of points-particular
combinations or bundles of goods-which yield the same utility
to a consumer indifference curve.
Characteristics of Indifference Curves:
 Indifference curves have negative slope (downward
sloping to the right).
 Indifference curves do not intersect each other
 The further away from the origin an indifferent curve lies,
the higher the level of utility it denotes
 Indifference curves are convex to the origin.
Convexity is a reflection of decreasing marginal

16
rate of substitution,
6
 The Marginal Rate of Substitution (MRS)
The negative of the slope of an indifference
curve at any point is called the marginal rate
of substitution of the two commodities X and
Y, and
It is given by the slope of the tangent at that
point: i.e.
Slope of indifference curve = y / x dy / dx MRS
XY

16
7
 Cont’d
It refers to the amount of one commodity that an
individual is willing to give up to get an additional unit
of another good while maintaining the same level of
satisfaction or remaining on the same indifference
curve.
Measures the downward vertical distance (the amount
of y that the individual is willing to give up) per unit of
horizontal distance (i.e. per additional unit of x
required) to remain on the same indifference curve.
That is, MRSxy= - or - , because of reduction in Y, MRS is
negative. However, we multiply by negative one and
express MRS as positive value.
16
8
 3.3. The consumer Budget Line
 The budget line is a line indicating different
combinations of two goods that a consumer can
buy with a given income at a given prices.
 It Shows all possible commodity bundles
that can be purchased at given prices with a
fixed money income.
Budget Constraint is all possible
combinations of goods and services that can
be attained given current prices and limited
income.
16
9
 Cont’d
Budget Line is a graphical representation of
a consumers budget constraint
Price Ratio is the slope of the budget line,
represents the price of x in terms of good y
Size Effect is the impact of a price
change on the purchasing power of the
consumer
Slope Effect is the impact of a price change
on the relative prices of good x and y
17
0
 Cont’d
By assuming that the consumer spends all his/her
income on two goods (X and Y), we can express
the budget constraint as:
I =PXX+PYY Where,
I=consumer’s money income it will be (M, Y)
PX=price of good X
PY=price of good Y
X=quantity of good X, Y=quantity of good Y
 In the real world, it is unrealistic to assume that
there are only two commodities in existence but
17 the notion is to simplify the model.
1
 Cont’d
Suppose This means that the amount of money spent on
X plus the amount spent on Y equals the consumer’s
income.
the situation of a household with 10 Birr per day to
spend on food items, like meat at 2 Birr each and
potatoes (good y) at 1 Birr each. That is,
Example: Alternative purchase possibilities of two
goods X and Y (With income=birr 10).
Consumption
A B C D E F
Alternatives
Kgs of Meat (X) 0 1 2 3 4 5
Kgs
17
of Potatoes (Y) 10 8 6 4 2 0
2
 Effect of changes in income and price on the
budget line
A. Effects of changes in income
If the income of the consumer changes (keeping
the prices of the commodities unchanged) the
budget line also shifts (changes).
 Increase in income causes an upward (but parallel)
shift of the budget line and decreases in income cause
a downward (but parallel) shift of the budget line.
 It is important to note that the slope of the budget
line does not change when income rises or falls.
 This is because there exists a parallel shift in the
budget line as a result of change in income
17
3
 Change effects
The last type of change is when both price and
income change. Suppose the price of movies
increases from $7 to $12 and José’s budget
increases to $63. To plot the new budget line,
follow the same steps as before: Budget: $63,
Price of movies: $12, Price of T-shirts: $14.
Maximum number of movies (y-intercept):
$63/$12 = 5.25 and Maximum number of T-
shirts (x-intercept): $63/$14 = 4.50

17
4
 B. Changes in the prices
Changes in the prices of the commodities
change the position and the slope of the budget
line.
But, proportional increases or decreases in the
price of the two commodities (keeping income
unchanged) do not change the slope of the
budget line if it is in the same direction.
Nevertheless, the effects of the simultaneous
changes in and in opposite direction depend on
the strength of the changes of each of them.
17
5
 3.4. Consumer Optimum: Utility
Maximization
A rational consumer maximizes utility by trying to attain
the highest possible indifference curve, given the budget
line.
This occurs where an indifference curve is tangent to the
budget line so that the slope of the indifference curve is
equal to the slope of the budget line
Thus, the condition for constrained utility maximization,
consumer optimization, or consumer equilibrium occurs
where the consumer spends all income (i.e. he/she is on the
budget line) and
MRS XY PX / PY
17
6
Graphical configuration of consumer optimum is given by :

17
7
 Cont’d
At point ‘e’ (which represents combination X and Y)
is the most preferred position by the consumer since
he/she attains the highest level of satisfaction within
his/her reach.
And point ‘e’ is known as the point of consumer
equilibrium (consumer optimum).
This occurs at the point of tangency between the
highest possible indifference curve and the budget line.
In other words, equilibrium is established at the point
where the slope of the budget line is equal to the slope
of the indifference curve.
17
8
 Cont’d
Symbolically consumer
optimum is attained at the point
where:
PX MU X MU Y
MRS XY  , But we know  
PY PX PY
MU X PX
.......MU X PY MU Y PX ..., 
MU Y PY
17
9
 Example
A consumer consuming two commodities X and Y
has the utility function U(X.Y)=XY+2X. The
prices of the two commodities are 4 birr and 2 birr
respectively. The consumer has a total income of
60 birr to be spent on the two goods.
a. Find the utility maximizing quantities of good X

and Y.

b. Find the MRSxy, at equilibrium

18
0

c. Draw the graph

 Solution
Given Px =birr 4, Py = birr 2 and M=birr 60
with U(X.Y) = XY+2X.
60 = 4X+2Y……………………………. (1)
MUX = =
MUY = =
 = = = Y=2x-2 ………(2)
Equating the 2 equations together and solve
for both values of X and Y. then X = 8units and
Y= 14 Units at them equilibrium state.
MRSxy = = = = 2.

18
1
 Graph
The Solution will be seen on Graph like the
following

14

equilibrium is at 2

8
18
2
Chapter Four
THE THEORY OF
PRODUCTION AND
COST IN RELATION
TO AGRICULTURAL
FIRMS 18
3
 Chapter Four
Outlines
1. Concepts Of Production Behavior
2. Technique of production
3. Short Runs of Production
4. Stage of Production
5. Long Runs of Production
6. Isoquants and Isocosts 18
4
7. Return to Scales
 3.1 Concepts Of Production Behavior
A. Technique of production
How a farmer/firm combines economic
resources so as to maximize output, given the
technology?
Production Technique: is any feasible
method by which inputs can be
converted in to outputs.
Production or production process: is the
transformation of resources (inputs) in to
outputs of goods and services.
Production technology: relates inputs to
outputs- specific quantities of inputs are
required to produce any given good or service.
18
5
Output: is not only to final commodities like;
Automobiles
TV
Bread etc. but also to intermediate
products like;
Steel
Wires
Flour etc that are used in the production of
final commodities.
 Output are classified in to two as follows;
I. Final commodity is for directly use for
consumption
II. Intermediate commodity this are output
of one factory and input for other
18
6
 Output also divide in to goods and services
 Output of services are like;
 Banking
 Legal counsel
 Transportation
 Storage
 Marketing (e.g.: wholesaling)
 Medicine Usage etc.
 A firm (farmer, organization, enterprise) that
combines and organizes resources for the purpose
of producing goods and services) will use
technologically efficient production methods so as
to maximize its profit or productions.
In choosing the most appropriate technology, firms
choose the one that minimizes the cost of
18
production and maximizes outputs. 7
Techniques of production: How to produce
economics question answered by technique
of production.
There are two types of techniques of
production
1. labor-intensive technique (capital
saving)
 For a firm in an economy with a
abundant supply of inexpensive labor
but not with much capital, the optimal
method of production will be labor-
intensive technique.
 Example Textile production in Ethiopia
18
involves larger amount of labor than
8
2. Capital-intensive (Labor saving )
In the contrary, firms in an economy with
high wage rate and high labor cost have an
incentive to substitute away from labor and
use more capital.
Production Function:
shows the relationship between various
combinations of inputs and the maximum
output obtained from those combinations
with the given technologies.
The production function can expressed by
table, graph or an equation by showing the
maximum output of a commodity that can be
18
produced in specific period of time. 9
 The general mathematical representation of production
function showing units of total output as a function of units
of inputs is given by:
Q= f(L, L, K, E)
Types of inputs
 Inputs are ingredient or means of production or factors of
production.
we have two types of inputs
 Variable Inputs: are an inputs whose quantity can be
changed (Increased or decreased) during a given period of
time.
Example: Unskilled labor, raw materials, etc.
 Fixed Inputs: are an input whose quantity cannot change
during a given period of time.
Example: Highly skilled labor and capital (firms plant and
equipment)
19
i.e. the factory, buildings, Machinery, etc. 0
The Short Run and the Long Run
Productions
Short Run and the Long Run are economics conceptual
period.
It is the length of time varies from one firm to another

The short run

 Is the time period in which the quantity of at least one
input remains varies or changes.
Its time period is so short that a firm can vary the
quantity of at least one of its inputs.
The long run
 Is a time period so long that a firm can vary the
quantities of all of its inputs.
 In the long run, a firm can make a complete
19
adjustment to any change in its environment. 1
Example
 For a firm engaged in the
production of foodstuff has a short
run.
 Whereas, for a firm engaged in
the production of automobiles and
airplanes such as Toyota and
Boeing.
They will take them 50 years to
construct and install new plant.
This has a long run. 19
2
The short Run Production Function
(Production with at least one variable input)
 A firm’s short run production function describes
how the maximum attainable output varies as the
quantity of labor employed in a given production
plant varies.
Most of the time variable input is= labour with
constant K, L and, E.
The increase or decrease in total output (Q) is
represented as, a function of, depends only on, the
quantity (and of course quality) of labor (L)
available on the given time period.
Short run production function Q= f(L), Where
land, capital and technical knowledge remain fixed.
19
3
 Definition of TP, AP and MP
A. Total product (TP): TP refers to the total
quantity of output that a given input can
produce over a given period.
B. Average product (AP) –refers to output
per unit of labor input.
AP= TP/L
Average product is also called Labor
productivity. (in this case the only variable
input is labour)
It is an output per unit of labor.
C. Marginal product (MP): The marginal
product of any input is the increase in
19
(additional) to the total product that resulting
4
 MP= change in total production/change in labor input
 MP= ∆TP where ∆ signifies “change in”
∆L
 In order to determine which production technique, i.e.
which combination of inputs a firm/farm should use.
 It is necessary to consider: The Average product and
marginal product.
This is because they imply productivity– If labor
productivity is high use labor–intensive techniques
of production.
Otherwise, look for some other technology.
Both marginal product and average product of the
variable factor (i.e. labor) are derived from the total
product of the factor.
Thus, the three type of returns; total product, marginal
product, and average product are interrelated.
For this consider the following data in the table
19
5
Quantit Total Average Margina Stage of
y of Product Product l Producti
Labor (TP) in (AP) Product on
(L) quintal (MP)
0 0 - - Stage I
1 2 1 2
2 6 3 4
3 12 4 6
4 20 5 8
5 25 5 5
6 27 4.5 2 Stage II
7 28 4 1
8 28 3.5 0
9 27 3 -1 Stage III
10 20 2 -7 19
6
hypothetical graph

19
7
Properties of and relationships
between TP, AP, and MP curves
The Total product curve: starts from the
origin, rises to its maximum and then
declines.
The TP curve rises first at an increasing
rate and then at a decreasing rate until it
reaches its maximum point.
Ex From MP1-MP3 the TP is increasing with
increasing rate and from MP4 –MP7 the TP
is increasing with decreasing rate.
The marginal product curve: first rises and
reaches its maximum point known as the 19
8
  The MP, after achieving it maximum point,
declines and assumes a zero value when the TP
curve is at its maximum.
When the TP curve declines, MP becomes
negative.
 The AP curve: initially rises, attains its
maximum value, and then declines.
The point at which AP curve attains its
maximum point is known as the point of
diminishing average returns.
 Up to the highest point on the MP curve, if
additional units of labor are employed, total
product increases at an increasing rate, this is
the stage of increasing returns to labor.
 From the highest point of the MP to its zero
19
 When Marginal product is negative,
total product falls, this is the stage of
negative returns to scale.
The Law of Diminishing Marginal
Returns (LDRM)
State that as more and more
(successive) units of a variable input
(say, labor, in our case) are added to a
fixed input (say, land or capital), after
some point, the extra or marginal
product attributable to each additional
unit of the variable input (labor) gets
smaller and smaller. 20
 Assumption
The Law of Diminishing Marginal
Returns holds true only if the following
conditions are maintained.
When technology is assumed to
remain fixed (constant)
When there is at least one fixed input.
The LDMR assumes all units of the
variable input are of equal quality
The Law of Diminishing Marginal
Returns is a short run phenomenon.
20
1
 Stages of production
Stage I: The range from the origin to the
point where AP becomes maximum for the
variable input.
In this case, AP is rising to its maximum while
MP rises, reaches its pick point, and then
starts to decline.
Production In stage I are:
 The fixed input is underutilized
(underemployed)
 AP is rising (productivity is rising)
 As AP is the measure of productivity or
efficiency and since AP is rising in stage I, it
pays the firm to employ more and more labor20 2
 Example more production of wheat can be
made possible by employing successive
(additional) units of labor.
In this stage the MP of land is under utilized
and that of labor is positive.
Stage II: proceeds from the point where AP
is maximum to the point where MP is Zero.
Here, both AP and MP are declining but
remain positive.
This means that the productivity of all
workers decline.
In addition, the extra output from each
successive units of labor declines but still
20
 Resource in some extent efficiently utilized.
 Mp labor is +ve and MP of land +ve
 Increasing the output level.
 Maximum output(TP) produce.
Stage III: Ranges over the area where MP is negative.
 In this stage, total product is declining.
 Each successive units of labor brings no output but
makes TP to decline.
 This is because the fixed input (Land, in our example)
is over utilized.
 The overall labor employed does not have enough
complementary (land) to work with (on).
 It means greater output (TP) can be achieved by
decreasing workers (labor).
 It means that MP of labor is negative while that of land
20
4
is positive.
Labor is over employed and capital is over
utilized this stage is known as intensive margin.
Conclusion
 Rational producer would not produce in stage I
because excess capital for the very limited
variable input(labor).
 In stage I labor is under employed and capital is
under utilized. This stage of production is known
as extensive margin.
 Therefore, the only stage where production can
take place is the stage II where both MP labor
and AP labor
are showing positive values.
 This means that the only feasible stage of
production for a rational producer is Stage II 20
5
B. The Long Run Production Function
All resources used in Long run production
are variable.
In our previous discussion, we have kept
every other input fixed except labor.
The long run function, we will deal with
production behavior when we have two
variable input (Labor and Capital).
Assume that there are 2 variable inputs =
capital /K/ and Labor /L/.
Q= 500or Q = 500K1/2L1/2
 This Production function is the long run
production by using Isoquant and Isocosts.
20
 Isoquant
is a curve that shows the different combinations
of labor and capital inputs that yield the same
output.
In other words, an Isoquant is a graph that
shows all the possible combinations of two Inputs
(Labor and Capital) that yield the same maximum
output among which the producer is indifferent.
 An isoquant is a curve along which the
maximum achievement rate of productions
attain. 20
7
 Calculate for Q and draw the
Isoquants
Inputs Total Average Marginal
Labor Capital Produc Product Product
ts

1 1 500 1.Can we draw

IQC from this
example?
2 2 1000 2. Can we
calculate MP?
3 3 1500 3. Why and How?
4 4 2000 20
8
 Example :

Capital

20
Labor 9
Graphically

 Isoquants are combination of different level of L and

k that give the same level of output
Mathematically: Q= 500√LK Q= 500
√4*1
= 500 √3*1
= 500 *2
21
0
= 870
 Properties of Isoquants
1. An isoquant must be negatively sloped in the relevant range.
 In means that if the firm wants to reduce (increase) the quantity
of one input used in production, it must increase (reduce) the
quantity of the other input in order to continue to produce the
same level of output (remain on the same isoquant).
 Specifically, use of more capital requires the use of less of labor
and vice versa to maintain or produce the same (given) level of
output.
2. An isoquant that lies further away from the origin represents a greater
output (high level of output).
3. Isoquants cannot intersect or be tangent to each other.
This is because the point of intersection would imply two different
levels of output.
21
1
4. Isoquants are convex to the origin.
 Convexity of isoquants implies i.e. the slope
decline upward or downward in either direction.
 This follows from the fact that the two inputs
are not perfect substitutes.
5.Isoquants (production Ics) show cardinal
magnitudes Expressing in cardinal numbers.
Marginal Rate of Technical Substitution
(MRTS)
 Is the slope of an isoquant
Is the rate at which one input can be substituted
for another without changing the given output.
When output is constant. For instance , the
marginal rate of technical substitution of
capital(K) and labor( L) is the amount by which21
2
Consider the following figure on an isoquant
which define the combination of labor and
capital used in the production of Q.
K
C1 A
C2 B C

O L1 L2
 We can see from the figure the quantity of capital
decreased from OC1 to OC2 and the quantity of labor
increased from OL1 to OL2.
 The rate at which capital substitute by labor would be
the ratio of change in quantities of these units.
21
3
 forgone( given up)

i.e. MRTS Lk = OC2-OC1 = -AB = - ∆K = MPL

OL2-OL1 BC ∆L MP K
gain
gain forgone MP L =
∆TP

∆L = ∆ K = MPL/MPK
MP K=
∆TP ∆L

∆K
The absolute value of the slope of the
isoquants gives us MRTS.
21
MRTS KL = = - ∆L =MPK
4
∆K MPL
 Isocosts
To determine the combination of inputs
that will minimize the firm’s costs, one
can use the Isocost concept.
It is least cost combination of input used for
productions
The Isocost Line shows all the
alternative quantity combinations of
two inputs that the producer is able to
buy at current market prices in a given
period by fully using a given budget.
Shows the locus of input combinations
that can be purchased with a given 21
5
 B= PL* L + PK. K
or Xpx +Ypy
k=0
B= PL* L + PK. 0
B= PL* L
L= B
PL
L=0
B= PL* 0 + PK. K
B= PK* K
K= B/PK
Point on the cost line and inside the cost line are
attainable and the cost above the Isocost line are
unattainable which means the producer has no
capacity . 21
6
Ex : Tc= LPL+ KPK
K 8

birr 350

B
10 L

Suppose the unit of price of labor(PL)=

15 birr and the unit price of capital
(pk)= 25 birr, then the total cost of
labor and capital combined together
would be..
(15*10)+(8*25)= 350 21
7
B= PL* L + PK. K
(0 , B/PK ) ( B/PL , 0 )
X0 Yo X1 Y1
Slope = y1- y0/ x1- x0
=0-B/PK = -B/PK = -B*PL = -PL = PL
B/PL - 0 B/PL PK* B PK PK
Rate, change measured of cost
from
capital to labor cost

The Producer’s optimum Level (Max production

Level)
 The producers optimum point is at the
tangency of the Isoquant line and Isocost
line.
21
8
How can a firm minimize the cost of
producing any output it wishes to
produce? How can a firm maximize
the quantity of output it wishes to
produce with a given budget?
Given both the isoquant and the
Isocost curves, one can readily
determine the input combination that
will minimize the firm’s cost.
In order to minimize the cost of production,
the producer must use the input
combination that is located on the lowest
Isocost line that enables a specific quantity
21
of output to be produced. 9
 A producer in order to minimize his /her cost
of production must allocate his/her
expenditure between the two inputs in such a
way as to equalize the marginal product per
dollar of each input.
i.e. MPL = MPk
PL Pk
The producer Optimum occurs at the
tangency point of an isoquant and isocost
line.
It means, when the slope of the isoquant
(MRTSLk) equals to the slope of isocost line
(PL/PK).
Mathematically, MRTSLk (MPL/ MPk )= PL/PK
22
0
 The optimal input combination as such is thus the tangency
point.
 The movement along the isoquant from C to A, which
leaves the output unchanged, costs the producer less
(because point A is on a lower isocost than point C).
 Again, movement from B to A costs the producer less to
produce still the same output.
 Therefore, the minimum cost that the producer has to incur
so as to produce a specified level of output occurs when
the isocost is tangent to the isoquant.
22
 This tangency point is said to be the point of Producer
1
Shortly
A=B=C = 1120 = 500
I3> I2>I1 (Isocost)
Where the Isocost far from the
origin the cost of production
increase
The Expansion Path
 The equilibrium path along which
production expands as production
budget or expenditure increases is
called Expansion path. 22
2
An expansion path shows the locus of the
least cost input combinations for producing
various levels of output when input prices
remain constant. 22
3
 Returns to scales
It refer to the increase in output those results from
increasing all inputs by some proportion
(percentage).
It is change of output as the result of factor of
production (combination of input) change.
A. Constant Returns to Scale
It refers to the condition where output changes by
the same proportion as inputs.
 Ex: if input increase by 5% then the output
increase by 5% in this case, isoquants are
equidistant apart.
The size of the firm’s operation does not affect the
productivity of its inputs.
The average and marginal productivity of the firm’s
22
inputs remain constant. 4
 B. Increasing Returns to Scale
 It refers to the condition where output increases
by a larger proportion than inputs this is often
called economies of scale.
 Ex: if input increase by 5% then the output
increase > 5%.
 Isoquants get closer together (distance between
isoquants declines).
Increasing Returns to Scale can be made possible
by:
 Greater division of labor and specialization,
which enhances productivity of labor.
 Using more specialized and sophisticated
machines or equipment are more productive
than less specialized machines. 22
5
 C. Decreasing Returns to Scale
It refers to the condition where
output changes by a smaller
proportion than inputs.
Ex: if input increase by 5% then the
output increase < 5%.
 Isoquants become farther apart
(distance between isoquants
increases).
Decreasing returns to scale occurs
because as the scale of operation 22

increases, it becomes difficult to 6

 Chapter Five
Theory of cost in Agricultural
Firm

22
7
 Chapter Five
Outlines
1. Concepts of Agricultural Costs
2. Types of Agricultural Costs
3. Implications of Costs in Agricultural Sectors

18
4
 Concepts of Agricultural Costs
As we observed in the market model, the basic
factor underlying the ability and willingness of the
firm to supply a product in the market is the cost of
production.
Cost refers to the amount a firm spend on factors
of production to produce goods and services
Depending on various criteria, costs could be
classified as
 Explicit Vs Implicit costs by structure
 Privates Vs Social costs by Agriculture firms
(Actors, organizations)
 Economic Vs Accounting cost by analysis
 Fixed Vs Variable cost by input usage
22
 Short run Vs long run cost by input usage 9
 Cont’d
Explicit costs (accounting costs): are the
actual pocket expenditures of the firm to
purchases or hire the inputs it requires in
production.
Monetary payments to owners of market-supplied
resources
Payment for none owned factor of production.
Examples:
 Wages and salaries of labor
 Interest on borrowed capital
 Rent on land and buildings
 Expenditures or raw materials and semi finished
materials
 Payments made for utilities, taxes, machines etc.
23
0
 Cont’d
Implicit costs: refer to the value of the inputs
owned and used by the firm in its own production
processes.
The value of self owned or self employed inputs
must be estimated from what inputs could earn in
their best alternative uses.
Examples:
 Wages of labor rendered by the owner
/entrepreneur
 Interest on capital supplied by the owner
 Rent of land and buildings belonging the owner
 Normal profit of the entrepreneur’s is the
minimum payment needed to the entrepreneur
in the business for the entrepreneurial talent. 23
1
Short run cost
 Is expenditure incurred in the short run production process.
Long run costs
 Are costs incurred in the long run production process.
Private costs
 Are either explicit and implicit opportunity costs incurred by individuals and
firms in the process of producing goods and services
Social costs
 Are costs incurred by society as a whole.
Economic cost
 This means opportunity cost, the cost to a firm in using any input (hired or
owned) is what the input could earn in its best alternative use.
 The sum of EC and IC, (Explicit cost+ implicit cost)
Accounting cost= explicit cost
 Economic Profit (EP) = TR- TC = Economic cost and Accounting cost (TC) =Total
Revenue-Explicit cost (TC).

23
2
 Cont’d
Opportunity cost: Is the second best benefit
forgone (scarified) or best alternative forgone.
Short run costs
Short run costs are the costs over a period during
which some factors of production (usually capital
equipment and management/entrepreneurship) are
fixed.
At least it has 1 fixed cost. These costs are also
subdivided in to:
1. Totals,
2. Units or averages
3. Marginal
1. Total Costs: Total Costs are grouped in to two
Total Fixed costs (TFC) and Total Variable costs 23
(TVC) 3
 A. Total Fixed Costs (TFC)
 Are those costs do not vary with changes in output.
 They are payments for fixed inputs
 They are independent of output
• TFC= quantity of
fixed inputs * price
These include:
 Insurance premiums
of fixed inputs
Cost
 Property taxes
 Interests on borrowed capital k TFC
 Rental payment Quantity
 A portion of depreciation (wear & tear) on equipment &
buildings
 Fixed costs are associated with the very existence of the
firms plant, and therefore must be paid even the firms
output is zero.
 Hence fixed costs are unavoidable costs.
 Ex: machinery buy 20000 birr always 20000birr do not 23
4
depend of quantity or price change.
B. Total variable costs (TVC)
Costs that change with the level of
output.
This refers to the payment for variable
inputs.
TVC are dependent on the level of
outputs.
It is also called avoidable cost or
direct cost
These include
 Payment to raw materials
 Payment to Fuel
23
 5
These costs are direct costs of output because
when output increase, total variable cost
increases, when output decreases total
variable cost decrease, and when out put is
zero then total variable cost is zero.
TVC= quantity of variable inputs * price of variable inputs
Cost TVC

Quantity

C . Total cost
 It is the sum of fixed cost and variable cost at each level of
output.
 At zero levels of output, total cost is equal to the firm’s
fixed cost. 23
TC=TFC+TVC 6
The distinction between fixed and variable
cost is significant to the business manager.
Variable can be controlled or altered in the
short run by changing production levels.
Fixed costs are beyond the business
executive’, present control; they are incur in
the short run and must be paid regardless of
output level
When TP= 0, TVC= 0 TC= TFC+ 0
Cost TC TC= TFC……….TP=0
TVC

TFC
Quantity 23
7
 2. Units ( Average cost)
Unit costs are derived from the total costs
Producers are certainly interested in their
total costs.
In particular, average-cost data are more
meaning full for making comparisons with
product price, which is always stated on a
per-unit bases.
A. Average fixed cost (AFC)
Is found by dividing TFC by the level of
output.
AFC= TFC/Q Where Q is out put
Since TFC is the same regardless of 23
8
 B. Average variable cost (AVC)
Is found by dividing TVC by the level of output.
AVC= TVC/Q
As output increases by adding variable
resources, AVC declines initially, reaches
minimum, and then increases again.
AVC is a U-shaped curve.
Initially due to increasing marginal returns,
variable cost per unit (AVC) declines.
After the law of diminishing marginal returns starts
to operate, the AVC will increase.
In simpler terms, initially, at very low levels of
output production is relatively inefficient and
costly.
23
 Because the firm’s fixed plant (asset) is understaffed 9or
C. Average Total cost (ATC)
Is found by dividing total cost by output.
ATC= TC/Q = TFC +TVC/Q =AFC + AVC
3.Marginal cost (MC)
Is the additional or extra cost of producing one
more unit of output.
It measures the additional cost of inputs required
to produce each successive unit of output.
MC equals the change in TC or in TVC per unit
change in output.
MC= ∆ TC/ ∆Q
MC = ∆ (TFC+TVC)/ ∆Q
MC= ∆ (0+TVC)/ ∆Q
MC= ∆ TVC/ ∆Q 24
0
 Unit costs

MC
AC

AVC

TFC

AFC

Summary OUTPUT

 The AFC curve is a rectangular hyperbola, i.e. it approaches

both axes asymptotically because the TFC is constant
 ATC, AVC&MC curves are U-shaped, i.e. they at first
decrease reach minimum point and then increase as output
increases. This is because they all reflect the law of
diminishing returns.
 The vertical distance between ATC and AVC at any level of
24
output is AFC. 1
 Cont’d
AVC reaches its minimum before ATC
does.
This is because the continuous decline
in AFC as output increases.
The MC cuts both the AVC and ATC at
their minimum points.
The reason is MC is the change in TC for
producing an extra unit of output.
Assume that we start from the level of
n-units of output. If output increase by
one unit, MC the change in total cost 24
2
Exercise
Suppose Abebe runs a small potter firm, the hires
one helper at $12,000 per year, pays an annual
rent of Birr $5000 for his shop, and spends $20,000
per year on materials, Abebe has $40,000 of his
own funds invested in equipment which could earn
him $4000 per year alternatively invested. Abebe
has been offered $15,000 per year to work as a
potter for a competitor. He estimated his
entrepreneurial talents as worth $3000 per year.
Total annual revenue from sales is $ 72,000.
A. Calculate the accounting Cost & economic Cost
for Abebe’s pottery.
B. Calculate the accounting profit & economic profit
for Abebe’s pottery.
C. What is his decision?
24
3
Explicit cost =12000+5000+20000=$37000
Implicit cost=4000+15000+3000=$22000
Total revenue = $72000
A, I, Accounting cost= explicit cost=$37000
II, Economic cost =Explicit cost + Implicit
cost=$59000
B, I, Accounting profit=Total Revenue-Explicit cost
=$72000-$37000
=$35000
II, Economic profit=Total Revenue-Economic cost
=72000-59000
=$13000
C. By comparing the opportunity cost and economic
profit, it is possible to decide the decision of the
firm. If opportunity cost exceeds economic profit, 24
4
 Cont’d
Costs

24
 Cont’d
TR, TC, Q and Profit Relations

24
 Quiz 2 (10 pts.)
1. An individual starts a business and incurs
startup costs of $100,000. During the first
year of operation, the business earns
revenue of $120,000. This results in an
accounting profit of $20,000. However, if the
individual had stayed at her previous job,
she would have made $45,000. In this
example, the individual’s economic profit is
equal to:
A. What total revenue of the individual?
B. Calculate total costs
C. Calculate economic profit
D. Show on the graphs 24
 Quiz 2 (10 pts.)
1. An individual starts a business and
incurs startup costs of $100,000.
During the first year of operation, the
business earns revenue of $120,000.
This results in an accounting profit of
$20,000. However, if the individual had
stayed at her previous job, she would
have made $45,000. In this example,
the individual’s economic profit is
equal to:
24
8
 CHAPTER -SIX
Theory of the Firm/ Market
Structure

24
9
 Chapter Six
Outlines
1. Concepts of Market Structure
2. Types of Market Structure
3. Characteristics of Market Structure

25
0
A market is any arrangement through which
buyers and sellers exchange goods and
services.
Markets reduce transaction costs that are other than
the price of the good or service
MARKET STRUCTURES
Is market characteristics that determine the
economic environments
Based on the number of firms participating,
nature of the product and nature of entry the
general types of market are:
Perfectly competitive
Monopolistic competitive
Monopoly and 25
1
 Perfect Competitive Market
Perfect competition is a market structure
characterized by a complete absence of rivalry
among the individual firms.
Assumptions or General characteristics of
perfect competitive markets
Large numbers of sellers and buyers
Product homogeneity
Price taker
Free entry and exit of firms
Profit maximization
Equilibrium condition, MR=MC=P
It is Efficient and effective
Perfect mobility of factors of production 25
2

 Monopolistic competitive Market
General characteristics of this market
Many sellers and buyers
Differentiated or heterogeneous products
Narrow and limited price maker
Relatively easy to entry
Non-price competition with considerable
emphasis on advertising, brand names, trade
marks, copy rights, patents etc.
Equilibrium condition, MR=MC but P>MR
Inefficient
Information distributions are
Imperfect/asymmetric
25
E.g Retail trade, shops. 3
 Pure monopoly Market
It is a situation in which one company controls
an industry or provide a product or service.
Monopolies‘ profits are exceptionally high
earned by monopoly producers.
General characteristics of Pure monopoly
Market
Single or one firm
Unique with no close substitution for products
Price power is considerable or price maker is one
party
Entry is blocked
No non-price competition, mostly public relation but
not others
MR=MC but P>MR 25
4
 Oligopoly Market
 small number of sellers are participate in
economic condition without competitors.
 General characteristics of Oligopoly Market
A few firms
Standardized and Differentiated products
Price power is circumscribed by mutual
interdependence/ collusion Or price maker
Entry present with significant obstacles like
technology
Few none Price competition deals with product
differentiation
MR=MC but P>MR
Inefficient
Imperfect/asymmetry information 25
5
E.g. Automobiles, household appliances, beer
 CHAPTER- SEVEN
The Tools of Macroeconomic
Problems And Policies

25
6
 Chapter Seven
Outlines
1. Concepts on Macroeconomic
2. Tools and problems of Macroeconomics
3. Measuring National Accounts
4. Macroeconomic policies

25
7
 Concepts on Macroeconomics
Definition and objectives of
macroeconomics
Macroeconomics: is the is branches of
economics which study of behavior of
economy as a whole(deal general or
aggregate economic issue)
It examines and concerned with the
combined aggregate effects of million's
of individual choice on such variables as
national output, the overall level of
employment, the general level of price.
25
8
 Basic issues deals with macroeconomics are;
1. Aggregate price level Changes
 Inflation: decreasing the purchasing power of
money or increasing in general price level.
 Deflation: increasing the purchasing power of
money (the general price level decrease)
2. Unemployment
 Is a situation in which there is an idle labors force
that is seeking for job and has the capacity and
willingness to work.
 High employment( low unemployment): the
next major objective of economy policy is high
employment, which also requires low
unemployment
3. There is recession and depreciation 25
9
The ultimate yardstick of a country
economic success is its ability to
generate a high level of production
of economic goods and service for
its population.
GDP and GNP increment.
4. Foreign exchange policy:
To promote a proper foreign
economic policy.
Checking whether there is deficit
(trade deficit). 26
0
 2. National income accounting
Basic concepts GDP and GNP
GNP (Gross national product)
Is the total market value of all final goods and
services produced by the factor of production of
a country in a given year.
Nominal GDP and Real GDP
Nominal GDP: measures the value of output in a
given period in the price of that period (I,e. GDP
measures at current period).
The problem with nominal GDP is that the
change nominal Gross domestic product (GDP)
can be due to either a change in the production
of goods and service, or a change in price of
those goods and services. 26
1
So an increase in price will cause nominal GDP to
increase, even if production has not changed at all.
This gives a misleading picture of how well the
economy is doing.
It also makes it difficult to compare production
from year to year.
Real GDP: values of goods and services in any
given year by using the price of a set base period.
By holding using price constant, real GDP
measures only the change in production from year
to year.
Is measure that attempt to isolate changes in the
physical output in the economy b/n different
periods by valuing all goods produced in the two
periods at the same periods.
26
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Example
1972 1980
1980 Real GDP
15 bananas @ 15 c= 2.25 20 bananas @ 30c= 6 20
bananas @ 15c= 3
50 Oranges @ 18 c= 9.00 60 Oranges @ 25c= 15 60 Oranges @
18c= 10.90
Nominal GDP =11. 25 Nominal GDP = 21.00
real GDP = 13.90
1972 is the base period for calculating real GDP of 1980
Þ Used to calculate inflation ( Nominal and real GDP)
GDP deflator = Nominal GDP
Real GDP
GDP deflator = 21.00
13.90 26
3
= 1.52
Measuring (estimation) of
national income
There are three different methods,
but interrelated
A. Value added method
Intermediate goods: are goods and
services that are completely used in
the process of production
Value added: is the difference
between the value of production as
they leave that stage of production
26
4
Firm stage of production Value of sales
Value added
A sheep ranch $ 60
$ 60
B wool processor $ 100
$ 40
C suit manufacture $ 125
$ 25
D clothing whole sales $ 175
$ 50
E Retail clothes $ 250
$ 75
Total sale of Value = $ 710
$ 250
value added( total income) Use of value added in GNP
to avoid double counting
B. The expenditure Approach of national income
26 accounting
5

1. Personal consumption expenditure (C)
C- includes – expenditure goods – durable
goods, non-durable - service: e.g. payment
to lawyer, doctors etc.
2. Growth private investment (I)
Incorporate: Building – residential building -
non-residential building.
Fixed investment – expenditure on machinery
and
equipment change in inventory – the
difference b/n output produce and output
sold Inventory change= what is produce -
what is sold

26
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3.Government expenditure on goods and
services(G)
Incorporate all expenditure by federal and
regional government on produced goods.
Government transfer payments => It
could be social security
expenditure( pension).
4. Net export(NX)
The difference between value of export-
value of import (X-M)
Y= C+I+G+(NX)
Y denotes for total output( income).
26
7
 c. Income (allocation) Method
 According to the income method, total output can be
looked at in terms of the incomes generated in the
process of processing the output . All output
produced automatically generates income for the
factors that take part in the production process.
 measures the total income earned by citizens and
business in a country in one year. It consists of :
 Employee compensation
 Rent ( Land and Building)
 Interest
 Profit
GNP= wage+ Rent+ Interest+ profit
Wage- for labor income generate
Rent- owner of building
26
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Interest- for rent of machine etc
Macroeconomic policy instrument
1. Fiscal Policy
 The first instrument of macroeconomic management is
fiscal policy, which consists of setting the levels of
taxation and government expenditure to affect
macroeconomic performance.
 Expenditure :government spending for goods and services

 Government spending affects the overall levels of

spending in the economy and can thereby affect the level
of GNP.
 The other half of fiscal policy is taxation. In
macroeconomics , taxation play two key roles.
 Taxes reduce people’s incomes. By cleave households
with less spending income.
 High taxes tend to reduce their consumption spending,
lowering aggregated demand and actual GNP. 26
9
In addition, taxes help determine the
prices that businesses and individuals face
in markets and thereby affects incentives
and behavior. One important set of taxes
are those affecting the cost of investing in
capital goods.
2. Monitory Policy: the second major tool of
macroeconomic policy which comprises
the management of a nation’ central
bank. By speeding or slowing the growth
of money supply, the central bank makes
interest rates lower or higher or induces
or retards investment in houses, plant,
equipment etc. 27
0
 Business cycle and Macroeconomic policy
instruments
Concept of Business cycle
Business cycle is fluctuation of economic activities
about its long term growth trend. Inflation, growth and
unemployment are related through business cycle.
Business cycle involves features like boom, recession
and recovery.
Inflation is a general rise in price level measured
against standard level of purchasing power and it has
different methods to measure such as consumer price
index and GDP deflator.
Inflation has different causes and categorized under
three major factors (Demand pull inflation, Cost push
27 inflation and Built in inflation).
1
Core problems associated with
Inflation are:
Fixed income groups will be worse
off.
Causes wage spiral
Creates deficit on the current
account.
Mitigating measures to reduce
inflation
Reduce demand pressure
Reduce cost push pressure 27
2
 ! !! !
!! !! !
O U
K Y
A N
T H
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