Chapter Two

Fundamental Economic Concepts

This chapter deals about managerial analysis and the interaction of demand and supply. Furthermore the
chapter discuss about price ceiling, price floor and equilibrium price and quantity, and time value of money.

At the end of this chapter, students will be able to;

 Understanding the concept of managerial analysis

 Understand the interaction of demand and supply.
 Understand the meaning of price ceiling and price floor
 Solve the problem involving equilibrium price and quantity.
 Understand the time value of money

2.1 Concept of Marginal Analysis

Economists analyze relationships like revenue functions from the perspective of how the function changes in
response to a small change in the quantity. These marginal measurements not only provide a numerical value
to the responsiveness of the function to changes in the quantity but also can indicate whether the business
would benefit from increasing or decreasing the planned production volume and in some cases can even help
determine the optimal level of planned production. The marginal revenue measures the change in revenue in
response to a unit increase in production level or quantity.

The marginal cost measures the change in cost corresponding to a unit increase in the production level. The
marginal profit measures the change in profit resulting from a unit increase in the quantity. Marginal measures
for economic functions are related to the operating volume and may change if assessed at a different operating
volume level.

To analyze extent decisions, we break down the decision into tiny steps and then examine the costs and
benefits of taking another one of these tiny steps. You should take another step if the benefits of taking that
step are greater than the costs of doing so. Stop when the costs of taking another step are greater than the
benefits of doing so. We call this approach marginal analysis.

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To illustrate, we analyze the common extent decision of how much to sell, where marginal analysis applies to
both costs and revenues.

Marginal cost (MC) is the additional cost incurred by producing and selling one more unit.

Marginal revenue (MR) is the additional revenue gained from selling one more unit.

If the benefits of selling another unit (MR) are bigger than the costs (MC), then sell another unit. Sell more if
MR> MC ; sell less if MR< MC . If MR=MC , you are selling the right amount (maximizing profit).

Marginal analysis works for any extent decision, such as whether to change the level of advertising, the
quality of service, the size of your staff, or the number of parking spaces to lease. The same principle applies
to each decision do more if MR> MC , and do less if MR< MC .

The main difficulty in applying marginal analysis is measuring the costs and benefits of additional steps.
However, the following Example will help you to understand it in a better manner.

Example 2.1 Suppose you are working for Ethio-Telecom, communication company trying to decide
whether to adjust the amount you spend for TV advertising. If you recently increased your TV advertising
budget by Birr 50,000, and the ads yielded 1,000 new customers, the data can tell you something about
marginal benefit of additional TV advertising expenditures.

In this example, we have data on a big jump (Birr 50,000) but not on the little steps (Birr 1) that make up the
jump. The only available data correspond to the bigger change, so we do the best that we can. We estimate the
marginal effect of another dollar of advertising by dividing the Birr 50,000 by 1,000 customers to get Birr 50
per customer, sometimes called the acquisition cost of a customer. This means that the marginal cost of
acquiring another customer is Birr 50. If the marginal benefit of another customer is bigger than Birr 50,
then increase advertising. Otherwise, do not.

Note that marginal analysis points you in the right direction, but it cannot tell you how far to go. After taking
a step, re-compute marginal costs and benefits to see whether further steps are warranted. When the marginal
benefit equals the marginal cost, stop then because you are maximizing profit (i.e., further steps are
unprofitable).

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We can also use marginal analysis to compare the relative effectiveness of two different advertising media.
For example, suppose that you are trying to decide how to adjust your promotional budget, currently allocated
between TV advertising and telephone solicitation. How much should you spend on advertising for each
medium?

In this case, the opportunity cost of spending one more dollar on TV advertising is the forgone opportunity to
spend that dollar on telephone solicitation. Increase spending on whichever medium has a higher marginal
effect, and pay for the increase by reducing spending on the other medium.

If you recently decreased your telephone solicitation budget and this saved Birr 10,000, but you lost 100
customers, the marginal effectiveness of phone solicitation is one customer for Birr 100 (alternatively, the
marginal customer acquisition cost is Birr 100). Note that we are implicitly assuming that you could get the
customers back by restoring your telephone solicitation budget.

Since it is cheaper to gain another customer using TV advertising, increase TV advertising and spend less on
telephone solicitation. Note that marginal analysis doesn’t even require you to measure the marginal benefit
of acquiring a customer. All it requires is that you measure the marginal effectiveness of each activity. If one
activity has higher marginal effectiveness than the other, then increase that activity and reduce
expenditures on the other. Then re-measure and decide whether to make further changes.

When you adjust your advertising expenditures, make the changes one at a time. Do not increase telephone
solicitation at the same time you decrease TV advertising because you lose valuable information about the
marginal impact of each change when you change both at the same time. Only by changing them separately
can you measure the marginal effectiveness of each expenditure to see whether further changes are profitable.

It is essential that you not confuse marginal cost with average cost. Recall that to calculate the average cost,
divide total cost by the number of units produced. In our current example, the average per-customer cost for
TV would be computed by dividing the total spent on TV advertising by the total number of customers
gained. Remember that average costs do not provide the information you need to make extent decisions.
In some instances, they might lead to poor decisions. To compute marginal cost, look only at the additional
cost of producing one more unit. The two cost figures may be very different. For example, some
psychological models of advertising say that any fewer than four exposures to an advertisement has no effect
on purchase decisions. The marginal effectiveness of that fourth exposure is thus very large, but the
average effectiveness of the entire advertising budget would be much lower.

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Example 2.2: Consider the following hypothetical data which shows Abebe’s investment activity. He has
decided to engage in project A, B, C, & D each of them having variety proportion marginal gain and marginal
loss.

Cash flows Project activities

A B C D
Marginal befits 200 250 300 350
Marginal costs 180 250 380 390
Net results +20 0 (-80) (-40)

From the above given hypothetical projects, it is clearly shown that only project ‘’A’’ generates a positive net
marginal benefits. Concerning project ‘’B’’ Abebe is indifferent about whether to continue or quit the
proposed project idea while the remaining project ‘’C’’ and ‘’D’’ are clearly not valid projects.

2.2 Equilibrium Analysis: Supply and Demand Relationships

We can now use the concepts of demand and supply to explain the functioning of the market mechanism.
Consider the following figure, which brings together the market demand and supply curves. In our
hypothetical market, the market equilibrium price is P*. At that price, the quantity of a good or service that
buyers are able and willing to buy is precisely equal to Q*, the amount that firms are willing to supply. At a
price below P*, the quantity demanded exceeds the quantity supplied. In this situation, consumers will bid
among themselves for the available supply of Q, which will drive up the selling price. Buyers who are unable
or unwilling to pay the higher price will drop out of the bidding process. At the higher price, profit-
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maximizing producers will increase the quantity supplied. As long as the selling price is below P*, excess
demand for the product will persist and the bidding process will continue. The bidding process will come to
an end when, at the equilibrium price, excess demand is eliminated. In other words, at the equilibrium price,
the quantity demanded by buyers is equal to the quantity supplied. It is important to note that in the presence
of excess demand, the adjustment toward equilibrium in the market emanates from the demand side. That is,
prices are bid up by consumers eager to obtain a product that is in relatively short supply. Suppliers, on the
other hand, are, in a sense, passive participants, taking their cue to increase production as prices rise. On the
other side of the market equilibrium price is the situation of excess supply. At a price above P*, producers are
supplying amounts of Q in excess of what consumers are willing to purchase. In this case, producers’
inventories will rise above optimal levels as unwanted products go unsold. Since holding inventories is costly,
producers will lower price in an effort to move their product. At the lower price, the number of consumers
who are willing and able to purchase, say, wheat increases. Producers, on the other hand, will adjust their
production schedules downward to reflect the reduced consumer demand.

In this case, where the quantity supplied exceeds the quantity demanded, producers become active players in
the market adjustment process. That is, in the presence of excess supply, producers provide the impetus for
lower product prices in an effort to avoid unwanted inventory accumulation. Consumers, on the other hand,
are passive participants, taking their cue to increase consumption in response to lower prices initiated by the
actions of producers but having no direct responsibility for the lower prices.

Example: The market demand and supply equations for a product are given as

QD=25−3 P

QS=10+ 2 P

where Q is quantity and P is price. What are the equilibrium price and quantity for this product?

Solution. Equilibrium is characterized by the condition at which QD = QS. Substituting the demand and
supply equations into the equilibrium condition, we obtain:

25−3 P=10+2 P
¿
P =3
¿
Q =25−3 ( 3 )=10+2 ( 3 )=16

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 16=16

Figure 1 Equilibrium Analysis: Supply and Demand interaction

2.3 Price ceilings and price floors

2.3.1 Price ceiling

A ban on price increases above a certain level is called a price ceiling. The rationale underlying the imposition
of a price ceiling typically revolves around the issue of “fairness.” A price ceiling is a maximum price for a
good or service that has been legally imposed on firms in an industry.

The following figure depicts the situation of excess demand Q’’-Q’ at price P1 arising from a decrease in the
supply. Of course, the excess demand might also have arisen from an increase in the demand for a good or
service. Without price controls, the equilibrium quantity would have fallen from Q1 to Q2. Thus, the rationing
function of prices could have guaranteed that only the well-to-do had access to available, commodities. In the
interest of “fairness,” and to maintain morale on the home front, the government imposed price ceilings, such
as P1 as shown in the following figure.

Shortage

2.3.2 Price floors

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The counterpart to price ceilings is the price floor. Whereas price ceilings are designed to keep prices from
rising above some legal maximum, price floors are designed to keep prices from falling below some legal
minimum. A price floor is a legally imposed minimum price that may be charged for a good or service. The
problem with price floors is that they create surpluses, which ultimately have to be dealt with. In the case of
agricultural price supports, to maintain the price of the product at P1 in next Figure the government has two
policy options: either pay certain farmers not to plant, thereby keeping the supply curve from shifting
from SS to S’S’ or enter the market and effectively buy up the surplus product, which is analytically
equivalent to shifting the demand curve from DD to D’D’.

Excess supply

Reading Assignment

1. Suppose the market demand and supply equations for a product are given as

QS=100+ 5 P

QD=300−3 P

Where Q is quantity and P is price.

a. What are the equilibrium price and quantity for this product?
b. Suppose that an increase in consumer income resulted in the new demand equation of QD=420−3 P,
what are the new equilibrium price and quantity for this product?

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 c. Suppose the government enacts legislation that imposes a price ceiling equivalent to the original
equilibrium price. What is the result of this legislation?

2.4The Time Value of Money

The basic concept of mathematics of finance is that money has time value which is described either as present
value or future. Present value is the value of money today; future value is the value of money at some point in
the future. The different between money now and the same money in the future is called interest. Interest have
a wide spread influence over decisions made by businesses and every of us in our personal lives. Therefore,
the basic objective of this unit is to discuss interest rates and their effects on the value of money. Specifically,
it covers simple interest, compound interest, annuity and mortgage problems.

A. Interests

Interest is the price paid for the use of a sum of money over a period of time. It is a fee paid for the use of
another’s money, just rent is paid for the use of another’s house. A savings institution (Banks) pays interest to
depositors on the money in the savings account since the institutions have use of those funds while they are on
deposit. On the other hand, a borrower pays interest to a lending agent (bank or individual) for use of the
agent’s fund over the term of the loan.

Interest is usually computed as percentage of the principal over a given period of time. This is called interest rate.
Interest rate specifies the rate at which interest accumulates per year throughout the term of the loan. The original sum
of money that is lent or invested/ borrowed is called the principal. i. Simple Interest If interest is paid on the initial
amount of money invested or borrowed only and not on subsequently accrued interest, it is called simple interest. The
sum of the original amount (principal) and the total interest is the future amount or maturity value or in short amount.
Simple interest generally used only on short-term loans or investments – offen of duration less than one year. Simple
interest is given by the following formula.

I = prt------------------------------------------------------------------- (1)

Where: I = Simple interest

P = principal amount

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r = Annual simple interest rate

t = time in years, for which the interest is paid

If any three of the four variables are given, you can solve for the fourth (unknown variable) and their relationship is as
follows: Amount (A) = P + I

Example 1 l Ato Fikade wanted to buy TV which costs Br. 10,000. He was short of cash and went to Commercial Bank
of Ethiopia (CBE) and borrowed the required sum of money for 9 months at an annual interest rate of 6%. Find the total
simple interest and the maturity value of the loan.

Solution:

p = Br. 10,000 A=P+I

t** = 9 months = 9/12 = ¾ year = P (1 + rt)

r = 6% per year = 0.06 = 10, 000 (1 + 0.06 x ¾)

I=?A=? = 10, 000 x 1.045

= Br. 10, 450

Interest (I) = Prt

= 10, 000 x 0.06 x ¾

= Br. 450

The total amount which will have to be repaid to CBE at the end of the 9th month is Br. 10, 450
(the original borrowed amount plus Br. 450 Interest).

Example 2 l
How long will it take if Br. 10, 000 is invested at 5% simple interest to double in value?
Solution li
Given: p = Br.10, 000 I = prt
r = 10% = 0.10
A = Br.20, 000 (2 x 10, 000) t = I*/pr
t=? = 10.0000/10000 (0.10)
= 10 Years
I* = Amount (A) – principal (p)

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 = 20, 000 – 10, 000
= 10,000

Therefore, it will take 20 years for the principal (Br. 10, 000) to double itself in value if it is
invested at 10% annual interest rate.

Present Value of Future Amount

Example 3 l
How much money you have to deposit in an account today at 3% simple interest rate if you
are to receive Br. 5, 000 as an amount in 10 months?
Solution
A = Br. 5, 000 P= A

t = 10 month 1+ rt

r = 3% = 0.03 = 5000

P=? 1+(.03 x10/12)

= Br. 4878.05
In order to have Br. 5, 000 at the end of the 10th month, you have to deposit Br. 4878.05 in
an account that pays 3% per year.

Example 4.

At what interest rate will Br. 5, 000 yield Br. 2, 000 in 8 month time.

Solution:

P = Br. 5, 000 r = I/pt

I = Br. 2, 000 = 2000

t = 8 years 5000 x 8

r=?

= 0.05 = 5%

Example 5.

Find the Interest on Br. 5, 000 at 10% for 45 days.

Solution:

P = Br. 5, 000 I = Prt

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 t = 45 days = 45/360 years = 5, 000 x 0.1 x 45/360

r = 10% = 62.50 Br.

I=?

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 i. Compound Interest
Dear students, If the interest which is due, is added to the principal at the end of each interest
period (such as a month, quarter, and year), then this interest as well as the principal will earn
interest during the next period. In such a case, the interest is said to be compounded. The
result of compounding interest is that starting with the second compounding period, the
account earns interest on interest in addition to earning interest on principal during the next
payment period. Interest paid on interest reinvested is called compound interest.
The sum of the original principal and all the interest earned is the compound amount. The
difference between the compound amount and the original principal is the compound interest.
The compound interest method is generally used in long-term borrowing unlike that of the
simple interest used only for short-term borrowings. The time interval between successive
conversions of interest into principal is called the interest period, or conversion period, or
Compounding period, and may be any convenient length of time. The interest rate is usually
quoted as an annual rate and must be converted to appropriate rate per conversion period for
computational purposes. Hence, the rate per compound period (i) is found by dividing the
annual nominal rate (r) by the number of compounding periods per year (m):

i = r/m
Example if r = 12%, i is calculated as follows:
Conversion period (m) Rate per compound period (i)
1. Annually (once a year)--------------------------------------= r/1 = 0.12/1 = 0.12
2. Semiannually (every 6 months) --------------------- i = r/2 = 0.12/2 = 0.06
3. Quarterly (every 3 months) -------------------------- i = r/4 = 0.12/4 = 0.03
4. Monthly i = r/12 = 0.12/12 = 0.01

Example 1
Assume that Br. 10, 000 is deposited in an account that pays interest of 12% per year,
compounded quarterly. What are the compound amount and compound interest at the end of
one year?
Solution
P = Br. 10, 000
r = 12%
t = 1 year

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 m = No. of conversion periods = 4 times per quarter. This means interest will be computed at
the end of each three-month period and added in to the principal.
i = r/m 12%/4 = 3%

In general, if p is the principal earning interest compounded m times a year at an annual rate
of r, then (by repeated use of the simple interest formula, using i = r/m, the rate per period,
the amount A at the end of each period is:
(1) A = p (1 + i)…......................compound amount at the end of first period.

If we are interested in determining the compound amount after two periods, it may be
computed using the equation:
(2) Compound amount = Compound amount + Interest earned during the 2nd
period A = p (1 + i) + [P (1 + i)] (i)
Factoring P and (1 + i) from both terms of the right side of the equation gives us:
A = P (1 + i) (1 + i)
= P (1 + i)2

(3) Compound amount = Compound amount + Interest earned after three periods after two
period during the 3rd period
A = P(1 + i)2 + [P (1 + i)2] (i)

Factor out p and (1 + i)2 from the terms on the right side of the equation and it gives
you:

A= P (1 + i)2 (1 + i)

= P (1 + i)3

(4) Compound amount after nth period = P (1 + i)n

The compound amount formulas developed so far are summarized below:

1. Compound amount after one period = p (1 + i)1

2. Compound amount after two periods = p (1 + i)2
3. Compound amount after three periods = p (1 + i)3
4. Compound amount after nth periods = p (1 + i)n
A = P (1 + i)n............................* Compound amount formula.

Where: A = amount (future value) at the end of n periods.

P = Principal (present value)

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 i = r/m = Rate per compounding period.

n = mt = total number of conversion periods

t = total number of years

m = number of compounding/ conversion periods per

year

r = annual nominal rate of interest

Now let us solve the above problem.

A = 10, 000 (1.03)1 = Br. 10, 300…......1st quarter

A = [10, 000 (1.03)] (1.03) = 10, 000 (1.03)2 = 10, 609..........2nd quarter.

A = [10, 000 (1.03)2] (1.03) = 10, 000 (1.03)3 = 10, 927.27..........3rd quarter.

A = [(10, 000) (1.03)3] (1.03) = 10, 000 (1.03)4 = 11, 255.088...........4th quarter.

In general, the compound amount can be found by multiplying the principal by (1 + i)n. So for
the above problem the amount at the end of the year, using the general formula, is equal to:

A = P (1 + i)n n = mt = 4 x 1 = 4

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 = 10, 000 (1.03)4 i = r/m = 12%/4 = 3%

= Br. 11, 255.088

Compound Interest = Compound amount – original principal

= 11, 225.088 – 10, 000

= Br. 1, 255.088

We may evaluate “A” in several different ways. Among the possible alternatives are:
1. Use a hand-held calculator with a Y x function key. This is the procedure most often
used.
2. Using Logarithms
Restate the equation by finding for log A (or In A) and then finding the antilog, using
either a hand-held calculator with logarithmic functions or a table of logarithms. Let
us illustrate this alternative.
A = 10, 000 (1.03)4

log A = log 10, 000 + log (1.03)4

= log 10,000 + 4 log 1.03

= log 104 + 4 log 1.03

= 4 + 4(0.01284)

= 4 + 0.05135

log A = 4.05135

A = Antilog 4.05135

= Br. 11255.117

3. The third way of finding the compound amount is using specially prepared tables
which provide values of (1 + i)n for selected values of i and n.
Therefore students, to calculate the value of “A” or other variables in the compound interest
formula, you can use any of these three approaches which ever convenient to you.

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 Example 2. Find the compound amount and compound interest after 10 years if Br. 15, 000
were invested at 8% interest;
a) If compounded annually
Compounding annually means that there is one interest payment period per year. Thus
t = 10 years
m=1
n = mt = 1 x 10 = 10
i = r/m = 8 %/1 = 8% = 0.08
The compound amount will be:
A = 15, 000 (1.08)10
= 15, 000 (2.158925)
= Br. 32, 383.875
 Compound Interest = compound amount (A) – Principal (P)
= 32, 383.875 – 15, 000
= Br. 17, 383.875

b) If compounded semiannually
Compounding semiannually means that there are two interest payment periods per year.
Thus, the number of payment periods in 10 years’ n = 2 x 10 = 20 and the interest rate per
conversion period will be i = r/m = 8%/2 = 4%. The compound amount then will be:
A = P (1 + i)n
= 15, 000 (1.04)20
= 15, 000 (2.191123
= Br. 32, 866.85
Compound Interest = A – P
= 32, 8666.85 – 15, 000
= Br. 17, 866.85

c) If Compounded quarterly
If compounding takes place quarterly (four times a year), then an 8% annual interest rate, the
interest rate per conversion period will be i = 0.08/4 = 0.02, there will be a total of n = 4 x 10
= 40 conversion periods over the 10 years. The compound amount will be:

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 A = 15, 000 (1.02)40

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 = 15, 000 (2.208039)
= Br. 33, 120.60
d) If compound monthly
p = 15, 000
t = 10 years
m = 12 (12 payment periods per year)
n = 12 x 10 = 120 payment periods over the 10
years i = r/m = 8%/12 = 0.667% = 0.00667
Under these conditions:
A = 15, 000 (1. 00667)120
= 15, 000 (2.220522)
= Br. 33, 307.84
Interest = Br. 18, 307.84 (33,307.84 – 15,000)
e) If compounded weekly
m = 52
n = 10 x 520 = 520
i = 8%/52 = 0.154% = 0.00154, then
A = 15, 000 (1.00154)520
= Br. 33, 362.60
Interest = 33,362.60 – 15,000
= 18362.60
f) Try yourself: if Compounded daily, and hourly, what will be the compound amount
respectively? Answer = Br. 33,380.19 and Br. 33, 382.99 respectively.
g) If compounded continuously (Instantaneously), what happens to the compound
amount if interest is compounded continuously? To drive a formula for continuous
compound interest, we begin by writing:
(1 + i)n = (1 + r/m) mt
Then, by inserting 1 = r/r in the exponent, we
obtain (1 + r/m)mt(r/r) = (1 + r/m) (m/r). (rt)

Then, letting m/r = X, we have

[(1 + 1/x)x] rt
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 As X increases indefinitely, the term (1 + 1/x) x approaches the value of the familiar
mathematical constant e = 2.7182818……. This means that the factor

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 (1 + i)n = [(1 + 1/x)x]rt approaches
ertas n increases indefinitely. The resulting formula for the amount under continuous
compounding of interest is given by:

A = P ert
………………..**

Where: A= amount at the end of time t under continuous compounding

p = principal
r = annual rate, compounded continuously
t= time, in years
Note: the value of ert may be found using a calculator.
Solution:
p = br. 15, 000 A = P ert
t = 10 years = 15, 000 (e0.08 x 10)
A=? = 15, 000 x e0.8
= 15, 000 x 2.22554
= Br. 33, 383.11
Compound Interest = 33, 383.11 – 15, 000
= Br. 18, 383.11
What can you observe from the above discussion? When a number of conversion period
within a year increases, the interest earned also increases continuously toward an upper limit.
The limiting case occurs where interest is compounded continuously.
Example 3.
How long it take to accumulate Br. 8, 000 if you invest Br. 6, 000 at 12% compounded
monthly?
Solution:
P = Br. 6, 000 A = P (1 + i)n
A = Br. 8, 000 8000 = 6000 (1.01)n
r = 12% we can use logarithm to solve this problem
8000
i = r/m = 1%= 0.01 = (1.01)n

t = ? n? 6000

log 1.3 3 = (1.01)n

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 l
o
g

1
.
3

3


l
o
g

1
.
0
1

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 log1.33
n=
log1.01
n = 28.92  29 months
It takes 29 months for Br. 6000 invested at 12% to grow to Br. 8000

ii. The present value

Frequently it is necessary to determine the principal P which must be invested now at a given
rate of interest per conversion period in order that the compound amount A be accumulated at
the end of n conversion periods. Under these conditions, p is called the present value of A.
This process is called discounting and the principal is now a discounted value of future
income A. If:
A = P (1 + i)n then dividing both sides by (1 + i)n leads to
A
P=
(1  i) n
= A (1 + i)-n

P = A (91 + i) -n
… * Present value of compound amount.

Example 4. How much should you invest now at 8% compounded semiannually to have Br.
10, 000 toward your brother’s college education in 10 years?
Solution
A = Br. 10, 000 P = A (1 + i)-n
t = 10 years = 10, 000 (1.04)-20
m=2 = 10, 000 (0.456387)
n = mt = 20 = Br. 4563.87
r = 8%
i = r/m = 4% = 0.04
p=?
Summary
The supply-and-demand model applies most accurately when there is perfect competition. This is
an abstraction, because no market is actually perfectly competitiv e, but the supply-and-demand
framework still provides a good approximation for what is happening much of the time.
Equilibrium represents the equality of the quantity demand and quantity supplied. Marginal analysis is used to measure
the benefit of the additional unit of goods or services in the business activities. Money has time value which is described
either as present value or future. Present value is the value of money today; future value is the value of money at some
point in the future. The different between money now and the same money in the future is called interest. Interest have a
wide spread influence over decisions made by businesses and every of us in our personal lives.
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