Chapter One

Introduction to Economics

1.1. Definition and Scope of Economics

What is Economics?
There are two fundamental facts that provide the foundation for the field of economics: these are

1. Human or society’s material wants are unlimited.

2. Economic resources are scarce or limited in supply
But what do we mean by society’s material wants? And what do we mean that these wants are
unlimited?

By society’s material wants we mean:

I. Consumer’s (households) desire to get goods and services to satisfy their wants. Goods are
tangible things that can help a consumer to satisfy his/her wants. Automobile, chairs,
pencils, house, etc are some of the examples of goods. On the other hand, services are
intangible things from which the consumer can derive satisfaction. They have no physical
characteristics. The medical service you get from clinics, the legal service we get from a
lawyer or court, counseling service you get from guidance and counseling officer in your
school, the defense service we get from our defense forces, etc., are all considered as
services. We can think of services as intangible goods.
II. Businesses also want to have things that can assist them to produce goods or services. To
produce goods and services they need inputs like labor, land, machinery, equipment, etc.
III. The government of a country also wants to have different types of goods and services that
assist it satisfy the collective wants of its citizens. For example, it needs public schools,
public health stations, armaments, etc to educate, treat and defend it citizens. In short, by
society’s material wants we refer to the desires of consumers, businesses, and
government to get those things that help them realize their respective goals. Note that
the goal of the consumers is to get maximum satisfaction, the goal of the businesses is to
produce goods and services and get profit, and the goal of the government is to satisfy the
collective wants of its citizens.

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All of these wants are not only numerous but also multiply through time. Consider the
following example. An average Ethiopian wants to have a beautiful house, automobile, clothes,
good vacation, television set, etc. Let us take one of these goods only: television set. Twenty
years ago, an Ethiopian wants to have a black and white television set. Now he/she does not want
to have a black and white television (TV) set but a colored TV; not a colored TV as such but a
multi system stereo TV with many channels, etc. From this we can see that human wants are not
only numerous but also expand and diversify through time. Therefore, human wants are
unlimited.

What do we mean by economic resources?

By resources, we refer to anything-natural or manmade that can be used in production of goods

and services. By economic resources, we refer to the various types of labor, oil deposits,
minerals, buildings, trucks, communication facilities, etc., that can be used in the production of
goods and services. And all these resources are scarce or limited in supply.

So, on the one hand, society’s material wants are unlimited; on the other hand, economic
resources are limited. These two contradictory facts lay the foundation for the field of
economics.

Definition of Economics

Economics: is thus defined as a social science, which studies how to allocate scarce resources in
the production, distribution and consumption of goods and services so as to attain the maximum
fulfillment of society’s material wants. Economics also defined as the study of how society
manages its scarce resources.

Economics is a science of choice; this is because it is a study of how people choose scarce
productive resources to produce different commodities in an economy. Since resources are
scarce and human wants is unlimited, so that one is required to choose the best amongst the
available alternatives.

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From the above definition you understand the following points.

I. Economics is a science because it is a systematized body of knowledge about human

behavior in production, exchange and consumption of goods and services through time.
And it is constituted based on systematically collected and analyzed facts. But it is also
an art.
II. Any society faces a problem of scarcity. If economic resources are scarce, then outputs
are also limited. A society, therefore, tries to allocate its scarce resources so as to satisfy
as much society’s material wants as possible. Satisfying human material wants are the
goal of production.
III. To satisfy its competing ends, a society is forced to make choice as to what outputs to
produce, in what quantities, how to use the available resources, etc. Hence, there is a
problem of choice.

Nature of Economics

Economics is considered as science as well as art, i.e. science in terms of its methodology and
arts as in application. Hence, economics is concerned with both theoretical and practical
aspects of the economic problems which we encounter in our day to day life.

1. Economics is a science: Science is an organized branch of knowledge that analyses cause

and effect relationship between economic agents. Further, economics helps in integrating
various sciences such as mathematics, statistics, etc. to identify the relationship between
price, demand, supply and other economic factors. Also Economics is also regarded as a
science because it adopts the scientific method. The scientific method involves the following:
observation, formulating a hypothesis, collection of data, organizing or analyzing the data,
formulating laws, testing the laws and prediction on the basic of the laws.
Even though economics is often regarded as a science subject, it does not assume the same
level of precision and accuracy as any of the natural pure or physical and biology. This is

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 because economics deals with human behavior, which is very complex and changes from
time to time depending on the circumstances.
 Positive Economics: A positive science is one that studies the relationship between
two variables but does not give any value judgment, i.e. it states what was, ‘what is’
and what will be. It deals with facts about the entire economy.
 Normative Economics: As a normative science, economics passes value judgment,
i.e. ‘what ought to be’. It is concerned with economic goals and policies to attain
these goals.

2. Economics is an art: Art is a discipline that expresses the way things are to be done, so as to
achieve the desired end. Economics has various branches like production, distribution,
consumption and economics that provide general rules and laws that are capable of solving
different problems of society.

Scope of Economics

To understand the depth of economics it is better to explore the way it is organized. We have two
major divisions of economics: namely; microeconomics and macroeconomics. Both are
important in dealing with the problem of scarcity. However, under each of these two branches
we have many fields and sub-fields of economics.

1.2. Branches of Economics

This is about the subdivisions of economics. Generally, economics can be divided in to two main
branches: microeconomics and macroeconomics.

1. Microeconomics: is the part of economics whose subject matter of study is individual units,
i.e. a consumer, a household, a firm, an industry, etc. It analyses the way in which the
decisions are taken by the economic agents, concerning the allocation of the resources that

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 are limited in nature. It studies consumer behavior, product pricing, firm’s behavior and
factor pricing, etc.
In general microeconomics is concerned with the economic behavior (or action) of individual
economic units, well-defined groups of individual economic units, and how markets of
individual commodities function. These individual economic units can be a household or a
firm. It is concerned with individual economic units in an economy and their interaction. For
example, questions like how does a particular person or household maximize satisfaction,
how does a particular business enterprise strive to get maximum possible profit by producing
and selling a product, etc are studied in microeconomics.
2. Macroeconomics: it is that branch of economics which studies the entire economy, instead
of individual units, i.e. level of output, total investment, total savings, total consumption, etc.
Basically, it is the study of aggregates and averages. It analyses the economic environment
as a whole, wherein the firms, consumers, households, and governments make decisions. It
covers areas like national income, general price level, the balance of trade and balance of
payment, level of employment, level of savings and investment.

In general macroeconomics is a branch of economic analysis which deals with the economy as
a whole and sub aggregates of the economy. It does not deal with individual household, firm, or
industry. That means it does not deal with individual quantities such as output level of a firm or
industry, income level of a household or family, employment level in an industry, price of a
product, etc. Rather it deals with magnitudes such as the total output level in an economy,
national income of a country, total employment level in an economy, the general price level of
goods and services in the economy, etc. For example, in microeconomics we can study why the
price of “teff” increases or decreases in Addis Ababa. But this increase or decrease in the price
level of “teff” is not the concern of macroeconomics. Macroeconomics is rather concerned with
whether the average level of prices of goods and services in the economy as a whole is
increasing or decreasing. In short, in microeconomics we study a tree in a forest; but in
macroeconomics, we study the forest, not a tree.
The fundamental difference between micro and macroeconomics lies in the scale of study.
Further, in microeconomics, more importance is given to the determination of price, whereas
macroeconomics is concerned with the determination of income of the economy as a whole.
Nevertheless, microeconomics and macroeconomics are complementary to one another, as they

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both aimed at maximizing the welfare of the economy as a whole. From the standpoint of
microeconomics, the objective can be achieved through the best possible allocation of scarce
resources. Conversely, if we talk about macroeconomics, this goal can be attained through
the effective use of the resources of the economy.

Remember that, like macroeconomics, microeconomics also uses aggregates. For example, we
talk of the total market demand for wheat, total market demand for maize, total market supply of
wheat, total market supply of automobile, etc. In microeconomics, we aggregate over
homogeneous or identical product, but in macroeconomics, the aggregation is at the economy
level. For example, in microeconomics, we cannot aggregate the total market demand for wheat
and maize together. But in macroeconomics, we can aggregate the total of several products and
talk about the total level of outputs currently produced in a country this year.

1.3. Methods in Economics

The methodology used by economics to arrive at an understanding of economic phenomena is

similar to that is used in other social sciences and the natural sciences. It is generally referred to
as the scientific method. All sciences are based on observable and verifiable behavior, realities,
or facts. As a social science, economics examines the observable and verifiable behavior of
individuals (consumers, workers) and institutions (business, government) engaged in the
production, exchange and consumption of goods and services. But fact gathering about
economic activities and economic outcomes can be a complex process. Because the world of
reality is cluttered with millions of facts, economists must be highly selective in gathering
information. What they are looking for are regularities in the data that can give them an
understanding of economic event under investigation.

There are two methods of economic analysis known as inductive method and deductive
method.

1) Inductive Method: this is the process of deriving a principle or theory by moving from basic
facts to theories and from particular to general economic analysis. The inductive method is
based on historical data or facts which are supplemented by experiments. The data or facts

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 are collected, analyzed and finally conclusions are induced on the behavior of the object
under study.
2) A deductive Method: this method of economic analysis deals with conclusions about
economic phenomenon from certain fundamental assumptions or truths through a process of
logical arguments. The theory may agree or disagree with the real world and we should check
the validity of the theory to facts by moving from general to particular. Such conclusions are
used in theoretical interpretations of the real world again. This is the way we develop theory
by using the deductive method. This is making of generalization from general facts to
specific one.

The knowledge of economic behavior which economic principles provide can be used to
formulate policies designed to solve economic problems. In economics, the stages of facts,
principles and theories are part and parcel of positive economics and the policy stage is a
category of normative economics.

So that economics as a science has developed specialized techniques in the process of fact
finding and solving of different economic problems. Its approach in this regard is based on the
following procedures:-
A. Observation of the real world and collection of appropriate information (data)
B. Employment of appropriate and relevant statistical measures
C. Statistical analysis, hypothesis testing and formulation of theory
D. Policy designing

The above two procedures are sometimes called descriptive economics. The economist at this
stage is expected to observe the real world, gather facts about economic phenomena and refine
them. Then generalization or hypothesis about the existing phenomena will be made to make a
hypothesis. The hypothesis is, however, further analyzed using appropriate statistical measures to
test its validity. If it is proved that it is true, it will be accepted as economic principle or theory; if
not the process goes on further. Note that an economic analysis is no longer useful to society
unless it tries to solve the problems of the society. To this end, therefore, economists attempt to
devise a means for treating society’s problem, which is called policy economics.

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The above procedures can be systematically presented as follows:

1.4. Economic problems and Economic System

Economic problems (Scarcity, Choice and Opportunity cost)

Scarcity

Scarcity can be defined as a situation in which the amount of something available is insufficient
to satisfy the desire for it. Since skilled manpower, some natural resources and property
resources are scarce or limited, it follows that goods and services we can produce must also be
limited to the capacity of the limited resources.

To produce goods and services, we need resources. Resources can be divided as free resources
and economic [scarce] resources. A resource is said to be free if the amount available to a
society is greater than the amount people desire at zero price [i.e., when it is given freely]. A
resource is said to be scarce or economic resource when the amount available to a society is less
than the amount people desire at zero price.

The scarce resources are classified in to four major categories: Land, Labor, Capital and
Entrepreneurial ability. Land and Capital are property resources while labor and entrepreneurial
ability are human resources. Since scarce resources are used in production of goods or services,
they are known as factors of production. This naming is to signify that these are the factors

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which determine production of particular good or service. Economic resources or factors of
production are as follow:-

 Land: it is a property resource which includes all natural resources that are used in
production process, such as arable land, forests, mineral and oil deposits, etc. The reward
or payment for land resources is rent.
 Capital: it is also known as investment good. It is a property resource which includes all
manufactured goods used in producing other goods and services. This includes tools,
machinery, equipment, factory, storages, and transportation and distribution facilities.
The reward or payment for capital resources is interest.
 Labor: it represents physical and mental ability of a human being in production of goods
or services. This may include physical ability in road construction, an engineer’s ability
to sketch electrical installation of a building, an economist skill to conduct economic
research, etc. The reward or payment for physical and mental ability of a human being is
wage.
 Entrepreneurial Ability: it is a human resource which includes human’s talent in
organizing resources in production process. It is about those individuals who initiate in
combining factors of production to produce goods and services. The reward or payment
for entrepreneurial ability is profit.

Choice

If resources are scarce, then output would be limited. If output is limited, then we cannot satisfy
all of our wants. Thus, choice must be made. The society must make choices as to what output to
produce, in what quantities, and what output not to produce. In other words, due to the problem
of scarcity, individuals, firms and government are forced to choose as to how to use their scarce
resources and for what purpose. In short, scarcity implies choice.

Choice, in turn, implies cost, i.e., choice involves sacrifice. That means whenever choice is
made, an alternative opportunity is sacrificed. Consider that you have 10 Birr. You can use your
money to buy three loaves of bread or one ticket for a football game. The price of the ticket is 10
Birr and three loaves of bread are also worth 10 Birr. If you choose to buy three loaves of bread,
then you would forgo the ticket. It means that when you decide to have three loaves of bread, at

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the same time, you decide not to have the ticket. The cost of having three loaves of bread is,
therefore, sacrificing one football game ticket. In short, cost is the forgone opportunity. This
leads us to a new concept known as opportunity cost.

Opportunity Cost

In a world of scarcity, a decision to have more of one thing, at the same time, means a decision
to have less of another thing. The value of the next-best alternative that must be sacrificed is,
therefore, the opportunity cost of the decision.

Definition: Opportunity cost is the amount or value of the next-best alternative that must be
sacrificed or foregone in order to obtain another alternative.

Note that the opportunity cost of getting one more unit of a product is the amount or value of the
next- best alternative that is sacrificed, not the value of all alternatives. The value of the next-
best alternative is determined by the decision maker himself/herself. In the above example, the
opportunity cost of getting one more ticket is three loaves of bread.

the amount of the next best alternative given up

Opportunity cost of a good = The amount of a good gained

The Production Possibilities Frontier or Curve [PPF or PPC]

Once we understand the concept of scarcity, choice and opportunity cost, the next task is to
investigate into the production possibilities available to a society given the problem of scarcity.
The production possibilities frontier or curve (PPF or PPC) is a curve that shows the various
possible combination of two goods and services that the society can produce given its resources
and technology.

To draw the PPF we have the following assumptions.

I. Full employment and Efficiency: “the economy is operating at full employment and is
achieving full production. By full employment we mean all the available resources are used
in production of goods and services. That means there is no idle resource. All labor, capital,
land and entrepreneurial abilities available in the economy will be used in the production of
goods and services. By full production we mean that those resources should be used in a

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 way that can give us the maximum possible output level. Efficiency refers to utilization of
our resources effectively without wastage.
II. Fixed resources: the quantity or amount of resources of a given quality is fixed in supply.
That means both the quantity and quality of labor, land, capital and entrepreneurship
available in the economy remain fixed or constant. But this does not mean that we cannot
reallocate resources for different uses. For example, a farmer who is working on a farm to
produce agricultural products can be used as a soldier to give defense service [for defense].
Or, a building used as a restaurant can be used as an office.
III. Fixed technology: technology does not change for a given period of time, say for a year. The
society uses its current state of technology, i.e., the best technology it has, to produce goods
and services. And technological advancement helps a society reduce the problem of
scarcity by making its economic resources more productive. In our case, we assume that
there is no technological advancement, for the time being.
IV. Two products: for simplicity purpose, let us assume that the society is producing two goods:
say teff and tractor.

Given the above assumptions, lets we see some example:

Annual Production Possibilities of Ethiopia

Production Possibilities
Types Of Products Unit
A B C D E
Teff Tons 500,000 420,000 320,000 180,000 0
Tractor No. 0 5,000 10,000 15,000 20,000

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The country has 5 production possibilities. If the country decides to use all of its economic
resources to produce teff only, it can produce 500,000 tons of teff and 0 tractor. This is the
maximum combination of the two goods that the society can produce if it uses all the available
resources in teff production. This combination of the two products is represented by point “A” on
fig 1.1. Now consider that Ethiopia want to produce 5,000 tractors. This option requires transfer
of resources from the production of teff to that of tractor. It means that some amount of labor,
land, capital and entrepreneurial ability should be transferred from production of teff to that of
tractor. Given these resources, the economy can produce 5,000 tractors. But production of teff
declines to 420,000 tons of teff. Similarly, if the country insists to have more of tractors, it has to
divert more and more of workers, land, capital, and entrepreneurship from the agricultural sector
[teff production] to that of the industrial sector [tractor production]. This further reduces
production of teff. Thus, if the society wants to produce 10,000 tractors, the maximum teff
production declines to 320,000 tons. Finally, if the society decides to spend all of its resources to
tractors only, it can produce 20,000 tractors to the maximum but zero ton of teff. This
combination is represented by point “E”. If we put teff production on the vertical axis and
production of tractor on the horizontal axis, and draw the information given on the production
possibilities table, see table 1.1, we get a curve; and that curve is known as the production
possibility frontier or, in short, PPF or PPC. Transformation curve is another name for PPF or

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PPC. Some people perceive this process as the transformation of one good for another and hence
call it transformation curve.

The PPF describes three important concepts

i. The concept of scarcity: the curve indicates the maximum combinations of the two
goods that the society can produce given the resources and technology. Any combination
of the two outputs outside the curve is unattainable. The idea is that the society cannot
have unlimited amount of outputs even if it employs all of its resources and utilizes them
in the best possible way.
ii. The concept of Choice: any movement on the curve indicates the change in choice. For
example, compare point B and D on the above figure. If the society produces at point B,
it means that the society wants to have more teff and less of tractors. But if the society
prefers point D, it means that the society chooses to have more tractors and less teff.
iii. The concept of opportunity cost: when the economy produces on the PPF, production
of more of one good requires sacrificing some of another product. It is reflected by the
downward sloping of the PPF.
The Law of Increasing Opportunity Cost

The more we focus in transferring resource from production of one good to another good the
opportunity cost of producing the other good will increase.

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Consider that Ethiopia produces at point A, i.e., 500,000 tons of teff and no tractor. If the society
chooses to produce 5,000 more tractors, the maximum teff production decreases to 420,000 tons.
This means, to produce 5,000 more tractors, i.e., to move from point A to B, total teff production
should decrease by 80,000 tons [i.e., 500,000-420,000]

Generally, the opportunity cost of producing a good is calculated as follows:

the amount of the next best alternative given up

Opportunity cost of a good = The amount of a good gained

ΔT 420 ,000−500 , 000 −80 , 000

In our case, Opportunity cost of producing Tractors = ΔTr = 5000−0 = 5000 = 16
tons of teff per tractor.

Here T = change in production of teff

Tr = change in production of tractor

It means that to get one more tractor, the society sacrifices 16 tons of teff.

Similarly, if the society moves from point 'B' to point 'C', it gets more tractors (5000 additional
tractors) but sacrifices some amount of teff.

The opportunity cost of getting additional tractors equals

ΔT 320 , 000−420 , 000 −100 , 000

Δ Tr = 10 , 000−5000 = 5000 = 20 tons of teff per tractor.

If it moves from point "C" to "D", the opportunity cost of getting additional unit of tractor equals

ΔT 180 , 000−320 ,000 −140 , 000

ΔTr = 15 , 000−10 , 000 = 5 ,000 = 28 tons of teff per tractor.

This indicates that, as we produce more and more tractors, its opportunity cost per unit of tractor
increases. The question is why?

Initially, the society was producing teff only. This is represented by point ‘A’. But, as the society
wants to produce more tractors, resources should be diverted from teff production to tractor
production. This is due to the scarcity of resources. Initially, when the society transfers
resources, to tractor production, it will transfer the least productive inputs. As a result, the

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amount of teff the society sacrifices will be minimum. In our example, to get the first 5,000
tractors, the society sacrifices only 80,000 tons of teff or 16 tons of teff per tractor. If the society
insists to produce more tractor (to move from point B to C), the society is forced to transfer more
and more resources towards tractor production. Now, to get 5,000 additional tractors [equal
amount], more and more fertile land, specialized laborer [productive farmers], etc. should be
transferred towards tractor production. As a result the society sacrifices more teff than before
[i.e., 100,000 tons of teff or 20 tons of teff per tractor which is greater than the previous sacrifice,
16 tons per tractor]. In short, as more and more tractors are produced, its opportunity cost per
tractor increases. Graphically, it is represented as follows:

Economic Growth and the PPF

Economic growth is the increase in the real output level of an economy over time. Economic
growth or an increase in the total output level occurs when one or both of the following factors
occur.

i. Increase in the quantity or/and quality of economic resources.

ii. Advances in technology
The increase in total output is represented by an outward shift of the PPF.
In other words, economic growth is represented by outward shift of the PPF.

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Economic system

Before we deal with economic systems lets understand the three Basic Economic Questions
because economic systems are adopted to deal with these three basic economic questions these
area:-

1. What to produce?

This question involves identifying goods and services that should be produced with society’s
available resources. Or it deal with deciding which goods to produce in what quantities. This
question arises because of the scarcity of resources.

2. How to produce?

This question deals with what combination of resources and technology should be used for
producing the goods which have been decided on in response to the first question. This question
arises because any given good can be produce through various alternative methods.

3. To whom to produce?

This question in its regard involves identifying those who are going to get the produced goods or
services. It is about to whom we are going to distribute every goods and services produced.

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Answering the above three basic economic questions make possible for a society to resolve
problem of resource allocations. Different countries use different ways to answer the basic
economic questions. These ways are known as economic system.

In every country, economic systems are mainly determined by the political ideology and thus
policy of the government of a country.

Economic system: is defined as the means in which the economy of a given country is organized
and the type of resource ownership it applies in order to answer the basic economic question. Or
it is a set of organizational and institutional arrangements established to answer the basic
economic questions.

Also economic system is a system of production, resource allocation, and distribution of goods
and services within a society or a given geographic area. It includes the combination of the
various institutions, agencies, entities, decision-making processes, and patterns of consumption
that comprise the economic structure of a given community. As such, an economic system is a
type of social system. Customarily, we can identify three types of economic systems.

A. Pure capitalism (free-market economy)

B. Command economy (socialism)
C. Mixed economy

A. Pure capitalism (free-market)

This type of economy is regulated by the market prices of different commodities and services as
determined by their respective markets in which demand and supply forces interact. The
investment pattern or what we call as resource allocation is also done by the markets. In a free
market economy the basic economic problem of what, how and for whom to produce are
resolved by the market mechanism. Firms resolve the economic problem of what to produce
by producing goods and services that yield high profits. The choice of technology for the how to
produce problem is resolved based on the least-cost combination of inputs and the for whom to
produce is resolved based on the owner of the means of production. In any way, in a free market
economy, the three basic economic questions of what to produce, how to produce and for whom
to produce are conditioned and determined by the price mechanism in accordance with the theory
of the invisible hand.

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B. Command economy (socialism)

This is a form of economic system in which the means of production except labor are owned by
the state. The state, in fact owns the resources on behalf of the society as a whole. Alternatively,
we call it as public ownership or collective ownership of the resources. Both resource allocation
and pricing decisions are undertaken by a centralized planning commission. Production of goods
and services is undertaken for uses keeping in mind the needs of consumption rather than profit.
All decisions regarding production, choice of technology and distributions of national income are
determined by the government.

C. Mixed Economy

A mixed economy will have private as well as public sectors within its scope. The shortcomings
of capitalist or socialist economic systems gave rise to the evolution of a modern mixed economy
which involves both market and government participation in the allocation of economic
resources. The basic economic problems are resolved by a mixture of government decisions and
market forces of demand and supply. However, the role of the government is intermediate in a
mixed economy. Most of the world economies are mixed at present. The degree of the mixture of
the two systems differs across countries.

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 Chapter Two

Theories of Demand and Supply

The markets we will be examining are highly competitive ones, with many firms competing
against each other. In economics we call this perfect competition. This is where consumers and
producers are too numerous to have any control over prices: they are price takers.

2.1. Definition and law of demand

Quantity demanded refers to the amount that consumers are willing and able to purchase at a
given price over a given period (e.g. a week, or a month, or a year). They do not refer to what
people would simply like to consume.

The relationship between demand and price

Law of demand: the quantity of a good demanded per period of time will fall as price rises and
will rise as price falls, other things being equal (ceteris paribus).
This is due to when price rise;
 People will feel poorer. They will not be able to afford to buy so much of the good with
their money. The purchasing power of their income (their real income) has fallen. This is
called the income effect of a price rise.
 The good will now cost more than alternative or ‘substitute’ goods, and people will
switch to these. This is called the substitution effect of a price rise.
The demand curve
Consider the hypothetical data in Table 2.1, which shows how many kilograms of potatoes per
month would be purchased at various prices. Columns (2) and (3) show the demand schedules
for two individuals, Tracey and Darren. Column (4) by contrast, shows the total market demand
schedule. This is the total demand by all consumers. To obtain the market demand schedule for
potatoes, we simply add up the quantities demanded at each price by all consumers: i.e. Tracey,
Darren and everyone else who demands potatoes.
Table 2.1 the demand for potatoes (monthly)

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NB Demand schedule for an individual: a table showing the different quantities of a good that
a person is willing and able to buy at various prices over a given period of time.

Market demand schedule a table showing the different total quantities of a good that consumers
are willing and able to buy at various prices over a given period of time.

The demand schedule can be represented graphically as a demand curve. Demand curve is
graph showing the relationship between the price of a good and the quantity of the good
demanded over a given time period. Price is measured on the vertical axis; quantity demanded
is measured on the horizontal axis. A demand curve can be for an individual consumer or group
of consumers, or more usually for the whole market. It slopes downward from left to right: they
have negative slope. This indicate the lower the price of the product, the more is the person
likely to buy.

Figure 2.1 shows the market demand curve for potatoes corresponding to the schedule in Table
2.1. Point E shows that at a price of 100p per kilo, 100 000 tonnes of potatoes are demanded each
month. When the price falls to 80p we move down the curve to point D. This shows that the
quantity demanded has now risen to 200 000 tonnes per month. Similarly, if the price falls to 60p
we move down the curve again to point C: 350 000 tonnes are now demanded. The five points on
the graph (A–E) correspond to the figures in columns (1) and (4) of Table 2.1.

20
 Price (pence per kg)
Market demand for potatoes (monthly)
E
100

D
80

C
60

B
40

A
20
Demand

0
0 100 200 300 400 500 600 700 800
Quantity (tonnes: 000s)

Fig 2.1 Market demand for potatos (monthly)

2.2. Determinants of demand

Price is not the only factor that determines how much of a good people will buy. Demand is also
affected by the following.

Tastes: the more desirable people find the good, the more they will demand. Tastes are affected
by advertising, by fashion, by observing other consumers, by considerations of health and by the
experiences from consuming the good on previous occasions.

The number and price of substitute goods (i.e. competitive goods or goods considered by
consumers to be alternatives to each other e.g. Coffee & Tea): the higher the price of substitute
goods, the higher will be the demand for this good as people switch from the substitutes.

The number and price of complementary goods: Complementary goods are those that are
consumed together: cars and petrol, shoes and polish. The higher the price of complementary
goods, the fewer of them will be bought and hence the less will be the demand for this good.

Income: As people’s incomes rise, their demand for most goods will rise. Such goods are called
normal goods. There are exceptions to this general rule, however. As people get richer, they
spend less on inferior goods, such as cheap margarine, and switch to better quality goods. N.B
Normal goods Goods whose demand increases as consumer incomes increase. Inferior goods
Goods whose demand decreases as consumer incomes increase.

21
Distribution of income: If national income were redistributed from the poor to the rich, the
demand for luxury goods would rise. At the same time, as the poor got poorer they might have to
turn to buying inferior goods, whose demand would thus rise too.

Expectations of future price changes: If people think that prices are going to rise in the future,
they are likely to buy more now before the price does go up.

Movements along and shifts in the demand curve

A demand curve is constructed on the assumption that ‘other things remain equal’ (ceteris
paribus). In other words, it is assumed that none of the determinants of demand, other than price,
changes. The effect of a change in price is then simply illustrated by a movement along the
demand curve: for example, from point B to point D in Figure 2.1 when the price of potatoes
rises from 40p to 80p per kilo.

What happens, then, when one of these other determinants does change? The answer is that we
have to construct a whole new demand curve: the curve shifts. If a change in one of the other
determinants causes demand to rise – say, income rises – the whole curve will shift to the right.
This shows that at each price more will be demanded than before. Thus in Figure 2.2 at a price of
P, a quantity of Qo was originally demanded. But now, after the increase in demand, Q1 is
demanded. (Note that D1 is not necessarily parallel to D0.) If a change in a determinant other than
price causes demand to fall, the whole curve will shift to the left.

An increase in demand
Price

D0 D1

O Q0 Q1
Quantity

Fig 2.2 shift in demand curve

22
To distinguish between shifts in and movements along demand curves, it is usual to distinguish
between a change in demand and a change in the quantity demanded. A shift in the demand
curve is referred to as a change in demand, whereas a movement along the demand curve as a
result of a change in price is referred to as a change in the quantity demanded.

Demand function

We can represent the relationship between the market demand for a good and the determinants of
demand in the form of an equation. This is called a demand function. It can be expressed either
in general terms or with specific values attached to the determinants.

Simple demand functions. Demand equations are often used to relate quantity demanded to just
one determinant. Thus an equation relating quantity demanded to price could be in the form:

Qd = a - bP………………………………… (1)

For example, the actual equation might be: Qd = 10 000 - 200P

More complex demand functions. In a similar way, we can relate the quantity demanded to two
or more determinants. For example, a demand function could be of the form:

Qd = a - bP + cY + dPs - ePc………………………………….. (2)

Where Qd = quantity demanded

p = price of the good
Y= income
Ps= price of substitute good
Pc= price of complement
2.3. Definition and law of Supply

Quantity supplied is the amount of a good that sellers are willing and able to sell

Supply and price

Law of supply the claim that, other things equal, the quantity supplied of a good rises when the
price of the good rises.

There are three reasons for this:

23
  As firms supply more, they are likely to find that beyond a certain level of output, costs
rise more and more rapidly. If higher output involves higher costs of producing each unit,
producers will need to get a higher price if they are to be persuaded to produce extra
output.
 The higher the price of the good, the more profitable it becomes to produce. Firms will
thus be encouraged to produce more of it by switching from producing less profitable
goods.
 Given time, if the price of good remains high, new producers will be encouraged to set up
in production. Total market supply thus rises.
The first two determinants affect supply in the short run. The third affects supply in the long run.

The supply curve

The amount that producers would like to supply at various prices can be shown in a supply
schedule. Table 2.2 shows a monthly supply schedule for potatoes, both for an individual farmer
(farmer X) and for all farmers together (the whole market).

The supply schedule can be represented graphically as a supply curve. A supply curve may be
an individual firm’s supply curve or a market curve (i.e. that of the whole industry). Take the
same definition for supply schedule and supply curve as we defined for demand.

Table 2.2 supply of potatoes (monthly)

The supply curve:

The supply of potatoes (monthly)

Price of Farmer X's Total Market

potatoes supply supply
(pence per kg) (tonnes) (tonnes: 000s)

a 20 50 100

b 40 70 200

c 60 100 350

d 80 120 530

e 100 130 700

24
 Market supply of potatoes (monthly)
Price (pence per kg) 100 e
Supply
d
80

c
60

b
40

a
20

0
0 100 200 300 400 500 600 700 800
Quantity (tonnes: 000s)

Fig 2.3 Market supply of potatoes (monthly)

Figure 2.3 shows the market supply curve of potatoes. As with demand curves, price is plotted
on the vertical axis and quantity on the horizontal axis. Each of the points a–e corresponds to a
figure in Table 2.2. Thus, for example, as price rise from 60p per kilogram to 80p per kilogram
will cause a movement along the supply curve from point c to point d: total market supply will
rise from 350 000 tonnes per month to 530 000 tonnes per month. Not all supply curves will be
upward sloping (positively sloped). Sometimes they will be vertical, or horizontal or\ even
downward sloping. This will depend largely on the time period over which firms’ response to
price changes is considered.

2.4. Determinants of supply

Like demand, supply is not simply determined by price. The other determinants of supply are as
follows.

The costs of production: The higher the costs of production, the less profit will be made at any
price. As costs rise, firms will cut back on production, probably switching to alternative products
whose costs have not risen so much.

The profitability of alternative products (substitutes in supply): If a product which is a

substitute in supply becomes more profitable to supply than before, producers are likely to

25
switch from the first good to this alternative. Supply of the first good falls. Other goods are likely
to become more profitable if:

 Their prices rise;

 Their costs of production fall.

The profitability of goods in joint supply: Sometimes when one good is produced, another
good is also produced at the same time. These are said to be goods in joint supply. An example
is the refining of crude oil to produce petrol. Other grade fuels will be produced as well, such as
diesel and paraffin. If more petrol is produced, due to a rise in demand and hence its price, then
the supply of these other fuels will rise too.

NB Substitutes in supply These are two goods where an increased production of one means
diverting resources away from producing the other. Goods in joint supply these are two goods
where the production of more of one leads to the production of more of the other.

Nature, ‘random shocks’ and other unpredictable events: In this category we would include
the weather and diseases affecting farm output, wars affecting the supply of imported raw
materials, the breakdown of machinery, industrial disputes, earthquakes, floods and fire, etc.

The aims of producers: A profit-maximizing firm will supply a different quantity from a firm
that has a different aim, such as maximizing sales. For most of the time we shall assume that
firms are profit maximisers.

Expectations of future price changes: If price is expected to rise, producers may temporarily
reduce the amount they sell. Instead they are likely to build up their stocks and only release them
on to the market when the price does rise. At the same time they may install new machines or
take on more labour, so that they can be ready to supply more when the price has risen.

The number of suppliers: If new firms enter the market, supply is likely to increase.

Movements along and shifts in the supply curve

The principle here is the same as with demand curves. The effect of a change in price is
illustrated by a movement along the supply curve: for example, from point d to point e in Figure

26
2.3 when price rises from 80p to 100p. Quantity supplied rises from 530 000 to 700 000 tonnes
per month.

If any other determinant of supply changes, the whole supply curve will shift. A rightward shift
illustrates an increase in supply. A leftward shift illustrates a decrease in supply. Thus in Figure
2.4, if the original curve is S0, the curve S1 represents an increase in supply (more is supplied at
each price), whereas the curve S2 represents a decrease in supply (less is supplied at each price).

Shifts in the supply curve

P
S2 S0 S1

Decrease Increase

O Q

Fig 2.4 shifts in supply

A movement along a supply curve is often referred to as a change in the quantity supplied,
whereas a shift in the supply curve is simply referred to as a change in supply.

Supply function

The simplest form of supply equation relates supply to just one determinant. Thus a function
relating supply to price would be of the form:
Qs = c +dP…………………………………………………… (1)
Thus an actual supply equation might be something like:
Qs = 500 + 1000P (2)
? Draw the schedule (table) and graph for equation (2) for prices from £1 to £10. What is it in the
equation that determines the slope of the supply ‘curve’?
More complex supply equations would relate supply to more than one determinant.

27
Qs = c+ dP –e a1 –f a2 + gj……………………………..……. (2)
Where P is the price of the good, a1 and a2 are the profitabilities of two alternative goods that
could be supplied instead, and j is the profitability of a good in joint supply.
? Explain why the P and j terms have a positive sign, whereas the a1 and a2 terms have a negative
sign.

2.5. Market equilibrium approaches

Equilibrium price and output

We can now combine our analysis of demand and supply. This will show how the actual price of
a product and the actual quantity bought and sold are determined in a free and competitive
market.

Equilibrium is the point where conflicting interests are balanced. Only at this point is the
amount that demanders are willing to purchase the same as the amount that suppliers are willing
to supply. It is a point that will be automatically reached in a free market through the operation
of the price mechanism. The price where demand equals supply is called the equilibrium price
and the quantity where demand equals supply is called the equilibrium quantity.

Let us return to the example of the market demand and market supply of potatoes, and use the
data from Tables 2.1 and 2.2. These figures are given again in Table 2.5.

Table 2.5. The market demand and supply of potatoes (monthly)

28
 Equilibrium price and output :
The Market Demand and Supply of Potatoes (Monthly)

Price of Potatoes Total Market Demand Total Market Supply

(pence per kilo) (Tonnes: 000s) (Tonnes: 000s)

20 700 (A) 100 (a)

40 500 (B) 200 (b)
60 350 (C) 350 (c)
80 200 (D) 530 (d)
100 100 (E) 700 (e)

PRICE AND OUTPUT DETERMINATION

The determination of market equilibrium

(potatoes: monthly)
E e
100
Price (pence per kg)

Supply
D SURPLUS d
80
(330 000)

60

b SHORTAGE B
40
(300 000)
a A
20

Demand
0
0 100 200 300 Qe 400 500 600 700 800
Quantity (tonnes: 000s)

Fig 2.5 The determination of market equilibrium (potatoes: monthly)

The determination of equilibrium price and output can be shown using demand and supply
curves. Equilibrium is where the two curves intersect. Figure 2.5 shows the demand and supply
curves of potatoes corresponding to the data in Table 2.3. Equilibrium price is Pe (60p) and
equilibrium quantity is Qe (350 000 tonnes).

At any price above 60p, there would be a surplus. Thus at 80p there is a surplus of 330 000
tonnes (d - D). More is supplied than consumers are willing and able to purchase at that price.
Thus a price of 80p fails to clear the market. Price will fall to the equilibrium price of 60p. As it

29
does so, there will be a movement along the demand curve from point D to point C, and a
movement along the supply curve from point d to point c.

At any price below 60p, there would be a shortage. Thus at 40p there is a shortage of 300 000
tonnes (B - b). Price will rise to 60p. This will cause a movement along the supply curve from
point b to point c and along the demand curve from point B to point C. Point Cc is the
equilibrium: where demand equals supply.

In fact, only one price is sustainable – the price where demand equals supply: namely, 60p per
kilogram, where both demand and supply are 350 000 tonnes. When supply matches demand the
market is said to clear. There is no shortage and no surplus.

Movement to a new equilibrium

The equilibrium price will remain unchanged only so long as the demand and supply curves
remain unchanged. If either of the curves shifts, a new equilibrium will be formed.

A change in demand

If one of the determinants of demand changes (other than price), the whole demand curve will
shift. This will lead to a movement along the supply curve to the new intersection point.

For example, in Figure 2.6, if a rise in consumer incomes led to the demand curve shifting to D2,
there would be a shortage of h - g at the original price Pe1. This would cause price to rise to the
new equilibrium Pe2. As it did so, there would be a movement along the supply curve from point
g to point i, and along the new demand curve (D2) from point h to point i. Equilibrium quantity
would rise from Qe1 to Qe2. The effect of the shift in demand, therefore, has been a movement
along the supply curve from the old equilibrium to the new: from point g to point i.

? What would happen to price and quantity if the demand curve shifted to the left? Draw a
diagram to illustrate your answer.

30
 Effect of a shift in the demand curve
P
S

i New equilibrium at
Pe2 point i

g h
Pe1

D2
D1
O Qe1 Qe2 Q

Fig 2.6 Effect of a shift in the demand curve

A change in supply

Likewise, if one of the determinants of supply changes (other than price), the whole supply curve
will shift. This will lead to a movement along the demand curve to the new intersection point.

For example, in Figure 2.7, if costs of production rose, the supply curve would shift to the left: to
S2. There would be a shortage of g - j at the old price of Pe1. Price would rise from Pe1 to Pe3.
Quantity would fall from Qe1 to Qe3. In other words, there would be a movement along the
demand curve from point g to point k, and along the new supply curve (S2) from point j to point
k.

Effect of a shift in the supply curve

P
S2

S1

k
Pe
3

j g New equilibrium at
Pe point k
1

D
O Qe3 Qe1 Q

Fig 2.7 Effect of a shift in the supply curve

31
To summarize: a shift in one curve leads to a movement along the other curve to the new
intersection point. Sometimes a number of determinants might change. This might lead to a shift
in both curves. When this happens, equilibrium simply moves from the point where the old
curves intersected to the point where the new ones intersect.

2.6. Elasticities of demand and supply

Price elasticity of demand

When the price of a good rises, the quantity demanded will fall. That much is fairly obvious. But
in most cases we will want to know more than this. We will want to know by just how much the
quantity demanded will fall. In other words, we will want to know how responsive demand is to
a rise in price.

We call the responsiveness of demand to a change in price the price elasticity of demand if we
know the price elasticity of demand for a product, we can predict the effect on price and quantity
of a shift in the supply curve for that product.

Figure 2.10 shows the effect of a shift in supply with two quite different demand curves (D and
D’). Curve D’ is more elastic than curve D over any given price range. In other words, for any
given change in price, there will be a larger change in quantity demanded along curve D’ than
along curve D.

Market supply and demand

S2
S1

b
Price

P2

c
P3
a
P1
D'

D
O Q3 Q2 Q1
Quantity

Fig 2.10 Market supply and demand

Assume that initially the supply curve is S1, and that it intersects with both demand curves at
point a, at a price of P1 and a quantity of Q1. Now supply shifts to S2. What will happen to price

32
and quantity? In the case of the less elastic demand curve D, there is a relatively large rise in
price (to P2) and a relatively small fall in quantity (to Q2): equilibrium is at point b. In the case of
the more elastic demand curve D′, however, there is only a relatively small rise in price (to P3),
but a relatively large fall in quantity (to Q3): equilibrium is at point c.

Measuring the price elasticity of demand

What we want to compare is the size of the change in quantity demanded with the size of the
change in price. But since price and quantity are measured in different units, the only sensible
way we can do this is to use percentage or proportionate changes. This gives us the following
formula for the price elasticity of demand (PεD) for a product: percentage (or proportionate)
change in quantity demanded divided by the percentage (or proportionate) change in price.
%Q D
Putting this in symbols gives: PεD =
%Δ P

Where ε (the Greek epsilon) is the symbol we use for elasticity, and  (the capital Greek delta) is
the symbol we use for a ‘change in’. e.g. Thus if a 40 per cent rise in the price of oil caused the
quantity demanded to fall by a mere 10 per cent, the price elasticity of oil over this range will be:
-10%/40% = 0.25

Interpreting the figure for elasticity

The sign (positive or negative) indicates as p and Qd are negatively related.

The value (greater or less than 1)
If we now ignore the negative sign and just concentrate on the value of the figure, this tells us
whether demand is elastic or inelastic.
Elastic (ε > 1). This is where a change in price causes a proportionately larger change in the
quantity demanded. In this case the value of elasticity will be greater than 1, since we are
dividing a larger figure by a smaller figure.
Inelastic (ε < 1). This is where a change in a price causes a proportionately smaller change in the
quantity demanded. In this case elasticity will be less than 1, since we are dividing a smaller
figure by a larger figure.

33
Unit elastic (ε = 1). Unit elasticity of demand occurs where price and quantity demanded change
by the same proportion. This will give elasticity equal to 1, since we are dividing a figure by
itself.
Determinants of price elasticity of demand

The price elasticity of demand varies enormously from one product to another. But why do some
products have a highly elastic demand, whereas others have a highly inelastic demand? What
determines price elasticity of demand?

The number and closeness of substitute goods: This is the most important determinant. The
more substitutes there are for a good, and the closer they are, the more will people switch to
these alternatives when the price of the good rises: the greater, therefore, will be the price
elasticity of demand.

The proportion of income spent on the good: The higher the proportion of our income we
spend on a good, the more we will be forced to cut consumption when its price rises: the bigger
will be the income effect and the more elastic will be the demand. E.g. demand for salt and car.

The time period: When price rises, people may take a time to adjust their consumption patterns
and find alternatives. The longer the time period after a price change, then, the more elastic is the
demand likely to be.

Special cases

Figure 2.13 shows three special cases: (a) a totally inelastic demand (PεD = 0), (b) an infinitely
elastic demand (PεD = -) and (c) a unit elastic demand (PεD = -1).

Totally inelastic demand. This is shown by a vertical straight line. No matter what happens to
price, quantity demanded remains the same.

Infinitely elastic demand. This is shown by a horizontal straight line. At any price above P1 in
Figure 2.13(b), demand is zero. But at P1 (or any price below) demand is ‘infinitely’ large.

Unit elastic demand. This is where price and quantity change in exactly the same proportion.
Any rise in price will be exactly offset by a fall in quantity.

34
 Totally inelastic demand (PD
D = 0)
P
D

P2

P1

O Q1 Q

Fig. 13 (a) Totally inelastic demand (PεD = 0)

D = - )
Infinitely elastic demand (PD
P

P1 D

O Q1 Q2 Q

(b) Infinitely elastic demand (PεD = )

Unit elastic demand (PD
D = –1)
P

20

8
D

O 40 100 Q

(c) Unit elastic demand (PεD = –1)

The measurement of elasticity: arc elasticity

We have defined price elasticity as the percentage or proportionate change in quantity demanded
divided by the percentage or proportionate change in price. But how, in practice, do we measure
these changes for a specific demand curve? We shall examine two methods. The first is called
the arc method. The second is called the point method.

A common mistake that students make is to think that you can talk about the elasticity of a whole
curve. The mistake here is that in most cases the elasticity will vary along the length of the curve.

35
Take the case of the demand curve illustrated in Figure 2.14. Between points a and b demand is
elastic. Between points b and c, however, demand is inelastic.

Different elasticities along different portions of a demand curve

P
Elastic
a
demand
P1

b Inelastic
P2 demand

c
P3
D

O Q1 Q2 Q3 Q

Fig 2.14 Different elasticities along different portions of a demand curve

Normally, then, we can only refer to the elasticity of a portion of the demand curve, not of the
whole curve. There are, however, two exceptions to this rule. The first is when the elasticity just
so happens to be the same all the way along a curve, as in the three special cases illustrated in
Figure 2.13. The second is where two curves are drawn on the same diagram, as in Figure 2.10.
Here we can say that demand curve D is less elastic than demand curve D′ at any given price.
Note, however, that each of these two curves will still have different elasticities along its length.

Although we cannot normally talk about the elasticity of a whole curve, we can nevertheless talk
about the elasticity between any two points on it. This is known as arc elasticity. In fact the
formula for price elasticity of demand that we have used so far is the formula for arc elasticity.
Let us examine it more closely. Remember the formula we used was:

Proportionate ΔQ / Proportionate ΔP (where Δ means ‘change in’)

The way we measure a proportionate change in quantity is to divide that change by the level of
Q: i.e. ΔQ/Q. Similarly, we measure a proportionate change in price by dividing that change by
the level of P: i.e. ΔP/P. Price elasticity of demand can thus now be rewritten as: ΔQ/Q÷ΔP/P.
But just what value do we give to P and Q?

Consider the demand curve in Figure 2.15. What is the elasticity of demand between points m
and n? Price has fallen by £2 (from £8 to £6), but what is the proportionate change? Is it −2/8 or

36
−2/6? The convention is to express the change as a proportion of the average of the two prices,
£8 and £6: in other words, to take the midpoint price, £7. Thus the proportionate change is −2/7.

Measuring elasticity using the arc method

10
Q P
P d = 
mid Q mid P
m
8 10 2
= 
15 7
7 P = –2 = 10/15 x 7/2
n
6 = 70/30
Q = 10 = 7/3 = 2.33
P (£) Mid P
4

2 Demand

0
0 10 15 20 30 40 50
Mid Q Q (000s)

Fig 15 Measuring elasticity using the arc method

Similarly, the proportionate change in quantity between points m and n is 10/15, since 15 is
midway between 10 and 20. Thus using the average (or ‘midpoint’) formula, elasticity between
m and n is given by: ΔQ/ average Q ÷ ΔP/ average P = 10/15 ÷ −2/7 = −2.33. Since 2.33 is
greater than 1, demand is elastic between m and n.

? Referring to Figure 2.15, use the midpoint formula to calculate the price elasticity of demand
between (a) P = 6 and P = 4; (b) P = 4 and P = 2. What do you conclude about the elasticity of a
straight-line demand curve as you move down it?

Point elasticity

Rather than measuring elasticity between two points on a demand curve, we may want to
measure it at a single point: for example, point r in Figure 2.16.

Measuring elasticity at a point

50
P d = (1 / slope) x P/Q

= 100/50 x 30/40
= 60/40
=  1.5
r
30
P

0 40 100
Q

Fig 2.16 Measuring elasticity at a point

37
In order to measure point elasticity we must first rearrange the terms in the formula

Q/Q ÷ P/P. By doing so we can rewrite the formula for price elasticity of demand as:

ΔQ/ΔP  P/ Q

Since we want to measure price elasticity at a point on the demand curve, rather than between
two points, it is necessary to know how quantity demanded would react to an infinitesimally
small change in price. In the case of point r in Figure 2.16, we want to know how the quantity
demanded would react to an infinitesimally small change from a price of 30. An infinitesimally
small change is signified by the letter d. The formula for price elasticity of demand thus
becomes:

dQ/ dP P/ Q

dQ/dP is the differential calculus term for the rate of change of quantity with respect to a change
in price. And conversely, dP/dQ is the rate of change of price with respect to a change in
quantity demanded. At any given point on the demand curve, dP/dQ is given by the slope of the
curve (its rate of change). The slope is found by drawing a tangent to the curve at that point and
finding the slope of the tangent. The tangent to the demand curve at point r is shown in Figure
2.16. Its slope is -50/100. dP/dQ is thus -50/100 and dQ/dP is the inverse of this, -100/50 = -2.
Returning to the formula dQ/dP  P/Q, elasticity at point r equals: -2  30/40 = -1.5

Rather than having to draw the graph and measure the slope of the tangent, the technique of
differentiation can be used to work out point elasticity as long as the equation for the demand
curve is known.

Price elasticity of supply (Pεs)

Price elasticity of supply The responsiveness of quantity supplied to a change in price. Figure
2.17 shows two supply curves. Curve S2 is more elastic between any two prices than curve S1.
Thus, when price rises from P1 to P2 there is a larger increase in quantity supplied with S2
(namely, Q1 to Q3) than there is with S1 (namely, Q1 to Q2). For any shift in the demand curve
there will be a larger change in quantity supplied and a smaller change in price with curve S2 than

38
with curve S1. Thus the effect on price and quantity of a shift in the demand curve will depend on
the price elasticity of supply.

S1
P
S2

P2
P1

Q1 Q2 Q3 Q

Fig 2.17 Two supply curves with different price elasticities of supply

The formula for the price elasticity of supply (Pεs) is: the percentage (or proportionate) change
in quantity supplied divided by the percentage (or proportionate) change in price. Putting this in
%Q s
symbols gives: Pεs =
%Δ P

In other words, the formula is identical to that for the price elasticity of demand, except that
quantity in this case is quantity supplied. Thus if a 10 per cent rise in price caused a 25 per cent
rise in the quantity supplied, the price elasticity of supply would be: 25%/10% = 2.5 (elastic)
Notice that, unlike the price elasticity of demand, the figure is positive. This is because price and
quantity supplied change in the same direction.

Determinants of price elasticity of supply

The amount that costs rise as output rises. The less the additional costs of producing additional
output, the more firms will be encouraged to produce for a given price rise: the more elastic will
supply be.

39
Time period: Immediate time period. Firms are unlikely to be able to increase supply by much
immediately. Supply is virtually fixed, or can only vary according to available stocks. Supply is
highly inelastic. Short run if a slightly longer period of time is allowed to elapse, some inputs
can be increased (e.g. raw materials) while others will remain fixed (e.g. heavy machinery).
Supply can increase somewhat. Long run in the long run, there will be sufficient time for all
inputs to be increased and for new firms to enter the industry. Supply, therefore, is likely to be
highly elastic.

The measurement of price elasticity of supply

A vertical supply has zero elasticity. It is totally unresponsive to a change in price. A horizontal
supply curve has infinite elasticity. There is no limit to the amount supplied at the price where
the curve crosses the vertical axis. When two supply curves cross, the steeper one will have the
lower price elasticity of supply (e.g. curve S1 in Figure 2.17). Any straight-line supply curve
starting at the origin, however, will have an elasticity equal to 1 throughout its length,
irrespective of its slope. This demonstrates nicely that it is not the slope of a curve that
determines its elasticity, but its proportionate change.

Other supply curves’ elasticities will vary along their length. In such cases we have to refer to the
elasticity either between two points on the curve, or at a specific point. Calculating elasticity
between two points will involve the arc method. Calculating elasticity at a point will involve the
point method. These two methods are just the same for supply curves as for demand curves: the
formulae are the same, only the term Q now refers to quantity supplied rather than quantity
demanded.

Income elasticity of demand (YεD)

In practice there are just two other elasticities that are particularly useful to us, and both are
demand elasticities. The first is the income elasticity of demand (YεD). This measures the
responsiveness of demand to a change in consumer incomes (Y). It enables us to predict how
much the demand curve will shift for a given change in income. The formula for the income
elasticity of demand is: the percentage (or proportionate) change in demand divided by the
percentage (or proportionate) change in income. Putting this in symbols gives:

40
 %Q D
YεD =
%ΔY

Thus if a 2 per cent rise in income caused an 8 per cent rise in a product’s demand, then its
income elasticity of demand would be: 8%/2% = 4

The major determinant of income elasticity of demand is the degree of ‘necessity’ of the good. In
a developing country, the demand for normal goods expands rapidly as people’s incomes rise,
whereas the demand for inferior goods fall. Thus items such as meat and TV have a high income
elasticity of demand, whereas items such as vegetables and radio have a low income elasticity of
demand. Unlike normal goods, which have a positive income elasticity of demand, inferior
goods have a negative income elasticity of demand.

Cross-price elasticity of demand (CεDAB)

It is a measure of the responsiveness of demand for one product to a change in the price of
another (either a substitute or a complement). It enables us to predict how much the demand
curve for the first product will shift when the price of the second product changes. The formula
for the cross-price elasticity of demand (CεDAB) is: the percentage (or proportionate) change in
demand for good A divided by the percentage (or proportionate) change in price of good B.
% Q DA
Putting this in symbols gives: CεD AB=
%Δ PB

If good B is a substitute for good A, A’s demand will rise as B’s price rises. In this case, cross
elasticity will be a positive figure. For example, if the demand for butter rose by 2 per cent when
the price of margarine (a substitute) rose by 8 per cent, then the cross elasticity of demand for
butter with respect to margarine would be: 2%/8% = 0.25

If good B is complementary to good A, however, A’s demand will fall as B’s price rises and thus
as the quantity of B demanded falls. In this case, cross elasticity of demand will be a negative
figure. For example, if a 4 per cent rise in the price of bread led to a 3 per cent fall in demand for
butter, the cross elasticity of demand for butter with respect to bread would be: -3%/4% = -0.75

The major determinant of cross elasticity of demand is the closeness of the substitute or
complement. The closer it is, the bigger will be the effect on the first good of a change in the

41
price of the substitute or complement, and hence the greater the cross elasticity – either positive
or negative.

Firms need to know the cross elasticity of demand for their product when considering the effect
on the demand for their product of a change in the price of a rival’s product or of a
complementary product. These are vital pieces of information for firms when making their
production plans.

Chapter Three

Theory of Utility and Consumer Behavior

3.1. Definition of Utility

Meaning of utility

Utility is the level of satisfaction/pleasure that the consumer can derive from consumption of
goods and services or by undertaking a certain activity. Utility means the power of a good to
satisfy a want. Any commodity or service which can satisfy a human want is said to have utility.
Utility is subjective, not objective. Utility resides in the mind of consumer. The consumer knows
it by introspection.

3.2. Axioms of consumer preferences and consumer behavior

Before looking at what the theory of consumer behavior is all about, let’s first see what a
consumer is.
A consumer is an individual or a household who uses/consumes final goods and services with a
primary objective of maximizing utility.

The theory of consumer behavior is a description of how consumers allocate income among
different goods and services to maximize their well-being. It answers the question: “How can a
consumer with a limited income decide which goods and services to buy with the objective of
maximizing their utility?” It deals with how consumers allocate their income across various
goods and services and explain how these allocation decisions determine the demands for the
various goods and services.

42
The problem of a consumer consists of things: (a) the object, (b) the constraints, and (c) the
decision variable. The object of a consumer is to maximize his total utility (satisfaction). He
always tries to perform those economic activities which add to his total satisfaction. The
constraints are the limited means. A consumer is unable to satisfy all of his wants from his given
income. Thus, his decision variable is the quantity purchased of various commodities. He is to
follow a law which enables him to attain maximum satisfaction. Two approaches have been
developed to deal with the problem of a consumer: (1) the cardinal utility approach ( marginal
utility approach) and (2) the ordinal utility approach (the indifference approach).

3.3. Methods of measuring utility

There are two basic approaches for measuring utilities. These methods are the Cardinalist
approach and the Ordinalist approach.

There are two views on the question whether utility can be measured. Some economists (ordinal
utility advocators) are of the opinion that utility cannot be measured in quantitative terms.
According to them, utility is a subjective concept. The mental attitude on which utility depends
differs from person to person. For the same consumers it differs from time to time. Other
(cardinal utility advocators) are of the opinion that it is possible to measure utility indirectly by
finding out how much a consumer is prepared to scarify in order to get one unit of a certain
commodity. An indirect measure for utility is “the price which a person is willing to pay for the
fulfillment or satisfaction of his desire or want.” Higher the price paid by a consumer for a
commodity higher shall be its utility and vise versa. Price can, thus, be a measure of the utility of
a commodity. The unit of measurement for utility is called ‘util’.

3.4. Total Utility and Marginal Utility

Total and marginal utility

Total utility (TU) is the total satisfaction a person gains from all those units of a commodity
consumed within a given time period. Thus if Tracey drank 10 cups of tea a day, her daily total
utility from tea would be the satisfaction derived from those 10 cups.

43
Marginal utility (MU) is the additional satisfaction gained from consuming one extra unit
within a given period of time. Thus we might refer to the marginal utility that Tracey gains from
her third cup of tea of the day or her eleventh cup.

Diminishing marginal utility

Up to a point, the more of a commodity you consume, the greater will be your total utility.
However, as you become more satisfied, each extra unit that you consume will probably give
you less additional utility than previous units. In other words, your marginal utility falls, the
more you consume. This is known as the principle of diminishing marginal utility. For example,
the second cup of tea in the morning gives you less additional satisfaction than the first cup. The
third cup gives less satisfaction still. At some level of consumption, your total utility will be at a
maximum. No extra satisfaction can be gained by the consumption of further units within that
period of time. Thus marginal utility will be zero. Your desire for tea may be fully satisfied at 12
cups per day. A thirteenth cup will yield no extra utility. It may even give you displeasure (i.e.
negative marginal utility).

Total and marginal utility curves

If we could measure utility, we could construct a table showing how much total and marginal
utility a person would gain at different levels of consumption of a particular commodity. This
information could then be transferred to a graph. Table 2.4 and Figure 2.20 do just this. They
show the imaginary utility that Darren gets from consuming packets of crisps.

44
 Darren’s utility from consuming crisps (daily)
16

14 TU
Table 2.4
12 TU =2
Packets TU MU
Utility (utils)

of crisps in utils in utils

10 Q = 1
0 0 -
8 1 7 7
2 11 4
6
MU = TU / Q 3 13 2
4 14 1
5 14 0
4 6 13 -1

0
0 1 2 3 4 5 6
-2 MU
Packets of crisps consumed (per day)

Fig 2.20 Darren’s utility from consuming crisps (daily)

Notice the following points about the two curves:

 The MU curve slopes downwards. This is simply illustrating the principle of diminishing
marginal utility.
 The TU curve starts at the origin. Zero consumption yields zero utility.
 It reaches a peak when marginal utility is zero. When marginal utility is zero (at 5 packets
of crisps), there is no addition to total utility. Total utility must be at the maximum – the
peak of the curve.
 Marginal utility can be derived from the TU curve. It is the slope of the line joining two
adjacent quantities on the curve. For example, the marginal utility of the third packet of
crisps is the slope of the line joining points a and b. The slope of such a line is given by
the formula:
ΔTU / ΔQ (= MU)
In our example ΔTU = 2 (total utility has risen from 11 to 13 utils), and ΔQ = 1 (one more
packet of crisps has been consumed). Thus MU = 2.

45
3.5. Indifference curves and Budget constraint

Indifference Analysis

Even though the multi-commodity version of marginal utility theory is useful in demonstrating
the underlying logic of consumer choice, it still has a major weakness. Utility cannot be
measured in any absolute sense. We cannot really say, therefore, by how much the marginal
utility of one good exceeds another.

An alternative approach is to use indifference analysis. This does not involve measuring the
amount of utility a person gains, but merely ranking various combinations of goods in order of
preference. In other words, it assumes that consumers can decide whether they prefer one
combination of goods to another. The aim of indifference analysis, then, is to analyze, without
having to measure utility, how a rational consumer chooses between two goods. Indifference
analysis involves the use of indifference curves and budget lines.

Indifference curves

An indifference curve shows all the various combinations of two goods that give an equal
amount of satisfaction or utility to a consumer. The table below is known as an indifference set.
It shows alternative combinations of two goods that yield the same level of satisfaction. From
this we can plot an indifference curve. The curve shows that Clive is indifferent as to whether he
consumes 30 pears and 6 oranges (point a) or 24 pears and 7 oranges (point b) or any other
combination of pears and oranges along the curve.

An indifference curve
30 a
28 MRS = 6
Table 2.5
Y = 6
26 Pears Oranges Point
b 30 6 a
24
24 7 b
22
X = 1 20 8 c
c
Pears

20 14 10 d
18 10 13 e
8 15 f
16
d 6 20 g
14
12
e MRS = 1
10
Y = 2 f
8
6 X = 2 g
4
2
0
0 2 4 6 8 10 12 14 16 18 20 22
Oranges

Fig 2.22 An indifference curve

46
The shape of the indifference curve

Indifference curve is bowed in towards the origin. In other words, its slope gets shallower as we
move down the curve. The slope of the curve shows the rate at which the consumer is willing to
exchange one good for the other, holding his or her level of satisfaction the same. For example,
consider the move from point a to point b in Figure 2.22. Clive gives up 6 units of pears and
requires 1 orange to compensate for the loss. The slope of the indifference curve is thus - 6/1 = -
6. Ignoring the negative sign, the slope of the indifference curve (that is, the rate at which the
consumer is willing to substitute one good for the other) is known as the marginal rate of
substitution (MRS). In this case, therefore, the MRS = 6.

Note that as we move down the curve, the marginal rate of substitution diminishes as the slope of
the curve gets less. For example, look at the move from point e to point f. Here the consumer
gives up 2 pears and requires 2 oranges to compensate. Thus along this section of the curve, the
slope is −2/2 = −1 (and hence the MRS = 1). The reason for a diminishing marginal rate of
substitution(The more a person consumes of good X and the less of good Y, the less additional
Y will that person be prepared to give up in order to obtain an extra unit of X: i.e. ΔY/ΔX
diminishes) is related to the principle of diminishing marginal utility. This stated that individuals
will gain less and less additional satisfaction the more of a good that they consume. This
principle, however, is based on the assumption that the consumption of other goods is held
constant. In the case of an indifference curve, this is not true. As we move down the curve, more
of one good is consumed but less of the other. Nevertheless the effect on consumer satisfaction is
similar. As Clive consumes more pears and fewer oranges, his marginal utility from pears will
diminish, while that from oranges will increase. He will thus be prepared to give up fewer and
fewer pears for each additional orange. MRS diminishes.

The relationship between the marginal rate of substitution and marginal utility

In Figure 2.22, consumption at point a yields equal satisfaction with consumption at point b.
Thus the utility sacrificed by giving up 6 pears must be equal to the utility gained by consuming
one more orange. In other words, the marginal utility of an orange must be six times as great as
that of a pear. Therefore, MUoranges/MUpears = 6. But this is the same as the marginal rate of

47
substitution. With X measured on the horizontal axis and Y on the vertical axis, then: MRS =
MUX / MUY = slope of indifference curve (ignoring negative sign)

An indifference map

More than one indifference curve can be drawn. Indifference map is a graph showing a whole
set of indifference curves. Although the actual amount of utility corresponding to each curve is
not specified, indifference curves further out to the right would show combinations of the two
goods that yield a higher utility, and curves further in to the left would show combinations
yielding a lower utility.

An indifference map
30

The further out the curve, the

Units of good

higher the level of utility

Y

20

An indifference curve shows all

combinations of X and Y that
give a particular level of utility.
10

I5
I4
I3
I2
0 I1
0 10 20
Units of good X

Fig 2.23 An indifference map

Combinations of goods along I2 in Figure 2.23 give a higher utility to the consumer than those
along I1. Those along I3 give a higher utility than those along I2, and so on.

The budget Constraint/line

The other important element in the analysis of consumer behaviour is budget line. Whereas
indifference maps illustrate people’s preferences, the actual choices they make will depend on
their incomes. The budget line shows what combinations of two goods you are able to buy, given
(a) your income available to spend on them and (b) their prices.

The first two columns of Table 2.6 shows various combinations of two goods X and Y that can
be purchased assuming that (a) the price of X is £2 and the price of Y is £1 and (b) the consumer
has a budget of £30 to be divided between the two goods. In Figure 2.24, then, if you are limited

48
to a budget of £30, you can consume any combination of X and Y along the line (or inside it).
You cannot, however, afford to buy combinations that lie outside it: i.e. in the darker shaded
area. This area is known as the infeasible region for the given budget.

A budget line
30 a
Table 2.6
Units ofYgood

Units of Units of Point on

good X good Y budget line

0 30 a
b
20 5 20 b
10 10 c
15 0 d

c Assumptions
10

PX = £2
PY = £1
Budget = £30

0 d
0 5 10 15 20
Units of good X

Fig 2.24 A budget line (budget of £30)

The relative prices of the two goods are given by the slope of the budget line. The slope of the
budget line in Figure 2.24 is 30/15 = 2. (We are ignoring the negative sign: strictly speaking, the
slope should be −2.) This is simply the ratio of the price of X (£2) to the price of Y (£1). Thus
the slope of the budget line equals PX/PY.

3.6. Utility Maximization

The optimum consumption point

We are now in a position to put the two elements of the analysis together: the indifference map
and a budget line. This will enable us to show how much of each of the two goods the ‘rational’
consumer will buy from a given budget.

Let us examine Figure 2.27. The consumer would like to consume along the highest possible
indifference curve. This is curve I3 at point t. Higher indifference curves, such as I4 and I5,
although representing higher utility than curve I3, are in the infeasible region: they represent
combinations of X and Y that cannot be afforded with the current budget. The consumer could
consume along curves I1 and I2, between points r and v, and s and u respectively, but they give a
lower level of utility than consuming at point t. The optimum consumption point for the
consumer, then, is where the budget line touches (is ‘tangential to’) the highest possible

49
indifference curve. At any other point along the budget line, the consumer would get a lower
level of utility.

Finding the optimum consumption

Units of good Y

r
s

Y1 t

u I5
I4
v I3
I2
I1
O X1
Units of good X

Fig 2.27 The optimum consumption point

If the budget line is tangential to an indifference curve, they will have the same slope. (The slope
of a curve is the slope of the tangent to it at the point in question.) But as we have seen:

The slope of the budget line = Px / Py

And the slope of the indifference curve = MRS = MUX / MUY

Therefore, at the optimum consumption point: PX / PY = MUX / MUY

But this is the equi-marginal principle. Only this time, using the indifference curve approach,
there has been no need to measure utility. All we have needed to do is to observe, for any two
combinations of goods, whether the consumer preferred one to the other or was indifferent
between them.

The optimum combination of goods consumed

We can use marginal utility analysis to show how a rational person decides what combination of
goods to buy. Given that we have limited incomes, we have to make choices. It is not just a
question of choosing between two obvious substitutes, but about allocating our incomes between
all the goods and services we might like to consume. If you have, say, an income of £10 000 per
year, what is the optimum ‘bundle’ of goods and services for you to spend it on?

50
The rule for rational consumer behaviour is known as the equi-marginal principle. This states
that a consumer will get the highest utility from a given level of income when the ratio of the
marginal utilities to prices of all bundles of goods and services he consumed are equal.
Algebraically, this is when, for any pair of goods, A and B, that are consumed:

MUA / PA= MUB / PB = …

At this point, no further gain can be made by switching from one good to another. This is the
optimum combination of goods to consume.

3.7. Change in income and consumer choices

Understanding the consumers’ purchasing decisions will help us understand how changes in
income and prices affect demands for goods and services, and why the demands for some
products are more sensitive than others to changes in prices and income. In general, the idea of
consumer behavior is the basis for the theory of demand. Under the definition of utility that
consumers are the primary consuming units with an objective of maximizing their
utility/satisfaction. In order to attain this objective, the consumer must be able to compare the
utility/satisfaction of the various baskets of goods and services which he/she can buy with his/her
income.

3.8. Change in price: substitution and income effects on consumer choices

Income effect: a higher price means that, in effect, the buying power of income has been
reduced, even though actual income has not changed; always happens simultaneously with a
substitution effect

Substitution effect: when a price changes, consumers have an incentive to consume less of the
good with a relatively higher price and more of the good with a relatively lower price; always
happens simultaneously with an income effect

51
 Chapter four

Theory of Production

4.1. Introduction to Inputs and Production Function

Production: is the process of transforming factors of production (inputs) into output, or it is the
process of using economic resources to produce outputs.

Production activities can be generally classified into primary, secondary and tertiary.

1. Primary production: this involves the first direct process in which goods originate.
Agriculture, fishing, forestry and mining are typical examples of primary production.

2. Secondary production: this type of economic activity refers to the processing of raw
materials into final outputs. All products which are processed by manufacturing activities
are said to be secondary productive activities.

3. Tertiary production: the intangible items which carried out in the form of trade and
tourism as well as all forms of provision of services are a tertiary production.
Inputs: are anything that can be used in the production of goods and services. This includes
labor, land, capital and entrepreneurship etc. All inputs can be divided into two categories: fixed
inputs and variable inputs:-

Fixed inputs are those inputs whose quantity remains fixed for a given period of time. On the
other hand, variable inputs are those inputs whose quantity can be increased or decreased
during a given period of time. For example, a farmer requires land surface, water, capital goods,
labor etc. Labor can be considered as variable input while land and capital goods are fixed
inputs assuming that the size of the plot and the capital goods available for production remain
fixed.

Factors of production

The resources that are mobilized in the process of production are termed as factors of production.
Such resources (inputs) which are used in the production of goods and services are categorized
as labor, land, capital and entrepreneurship.

52
Land: it is a property resource which includes all natural resources that are used in production
process, such as arable land, forests, mineral and oil deposits, water resources, etc. The reward or
payment for land resources is rent.

Capital: it is also known as investment good. It is a property resource which includes all
manufactured goods used in producing other goods and services. This includes tools, machinery,
equipment, factory, storages, and transportation and distribution facilities. The reward or
payment for capital resources is interest.

Labor: it represents physical and mental ability of a human being in production of goods or
services. This may include physical ability in road construction, an engineer’s ability to sketch
electrical installation of a building, an economist skill to conduct economic research, etc. The
reward or payment for physical and mental ability of a human being is wage.

Entrepreneurial Ability: it is a human resource which includes human’s talent in organizing

resources in production process. It is about those individuals who initiate in combining factors of
production to produce goods and services. The reward or payment for entrepreneurial ability is
profit.

Production Function

Production function describes the transformation of inputs into outputs. Production function
shows the relationship between various combinations of inputs and the maximum outputs
obtainable from those combinations. It represents the maximum output that can be produced
from given combination of inputs. It describes technological relationship between inputs and
output.

Mathematically, it can be represented as: Q = f (X1,X2,X3…..,Xn)

Where, Q represents the maximum quantity of output X 1, X2, X3, - - -, Xn, are different types of
inputs.

If the quantity of at least one input remains fixed, the above mentioned production function is
called short run production function. But if all of the inputs are variable, the production
function is called long run production function. In this chapter, we will give emphasis to short
run production function.

53
In economics, production period is classified as short run or long run. Short run refers to a
period of time in which the quantity of at least one input remains fixed. On the other hand, the
term long run refers to period of time in which all inputs are variable. Here, you should note
that short run doesn’t refer to relatively short period of time like a year or less than a year and
long run doesn’t refer to period of time greater than a year or 5 years. They rather refer to the
nature of economic adjustment in the firm to changing economic environment.

4.2. Short run production function

The short-run production is a time period over which production is carried out with the help of
two categories of inputs these are fixed input and variable input. The length of short-run period
depends on the type of fixed factors. Some may be fixed for only a month, others for one year or
more.

To explain the most important features of short-run productions, consider a production which
uses two inputs: Capital (K) which is fixed input and Labor (L) which is variable input. Then, a
short-run production function is stated as:

Q=f(K,L)

Production Function with One Variable Input

Consider that a farmer wants to produce maize on 2 hectare of land. To produce maize, he needs
land, fertilizer, water, some equipment and labor. Assume that all of the inputs except labor are
fixed at certain quantity. Given this, the farmer can increase maize production by increasing the
unit of labor only. But the farmer cannot increase maize production indefinitely since he is
combining increasing unit of labor with fixed inputs - land and capital. Eventually, total output
will decline.

Total, Average and Marginal product

In short run, the relation between output and the quantity of labor employed is described using
three related product measurement concepts: Total product, Marginal product and Average
product.

1. Total Product: is the overall amount of output produced by the factors of production
employed over a given period. It is the gross or entire output produced by workers and
54
 expressed in terms of quantity (Q). In the short-run production function, a firm obtains its
total product by using a combination of variable inputs with specific amount of fixed input.
As the farmer employs more and more labor, total product first increases, reaches its
maximum (when 8 unit of labor is employed, total product = 28) and then declines. As
shown in Fig 4.2.1 above, When the amount of labor increases, total product first increases
by an increasing amount (up to point ‘a’), and then increases by decreasing amount
(between point ‘a’ and ‘c’); after point ‘c’ it declines. Since total product of maize depends
on the unit of labor employed, the total product is also known as total product of labor.

2. Average Product (AP): is the per unit product and it is obtained as the total product per unit
of the variable input.

AP = TP/L
As the amount of labor increases and combined with the fixed inputs (land, oxen…) average
product of labor initially increases, reaches its maximum (AP=5 when L=4) and then
declines.

3. Marginal Product: is a measure of change in total product resulting from one unit change in
the amount of the variable input assuming the other inputs remain fixed. Mathematically, it
can be stated as

MP = TP/L

In our example, it measures the contribution of each additional unit of labor employed to the
total product. Like average product, marginal product initially increases, reaches its maximum
(in our example, at the third labor, MP= 6), and then declines as the quantity of variable input,
increases.

55
 Table 4.2. Short Run Production

Fixed Inputs Variable Input Total product Average Marginal Stages of

Labor (TP) (in qn) product (AP) product Production
Land No. of
(MP)
(in worker-day)
(in ha) oxen
2 2 0 0 - -
2 2 1 4 4 4
2 2 2 9 4.5 5 STAGE I
2 2 3 15 5 6
2 2 4 20 5 5
2 2 5 24 4.8 4
2 2 6 27 4.5 3 STAGE II
2 2 7 28 4 1
2 2 8 28 3.5 0
2 2 9 27 3 -1 STAGE III
2 2 10 25 2.5 -2
Graphically,
Outputs (in quintals)
28- Stage I Stage II c Stage III

b
TP
24-

20-

Labour (in worker -day)

16- 1 2 3 4 5 6 7 8 9 10

6-

5-
APL

1 2 3 4 5 6 7 8 9 10
4-

MPL
3-
Fig. 4.2 Total Product, Marginal Product & Average Product Curves

2-

56
The relationship between Total product and Marginal product

1. When MP>0
 MP>0 and increase, TP is increase at an increasing rate.
 MP>0 and decrease, TP is increase at decreasing rate.
2. When MP=0, TP is constant or reaches a maximum point.
3. When MP<0, TP decrease.
The relationship between Average Product and Marginal Product

Note the following points by referring to Fig. 4.2.

i. The patterns of average product and marginal product curves are similar. As the amount of
the variable inputs increases, both average product and marginal product curves rise; reach
their respective maximum and then decline.
ii. Whenever marginal product of the variable input is greater than the average product, the
average product increases [whenever MP>AP AP increases].
iii. Whenever marginal product of the variable input is less than the average product, the
average product decreases [whenever MP<AP AP decreases].
iv. Finally, when the marginal product equals average product, average product reaches its
maximum.

The Law of Diminishing Marginal Returns (LDMR)

The law states that as increasing amount of a variable input is combined with fixed inputs,
eventually the contribution of each additional amount of the variable input to the total product
declines. In other word this low states that when more and more variable inputs are applied to
fixed inputs, the total output initially increase at an increasing rate, but beyond a certain level of
output, it increases at a diminishing rate and finally it starts to decrease. This is due to the fact
that the amount of fixed input per variable input declines. In our case, as the amount of labor
used in production process increases, the amount of capital per worker decreases. Note that the
law starts to operate after the marginal product curve reaches its maximum. (See Table 4.2. and
Fig 4.2.)

57
Stages of Production

The short run production function can generally be classified into three stages of production, as
shown in table 4.2. and Fig 4.2.

Stage I: From the origin up to the point where AP is maximum. Note that MP = AP when AP
is maximum.

Stage II: From AP= MP up to MP is zero. Note that MP is zero when TP is maximum.

Stage III: whenever MP is negative.

From this one can understand that a producer should not produce in stage I and III. In stage III,
each additional unit of labor is contributing negatively to total product, i.e. MP is negative
because the amount of the variable input, in our example, labor, is excessive compared to the
quantity of the fixed input. In other words, there is over employment of the variable input, labor.
As a result, the fixed inputs are over utilized. This stage is also known as extensive margin.

The producer should not also limit himself in stage I. In this stage each additional unit of labor is
contributing more than the average product. As a result, the average product rises. This is the
initial stage of production in which the quantity of the variable input is relatively small compared
to that of fixed input. In short, labor is underemployed and, hence, the fixed inputs are
underutilized. Therefore, as the quantity of the variable input increases the total product also
increases. In fact this stage is very attractive to the producer, because each additional unit of
labor brings a more than proportionate increase in total product. For example, when the amount
of labor increases from one to two, total product increased from four to nine quintals. (See Table
4.2.1) When it increases from three to four, TP further increased from fifteen to twenty, and so
on. Hence, the producer would expand production in to the second stage. Thus, it can be
concluded that a rational producer should produce in stage two where both the average product
and marginal product are positive but declining.

4.3. Long-run production function

The long-run is a time period over which all factors of production including the scale of the plant
are variable. Let’s assume only two inputs are used, say labor and capital, and both are variable
inputs. Therefore, output depends on quantities of both inputs used. Functionally, = f(L,K). In

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the short-run, increase in output results from change in variable input only. However, in the long-
run production, since all inputs are variable, change in output can result from change in any
input.

Production Function with Two Variable Input

Up to now we have been assuming that there is only one variable input, labor. But, in reality,
there are many variable inputs in production process. Let us assume that there are two variable
inputs in maize production: labor and capital. Technology is still constant, i.e., there is no
technological advancement in maize production.

Given the two variable inputs, the farmer can produce the same amount of maize by using
different combinations of labor and capital.

Isoquant

An isoquant is a set of all possible combinations of inputs that yield the same maximum possible
level of output. An isoquant curve also known as iso- product curve which means same product
curve.

A table that represents the various combinations of labor and capital which gives the farmer the
same level of the output is called isoquant schedule or equal product schedule.

Table 4.3. Isoquant Schedule (Equal Product Schedule)

Capital Labor ( in Maximum Maize

Combination worker-hour) Output (in quintals)
( in machine-hour)
A 1 11 60
B 2 7 60
C 3 4 60
D 4 2 60
E 5 1 60

A graphical representation of the isoquant schedule is called iso product curve or equal product
curve or simply isoquant. In Greek ‘iso’ means ‘equal’ or ‘same’. Isoquant, therefore, represents
those combinations of two variable inputs which give the producer equal level of output. In

59
other words, isoquant is a production function that relates the various combinations of two
variable inputs with a maximum amount of total output, assuming the technology constant.

An isoquant curve

Capital

3
2
1
TP = 60
Quintals Labour
2 4 6 8 10 12

Fig. 4.3. Isoquant

Any combination of labor and capital on the isoquant gives the farmer 60 quintals of maize.

Isoquant Map: is a set of isoquants or equal product curves

Capital

h
3
2 g
70
quintals
60
50quintals
quintals Labor
3 4
Fig. 4.3 Isoquant map

Each successive isoquant to the right represents higher level of total product because it reflects
the use of more of at least one of the two inputs. For example, point ‘h’ on Fig 4.3. Represents a
combination of four unit of labor and three unit of capital. This definitely enable the producer to

60
produce more output than combination ‘g’ where he used less of both inputs, i.e., three units of
labor with two units of capital.

Lower isoquant represents lower level of total product.

Properties of Isoquants

1. Isoquant curve is slope downward or negatively: As the use of one variable input
increases, the quantity of the other variable input should decrease so as to produce the
same level of total product.
2. Isoquant is convex to the origin: When we say isoquants are convex to the origin, it
implies they are bowed to origin. The property results from diminishing marginal rate of
technical substitution.
3. Isoquants curve do not intersect each other: By principle two isoquant curves do not
represent same output level. If two isoquant curves did intersect each other, at point of
intersection, we read same amount of combination of inputs, but two different output
levels at a time which is impossible. Therefore isoquant curves do not intersect each other.

Capital

c b
3 50
2 a 40
Labour
6 7

Fig. 4.4 Intersecting isoquants show inconsistent preference

The capital- labor combination represented by point ’b’ yields 50 quintals of maize. On the other
hand, the capital – labor combination shown by point ‘a’ gives 40 quintals of maize because it
represents the use of low level of labor and capital per period. Since point ‘c’ and point ‘b’ are on
the same isoquant, they give equal level of total product i.e., 50 quintals. But point ‘c’ and ‘b’ are
also on the same isoquant, hence, they give equal level of total product, in this case it would be

61
40 quintals. But this cannot be the case because the capital – labor combination shown by point
‘c’ cannot give different level of total output, given the constant technology.

4. Upper isoquant curves represent higher level of out

Marginal Rate of Technical Substitution [MRTS]

An entrepreneur usually attempts to substitute one input for another so as to be able to produce
efficiently. For instance, when cost of labor tends to be high, an entrepreneur tends to substitute
capital for labor. The rate by which one factor of production is substituted for another,
keeping the output constant, is called MRTS. Note that substitution of one factor of
production for another takes place without any change on the output level. The marginal rate of
technical substitution of capital for labor is measured as

MRTS of capital for labor = L/C or MRTS of labor for capital= C/L

Where, L is change in unit of labor

C is change in unit of capital

Returns to Scale

When all inputs become variable, the production function is called long run production function.
Returns to scale are a property of production function that indicates the relationship between
proportionate change in all inputs and the resulting change in total product. It is a property that
applies only in the long run.

We can identify three types of returns to scale.

i. Constant Returns to Scale: if a certain percentage change in all inputs results in the same
percentage change in output, a production function is said to exhibit constant returns to
scale.[ i.e., %  in all inputs = %  in output]. It is a situation in which a percentage change
in all inputs leads to the same percentage change in output. For example, if the farmer
manages to increase all the inputs he uses in production of maize by 5%, and as a result total
maize production increases by 5 %, the return is said to be constant returns to scale.
ii. Increasing Returns to Scale: is a situation in which a percentage change in all inputs
causes a more than proportionate change in output.[i.e., %  in all inputs < %  in output].

62
 For Example, if a 5% change in all inputs leads to a more than 5% change in maize
production, this relationship is called increasing returns to scale.
Increasing returns to scale may occur because of:

a. An increase in the scale of operation of firm: it may permit the use of more
productive, specialized machinery which was not feasible at lower scale of
production.
b. Greater division of labor
c. Greater degree of specialization: each worker can specialize in specific piece of work
rather than doing many different tasks. This increases the productivity of workers,
thereby, increases total product.
iii. Decreasing Returns to Scale: is a situation in which a percentage change in all inputs
causes a less than proportionate change in output.[ i.e., %  in all inputs > %  in output].
For Example, if a 5% change in all inputs leads to a less than 5% change in maize
production, this relationship is called decreasing returns to scale. For example, as the scale
of production increases, if communication difficulties arise, it may lead to a decrease in
total product per period.
In summary,

Change in Output Relative to a Proportionate Change in Returns to Scale

All inputs

%  in all inputs < %  in output Increasing

%  in all inputs = %  in output Constant

%  in all inputs > %  in output Decreasing

63
 Chapter Five

Theory of cost

Any production of good or service involves expenditure for inputs used. Also, no one incur cost
without expected output, since cost without output is economically meaningless. Therefore, cost
and output are not separable; if there is output, necessarily there is cost incurred; if some cost is
incurred, there is expected output.

5.1. Basic Concepts of Costs

To produce goods and services, producers need factors of production. To acquire most of these
factors of production, or simply inputs, they have to buy them from the resource suppliers.

Cost is, therefore, the monetary value of inputs used in production of an item.

We can identify two types of cost of a product: social cost and private cost.

1. Social Cost: refers to cost of producing an item to the society. You know that economic
resources are limited. For example, when an individual producer wants to produce leather
products in Ethiopia, the society as a whole also incurs cost. Because the next- best
alternative use of the resources used to produce leather products are sacrificed. This is the
opportunity cost of the resources used to produce the item. In addition to this, production of
the item may also force the society to incur additional costs. For example, dangerous
chemicals, bad smell, etc may be emitted while the item is produced. To control the
undesirable consequences of the production process on the environment, the society incurs
cost.

2. Private Cost: refers to the cost of producing an item to the individual producer. This is the
cost that the individual producer incurs to produce the product. Or it can be expressed as the
sum of all explicit and implicit costs. In the above example: Private cost of production can be
measured in two ways as:-
A. Economic Cost: It is the value of non-purchased inputs owned and used by a firm. The
producer buys part of the inputs from the market. He/she employs workers, buy raw
materials, the necessary machines, power, etc. But the producer can also use his/her own

64
 inputs which are not purchased from the market. Example, the owner can be the manager
of the firm or the owner can use his/her own building or/and as a production place, etc.
Since these inputs are used for the purpose of producing the item, their value has to be
estimated. We usually estimate the cost of non-purchased inputs by taking what they can
earn in their best alternative. For instance, if a teacher quits his job and becomes the
manager of his/her own small farm, then the next best alternative of his labor may be the
salary that he sacrificed to be the manager of his farm.
On the other hand, the estimated costs of the non- purchased inputs are called implicit costs. This
includes the salary of the owner acting as a manager, the estimated rent of the building of the
owner, etc.

B. Accounting Cost: refers to the cost of purchased inputs only. It is the explicit cost of
production only. The actual or out-of-pocket expenditures the firm incurs to purchase
inputs from the market are called explicit costs. This includes the wage of workers, cost
of power [electricity and fuel], cost of raw materials, etc.
5.2. Short Run Costs

Short Run Total Costs: Total Fixed Cost, Total Variable Cost, and Total Cost

In the short run, inputs are divided in to two: fixed inputs and variable inputs. Likewise, short run
costs are divided in to two: fixed costs and variable costs.

i. Fixed Costs: are those costs that do not vary as the firm changes its output level. These are
costs that must be incurred even if the firm does not produce anything. Examples for fixed
inputs are rents on leased properties, interest on borrowed funds, the wear and tear of
machinery, etc.
ii. Variable Costs: are those costs of production that change directly with the output level of the
firm. When output is zero, variable costs are also zero. But as the firm expands its output
level the variable costs also rise. In short, variable costs of a firm are dependent on the output
level of the firm. Some of the examples of variable costs are wages of workers (excluding the
administrative staff), cost of raw materials, etc.

65
The sum of total fixed costs and variable costs constitutes the total cost of production.

TC = TFC + TVC………….(1)

Where, TFC = total fixed cost, TVC = total variable cost and TC = total cost

Example: the following table represents the short run cost of production of shoes by Rain Bow
shoes factory.

Table 1 Short Run Cost of the Firm

Q TFC TVC TC
0 100 0 100
1 100 50 150
2 100 90 190
3 100 120 220
4 100 140 240
5 100 150 250
6 100 170 270
7 100 200 300
8 100 240 340
9 100 290 390
10 100 360 460
The data on table 5.2 can also be shown graphically.

i. TFC: is Birr 100, irrespective of the increase or decrease in output.

Cost

Birr 100 TFC

Quantit
y
Fig. 1 Total Fixed Cost

66
 ii. TVC: as output increases, the variable input that the firm uses also increases. As a result,
total variable cost also increases. However, the TVC is not increasing by the same
amount. For example when producing the first output, TVC increased by Birr 50 [i.e., 50
–0]. When producing two unit of the output, TVC increases from Birr 50 to Birr 90.
Hence it increases by Birr 40, etc. Generally, TVC first increases by a decreasing amount
[ in our example up to the fifth output ] and then increases by an increasing amount as the
firm expands its output level.
iii. TC: total cost of production varies directly with the output level. The pattern it follows is
the same as that of the TVC because it is the sum of TFC and the changing TVC.
Graphically, it can be shown as follows.

Costs

TC
TVC

240

140
100 TFC

Quantity
4

Fig.2 Total Variable Cost and Total Cost Curves

Short Run Average Costs: Average Fixed Cost, Average Variable Cost, Average Total Cost
and Marginal Cost

In addition to total fixed and variable costs producers are also interested in the average costs of
production. Here, we will see four of them.

1. Average Fixed Cost [AFC]: is total fixed costs per unit of output. It is calculated
as
AFC = TFC/Q …………………….(2)

Where, Q is total product

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 2. Average Variable Cost [AVC]: is total variable cost per unit of output. It is
calculated as
AVC = TVC /Q ……………………. (3)

3. Average Total Cost or Average Cost [ATC or AC]: is total cost per unit of
output. It is calculated as
AC = T C/Q

4. Marginal Costs [MC]: is the additional cost incurred to get one more unit of the
output. It is measured as
MC = ( TC)/Q = (TFC)/Q + ( TVC)/Q
MC = (  TC )/Q = (TVC)/Q , Since TFC = 0
Let us analyze the nature of short run costs of a Rainbow Shoe Factory to see their properties.

Table 2 Short Run Cost of the Rainbow Shoe Factory

Q TFC TVC TC AFC AVC AC MC
0 100 0 100 - - -
1 100 50 150 100 50 150 50
2 100 90 190 50 45 95 40
3 100 120 220 33.33 40 73.33 30
4 100 140 240 25 35 60 20
5 100 150 250 20 30 50 10
6 100 170 270 16.67 28.33 45 20
7 100 200 300 14.29 28.57 42.86 30
8 100 240 340 12.50 30 42.50 40
9 100 290 390 11.11 32.22 43.33 50
10 100 360 460 10 36 46 70
The change pattern of average costs can also be presented graphically as follows

1. AFC: AFC declines continuously as the firm increases its output level.
Unit Cost

AFC
68
Quantity
Fig.3 Average Fixed Cost curve
 2. AVC: As it shown in Table 4, AVC first declines, reaches its minimum (when the firm
produces 6 units of output, AVC is Birr28.33) and then rises as the output level increases.

AVC curve has a ‘U’ shape because the average Unity Cost

variable cost has inverse relationship with average

AVC
product of the variable input. In our example, AVC is
inversely related to AP of the variable input, labor.

When AP of labor increases, AVC decreases. Birr 28.33

When AP of labor reaches its maximum, AVC reaches

its minimum; and when AP of labor decreases, AVC
6 Quantity
rises. Fig. 4 Average Variable Cost curve

Unit Product

AP
Labour
Unit Cost

AVC

Quantity
Fig. 5 Relationship between AP

And AVC
3. AC: As output increases, initially unit cost of production (AC) declines, after a while it
starts to rise after it reaches its minimum. In our example, AC reaches its minimum when
the firm produces 8 units of the output. In short, AC curve has also a “U” shape.
Unit Cost
AC

Birr 42.50

8 Quantity
Fig.6 Average Cost curve
69
Note that the AC reaches its minimum after the AVC reaches its minimum. In other words, the
AC reaches its minimum at a higher output level than that of the AVC.

4. MC: marginal cost initially fall at higher rate, reaches its minimum ( at the fourth level of
output MC = Birr 10) and then rises.
Unit Cost

MC

Birr 10

Quantity
5

Fig.7 Marginal Cost curve

Marginal cost has inverse relationship with marginal product.

Unit product

Labor
MP
Unit cost
MC

Quantity

Fig. 8 Relationship between MC and MP

When MP of labor increases, MC curve decreases. When MP of labor reaches its maximum, MC
curve reaches its minimum; and when MP of labor decreases MC curve rises.

Note that, in the previous chapter we have said that the law of diminishing marginal returns starts
to operate after the MP reaches its maximum. This means that the law starts to operate after the
MC curve reaches its minimum. In other words, the MC starts to rise due to the law of
diminishing marginal returns.

70
 Now let us bring all the average and marginal cost curves together.
Unit Cost MC AC
AVC

Birr
42.50

Birr
28.33
Birr 10 Quantity
4 6 8

Fig. 9 AC, AVC and MC Curves

Note

1. The relationship between AVC and AC:

A. They have similar pattern, i.e., they are “U” shaped.
B. The AC is above the AVC curve because AC is the sum of AVC and AFC.
C. The gap between AC and AVC is getting smaller and smaller as output level
increases.
AC = AFC+AVC. The gap between AC and AVC means

AC- AVC = AFC. And we know that AFC continuously declines as output level increases.

2. Relationship between AC and MC: whenever MC is less than AC, the AC declines.
Whenever MC is greater than AC, the AC rises. When the MC is the same as the AC, the
AC remain unchanged, and that is when the AC reaches its minimum. From this we can
understand that the MC curve cuts the AC curve at the minimum of the AC curve.
3. Relationship between AVC and MC: Similar to the above relationship, whenever MC is
less than AC, the AVC declines. Whenever MC is greater than AVC, the AVC rises.
When the MC is the same as the AVC, the AVC remains unchanged, and that is when the
AVC reaches its minimum. From this we can understand that the MC curve cuts the AVC
curve at the minimum of the AVC curve.

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The Link between Production and Cost

In the previous subsection, we said that there is inverse relationship between AP and AVC.
Similarly, there is also inverse relationship between MP and MC. These relationships between
production and cost can easily be depicted by the following figure.

Unit Product

AP

Labour
MP
Unit MC
AVC

Quantity

Fig. 10 The link between production and cost

The MC and AC curves are mirror reflections of the MP and AP curves.

 Whenever MP is above AP, the MC is below AVC.

 Whenever MP is below AP, the MC is above AVC.
 Whenever MP is equal to AP, the MC is equal to AVC. Note that MP equals AP when AP
is maximum. Hence, MC equals AVC, when AVC is at its minimum.
5.3. Long Run Cost

In the long run production, all inputs are variable. If all inputs of a firm change, the scale of the
firm changes. Therefore, producers increase size or scale of a firm production in order to
increase output. In other word, in the long run the amounts of all factors of production can be
varied, so there are no fixed costs. Thus, the size of the plant is variable, so fixed cost will be
variable in the long run decision of production. When we say that fixed costs vary with the size

72
of the plant, it means that all costs behave in the same way as all other components of variable
costs.

Long-run total cost

If we assume a producer has only one plant, the corresponding total cost is only a single plant.
Thus, a short run total cost of the first plant can be denoted as STC 1. If the producer increases the
scale of production establishing another two plants, we should introduce the STC 2 and STC3to
represent their corresponding total cost. Assume also a single plant is a small scale, two plants is
medium scale production and three plants is large scale production for the firm.

If the firm plans to produce let us say Q 1 level of output, it uses only the first plant producing at
STC1. This is because all other scales of productions, except small scale, require higher total
cost. Again, if the firm plans to produce Q 2 output, the firm prefers to produce on STC 2 which is
medium scale production establishing another secondary plant. This is because except medium
scale, all other firm sizes require higher cost for producing Q 2. Further, if the plan is to produce
Q3 output level, the firm chooses and produce in a large scale production establishing a third
plant, since all other firm sizes require higher cost.

Therefore, the long run cost decision of the firm involves the cost of all plants of the firm.
Accordingly, we can derive long run total cost by producing all output level.

Chapter Six

Perfect Competitive Market

6.1. Definitions and basics of market structures

Market is a mechanism that brings buyers and sellers of a product together. It consists of those
firms that provide a product for the market, and those individuals that buy the product. We can
identify four major types of market structures. They are:

1. Perfectly competitive market

2. Monopolistically competitive market
3. Oligopoly market, and
4. Pure monopoly
Except the first type, the remaining types of markets are known as imperfect markets.

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Monopolistic competition
The real world is neither perfectly competitive nor perfectly monopolistic. The type of
competition found in the real world lies between the two extremes. This form of competition is
known as ‘imperfect competition’. Monopolistic competition is one form of imperfect
competition. It is a market structure in which many sellers compete to sell a differentiated
product. As the name suggests, it combines some aspects of both perfect competition and
monopoly.
Characteristics of monopolistic competition
 Many sellers and buyers: the market consists of large number of producers and
customers. But the number may not be as large as that in perfect competition.
 Product differentiation: product differentiation is the production of different varieties
or brands of the same product in the industry which consumers buy according to their
preferences. Each supplier’s product has unique qualities that cause some buyer as to
prefer it to products of competing firms. The difference can be in quality, style, color,
durability, brand name etc. The products of the many sellers are close substitutes for
each other, but the individual seller has an element of monopolistic control over its own
product.
 Free entry and exit: in the monopolistically competitive markets, it is easy to set up
new firms, and firms established in the industry find it easy to exit.
 No collusion: it is difficult for the firms to act in concert because they are many and they
may not recognize their interdependence. This means the firms do not cooperate to fix
prices so as to increase their group profits.

Because products are differentiated, the monopolistically competitive firm determines price like
the monopolist. Price cuts increase quantity demanded by capturing part of the competitor’s
market. Unlike a perfectly competitive firm, a monopolistic competitive firm can raise its price
and not loss all of its sales. In a monopolistic competition, some consumers will remain loyal to
the firm’s product and continue to purchase it even though the price has gone up and there are
close substitutes.

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Non-price competition
For monopolistic competitive firms there is not only price competition but also non-price
competition. Advertisement is one of the most common types of non-price competition. It is
supposed to provide useful information to buyers. By telling customers about the characteristics
of products, their prices, and where they are available, firms try to increase their sales revenue.

Typical monopolistic competitors

Although it is difficult to identify industries that fit precisely our description of monopolistic
competition, the following one approximate it: barbershops, grocery stores, laundries, clinics,
retail stores, beauty shops, textile manufactures, furniture producers

4.4 Oligopoly
The other type of market imperfection is oligopoly. Oligopoly is market structure where a few
sellers dominate the industry.
Characteristics of oligopoly
 Barriers to entry: this refers to conditions that hinder the entry of new firms into the
industry. These barriers may be in the form of ownership of resources, larger capital
requirements, control of patents by existing firms.
 Few sellers: ‘Few sellers’ does not necessarily mean the number of sellers is very small.
The number of firms may be large but few firms account for the major portion of the
industry’s productive capacity. That is, others are insignificant as far as their market
share is concerned.
 Recognized mutual interdependence: each firm recognizes that its profits are heavily
dependent on the actions of the other firms in the industry.
 Types of products: under oligopoly products are either identical or differentiated.

There is no other market structure that is more difficult to analyze than oligopoly. The difficulty
arises from the interdependence nature of oligopolistic decisions. Oligopolists have a common
interest in setting prices so that monopoly profits are made, and an individual interest in an
attempting to get the maximum possible profit. These interests are contradictory in nature, and

75
hence the economic theory of oligopoly concerning pricing and output decisions has not yet been
standardized.

Oligopolistic industries

Although it is common to analyze monopolistic competition and oligopoly separately, it is not

always easy to draw very sharp distinctions between the two types of market structure. From the
point of view of the number of producers and the ease of entry, some industries might be
classified as monopolistically competitive. On the other hand, from the point of view of
recognized mutual interdependence it might be reasonable to classify the same industries as
oligopolistic, that is, they cannot be so easily classified. However, goods like oil, steel, tires,
synthetic fibers, soap, and electric bulbs are usually produced under conditions of oligopoly.

Features of the four market structures

Type of Number Freedom of Nature of Examples Implications for

market of firms entry product demand curve
faced by firm

Perfect Very Homogeneous Cabbages, carrots Horizontal:

competition many Unrestricted (undifferentiated) (approximately) firm is a price taker

Monopolistic Many / Builders, Downward sloping,

Unrestricted Differentiated but relatively elastic
competition several restaurants

Undifferentiated Cement Downward sloping.

Oligopoly Few Restricted Relatively inelastic
or differentiated cars, electrical (shape depends on
appliances reactions of rivals)

Local water Downward sloping:

Monopoly One Restricted or Unique company, train more inelastic than
completely operators (over oligopoly. Firm has
blocked particular routes) considerable
control over price

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6.2. Perfect competitive market structure

Perfect competition is an extreme situation where competition reaches its maximum possible
degree. The model of perfect competition however cannot be realistically expected to exist in
totality in everyday life. It is highly theoretical, but the model provides a useful tool of economic
analysis.

6.2.1. Basic features of Perfect competitive market structure

A market is said to be a perfectly competitive market if the following assumptions hold true:-

1. Large number of buyers: the number of buyers of a product is so large that a single
buyer cannot influence the market price of the product. In other words, since his/her
purchase of the product is a small fraction of the market demand, a buyer’s decision to
buy or not to buy the product will have no effect on the price of the product.
2. Large number of sellers: there is large number of independent firms of a product in the
market. The share of a single firm’s supply of the product out of the market supply is so
small that its decision to sell or not to sell the product will not affect the market price.
This seems the case for several agricultural products. For example, there are large
number of buyers and large number of producers of maize on a market day. A single
buyer’s decision to buy more maize will not have any impact on the market price of
maize. Similarly, a single farmer’s decision to sell more maize will not alter the market
price of the product.
3. Homogenous products: the product that each firm provides for sale is identical or
homogenous. This implies that a buyer is indifferent about from whom he/she buys the
product. In the above example, a buyer does not care buying the maize from farmer
Dejene or farmer Tekeste.
4. Perfect knowledge or perfect information: every buyer and seller has full information.
Each buyer has full information regarding the quality, price or other characteristics of the
product. Sellers have also equal and complete information regarding the input prices, the
price and quality of the product, technology, future price of the product, etc.
5. Free entry and exit: a new firm has freedom to produce and supply a product. There is
no constraint or barrier from government or any other sources. If the firm believes that it
is not worth to stay in the business, it can go out of the market.

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6.2.2. Nature of demand and revenue curve under Perfect competitive market

From the above discussion we can understand that, in a perfectly competitive market, an
individual producer or firm is a price taker. Graphically it means the following.

P P

Dm
Sm

Po Po d

Sm Dm

o Q Q o g

A Firm's Demand Curve

Fig. 6.1 Demand curve of a perfectly competitive firm

Once the price of the product is determined in the market, the producer takes the price, P o and
sells any amount it can at that price. The firm cannot charge higher price than P o because nobody
will buy from it since there are several firms selling the same product at the ongoing price, P o.
Similarly, the firm has no reason to sell the product at a price less than P o because it can sell its
product at the market price. From this we conclude that: a perfectly competitive firm is a price
taker, not a price setter, a perfectly elastic [horizontal] demand curve is, therefore, the main
feature of a perfectly competitive firm.

Revenue of a Perfectly Competitive Firm

1. Total Revenue [TR]: is the total amount of money a firm receives from a given quantity of
a product sold. It is measured as price times the amount of the product sold.
TR = P X Q, Where, P is the price of the product, and Q is the amount of the product sold.

2. Average Revenue [AR]: is revenue per unit of item sold. It is calculated by dividing the TR
by the amount of the product sold.

AR = TR / Q
= (P X Q)/ Q = P and AR = P

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As shown in figure 6.2.2, the perfectly competitive firm faces a horizontal demand curve. This
curve is also known as the AR curve because, from the firm’s point of view, the demand curve is
the AR curve.

3. Marginal Revenue [MR]: is additional amount of money the firm receives by selling one
more unit of the product. It is a change in total revenue resulting from a sale of an extra unit
of the item. It is calculated as
MR = (TR)/ (Q)

= (P X Q)/(Q)

To increase its total revenue, the firm can increase its sales volume, but it cannot raise the price.

MR = P (Q)/ (Q)

MR = P
Thus, in a perfectly competitive market, a firm’s average revenue, marginal revenue and price of
the product are equal, i.e. AR = MR = P = d

Example: Revenue of a Competitive Firm

Price per unit Quantity per unit TR [= PxQ] AR [ = TR/Q] MR [= TR/Q]

0 0 0 - -
50 1 50 50 50
50 2 100 50 50
50 3 150 50 50
50 4 200 50 50

Revenue P

TR
200

150

100
AR = MR = P = d
50 50

O O Q
1 2 3 4 Q

Fig. 6.2.2. Revenue curves of a perfectly competitive firm

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Consider that the firm is producing and selling maize. The interaction of market demand and
supply determines the actual price of maize, and its price is Birr 50 per quintal. If the individual
firm sells one quintal, its TR is Birr 50. If it sells two quintals, the firm’s revenue increases to
Birr 50, and so on.
When you divide the TR by the amount of the product sold, you get the AR of the firm, and it is
always equal to the price of the product. Marginal revenue, on the other hand, is measured as a
difference in total revenue resulting from the sale of one more unit of the product. For instance,
when the firm sells 1 quintal of maize, its TR is Birr 50. But when it sells 2 quintals, TR
increases to Birr 100. The additional revenue the firm gets by selling the second quintal of
maize is Birr 50 [i.e.TR/Q = (100-50)/(2-1) = Birr 50]. Similarly, when the firm sells 3
quintals of maize TR raises from Birr 100 to 150. The MR the firm gets from the sale of the 3 rd
quintal of maize is Birr 50 [i.e., TR/Q = (150-100)/ (3 -2) = Birr 50]. Hence, we see that
P=AR=MR= d.

6.3. Determination of equilibrium price and output under perfect competitive market

Equilibrium under Perfect Competition:

In perfect competition, the price of a product is determined at a point at which the demand and
supply curve intersect each other. This point is known as equilibrium point. At this point, the
quantity demanded and supplied is called equilibrium quantity.

The determination of market equilibrium

(potatoes: monthly)
E e
100
Price (pence per kg)

Supply
D SURPLUS d
80
(330 000)

60

b SHORTAGE B
40
(300 000)
a A
20

Demand
0
0 100 200 300 Qe 400 500 600 700 800
Quantity (tonnes: 000s)

Figure above shows the equilibrium under perfect competition:

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In the above figure, it can be seen that at price 80, supply is more than the demand. Therefore,
prices will fall down to 60. Similarly, at price 80, demand is more than the supply. Similarly, in
such a case, the prices will rise to 100. Thus, the middle is the equilibrium at which equilibrium
price is 60 and equilibrium quantity is Qe.

Chapter Seven

Monopoly Market Structure

7.1. Basic features of monopoly market and causes of monopoly

Pure monopoly is the type of market structure in which there is only one firm that produces a
distinctive product. By distinctive product we mean a product for which there is no close
substitute.

Characteristics of Monopoly

1. Single seller and many buyers

2. The product has no close substitutes
3. The monopolist is price-maker
4. There is considerable entry barrier for a new firm. The barrier can be legal barrier,
technical or any other that hinder a new firm from producing and supplying the product.
For example, there is only one firm producing and supplying electric power in Ethiopia.
Other firms are restricted from supplying power by law.
As a result of all the above-mentioned characteristics, a monopoly firm has a great deal of
control over the price of the product. In short, a pure monopoly firm is a price setter, not a
price taker.

The reasons for the existence of pure monopoly are:

 Absence of close substitutes.
 Economies of Scale: the firm has cost advantage. In production of some outputs, unit cost
of production becomes minimum when the firm produces a huge amount of the product.
Small firms have no capacity to do so. The monopoly firm utilizes this advantage and
ousts the small ones from the market.

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  Patent right and legal barriers
 Control over essential raw material

7.2. The nature of demand and revenue curves under monopoly market

Market demand curve is its demand curve. Hence, the demand [AR] curve of the pure monopoly
firm is a negatively slopped curve. At a particular price, the firm sells a specific quantity. If it
wants to sell more, the price must be lowered. It means, to sell one more unit of the product, the
price must be decreased. As a result the MR is always less than the price of the product [i.e.,
MR<P]. Take the following example.

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Table 7.2. Demand and MR under Pure Monopoly
Quantity Price [= Average Revenue] TR MR
0 120 0 -
1 110 110 110
2 100 200 90
3 90 270 70
4 80 320 50
5 70 350 30
6 60 360 10
7 50 350 -10
8 40 320 -30
9 30 270 -50
10 20 200 -70

Revenu
e
120
110
100
90
80

70
60

50
40
30
20
D (=AR)
10
0
-10 1 2 3 4 5 6 7 8 9 10 11
-20
MR
-30

Fig. 7.2. Demand and MR curves of pure monopoly

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The firm faces a negatively slopped demand curve means that it has to decrease the price of its
product in order to increase the amount of the good sold. When price decreases, the additional
revenue it gets from the sale of a unit of the product will be less than the price for every level of
output. Because the price cut is not only for the additional output but also for the other units as
well. For example, when the price of the product is Birr 110, the TR is Birr 110, and the MR is
also Birr 110 because it is the initial output sold. To increase the sales volume from 1 to 2, the
firm has to reduce the price from Birr 110 to Birr 100. The additional revenue the firm gets from
the second unit of the item equals the price less the amount of the price cut from the first unit,
(i.e., 100 – 10= Birr 90), because, now, the first unit is sold not at Birr 110 but at Birr100. As
shown in the above table, therefore, the MR of the second unit of the product is [(200-110)/(2-1)
= Birr 90]. Similarly, to increase the sales level from 2 to 3 units, price has to be reduced from
Birr 100 to Birr 90. The addition to the total revenue resulting from the sale of the 3 rd unit is the
current price (Birr 90) less the price cut on the 1st and 2nd unit of the product, i.e., Birr 20. The
MR =90-20=Birr70, and so on. From this we conclude that:

 Marginal revenue is always less than price [P<MR], except the first unit of output,
 The MR curve is below the demand (AR) curve;
 Both the demand and the MR curves of a pure monopoly curve are always negatively
slopped.
7.3. Determination of equilibrium price and output under multi-plant and price
discriminating monopoly

The aim of monopolist is to increase total revenue and profit. Under price discrimination, the
monopolist will charge different prices in different sub-markets.
Suppose, the monopolist has two different markets having different elasticity of demand.

He has to take following three decisions in order to maximize his profits:

1. How much output should be produced?
2. How to divide total output between two different markets?
3. What price should be charged in each market?

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Now, let us examine these decisions in detail as per Figure below

1. How much Total Output should be Produced?

Since it is assumed that the product is homogeneous, the monopolist must consider his marginal
cost (MC) for the whole output irrespective of which market it is sold in. He equates this
marginal cost (MC) with the composite (combined) marginal revenue curve (ZMR) from both
markets-market-I and market-II. The composite (combined) marginal revenue curve (ZMR) is
found by adding the marginal revenue curves of Market-I and Market-II, horizontally.

The composite marginal revenue curve (combined marginal revenue curve) is represented as
2MR or CMR. Thus total output is fixed at the point where MC = CMR (or ZMR). Thus, in the
diagram 12, the monopolist will produce OM amount of output. At this output, the addition to his
cost of producing the last unit is just equal to the addition to his revenues from selling that unit in
either market.

2. How to Divide Total Output between Two Markets:

The monopolist will maximize his profits by equating the MC of the whole output with the MR
in Market I (MR1) and MC of the whole output with the MR in Market II (MR 2). In other words,
the total output (OM) is divided between two markets in such a way that marginal revenue in
each is equal to the marginal cost for the whole output which is also equal to the composite
(combined) marginal revenue at OR.
This means he will sell OM 1 output in market-I and OM2 output in market-II and the combined
output at price OR (where ZMR equals marginal cost for the whole output) is obtained by adding
the output in market-I and market-II at OR. MR must be the same in both the markets – (i.e.,
MR1 = MR2) for it has to be equated with the same MC (i.e., the marginal cost for the whole

85
output) which is also equal to OR. In any case, if it were not the same, the monopolist could
increase profits by transferring output from where marginal revenue was lower to where it was
higher.
3. What Price should be charged in Each Market?
Since the elasticity’s of demand are different in each market, the monopolist will charge different
prices in both the markets to maximize his profits. The price in market-I with less elastic demand
will be higher than the price in market-II with more elastic demand.

An output OM1 will be sold at OP1 price in market-1; an output OM2 will be sold at OP2 price in
market- II. The prices are different in both the markets (i.e., OP 1 = OP2), since the demand is less
elastic in market-I than in market II; hence, a smaller quantity can be sold at higher price in
market-I than the market-II.
The monopolist will be in equilibrium, where MR 1 = MR2 = CMR = MC (for the whole output).
It is this distribution where the monopolist maximizes his profits or it is this point where the
monopolist earns maximum profits. The monopolist is said to be in equilibrium.

7.4. Welfare loss of monopoly

Pure monopolies, and those firms with monopoly power, will attempt to maximize profits -
unless another objective takes precedence.

In the standard monopoly diagram below, the profit maximizing monopolist will operate at
output ‘Q’ and price ‘P’. While this is clearly to the benefit of shareholders (or other legal
owners) it is likely to result in the loss of welfare to society. We can compare the position of the
profit maximizing monopolist with the equivalent welfare if the industry is supplied under
perfect competition. If the industry is perfectly competitive, rather than a monopoly, equilibrium
would be at point ‘K’, with welfare at a maximum.

‘Welfare’ is the sum of the industry’s consumer and producer surplus.

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But if monopolized, demand becomes the average revenue (AR) curve, and supply becomes the
marginal cost (MC) curve. The price rises to P (rather than P1 for the competitive industry).
Here, consumer surplus shrinks while producer surplus grows. There is a loss of consumer
surplus and a net gain in producer surplus - but it is important to note that there is an overall (or
‘net’) loss of welfare of area A K L.

There are several possible interventions that can be employed to reduce the welfare loss,
including:

1. Opening up the market to competition

2. Price capping
3. Imposing regulations, such as stetting quality standards
4. De-regulating if the monopoly is state controlled
5. Nationalization, where the state takes over ownership and control

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