CHAPTER ONE

INTRODUCTION

1.1 Nature, Scope and Methods of Economics

The Foundation of Economics

The field of Economics bases itself on two fundamental facts:
1. Human wants are Unlimited: the material wants of people and institutions are
unlimited and insatiable. They multiply endlessly and have recurring nature. By material
wants we mean the desires of consumers to obtain and use various goods (e.g. bread,
shoes, books, etc.) and services (a doctor’s visit, haircut, city bus service, etc.) that
provide utility, meaning pleasure or satisfaction. These innumerable goods and services
can be classified as necessities (food, shelter and clothing) and luxuries (what is a luxury
good for one person may not be for the other).

2. Economic resources are limited or scarce. In economics, these productive resources,

which are the means of producing goods and services, are broadly classified as land,
capital, labor and entrepreneurial ability. Quantities of a nation's arable land, mineral
deposits, capital equipment, labor and entrepreneurial ability are limited in terms of both
quality and quantity. This in turn limits the amount of output that the nation can produce
over a given period of time.

The Central Aim of Economics

The imbalance between the unlimited human wants and the limited productive resources,
which is called scarcity, calls for economizing the scarce resources, which is the central
aim of economics. By economizing we mean the efficient use of the scarce productive
resources-minimizing wastage (loss) so as to get the maximum possible satisfaction. In
the absence of scarcity, there will be no need of economizing. Therefore, the foundation of
economics lies on the concepts of scarcity and Choice (unlimited human wants).

Thus, Economics is:

➢ A set of tools that enable us to use our resources efficiently. The end result is
achieving the highest possible standard of living.
➢ Concerned with the efficient use or management of limited productive resources to
achieve maximum satisfaction of human material wants.
➢ The allocation of scarce means of production (land labor, capital and managerial
abilities) towards the satisfaction of human wants.
➢ Is the study of our behavior in producing, distributing and consuming material
goods and immaterial services in the world of scarcity?
In general, economics can be defined as the study of how societies choose to use their
scarce productive resources that have alternative uses, to produce valuable commodities
and distribute them among its different groups to satisfy the unlimited human wants.

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 1.1.1 Levels and Methods of Economic Analysis

Levels of Economics

Economists operate (or economics is studied) on two levels. These are microeconomics
and macroeconomics.

Microeconomics: deals with the economic behavior of individual decision-making units

such as consumers, resource owners, business firms and individual markets, industries,
organizations etc. For instance, we measure the price of a specific product, the number of
workers employed by a single firm, the revenue or expenditures of a particular firm or
government entity, etc. The major goal of microeconomics is to understand how the prices
of particular commodities influence decisions. Because of its preoccupation with prices
and trading of goods and services, microeconomics is sometimes called price theory.
Microeconomics is partial analysis in which individual economic aspects (units) are
studied in isolation from the interconnections that exist between them and the rest of the
economy. In partial analysis economists use the phrase (concept) ‘other things being
equal’ or ‘ceteris paribus’ (Latin word) to acknowledge that other influences aside from
the one whose effect is being analyzed must be controlled.

Macroeconomics: examines the economy as a whole or its basic sub-divisions or

aggregates such as the government, household and business sector. An aggregate is a
collection of specific economic units treated as if they were one unit. These aggregate
macro variables include the aggregate level of output, national income, aggregate
employment, the general price level, national consumption, national saving and
investment, money supply, exchange rate, etc. Macroeconomics looks at the economy from
a broader perspective by considering its overall performance and the way various sectors
of the economy relate to one another. The performance of an economy is judged by the
total value of annual production, the capacity of the economy to provide jobs, stability of
prices, the changes in the purchasing power of money and the growth of employment and
output. Macroeconomics helps in explaining the causes of economic fluctuations and to
suggest appropriate policy measures.

If we consider a forest as the economy and the individual trees in the forest as specific
economic units, Macroeconomics would examine the forest as one entity and
microeconomics would do with the individual trees separately. However, this does not
mean that there is no relationship between the two. Many topics and subdivisions of
economics are rooted in both. Many macroeconomic concepts and theories base themselves
in microeconomic theories and concepts.

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Methods of Economic Analysis

In studying economics, economists derive economic principles (theories) which are useful
in the formulation of policies designed to solve economic problems. In order to derive these
theories, study economic problems and design appropriate economic policies to solve
economic problems, economists use different methods. The scientific approaches by which
the economic science progresses are:
➢ Observation of facts: Economic study begins by gathering facts (historical or current)
which are relevant to consideration of specific economic problem Observation of facts
provides countless information of economic events from which we can find patterns of
behavior about the decision-making units, the various sectors of the economy or the
economy as a whole.
➢ Economic analysis: is a detailed analysis of elements or structure of economic events
or behavior. It is an approach, which deduces and predicts certain kinds of economic
behavior on the basis of prior assumptions.
➢ Statistics: In recent years, the use of statistics is growing in importance. Economists
use statistics to find out cause and effect relationships among two or more economic
variables (such as saving and investment, price and quantity demanded, etc) and
understand complex economic behavior quantitatively. Data concerning various
economic units is collected and analyzed using different statistical tools to help us
understand complex economic behavior quantitatively.
➢ Experiment: When economic history, economic analysis and statistics fail to provide
a clear answer to important questions, economists go for closed (controlled)
experiments to understand complex economic processes. For example, an experiment
has recently been done in Ethiopia to see the effectiveness of extension services in the
health sector at household level (by selecting some households) and decided to expand
it throughout the country.

Definition of Important Terminologies

Theory:
A theory is a framework that helps us to understand cause-effect relationships. It is
simplification of an actual relationship. It is a hypothesis that has been successfully tested
i.e., it is a validated hypothesis. It holds true in general or on average (is less precise) and
is often subject to exceptions because of individual differences. For instance, the theory of
demand tells us that, other things remaining constant, when the price of a specific product
decreases, the quantity of the product demanded by consumers increases. This is generally
true. However, there may be some exceptional individuals who may not like to buy cheaper
products and decide to stop buying any quantity of this specific product whose price has
fallen.
▪ The purpose of a theory in all scientific analysis is to predict and explain the cause of
phenomena we observe. That is, a theory abstracts from the details of an event; it
simplifies, generalizes, and seeks to predict and explain the event.
For example, the theory of demand helps us to predict by how much the quantity demanded
of a product will decrease if its price is increased by a certain percentage and explains the
reasons for such an inverse (negative) relationship

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Hypothesis:
A hypothesis is an "if-then” proposition usually constructed from a casual observation of
a real-world event, which represents a tentative and yet untested explanation of the event.
For example, before collecting a data and analyzing it, you may hypothesize that an
increase in the income of households in Addis Ababa would increase their willingness to
pay for an improved solid waste service. However, the validity of this hypothesis is going
to be checked only after collecting and analyzing the data on the relevant variables such as
household income and their willingness to pay.

Law:
A law is a theory that is always true under the same circumstances.
Example: the law of gravity, the law of demand, the law of supply, etc.

Economic Model:
An economic model is a representation of the essential features of a theory or of a real-
world situation, expressed in the form of words, diagrams (graphs), mathematical
equations or tables (schedules). It is a simplified way of representing and explaining real
–world economic behavior and relationships, which are too complex by nature.
The relationship between the price and quantity demanded of a specific product X, for
instance, can be expressed verbally (with the help of the law of demand), mathematically,
using a schedule (table), or graphically by drawing the demand curve.
Consider the following arbitrary example;
d
Demand equation……………. Q X = 10 – 2 PX

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Demand
schedule
Price (P) Quantity demanded (Q)

0 10
1 8
2 6
3 4
4 2
5 0

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Demand Curve
4

0
2 4 6 8 10 Q

Methods of Reasoning

(i) Inductive method of Reasoning: Induction distils or creates principles from facts.
It involves three major steps. First facts are collected. Then they are arranged
systematically and analyzed repeatedly. Finally, general principle or theories are
derived and policies formulated. Induction moves from facts to theory (from the
particular to the general).

Facts Principles /theories/ Policies

(ii) Deductive method of Reasoning: deduces or goes from general
(principles/theories) to particular (facts). Here economists draw a tentative and yet
untested principles called a hypothesis (based on casual observation, logic, insight
etc.) and test the validity of the hypothesis through systematic and repeated
examination of relevant facts.
Facts Principles or theories Polices
Deduction and induction are complimentary, rather than opposing techniques of
investigation. Hypothesis formulated by deduction provides guidelines for the economists

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 in gathering and systematizing empirical data. Conversely, some understanding of factual
evidence of the ‘real world” is prerequisite to formulation of meaningful hypothesis.

Deduction

Facts Principles or theories Policies

Induction

Normative Vs Positive Approaches of Economic Analysis

i) Positive economics

It is that part of economic science which concerns itself with statements that are capable of
verification by reference to the facts through statistical methods. It is concerned with describing
and analyzing the economy as it is. It is an economic analysis, which provides descriptions or
statements about “what is", “what was” or “what will be " rather than “what should be".

It analyses the effects of changes in policies or conditions on observable variables such as

output, income, profit, prices, sales, cost, etc and tries to determine who gains and who losses
as a result of these changes through verification of facts. Because no one completely
understands how the economy works, economists often disagree about actual cause-and-effect
relationships. Positive analysis tries to resolve these disagreements by examining facts using
statistical methods to testing the relationships.

Example: the following are statements provided by positive economics.

➢ Unemployment is 7 % of the working population in country X. (e.g. of “what is”)
➢ This country’s GDP was 100 billion dollars last year (e.g. of “what was”)
➢ If investment increases, national income will rise. (e.g. of “what will be”)

Positive economics is not, however, concerned with providing value judgments about what
should be done. The statement “Investment should be increased”, for instance, is not a statement
of positive economics.

ii) Normative Economics

It is concerned with “what ought to be” or “what should be” done about the economy. It
is the way of evaluating the desirability of alternative outcomes of economic policies or
conditions according to underlying value judgments about what is good or bad. That is,
it involves ethics, value judgments and norms. The normative approach makes
recommendations regarding what ought to be and it is used to prescribe changes in policy.

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Example: the following are statements provided by normative economics.
➢ Families of four with incomes below $15,000 per year should be exempted from
income taxes.
➢ Unemployment should be reduced from 7% to 5% in 2008.
➢ Investment should be increased by 10 %.
➢ Tariffs and other restrictions that impede free trade must be eliminated.
➢ Infant industries ought to be protected.

1.1.3 The Concept of Economic Resources

To produce goods and services we need four main resources, usually refereed as “the means
of production.” These are the land, labor, capital and entrepreneurial ability.

1. Land as a resource includes the natural resources -all gifts of nature on or in it- usable
in the production process. This includes the arable land, forests, oil deposit, coal, iron
ore, water resources, etc. The basic payment (return) made to the owners of land is
rent.

2. Labor is a broad term for all the physical and mental talents of skilled, semi-skilled
and unskilled human resources (excluding entrepreneurs) available and usable in
producing goods and services. The services of a lecturer, a doctor, a clerk, a machinist,
or a daily laborer are examples of labor. The return paid to labor is referred to as wages
and salaries (includes basic salary and other fringe benefits).

3. Capital (capital goods or investment goods): includes all manufactured goods used
for further production, that is, all tools, machinery, equipment, factory, storage,
transportation, and distribution facilities used in producing goods and services and
getting them to the ultimate consumer. The process of producing and purchasing
capital goods is known as investment. Capital goods differ from consumer goods in
that the later satisfy human wants directly while the former do so indirectly by aiding
production of consumer goods. It is also important to note that the term “capital” here
defined does not refer to money. Money by itself produces nothing unless it is
converted into the factors of production. The return paid to the owners of capital is
interest.

4. Entrepreneurship: an entrepreneur is a person who

✓ Takes the initiative in combining the other factors of production (labor, capital, and
land), which are otherwise passive, to make available goods and services.
✓ Makes basic business-policy decisions (non-routine decisions).
✓ Is an innovator of new products, new productive techniques/processes and new
forms of business organization?
✓ Is a risk bearer/taker with a chance of profit or loss?
➢ The return paid to an entrepreneur is Profit.

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Resource Utilization

Full Employment (using available resources): refers to the use of all available resources
in the production process. That is, those who are willing and able to work are provided
with jobs, no arable land or capital equipment is sitting idle, etc. However, this does not
mean that there is no any kind of unemployment of resources. We could allow farmland to
lie fallow periodically, conserve resources for future generation, etc.

In other words, full employment can be defined as the level of employment below or equal
to the natural rate of unemployment. At full employment there are resources that are
temporarily unemployed. Some workers may temporarily be unemployed because their
employer, whose firm faced an acute loss, has fired them. Likewise, machinery might not
be utilized while it is transported from one project area to another one or while it is under
maintenance. Such level of unemployment is called the natural rate of unemployment.
Usually it is 4% up to 6 % of the labor force.

Unemployment: is a condition at which a person is unwillingly unemployed, .i.e. he/she

doesn’t have a job while he/she is willing and able to work.

Underemployment: is a condition at which an already employed resource is not used to

full capacity. I.e there is idleness and wastage.

Full Production (using resources efficiently): is the level of production at full

employment.

1.2 Basic Economic Problems and Economic systems

1.2.1 The basic economic problems/questions

Every human-society must confront and answer three fundamental economic problems and
questions.

(i) What to produce? (The Problem of Resources Allocation)

It refers to those goods & services, and the quantity of each that the economy should
produce. Since resources are scarce or limited, no economy can produce as much of every
good and service as desired by all members of society. For this reason, more of one good
or service means less of others. Therefore, every society must choose exactly;
(a) Which goods and services to produce and
(b) How much of each to produce.
The answer for this question depends on the objective of production and existing social,
economic and political situation of the society.

(ii) How to produce? (The problem of choice of technique of production)

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Refers to the choice of
1. the combination of factors, and
2. the particular technique to use in producing a good or service.
Since the same unit of a good or service can normally be produced with different factor
combinations and different techniques, the problem arises as to which of these to use. Since
resources are limited in every economy, when more of them are used to produce some
goods and services, less are available to produce others. Therefore, society faces the
problem of choosing the technique which results in the least possible cost (in terms of
resources used) to produce each unit of the good or service it wants. This problem is
answered based on the relative availability or abundance of resources. Though resources
are generally scarce, some of a country’s resources may be relatively abundant than others.
If labor is relatively abundant and capital is scarce (like the case of Ethiopia), we use more
of labor and less of capital (by introducing labor-intensive technologies) so that our cost
of production will be lower.

Consider the following hypothetical example in the production of cloth.

Technique Labor + Capital Units
I (Hand Loom) 12 5 (Labor-intensive)
II (Power Loom) 4 10 (Capital-intensive)

(iii) For whom to produce? (The Problem of Distribution of goods and services.)

Refers to how the total output produced is to be divided among different consumers. Since
resources and thus goods and services are scarce in every economy, no society can satisfy
all the wants of all people. Thus, the society has to choose how to distribute the output. In
market economies, for instance, the society has to exercise some sort of choice by making
available the product to those who command money income to pay for the goods and
services. Others who cannot pay for it are denied its use. Thus the problem of distribution
is related to income distribution in the nation.

1.2.2 Alternative Economic Systems

A society needs to select an economic system- a particular set of institutional arrangement

and a coordinating mechanism-to respond to the economizing problem. Economic systems
can differ as to:
a) Who owns resources? (Property right on resources)
b) The method used to coordinate and direct economic activity.

Accordingly, we have the following three alternative economic systems.

(1) Free Market Economy (pure capitalism/enterprise)

In the market system each participant acts in his/her own self-interest; each individual or
business seeks to maximize its satisfaction or profit through its own decision regarding
consumption or production.

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It is an economic system in which,
➢ Most resources are owned by private individuals and private firms
➢ Individuals and private firms make major economic decisions about production,
consumption and distribution
➢ The three basic questions/problems are solved with the help of the price mechanism
(market system).
This economic system, through its price mechanism, answers the basic questions as:
✓ What to produce? Those goods for which consumers are willing to pay a unit price
that is sufficient to cover at least the full cost of producing a unit of the product.
The more consumers are willing to pay a higher price (i.e the more the product is
demanded), producers will be encouraged to produce that product in large
quantities.
✓ How to produce? Using the best technique: the one that results in the least cost
production. Since producers have to incur a cost to get factors of production from
resource owners, they use less of the more expensive resources and more of the
cheaper resources to minimize cost and maximize profit.
✓ For whom to produce? To those consumers who have the money income to pay for
it.

The extreme case of free enterprise economy is the Leissez-faire economy in which the
government is not to intervene in the economy. Its role is limited to protecting private
property, establishing proper environment for the market system, and the like.

(2) Command Economy

The command economy is the polar alternative to (the opposite of) pure capitalism.
It is an economic system in which:
➢ The government makes all decision about production, distribution and consumption
etc.
➢ The government owns most of the productive resources (land, capital, etc, and is
the employer of most activities.
➢ The price mechanism is replaced by central planning (economic planning) i.e. most
economic activities are centrally planned.
The three basic economic problems (what / how/ for whom to produce?) are
answered directly by the central planning committee through economic order. This
committee determines production goals and the resources to be allocated for each
enterprise; and decides on the division between consumer and capital goods.

(3) Mixed Economy

The mixed economy is a compromise between the free market economy and the command
economy. It allows private property; the individual entrepreneurs are free to choose their
lines of production and individual consumers are free to decide on what to consume. The
state also plays an important economic role by directing the private sector to its best
optimum use and simultaneously, the state also owns, controls, and manages the public-
sector economy to fill the gap and maximize social welfare.

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The three basic economic problems (of what/how/for whom to produce?) are not
completely left to the price mechanism but are modified through different policy measures
such as taxation, subsidy, welfare payments and direct control.
In general, there exists no 100% free or command economy. All economies fall under the
mixed economic system. However, some are closer to the command economy (e.g. North
Korea and Cuba) and others are closer to the pure capitalism (e.g. USA, Japan).

1.2.3 The Production Possibilities Frontier/Curve (PPF or PPC)

The problem of scarcity can more clearly be shown with the aid of a simple model whose
purpose is to examine the relationship between the production of goods and services and
the availability and use of resources.
At any point in time a country can produce only a certain amount of goods and services
with its scarce resources. Moreover, the country cannot produce more of one good without
giving up (reducing) some of other good's production. In economics, we represent this
limitation on country's productive potential by the production possibility frontier (PPF).
Hence, the PPF/PPC is a curve that shows the maximum possible output of the
combinations of two goods (or broad classes of goods) that can be produced with available
resources and given technology at a given period of time when all resources are fully
(efficiently) utilized
Assumptions of the model:
1) The quantity and quality of economic resources available for use during the
period (year) are fixed.
2) There are only two goods (or broad classes of goods) we can produce with
available economic resources.
3) Some resources are better adapted to the production of one good than to the
production of the other.
4) Technology is fixed and does not advance (change) during the period (year).
5) All resources are used efficiently i.e. resources are not wasted (there is full
employment of resources and full production).
Movement along the same production possibilities frontier leads to a trade-off between
the production of two goods. Since it is impossible to produce more of one good without
reducing at least some of the production of the other goods, there is a trade-off between the
alternative possibilities of producing two goods. To see the concept of the trade of between
production of two goods, consider the following graphical illustrations.

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 Military goods
Per year
Environmental
improvement D
Services per year
A

B C

Other goods
 When production of Other goods and and services pr
military goods declines, services per year  When we increase year
we gain the opportunity to environmental quality,
produce more of other we must sacrifice other
goods. g and s in exchange for
clear air and water.
Now, let's take a hypothetical example for a given nation A and see its production
possibilities. Assume that this country produces only two goods: Machines (capital good)
and food (consumption good).
Possibilities Production of Machines (M) Production of Food Movement from A to F
Per year (in units) (F)Per year change in M change in F
(in tons)
A 150 0 - -
B 140 10 -10 10
C 120 20 -20 10
D 90 30 -30 10
E 50 40 -40 10
F 0 50 -50 10

Machine
150
140 M
120
100
80 R
60
40
20

0 10 20 30 40 50 Food

Points on this production possibility curve such as A, B, C, D, E & F show alternative

combinations of machines and food that can be produced in an economy assuming that no
other products are made. Each point on the curve gives the maximum amount of one good
that can be produced given the output of the other good. To reach a point on the curve, such
as A, B…F, resources must be fully utilized and there must be no waste or mismanagement
of resources in production. Hence, points such as A, B…F are efficient. The society has
to choose which combination of the two goods to produce i.e. at which point to produce.

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Productive Efficiency
Productive efficiency occurs when it is impossible to produce more of one good without
reducing the output of the other good, given existing resources and technology. Excessive
underutilization of resources prevents the economy from reaching a point on its production
possibilities curve. Similarly, waste or mismanagement in production results in production
at a point like R with in the PPC. Thus, points such as R are inefficient. Productive
efficiency is attained when the maximum possible output of any one good is produced
given the output of other goods. Attainment of productive efficiency means we can't
reallocate economic resources to increase the output of any single good or service without
decreasing the output of some other goods or services. Hence, points on the PPC represent
efficient use of productive resources. On the other hand, points such as point M are
unattainable because the available amount of resources and the existing level of technology
cannot allow the nation to produce such combination of the two goods.

The Law of increasing opportunity cost

The amount of other products which must be forgone or sacrificed to obtain one more unit
of a specific good is called the opportunity cost of that good (which is produced). The law
of increasing opportunity costs states that the opportunity cost of each additional unit of
output of a good or a service over a period increases as more and more of that good is
produced. This law is an implication of the assumption that some economic resources are
more suited than others to the production of a particular good (the third assumption of the
model).
The concave shape of the PPC reflects the law of increasing opportunity costs. The slope
y
of the curve at any point is where y is the annual reduction in the output of the good
x
on the y-axis necessary for each extra output of the good on the x-axis. In the example
M
above, Opportunity Cost = Slope of the PPC = at any point on the PPC.
F
M
➢ Gives the units of machine to be sacrificed for every one-unit extra food.
F
Annual output of food Increase (gain) in Opportunity cost of each
('tons) food output successive tons of food in terms of
('tons) the reduction in machines output
F M

0 - -
10 10 10
20 10 20
30 10 30
40 10 40
50 10 50
Generally, the PPF is concave to the origin and is downward (negatively) slopping. This
shape of the PPF also implies the existence of the law of increasing opportunity cost. If
you draw a tangent line to any point on the PPF, the slope of that tangent line goes on
increasing as you move from left to right along the X-axis.

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 Good Y In moving from A to B, the slope of the tangent
A line goes on increasing i.e. the slope of T1 is
greater than that of T2.
T1

T2
B

Good X

The Concept of Economic Growth

Economic growth is the expansion in production possibilities of a nation that results from
increased availability and increased productivity of economic resources. When economic
growth occurs over time, the production possibilities curve (PPC) will shift outwards. This
means that the economy will be able to produce more of all goods. When economic growth
occurs, production possibilities that were previously unattainable (such as point M) will
now be feasible (attainable). The sources of economic growth are:
(i) Increased quantities of economic resources
Machine
per
year
PPC2

PPC1

Food per year

The amount of output that can be produced depends, among other things, on the quantity
of resources (inputs) used in the production process. Other things remaining constant, the
more the inputs used, the more the output produced. An increase in the availability
(quantity) of resources enables the economy to produce more of at least one of the goods.
This would shift the PPC outwards from PPC1 to PPC2. Points in the shaded area represent
new production possibilities that would have been impossible at the previous quantity of
resources.

By the same token, the destruction of economic resources in a nation will move (shift) the
PPC inward. E.g. war destroys both human and physical resources, causing the PPC to
shrink (shift) inward.
(ii) Improved Quality of Resources
Having the same quantity of resources (land, labor, capital and entrepreneurial ability) as
before, an improvement in the quality of these resources can also increase the output obtainable

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from the same combination of inputs. Enhancement in the fertility of land (of the same hectares
as before) gives greater yield. Improvements in skills, education, or training of the labor force
enable workers to accomplish a given job better and produce more. Thus, devoting more
economic resources to education and training in the current year pays off in the future in terms
of greater production possibilities. Improvements in quality of capital such as using machines
that can accomplish more tasks more quickly or more accurately also increases the amount of
output. An increase in the quality of entrepreneurs also enhances their talents to innovate new
products and processes (techniques) and produce more than before. A change in the quality of
one or more of these resources expands the production possibilities (as shown by the shaded
region) of the economy - the PPF shifts outwards to the right.

Machine per year

PPC2

PPC1
Food per year
(iii) Technological Improvements.
Improved technology (productive potential) from development of new technologies is a very
important source of economic growth. Technological advances in one sector of the economy
cause gains in production possibilities in the other sector by making available more resources
to the production of the other. Example: if the technology in the production of food increase,
it is possible to produce more of both food and machines with the existing resources. The
opposite also holds true.
Food per year
(In tons)

PPC2 Technological advance in food

production shows expanded production
possibilities for both food and clothing.

PPC1

Clothing per year (no.

of garments)
If there is technological advancement, either more can be produced with the existing resources
or the same output can be produced with lesser amount of resources.

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 Consumption, Investment, and Economic Growth
In each economy, decision must be made about how to allocate currently available
resources between current consumption goods and future consumption goods. Education,
new structures and equipment to be used in production, and research for and development
of new technologies are investments in future prediction possibilities. The gain from these
investments is the expansion in production possibilities they allow in the future. In addition
to deciding what/how/and for whom to produce, each economy also must decide what and
how much it will sacrifice today to make investments that expand future production
possibilities.
The more the investment (the lesser the consumption) in the current year, the greater the
growth in production possibilities in the future years will be. If nation A invested more
than Nation B and, as a result, nation A's production possibilities curve shifts out farther in
the future than nation B's. Thus, societies must choose between consumption today and
consumption tomorrow. The society that devotes a greater share of its resources to
producing capital goods sacrifices consumption now but enlarges its supply of capital
goods and will thus have a higher rate of economic growth in the future and vice versa.
The circular flow diagram (flow of Economic Activities)
The circular-flow diagram summarizes the flows of goods and services from producers to
households and the flow of factors of production from households to business firms. It
illustrates the circular flow of economic activities. The flows from households to firms
and from firms to households are regulated by two markets: Goods market (product market)
-the market for goods and services and the factor- market (resource market) the market for
factors of production.

The circular flow diagram consists of two circles. The outer circle shows the physical flow
of goods and services and productive resources (factors) & the inner circle shows the flows
of money expenditures on goods and services and on productive factors. The physical flows
and the money flows go in opposite dissection.
and survives
Supply of goods
Demand for goods

Goods market
and service

Consumption

Receipt
Sales
Expenditure

What?
re

Households For whom? How? Business

interest profit]
capital entrepreneurial

[Wage, rent,

payment for

Factor
Income
Demand for factors
Supply of factors
[labor, land, and

factors

(Receipt)
ability]

Factors market

16
Note:
▪ For every physical flow in the economy there is a corresponding financial transaction.
▪ There are two pairs of supply and demand transactions in the circular flows
1. The supply and demand for consumer goods and services are mediated in the goods
market, where households are demanders and business firms are suppliers.
2. The supply and demand for factors of production (inputs) are mediated in the factor
market, where households are on the supply side and business firms are on the demand
side.

17
 CHAPTER TWO

THEORY OF DEMAND AND SUPPLY

Markets: a market is an arrangement or a mechanism through which buyers and sellers meet
or communicate in order to trade goods and services by determining price and quantity. Some
markets take place in physical locations while others are conducted without sellers and buyers
meeting face-to-face (through mail or telephone, internet/e-mail or agents).

Supply and demand analysis: a theory that explains how prices are established / determined
in markets through competition among buyers and sellers, and how those prices affect
quantities traded.
Rationality assumptions: - supply and demand analysis is made under the assumption that
consumers and producers are rational. i.e.
i) Consumers make consumption decisions in a way that maximizes their satisfaction, and
ii) Producers make production decisions in a way that maximizes their profits.

2.1 THE THEORY OF DEMAND

Definitions:
Quantity Demanded: is the amount of a commodity that consumers are willing and able to
buy at a specific price over a period of time, ceteris paribus (or holding other factors
influencing their decision constant).

Demand: is the relationship between the various amounts of a commodity that consumers are
willing and able to buy at each price in a series of possible prices during a given period of time,
all other influences held constant.
The term demand, as used in economics, is not a fixed number. It signifies how the quantity
buyers purchase varies with prices, ceteris paribus.
Demand is an effective desire which is backed by:
i) Willingness and ability of the consumer to purchase the desired commodity,
ii) Availability of the desired commodity in the market.
The law of Demand: is the principle that states that, other thing being equal, the lower the
price of a good/service, the greater the quantity of that good/service buyers are willing and able
to purchase over a given period
While nothing else changes,
➢ If price increases, quantity demanded decreases, and
➢ If price decreases, quantity demanded increases.
Demand Schedule: is a table that shows how an item’s quantity demanded would vary
with price, other things being equal.
Demand Curve: - is a graph of the data comprising a demand schedule. It shows how
quantity demanded varies with price graphically.

18
Example: consider the following demand schedule/equation and curve for an individual.
Demand Schedule for Meat (in K.g) per week (of Ato Kebede).

Price (Birr) Quantity Demanded

10 1
9 2
8 4
7 7
6 12

Graphically, this price-quantity relationship can be shown as follows

Price per k.g
(Birr)
10
9
8
7

6
5
4
3 Individual
2 Demand
1 Curve
Quantity of meat in
1 2 3 4 5 6 7 8 9 10 11 12 13 14 k.g Demanded

Individual Demand Equation: in general, the demand function is stated as Qd = a - bP,

ceteris paribus (i.e. Q=f(P)). We can use the following method to derive the demand
function when the relationship between price and quantity demanded is linear.

(Y- Y1) = m (X-X1)

where, m is the slope = Y2 – Y1, Y stands for price (P) and, X stand for quantity
X2 – X1 demanded (Qd)

Now, take any two pairs from the demand schedule, say
Y1=P1=10 and X1=Qd1=1
Y2=P2=8 and X2=Qd2=4 m= Y2-Y1 = P2-P1 = 8-10 = -2
X2-X1 Q2-Q1 4 –1 3

Thus, Y-Y1 = m ( X-X1) or P – P1 = m ( Q – Q1)

P-10 = - 2 (Q – 1) or P – 10 = - 2 Q + 2
3 3 3

P = - 2 Q + 32 This is the inverse demand function. To get the demand function,

3 3 we have to express Q in terms of P i.e. Qd = f(P).

19
Thus, Qd = 16 – 3 P
2
Note:
➢ - 2/3 is the slope of the inverse demand function and -3/2 is the slope of the demand
function.
➢ The slope – 3/2 implies that when the price of a k.g of meat increase by 1 birr,
o Quantity demanded decreases by 1.5 k.g per week.
➢ The X-intercept (when P=0) is 16. If price per k.g were zero, Ato Kebede’s quantity
demanded would have been 16 k.g per week.
➢ The Y-intercept (when Q=0) is 10.67. This means that if price goes as high as 10.67,
Ato Kebede would demand zero k.g of meat per week.
➢ The negative sign of the slope shows the inverse relationship between price and
quantity demanded, reflecting the law of demand.

Demand requires willingness or ability to pay and desiring the product.The demand curve
shown above moves down and to the right. This means at high price, people buy very little,
but as price declines, they buy more. The reverse is true when price comes down quantity
purchased goes up.
▪ But, what is the rationale for the law of demand? Discuss it.
Market Demand
The market demand for a certain product is the amount (quantity) of the product that all
consumers of the product in the market are willing and able to by at different price levels.
It can be derived from the individual demand schedules using the additive method
(horizontal summation). For ‘n’ number of consumers of a commodity, the market demand
is Dm = D1 + D2 + D3 + D4 +……. + Dn.

Consider the following hypothetical example.

Market demand schedule for oranges per week
Price per k.g Quantity Demand by individual Market Demand in
(birr) households ed (in k.g (horizontal
(hhs) k.g) summation)
hh. A hh. B hh. C hh. D = A+B+C+D
3 3 7 6 8 24
4 2 5 4 6 17
5 1 3 2 4 10
6 0 1 0 2 3
Draw the individual demand curves and the market demand on the same plane. Also derive
the market demand function using the previous method we used.

Determinants of Demand
When we constructed the demand curve,
a) we considered price as the most important influence(obstacle) on the amount of the
product purchased, and

20
 b) We isolated the influence of other factors, which we call determinants of demand,
using the phrases “other things are being equal”, “ceteris paribus”, etc.
These other factors or determinants of demand are:
1. The taste or preference of consumers:
2. The number of consumers (buyers) in the market (market size).
3. The money income of consumers
4. Prices of related goods
5. Consumer expectations about future prices and incomes

If we relax this, any change in one or more of these determinants would shift the demand
curve either to the right or to the left (changes its location). For this reason, they are also
known as demand shifters. Before analyzing the effect of a change in each demand shifter,
let’s discuss what a change in demand means.
Change in Demand: a change in one or more of the determinants of demand (but not in
its own price) will change
a) the demand data (demand schedule) and
b) the location of the demand curve i.e, shift to the right or to the left

This change in the demand schedule or, graphically, a shift in the location of the demand
curve is called a change in demand.
✓ a shift of the demand curve to the right is called an increase in demand. This means
that the consumer(s) become willing and able to buy more of the product at each
possible price than before.
✓ a shift of the demand curve to the left is called a decrease in demand. This means that
the consumer(s) become willing and able to buy less of the product at each possible
price than before.

P1

P0

P2

D1 D2
D3

Q3 Q1 Q2

The above graph shows us that:

1. When demand increases from D1 to D2, at price P0 quantity demanded increases
from Q1 to Q2 or the consumer is now willing to pay a higher price P1 for the same
quantity Q1.

21
 2. When demand decreases from D1 to D3, at price P0 quantity demanded decreases
from Q1 to Q3 or the consumer is now willing to pay a lower price P2 for the same
quantity Q1.
Now let's examine how changes in each demand shifter changes demand.

1. The taste or preference of consumers: Other factors remaining constant, A change in

consumers taste or preferences favorable to a product will mean that more will be
demanded, shifting the curve to the right. An unfavorable change in consumer
preference will, on the other hand, make the product less desirable and decrease the
demand.
2. The number of consumers (buyers) in the market. An increase in the number of
consumers in a market will increase demand. This means that consumers will be
demanding more of the product at each possible price. Trade agreements among
countries, globalization, immigration of people, etc could increase the market size for
the products of a given country or firm.
3. The money income of consumers. The effect of a change in consumer's money income
on the demand for a product depends up on the type of the product. For most
commodities a rise in income will cause an increase in demand. Such commodities
whose demand varies directly with money incomes are called Superior or normal
goods.
Although most products are normal goods, there are a few exceptions. Example: rising the
incomes may also decrease demand for used clothing and third hand automobiles. Goods
whose demand varies inversely with a change in money income are called Inferior goods

4. Prices of related goods. Whether a particular change in the price of a related good will
increase or decrease the demand for a product will depend on whether the related good
is a substitute for it or a complementary to it.
A substitute is a good, which can be used in place of another good. When two goods are
substitutes the price of one and the demand for the other move in the same direction. Coke
and Pepsi are substitutes. When the price of Pepsi increases, people consume less of Pepsi
and more of coke.
A compliment is a good used in conjunction with another. When two goods are
complementary, the price of one and the demand for the other move in the opposite
direction. Example: If the price of gasoline falls and as a result you drive your car more,
this extra driving will increase the demand for oil.
But many goods are not related to one another, they are independent (unrelated) goods. In
this case, a change in the price of one has little or no impact on the demand for the other.
Example: Butter and a ball, potato and automobiles.

5. Consumer expectations about future prices and incomes. Product availability and
future income can shift demand. Consumer’s expectations of higher future price may
promote them to buy now to “beat” anticipated price rises. Similarly, the expectation
of rising incomes may induce consumers to increase current spending and thus increase
current demand. Conversely, expectations of falling prices and income will decrease
current demand for products.
Change in quantity demanded

22
A change in demand should not be confused with a change in quantity demanded. Change
in quantity demanded implies:
 The movement from one point to another on the same demand curve but not a shift in
the demand curve.
 The movement from one price-quantity combination (pair) to another on the same
demand schedule but not a change in the demand schedule itself.

P1 A

P2 B

Q1 Q2 Q

Elasticity of Demand
1. Price elasticity of demand
Consider if your response (in terms of quantity demanded) to price changes in the following
cases will be the same:
i) A 10% increase in the price of a glass of juice versus the price of salt.
ii) A 10% increase in price when the initial price is one birr versus when
the initial price is 1000 birr.
Obviously, it will not be the same. In the first case, you will be more sensitive to changes
in the price of a glass of juice than that of salt. In the second case you will be more sensitive
to a 10% in price when the initial price is 1000 birr than if it were one birr because 10% of
1000 birr is 100 birr while 10 % of 1 birr is 10 cents.

Your responsiveness or sensitivity to a change in the price of a good or service depends on

i) the type of the product, and
ii) the price range (price level) of the product

The responsiveness or sensitivity of consumers to a change in the own price of a

commodity is measured by the product’s price elasticity of demand. Price elasticity of
demand measures the percentage change in quantity demanded of a good or a service as a
result of 1 % change in the own price of that good/service.

For a given commodity X, the price elasticity coefficient (Ed) and formula are given below:

Ed = % change in quantity demanded of X

% change in price of X

23
 Change in Qddx X 100%
= original Qddx = change inQ X 100% / change in P X 100%
change in Px X 100% Q P
original Px

= chnge in Q X P = change in Q X P
Q change in P change in P Q

Where, change in Q=Q2 – Q1 ,

change in P = P2 – P1,
P=P1 and Q=Q1.

Example1: if consumers decreased their quantity demanded from 100 to 60 units because
of an increase in price from 3 birr to 4 birr, then Ed is (given Q2 = 100, Q1= 60, P2= 4 and
P1 = 3)

= change in Q X P = 100 – 60 X 3 = -120 = - 1.2

Change in P Q 3–4 100 100

Example 2: Suppose that 10 oranges are demanded by a household at the price 30 cents
per piece. If the price fall to the price 25 cents per piece, 15 oranges are demanded. What
is the elasticity of demand for oranges?
Solution:
p0 = 30 cents, p1 = 25 cents, q0 =10 and q1 =15
Thus, Ed = (15 – 10)/(25 –30) * (30/10) = -3
Interpretation: Ed = 3 (in terms of absolute value), means that if the price of orange falls
by one percent, this households shall, ordinarily, demand 3 percent more oranges. i.e a one
percent fall in price of oranges will raise the demand for oranges by 3 percent for this
households.

Interpretations of Ed
1. Elastic Demand: demand is said to be elastic if a 1 % change in price results in a
more than 1 % change in Qdd. In this case, % change in P < % change in Qdd.
Thus, Ed>1. Example, if a 1% decline in price leads to a 2% increase in Qdd, then
demand is elastic. i.e.
Ed= 2% = 0.02 = 2 (greater than one)
1% 0.01
2. Inelastic Demand: demand is said to be inelastic if a 1 % change in price results in
a less than 1 % change in Qdd. In this case, % change in P > % change in Qdd. Thus,
Ed<1. Example, if a 1% decline in price leads to a 0.5% increase in Qdd, then demand
is inelastic. i.e.
Ed= 0.5 % = 0.005 = 0.5 (less than one)
1% 0.01
3. Unitary elastic demand: demand is said to be unitary elastic if a 1 % change in
price results in exactly 1 % change in Qdd. In this case, % change in P = % change in

24
 Qdd. Thus, Ed=1. Example, if a 1% decline in price leads to a 1% increase in Qdd, then
demand is unitary elastic. i.e.
Ed= 1 % = 0.01 = 1 (equal to one)
1% 0.01

Extreme Cases of Elasticity

a) Perfectly Elastic demand: is an extreme situation of an elastic demand where a small
price reduction would cause buyers to increase their purchase from zero to all they could
obtain, and vice versa. In this case Ed equals to infinity and the demand curve is a
horizontal line parallel to the X-axis
Graphically,
14
12
10
8 D
6
4
2

5 10 15 20 25 30
Mathematically it can be proved as:
%changeinQ P 20  10 8 10 8
Ed= *  *  * 
%changeinP Q 8  8 10 0 10

b) Perfectly inelastic demand: is an extreme situation of an inelastic demand where a

price change results in no change in quantity demanded i.e whatsoever the % change in P
is, % change in Qdd is equal to zero. Since zero divided by any number is equal to zero,
Ed=0. The demand curve is a vertical line parallel to the Y-axis. Example, an acute
diabetic’s demand for insulin or an addict’s demand for heroin is perfectly inelastic.

Graphically, price
40
35 Demand Curve
30
25
20
15
10
5
5 10 15 20 25 30 35 40 45
Quantity

Thus, mathematically, this is expressed as:

inQ P 15  15 10 0 10
Ed=      0
inP Q 30  10 15 20 15

25
Relative Elasticity

If the horizontal line in perfectly elastic and the vertical line is perfectly in elastic, what
would happen to the curves in between. Lets see the following figure and determine which
one is more elastic, D1 or D2

Price

10
9
8
7
6
5 D1
4 D2

1 2 3 4 5 6 7 8 9 10 11 12
Quantity

Without using the formula we can observe the D1 is closer to a horizontal line. The more
horizontal the demand curve is, the more elastic it is; and the more vertical the curve, the
more inelastic it is.

The Midpoint formula (Arc Elasticity)

Consider the following price-quantity combination.
Price Qdd
5 4
4 5

If you calculate elasticity for a price rise and a price fall using the same set of data, use of
the previous formula results in different elasticity. Take the above data as an example.
First, consider a price rise from 5 to 4 and calculate the elasticity.
Ed= % change in Qdd = 25 % = 0.25 = 1.25 ( demand is somewhat elastic)
% change in P 20% 0.2

If, on the other hand, we consider a price rise from 4 to 5, the elasticity will be

Ed= % change in Qdd = 20 % = 0.2 = 0.8 ( demand is slightly inelastic)

% change in P 25% 0.25
So which one is correct? Is the demand elastic or inelastic?
A solution to this problem is to use average of the two prices and two quantities as points
of reference. An alternative formula, which we call the mid point formula, of finding Ed

26
between two points is given as follows. In this case elasticity is estimated at the mid point
of the relevant price range, where

Ed = Change in Qdd / Change in P

((Q1+Q2)/2) ((P1+P2)/2)

Ed = Change in Qdd X ((P1+P2)/2) = Change in Qdd X (P1+P2)/2

((Q1+Q2)/2) Change in P Change in P (Q1+Q2)/2

Ed = Change in Qdd X P1+P2

Change in P Q1+Q2

Coming back to our previous example,

Ed = Change in Qdd X P1+P2 = 1 X 9 = 1 ( demand is unitary elastic)
Change in P Q1+Q2 1 9
Note:
1. Elasticity varies with price range.
2. Slope of the demand curve does not measure elasticity
3. Total revenue varies with elasticity

To make the above notes clear, let’s consider the following demand schedule.

Qdd Price/week Coefficient of Ed Total Revenue Total revenue/test

1 8 5.00 8 Elastic
2 7 2.60 14 Elastic
3 6 1.57 18 Elastic
4 5 1.00 20 unit elastic
5 4 0.64 20 Inelastic
6 3 0.38 18 Inelastic
7 2 0.20 14 Inelastic
8. 1 8

1. Elasticity varies with price range: for all straight line and most other demand
curves, demand is elastic towards the upper left part than the lower right part of the
demand curve. In the upper left segment of the demand curve, % Qdd is large
because the original reference quantity is small and % change in price is small
because the original the original reference is large.
Ed = relatively large % change in Qdd = large Ed.
relatively small % in price

In the lower right segment of the demand curve, the opposite holds true.

27
 2. Slope does not measure elasticity: the graphical appearance of the demand curve
– it’s slope is note a sound basis for judging elasticity. Flatness or steepness (slope)
of a demand curve is computed from absolute changes in P and Q while elasticity
involves relative or percentage change price and quantity. For instance, the slope
of a straight demand curve is constant. However, such a curve is elastic in its upper
left segment and vice versa.
3. Total revenue varies with elasticity: total revenue and elasticity are related.

Total revenue (TR) is the total amount of money the seller receives from the sale of a
product, where
TR = Price X Quantity

The total revenue test helps to infer whether demand is elastic or inelastic. It also helps to
predict whether a change in the price policy of a firm leads to an increase in revenue (profit)
or not.
a) If demand is elastic, a decrease in price increases total revenue because the decrease in
total revenue because of the decrease in price is more than compensated by the
increase in total revenue because of the increase in quantity sold. On the other hand, an
increase in price leads to a decrease in total revenue. Thus, demand is elastic if a price
change causes total revenue to move in the opposite direction.
b) If demand is inelastic, a decrease in price decreases total revenue because the decrease
in total revenue because of the decrease in price is less than compensated by the
increase in total revenue because of the increase in quantity sold. On the other hand, an
increase in price leads to an increase in total revenue. Thus, demand is inelastic if a
price change causes total revenue to move in the same direction.
c) If demand is unitary elastic, a decrease or increase in price leaves total revenue
unchanged because the decrease in total revenue because of the decrease in price is the
same as (off set by) the increase in total revenue b/se of the increase in quantity sold.

28
Price
9

8
Elastic, Ed>1
7

5 Unitary Elastic, Ed=1

2 Inelastic,Ed <1

0
1 2 3 4 5 6 7 8 9 Qdd
TR

20 * *

18 * *

16
When DD
14 * Unitary *
Elastic, TR
12 doesn’t change
when DD is When DD is inelastic,
10 elastic,
P TR P TR
8 * *TR
P TR P TR

0
1 2 3 4 5 6 7 8 9 Q

29
Point elasticity
Sofar we have been trying to calculate elasticity between two points. However, it is
possible to calculate elasticity at each point of the demand curve. The point elasticity refers
to the percentage change in quantity demanded for a very small percentage change in price.
Recall that we have defined elasticity of demand as

ChangeinQ P
ED  X
changeinP Q
And Ed = Change in Q X P1+P2 (in case of large or discrete changes )
Change in P Q1+ Q2
But
Change in Q is the reciprocal of the slope of the demand curve, which is
Change in P
given as:
Change in P, thus
Change in Q
Ed = 1/ Slope of demand curve X P/Q (for Point elasticity), and

Ed = 1/ slope of the demand curve X P1 +P2, (for discrete change)

Q1+Q2

Determinants of the Price Elasticity of Demand

What makes demand elastic or inelastic?

1. The availability of substitutes.
Generally, the larger the number of substitute goods that are available for a product, the
greater its price elasticity of demand and vice versa. This is because people will have more
alternatives and they will be more sensitive to price changes. The opposite holds true (i.e.
people will be less sensitive to price changes) if the good/service whose price has changed
has less or no substitutes. Example: BIC pen has more substitutes. Thus, you may stop
buying BIC pen or decrease your quantity demanded if its price increases. Salt on the other
extreme has no substitutes and you may not respond to an increase in the price of salt.
The price elasticity for a product also depends on how narrowly the product is defined.
Demand for Pepsi is more elastic than the overall demand for soft drinks. Many other
brands are substitutes for Pepsi: but there are few, if any, or no substitutes for soft drinks.

2. Nature of the commodity (luxury Vs Necessity).

If the commodity is a necessity rather than a luxury, it tends to be more inelastic. Example:
If the price of an ice cream goes up, you can leave it and buy nothing of it. But if the price
of a cup of water rises by 50 cents we will still buy it, because it may be hard to live by
consuming less of it. Goods and services that are necessities include bread, electricity,
water an operation for acute appendicitis, salt, etc.
3. Product price relative to buyer’s income (proportion of income).

30
Other things being equal, the higher the price of a commodity relative to consumers' income
and hence their budgets, the lower is the probability of purchasing this commodity, and
hence the greater its elasticity. A 10 % increase in the price of house rent affects our budget
greatly as compared to a 10 % increase in the price of cheaper goods such as matches. Thus
the demand for rental houses is elastic relative to that of matches.

4. Time
Generally, product demand becomes more elastic the longer the time period since the price
increased. The longer the time, consumers will have the chance to try other products and
develop a favorable taste for new products. The longer the time period, other business firms
will be able to produce and supply goods that substitute the product whose price has
increased.

2. Cross - Price Elasticity

When the price of a related good change, consumers would respond to the change by
changing the quantity of the product demanded. Cross-price elasticity measures consumers
responsiveness or sensitivity to changes in the price of other related goods. The cross price
elasticity of demand for good X with respect to changes in the price of good Y is given by
the percentage change in quantity demanded of good X divided by the corresponding
percentage change in the price of good Y, ceteris Paribus.
i.e.
Exy = % change in Qdd of X = Change in Qddx X Py
% change in Price of Y Change in Py Qx

Interpretations:

1. If Exy is positive, a rise in the price of Y increases the Qdd of X. Example, coffee and
tea are substitutes, if not perfect, and an increase in the price of coffee would increase
the quantity demanded of tea. Thus, if Exy for two goods is positive, then the two goods
are substitutes.
2. If Exy is negative, a rise in the price of Y decreases the Qdd of X. Example, fuel and
cars are complementary goods, and an increase in the price of cars would decrease the
quantity demanded of fuel. Thus, if Exy for two goods is negative, then the two goods
are complementary.
3. If the cross-price elasticity o is zero, a rise in the price of commodity Y has no effect
on the quantity demanded of X. Thus, the two goods are unrelated.

Income elasticity of Demand

It measures the responsiveness of consumers to a change in their income. For the time
being ignore the possibility of saving. If so, the increase in income would be equivalent to
the increase in consumer spending.
The income elasticity of demand for a good is the % change in quantity demanded divided
by the corresponding % change in income, ceteris paribus. i.e.

31
 Income elasticity = % change in Qdd
Of demand % change in income

It measures how far the demand curve shifts to the right or to the left when income changes,
ceteris paribus.
➢ A positive income elasticity implies a shift of the demand curve to the right
➢ A negative income elasticity implies a shift of the demand curve to the left.

Note:
1. The income elasticity coefficient for a normal good is positive (greater than zero).
2. The income elasticity coefficient for an inferior good is negative.
3. If the income elasticity of demand is greater than one, the commodity is a luxury.
4. If the income elasticity of demand is less than one, the commodity is a necessity.
5. A necessity could be a normal good or an inferior good. If it is an inferior necessity, then
the income elasticity is a negative number. If it is a normal necessity, then the income
elasticity coefficient will be between zero and one. Thus all inferior goods are
necessities but the opposite does not hold true.
6. Income elasticity forecast the growth prospect for different industries as income of the
society goes on increasing over the long run. An industry that produces goods that have
positive income elasticity has a growth potential as the consumers’ income (economic
growth) goes on increasing.

2.2 Theory of supply

Definition:
Supply is a relationship between the various amounts of a commodity that producers are
willing and able to produce and sell at each price in a serious of possible prices during a
given period of time, ceteris paribus.

Supply is a schedule or a curve showing how the amounts of a product a producer is willing
and able to produce and make available for sale with price, during a specific price, ceteris
paribus.

The law of supply: - States that as price rises, the corresponding quantity supplied raises;
as price falls, the corresponding quantity supplied falls, ceteris paribus. The law of supply
tells us that there is a direct or positive relationship between price and quantity supplied.
Though price is an obstacle to consumers, it is an incentive (revenue) to producers that
induces them to produce and sell more of the product, ceteris paribus. Price is an incentive
to producers because a higher price covers the costs associated with
Production and yield some profit.

Thus, if price increases,

1. Those already in business are willing to sell more because this will rise their profits;

32
2. New firms are attracted to the industry by the prospect of high profits.

The opposite holds true if price decreases.

Supply Schedule: - is a table that shows how an item's quantity supplied would vary with
its price, other things being equal.
Supply Equation: - is the mathematical representation of the price-quantity combinations
depicted in a supply schedule.
Example:
A hypothetical supply Schedule for individual (single) business firm

Price (birr) Quantity Supplied

10 14
9 12
8 9
7 5
6 1

The supply curve for the firm is drawn below depicting the relationship graphically.

Price
14-

12 Supply curve
-10
9-

8-

6-

4-

2-

0 2 4 6 8 10 12 14 16 18 Qss

The supply curve goes up and to the right. i.e it is upward slopping showing the positive
relationship between price and quantity supplied as reflected in the law of supply.

Supply equation for the firm

Other things being equal, the supply is a function of price in which quantity supplied is
expressed as a function of (in terms of) price. i.e.
Qss = f(price) and generally, Qss = a + bP

33
For a linear relationship between price and quantity supplied, the supply equation can be
derived by using the method that we used to derive the demand equation. i.e.
Y-Y1 = m(X-X1). Take any two pairs of price and quantity form the previous demand
schedule, say
P1 = 9, Q1 = 12 , P2 = 8 and Q2 = 9.
Thus m= P2 - P1 = 8 - 9 = - 1 = 1
Q2 - Q1 9 - 12 - 3 3
And P - P1= m (Q - Q1)
P - 9 = 1/3 (Q - 12) If you finish the workout, you will arrive at
P = 1/3 Q + 5
To get the supply equation, you have to express quantity in terms of price, i.e.
Qss = 3P - 15.The slope of the supply equation (i.e. 3 ) is interpreted in such a way that
when price increases by one unit ( say 1 birr), then quantity supplied increases by three
units. The slope is a positive number showing the positive relationship between price and
quantity supplies as reflected in the law of supply.

Market supply: is the horizontal summation of all individual supplies at each price level
at a given time.

The market supply curve can be obtained by aggregating the individual supply curves of
the commodity.
Suppose we have N producers in a given industry producing x commodity, the market
supply will be obtained as:

SM = SA + SB + SC +…+ SN.

Determinants of Supply
If one or more of the determinants of supply change the supply curve will shift. The basic
determinants of supply are:
1. Resource Prices: The relationship between production costs and supply is an intimate
one. A decrease in resource prices lowers production costs and increase supply, shifting
the supply curve to the right.
Example: If price of seed and fertilizer decreases, we can expect the supply of maize to
increase and vice versa.
2. The technology of production: Technological improvement means new knowledge
that permits us to produce a unit of output with fewer costs and increase supply.
3. Taxes and Subsidies: Business firms treat most taxes as costs. An increase in sales or
property taxes will increase costs and reduces supply.
Conversely, subsidies are “taxes in inverse” If government subsidizes the production of a
good, it in effect lowers costs and increases supply.
4. Price of other products: Change in the price of other products can also shift the supply
curve for a product. An increase in the price of wheat might cause a farmer to reduce
the production of maize and increase the supply of wheat. On the other hand a producer
producing complementary goods may increase the supply of one as a result of an
increase in the price of the other.

34
5. Price expectations: Farmers might withhold some of their current maize from market,
anticipating a higher price in the future. This will cause a decrease in the current supply
of maize. On the other hand, in many types of manufacturing industries expected price
increases may induce firms to add another shift of workers to expand their production
facilities causing supply to increase
6. The number of sellers in the market: Given the scale of operations of each firm, the
larger the number of suppliers the greater the market supplies. As more firms enter an
industry, the market supply curve will shift to the right. The smaller the number of
firms in the industry, the less the market supply will be.

Price Elasticity of Supply

Definition: Price elasticity of supply (Es) is the responsiveness of suppliers (in terms
of quantity supplied) to one percent change in price of the commodity. i.e., for a
commodity X,
Es = %change in Qsx = change in Qsx X Px
% change in Px change in Px Qsx
For reasons explained earlier, it is better to use the mid point elasticity formula where:
Es = %change in Qsx = change in Qsx X P1+P2
% change in Px change in Px Q1+Q2

Interpretations:
1. Elastic Supply (Es > 1)
In this case the % change in Qss is grater than the % change in price.i.e a one %
change in price leads to a more than one % change in quantity supplied.
2. Inelastic Supply (Es < 1)
In this case the % change in Qss is less than the % change in price. i.e a one %
change in price leads to a less than one % change in quantity supplied.
3. Unit Elastic Supply (Es = 1)
In this case the % change in Qss is equal to the % change in price.i.e a one % change
in price leads to exactly a one % change in quantity supplied.
Extreme Cases:
a) Perfectly inelastic supply(Es = 0)
In this case no matter what the % change in price above the minimum price is, the
% change in Qs is equal to zero.

price

Supply curve
for a perfectly inelastic supply

Quantity

35
Note that the supply curve does not hit the horizontal axis because sellers require a
minimum price to make the item available for sale in the market. A vertical supply curve
also implies that an increase in demand to an increase in price while quantity supplied
remains unchanged.
b) Perfectly Elastic Supply (Es = infinity):
In this case a very small % change in price leads to in a very large % change in Qs. This
means that a slight change in price would result in an infinite change in quantity supplied.

S
Price

Q
The supply curve for a perfectly elastic supply is a horizontal line. This horizontal line also
implies that a change in demand leads to a change in quantity supplied but not in price. A
perfectly elastic supply curve is exactly the same as a perfectly elastic demand curve.
1. Relative Elasticity of Supply

Price S1
S2

Quantity
In the graph S2 curve is more elastic than S1, since it is flatter and quantity supplied
would be fairly responsive to price changes.

Determinants of the price elasticity of supply

1. Cost of production: refers to the extent to which cost per unit of output rises as
sellers increase output. If unit cost of production does not increase as output
expands, a certain % changer in product price will result in larger % change in Qss.
In this case supply will be elastic.
2. Time: When an item’s price increases, it takes some time
a) For existing firms to shift more resources to the production of the product
whose price has increased.
b) For new firms to start producing the product whose price has increased.
Thus, the shorter the time period for adjustment the producers have, the less elastic
supply becomes and vice versa.

2.3 Market Equilibrium: Putting Demand and Supply Together

Bringing the two forces of market demand and market supply together helps us to see how
the buying decisions of consumers and supply decision of business firms (producers)
determine the price and quantity of the product bought and sold.

36
At market equilibrium, quantity demanded and quantity supplied are equal. At a certain
price all buyers who are willing to buy are able to get the commodity they require and all
sellers who are willing to sell will also be able to. That price is the Equilibrium price.

Consider the following example:

Price per Total Qss Total Qdd Surplus or shortage
bushel
$5 14000 4000 +10000
4 12000 6000 +6000
3 9000 9000 0
2 6000 13000 - 7000
1 3000 18000 -15000

To find the equilibrium price and quantity, we have to draw the demand and supply curves
on the same graph. Based on the previous data and curves we can plot the equilibrium in
the following graph.

Price
6

5 * *S

4 * *
E
3 *

2 * *

1 * *D

0
2 4 6 8 10 12 14 16 18 Q

We locate the equilibrium point by noting exactly where the two curves cross. Therefore,
the equilibrium point is the point where the demand and supply curves cross each other
(intersect) i.e. point E. But how does the market adjust and reach at equilibrium?

Consider the following cases.

1) Surpluses
For no particular reason let’s start with price $4.. At this price level
a) Qss equals 12,000 bushels per week and Qdd equals 6,000 bushels per
week, creating a surplus of 6,000 bushels.
b) This surplus would cause competing sellers to lower price to encourage
buyers take the surplus until no surplus remains in their hand.
c) As they bid down the price, the surplus goes on decreasing and at price $3,
no surplus exists

37
 2) Shortages
Again, for no particular reason let’s start with price $2. At this price level
a) Qss=6000 bushels and Qdd= 13,000 bushels creating a shortage of 7,000
bushels per week.
b) Many consumers who are able and willing to buy at this price level will not
get corn and they will bid up price by competing among themselves.
c) As they go on increasing price, suppliers will be encouraged to supply more
and at the same time consumers who are not willing and able to buy at the
increasing price will quit the market. This reduces the shortage and at $3,
Qss=Qdd (no shortage).
3) Equilibrium price and Quantity
At price level $3, and only at $3, Qdd=Qss. There is neither shortage nor surplus and
there is no reason for the price to change unless a change occurs in one or more of the
demand and supply shifters. Thus this $3 price is called the market clearing or market
equilibrium price. The quantity that corresponds to the equilibrium price is called
market equilibrium quantity (i.e 9,000 bushels per week).

Therefore, equilibrium price is the result of the forces of supply and demand. There will
be no tendency for price to change once it has reached its equilibrium. However, if either
demand or supply, or both, change there will be a new equilibrium price.
Mathematical Analysis of Equilibrium

Example:
Qd = 250 – 20p
Qs = 100 + 10p
Find equilibrium price and quantity
Solution:
At equilibrium
Qd = Qs
Using a simultaneous method of calculating,
250- 20p = 100 + 10p
150 = 30p
p = 150/30 = 5 birr

Qd = 250 – 20(5)
= 150 units
Therefore, at equilibrium point the level of price and quantity is 5 and 150 respectively.

Changes in Demand and Supply and Equilibrium

Whenever one or more of the determinants of demand and/or supply change, the demand
and/or the supply curves shift and change the equilibrium price and quantity. Let’s make
our analysis case by case.
Case 1: Change in Demand, Supply remaining constant

38
a) Increase in demand S

P2 B

P1 A
D2
D1

Q1 Q2 Q

Supply remaining constant, an increase in demand, when demand shifts from D1 to D2, we
have a new equilibrium point, point B. Therefore, an increase in demand, supply held
constant, leads to a rise in equilibrium price (from P1 to P2) and quantity (from Q1 to Q2).
b) Decrease in demand
S

P1 A

P2 B
D1
D2

Q2 Q1

Supply remaining constant, a decrease in demand, when demand shifts from D1 to D2, we
have a new equilibrium point, point B. Therefore, a decrease in demand, supply held
constant, leads to fall in equilibrium price (from P1 to P2) and quantity (from Q1 to Q2).
Case 2: Change in Supply, Demand remaining constant
a) Increase in Supply
P S1
P1 A S2

P2 B

D
Q
Q1 Q2

Demand remaining constant, an increase in supply, when supply shifts from S1 to S2, we
have a new equilibrium point, point B. Therefore, an increase in supply, demand held
constant, leads to a fall in equilibrium price (from P1 to P2) and a rise in equilibrium
quantity (from Q1 to Q2).

39
a) Decrease in Supply
P S2
P2 B S1

P1 A

D
Q
Q2 Q1

Demand remaining constant, a decrease in supply, when supply shifts from S 1 to S2, we
have a new equilibrium point, point B. Therefore, a decrease in supply, demand held
constant, leads to a rise in equilibrium price (from P1 to P2) and a fall in equilibrium
quantity (from Q1 to Q2).

Case 3: Complex Cases

a) Supply Increases; Demand Decrease

The effect of an increase in supply and a decrease in demand on equilibrium prices is that
both work in the same direction and tend to decrease equilibrium price. In the case of
equilibrium quantity, however, both changes work in opposite direction. The increase in
supply increases equilibrium quantity but the decrease in demand reduces the equilibrium
quantity. The direction of the change in quantity depends on the relative sizes of the
changes in supply and demand.
Thus, when supply increases and demand decreases.
1) Equilibrium Price decreases
2) The effect on quantity is indeterminate, i.e.
a) If the increase in SS = the decrease in DD, equilibrium Q remains constant.
b) If the increase in SS > the decrease in DD, equilibrium Q increases.
c) if the increase in SS < the decrease in DD, equilibrium Q decreases
b) Supply Decreases; demand increases
The effect of a decrease in supply and an increase in demand on equilibrium prices is that
both work in the same direction and tend to increase equilibrium price. In the case of
equilibrium quantity, however, both changes work in opposite direction. The decrease in
supply decreases equilibrium quantity but the increase in demand increases the equilibrium
quantity. The direction of the change in equilibrium quantity depends on the relative sizes
of the changes in supply and demand.
Thus, when supply decreases and demand increases.
1) Equilibrium Price increases
2) The effect on quantity is indeterminate, i.e.
a. If the increase in DD = the decrease in SS, equilibrium Q remains constant.
b. If the increase in DD > the decrease in SS, equilibrium Q increases.
c. If the increase in DD < the decrease in SS, equilibrium Q decreases.
C) Both Supply and Demand increase:

40
The effect of an increase in both demand and supply on equilibrium quantity is that both
work in the same direction and tend to increase equilibrium quantity. In the case of
equilibrium price, however, both changes work in opposite direction. The increase in
supply decreases equilibrium price but the increase in demand increases the equilibrium
price. The direction of the change in equilibrium price depends on the relative sizes of the
changes in supply and demand.
Thus, when both demand and supply increase,
1) Equilibrium quantity increases
2) The effect on equilibrium price is indeterminate, i.e.
a. If the increase in DD = the decrease in SS, equilibrium Q remains constant.
b. If the increase in DD > the increase in SS, equilibrium price increases.
c. If the increase in DD < the increase in SS, equilibrium price decreases.

D) Supply decreases; demand decreases

The effect of a decrease in both demand and supply on equilibrium quantity is that both
work in the same direction and tend to decrease equilibrium quantity. In the case of
equilibrium price, however, both changes work in opposite direction. The decrease in
supply increases equilibrium price but the decrease in demand decreases the equilibrium
price. The direction of the change in equilibrium price depends on the relative sizes of the
changes in supply and demand.
Thus, when both demand and supply decrease,
1) Equilibrium quantity decreases
2) The effect on equilibrium price is indeterminate, i.e.
a. If the decrease in DD = the decrease in SS, equilibrium Q remains constant.
b. If the decrease in DD > the decrease in SS, equilibrium price decreases.
c. If the decrease in DD < the decrease in SS, equilibrium price increases.

Summary of the complex cases.

Change in change in effect on effect on
Supply demand equilibrium price equilibrium quantity
Increase Decrease Decrease indeterminate
Decrease increase increase indeterminate
Increase increase indeterminate increase
Decrease decrease indeterminate decrease

Applications of supply and Demand analysis

One of the applications of this analysis is in determining the interest rate of money. Interest
rate is the price charged by the lenders of money. Demand reflects the credit needs of
consumers, homebuyers, business and federal, state and local governments. If the supply
and demand for money were shown as D1 and S1 in the figure below the interest rate is 20%
(vertical axis). This is the point where D1 and S1 intersect. Assume there was a major
business expansion i.e., consumers, retailers, manufacturers, and homebuyers want more
money. If the government doesn’t increase the money supply, the interest rate would rise
from 20% to 24% due to the rise in demand from D1 to D2. See the figure below.

41
 Interest rate
S (Supply of money)
28
24
20
16
12
8
4 D1 D2

5 10 15 20 25 30 35 Quantity of money

On the contrary an increase in the supply of money has a decreasing effect on interest rate
if the demand for money doesn’t increase. As shown in the figure below starting with a
money supply S1 and a demand D, the interest rate would be 24%. Then the money
increases from S1 to S2. This drives down the interest rate from 24% to 18%. Refer to the
figure below.

Interest rate

S1 S2
32
28
24
20
18
16
12
8 D
4
5 10 15 20 25 30 35 40 Quantity of money

The analysis of supply and demand is helpful also in the analysis of variables such as
savings, investment, consumption, and GNP, etc.

The effects of Fixing price ceilings and Price Floors

What do we mean by price ceilings and price floors? What is the difference between these
two concepts? To illustrate these concepts lets look at the following diagram taking the
following assumptions:
1. Price is fixed at 15 birr what ever the supply and demand conditions are;
2. The demand and supply operate until they find the equilibrium condition.
Now let see the condition of a price floor below.

42
 25
20 S
Price 15 price floor
10
5 D

10 20 30 40 50 60 70

When price is fixed at 15 birr the amount of quantity demanded is 20, while the amount
supplied is 60. Therefore, there are about 40 units of surplus in the market at this price. The
price at which the demand and supply became equal in the equilibrium point (10, 40)
Governments keeps price floors in effect by buying the surplus. In this case the extra 40
units.

Price ceilings are the mirror images of price floors. The figure below illustrates this
situation.
Price
D S
40
30
20 Price ceilings
10
10 20 30 40 50 60 70 80 90 Quantity

When the price is fixed at 20 birr the amount of product demanded were 60 units, while
the amount supplied was about 30 units the demand was 30 units higher than the supply.
This quantity would have been purchased if they were available in the market, and this
would have been supplied if the price were not fixed at 20 birr. The equilibrium point is
the point where the demand and supply meet, this is (30, 50). Price ceiling is set by the
government as a form of price control. Business firms don’t charge more than this amount.
Ceilings prevent price from rising. Ceilings are indicators of shortages.

A ration system is done to enable everyone to obtain its fair share of the commodities in
shortage. Example: The gas lines in the fuel stations.

One way of dealing with a shortage by the market is creating block illegally to those willing
to pay considerably more. Normally prices would fall to the equilibrium level, but a price
floor keeps price artificially high. By the same token, a price ceiling is intended to keep
price below equilibrium level. If not for the ceiling, price would rise. Therefore, a price
ceiling must be located below equilibrium to keep prices from rising to that level, while
the normal tendency of price is to move toward the equilibrium level. The ceiling prevents
prices from rising to that level, while a floor prevents prices from falling to equilibrium.

43
 CHAPTER THREE
THEORY OF CONSUMER BEHAVIOUR

Introduction
The main purpose of the theory of consumer behavior is to determine the various factors that affect
consumer’s consumption decision for a good. Some of the important determinants of the market
demand for a particular commodity include; own price of the good, prices of other goods,
consumers income, consumers taste and preference, market size or population size, consumers
wealth, government policy and etc.

The traditional theory of demand has concentrated on the first four determinants of demand while
the modern theory considers all factors. Moreover, the traditional theory of demand deals only with
consumers’ demand, which is only a fraction of the total demand. But in modern theories of
demand, total demand includes final demand (which in turn is subdivided in to consumers’ demand
and demand for investment goods), and intermediate demand. As a result, the traditional theory of
demand is often considered as partial in its approach.

Learning objectives:
At the end of the chapter you will be able to;
➢ Distinguish between cardinal and ordinal utility theory;
➢ Understand the law of diminishing marginal utility;
➢ Derive demand curve from marginal utility curve & price consumption curve;
➢ Analyze consumer optimum;
➢ Explain price consumption curve and income consumption curve for different
goods and services;
➢ Differentiate income & substitution effects of price change of d/t products;

3.1 Cardinal and Ordinal Utility

When a commodity is consumed, the consumer derives some benefits or satisfaction. Economists
have called this benefit or satisfaction utility, and have assumed that, in choosing among goods; a
consumer will attempt to gain the greatest possible utility, subject to the size of his/her income.
Utility is thus the satisfaction obtained from the consumption of a good. Some 19 th century
economists thought that utility might be measurable as if it were a physical commodity. These
economists have become known as cardinalists, because they believed that cardinal numbers (i.e.
1, 2, 3…) could be used to express the utility derived from the consumption of a commodity. Some
economists have suggested that utility can be measured in monetary units while others (in the same
school) suggested the measurement of utility in subjective units, called utils.

Example: a consumer may obtain 20 utils of utility from a consumption of good X, but only 10
utils from the consumption of good Y. The cardinals would conclude from this that the consumer
obtains twice as much utility from X as from Y, and the absolute difference between the utility
derived from X and that obtained from Y is 10 utils.
However, utility is an abstract, subjective concept and there are two major problems involved in
trying to measure it:
1) It is difficult to find an appropriate unit of measurement. If we call the unit a util, what is a
util? Are 10 utils enjoyed by one individual equivalent to 10 util enjoyed by another? Stated
differently, can we make interpersonal comparison of utility?

44
2) To measure the utility derived by an individual in consuming a good requires that all other
factors which affect his/her level of utility (satisfaction) be held constant, and it is clearly
impossible to carry out such a controlled experiment. There are too many other factors
(economic, social, and psychological) which influence an individual’s level of quantity.

By the 1930’s, many economists were coming to the view that utility could not be measured
cardinally and that cardinal measurement was not essential for a theory of consumer behavior.
These economists have become known as ordinalists. This is because they claimed that an
individual can only rank bundles of goods in order of his/her preference. And the consumer can
say that he/she obtains more utility from one bundle than from another, or the consumer derives
equal utility from two or more bundles. It is impossible, though, to measure by how much one
bundle is preferred to another. Only ordinal numbers (first, second, and so on) can be used to
“measure” utility, and these say nothing about the absolute difference of any other relationship
between utilities. Indifference curves and budget lines are the means of illustrating this ordinalist
approach to demand theory.

It is important to note here that both ordinalist and cardinalst rank items. The difference is that, in
ordinal system, one can say only that X is greater than Y, where as in a cardinal system it is possible
to say by how much X exceeds.

3.1.1 The Cardinalist Approach

The objective of this section is to outline the cardinalists’ explanation of why an individual’s
demand curve normally slopes down wards from left to right. Central to this approach are the
concept of marginal utility and the hypothesis of diminishing marginal utility.

Before examining this approach, we will first state the assumption underling it. Then, we will derive
the equilibrium of the consumer, and from this determine his demand for the individual producers.
Assumptions:
1. The consumer is rational: He/she aims at the maximization of his/her utility subject to the
constraint of income.
2. The utility of each commodity is cardinaly measurable: The most convenient measure is
money: the utility is measured by the monetary units that the consumer is prepared to pay for
the commodity.
3. Constant marginal utility of money: This assumption is necessary if the monetary unit is
used as a measure of utility. The essential feature of a standard unit of measurement is that it
be constant. If the marginal utility of money changes as income increases (or decreases) the
measuring rod for utility becomes like an elastic ruler, inappropriate for measurement.
4. Diminishing marginal utility : the utility gained from successive units of a
Commodity diminishes.
5. The total utility of a “basket of goods” depends on the quantities of the individual
commodities: If there are n commodities in the bundle with quantities x1,x2,…,xn, the total
utility is: U = f (x1,x2,…,xn)

In every early versions of the theory of consumer behavior it was assumed that the total utility is
additive:
U= U1(x1) + U2(x2) + … + Un (xn)
The additively assumption was dropped in later version of the cardinal utility theory. Additivity
implies independent utilities of the various commodities in the bundle, an assumption clearly
unrealistic, and unnecessary for the cardinal theory.

3.1.1.1 Equilibrium of the Consumer

45
We begin with the simple model of a single commodity X. Consider table 1 to illustrate the
equilibrium of the consumer.

Table 1: Total Utility and Marginal Utility

Quantity of X Total utility Marginal utility

Consumed per week (in birr) (in birr)
0 0 --
1 6 6
2 11 5
3 15 4
4 17 2
5 16 -1

When the individual consumes no units of x at all, utility is not derived from the activity.
Consuming one unit, though, yields a utility of 6 birr, and when two units are consumed, the total
utility rises to 11 birr. Adding further units up to the fourth continues to increase total utility, but at
a decreasing rate so that marginal utility (which is the extra utility obtained from the consummation
of an additional unit of commodity, in this case x) is falling. Finally, consuming the 5th unit actually
caused total utility to fall so that marginal utility is negative (disutility).
This example illustrates the reasonable proposition that as more and more units of a good is
consumed, the extra utility derived from the consumption of additional units eventually falls. This
is called the law of diminishing marginal utility.
In order to establish the equilibrium of the consumer, let’s make the following assumptions:
1) The individual consumer has a money income of birr 8, which the consumer can either use
it to buy x or retain it, and
2) The price of the commodity (x) is birr 2 considering table 1, what if the consumer wants to buy
the first unit of x. If he did, he will gain because with an outlay of birr 2 he obtains a utility
worth of 6 birr. The consumer is left with an income of birr 6. Will he buy the 2 nd unit of x?
The answer is yes, because he will gain a utility of birr 5 by spending birr 2. What about the
third one? Again the consumer will purchase the third unit 15 as it means gaining a utility worth
of birr 4. What if he purchases the 4th unit of X? In this case, the consumer is neither gaining
nor losing-i,e. he is indifferent. He has also exhausted his income by buying the 4 th unit of
commodity X At this level of consumption, we say the consumer is in a state of equilibrium
because the marginal utility of x is equated to its market price which is birr 2 symbolically, we
have:
Mux = PX = 2 birr
At this level of purchase, the consumer is deriving a total utility of birr 17 with a total outlay of birr
8.If the marginal utility of x is greater than its price; the consumer can increase his welfare by
purchasing more units of x. Similarly of the marginal utility of x is less than its price the consumer
can increases his total satisfaction by cutting down the quantity of x and keeping more of his income
unspent. If the consumer income were birr 10 instead of 8, will he buy the 5th unit of X? The answer
is definitely no! Why? Big by doing so, his total utility will come down to 16 with an outlay of birr
10. But if he keeps the money unspent he will have a total utility of birr 17 from the purchasing of
the first four units of x and an income of birr 2 in his pocket. Thus, the consumer attains the
maximization of his utility when Mux = PX.

If there are two commodities, good x and good y, the condition for consumer equilibrium is given
Mu x Mu y
by: 
Px Py

46
When the ratio on left side exceed on the right, the consumer can increase to total utility by
increasing consumption of good x and decreasing the consumption of good y.

If there are more commodities, the condition for the equilibrium of the consumer is the equality of
the ratio of the marginal utilities of the individual commodities to their prices mathematically,
Mu x Mu y Mu n
  ... 
Px Py Pn
The utility derived from spending an additional until of money must be the same for all
commodities. If the consumer derives greater utility from any one commodity, he can increase his
welfare by spending more on that commodity and less on the others, until the above equilibrium
condition is fulfilled. We will illustrate this using a three-commodity model.
Table: 2 MU Analyses
MU in Birr and MU per birr
Unit Mu of Mu x Mu of Mu y Mu of Mu z
good X P good Y P good z P
x y z

1 30 6 18 6 8 8
2 25 5 15 5 7 7
3 20 4 9 3 5 5
4 15 3 6 2 4 4
Assumptions:
1. The price of commodity X (Px) =birr 5, commodity Y (Py) = birr 3, and commodity Z (Pz) =
birr 1.
2. The total income of the consumer is birr 19, Now, would the consumer purchase the first unit
of X, Y or Z? The answer is the consumer would purchase the first unit of commodity Z. Why?
Because, the highest level of marginal utility per birr is obtained from the first unit of Z (see in
table 2 above). That is:
30
Commodity X will have = birr 6
5
18
Commodity Y will have  birr 6
3
8
Commodity Z will have  birr 8
1
Now the consumer is left with birr 18. Which unit of commodity will he buy next? Again, by the
same logic, he will purchase the 2nd unit of Z. This time he is having 17 birr.

The consumer’s next choice will be either the first unit of X or Y since both have the same level of
utility per birr, which is greater than from the 3rd unit of Z. Assuming that his 3rd purchase is
commodity X, the first unit of commodity Y will then be his 4th purchase (choice). Now he is left
with 9 birr, after he purchases 2 units of commodity Z and one unit each from X and Y. Next, the
consumer can purchase either the 2nd unit of X or the 2nd unit of Y or the 3rd unit of Z. Let us say
the consumer’s fifth, sixth and seventh choices are the 2nd unit of commodity X, the 3rd unit of Y
and the 3rd unit of Z, respectively. At this level of purchase (i.e. 2 units of X, 2 units of Y and 3
units of Z), the consumer has exhausted all his income and is in a position to purchase nothing.
Note here that the last units of expenditure spent on each commodity consumed bring about the
same level of utility. When this condition is satisfied no shifting of expenditure between goods can

47
 serve to increase total utility, and hence consumer equilibrium is said to exist. As we can clearly
see from our example, the last birr spent on X, Y and Z yields the same amount of utility, that is:
Mu x 25
  5birr
Px 5
Mu y 15
  5birr, and
Py 3
Mu z 5
  5birr
Pz 1
If this condition is not satisfied, then with the same fixed income, total utility can be increased by
altering the pattern of expenditure. In short, we may conclude that, as long as the objective of the
consumer is to maximize total utility, expenditure switching between goods will take place until
the marginal utility of a birr’s worth of each good consumed is equal to the marginal utility of a
birr’s worth of any other goods consumed. Thus, assuming ’n’ commodities, consumer equilibrium
is established provided that the following conditions are satisfied:
Mu1 Mu 2 Mu1
1.   ....  , and
P1 P2 Pn
2. P1Q1  P2 Q2  P2 Q3    Pn Qn  M I.e. when total expenditure is equal to total income.
Where Mu = marginal utility
P = price
Q= quantity of commodity
M =money income
n= 1, 2, 3, 4,…., n
3.1.1.2. Derivation of the Demand of the Consumer
The derivation of demand is based on the axiom of diminishing marginal utility. The marginal
utility of commodity X may be depicted by a line with a negative slope. Geometrically, the marginal
utility of X is the slope of the total utility curve.

MU
TUx

MU1 *

TUX
MU2
*

MU3 *

*
MU4

* ' MUx
Qx 0 X6
X1 X2 X3 X4 X5 X1 X2 X3 X4 X5

The total utility increases, but at a decreasing rate, up to quantity X4, and then starts to decline there after.
Accordingly the marginal utility of x declines continuously, and becomes negtive beyond quantity X 5. If
the marginal utility is measured in monetary units, the demand curve for X is identical to the positive
segement of the marginal utility curve. At X1 the marginal utility is Mu1, and this is equal to P1, by

48
 definition. Hence, at P1 the consumes demand X1 quantity of commodity X. Similarly at X2 the marginal
utility is Mu2 which is equal to P2. Hence at P2 the consumer will buy X2 units of X, and so on. The negative
section of the Mu curve does not form part of the demand curve, since negative quantities do not make
sense in ecoonomics.

The derivation of the dd curve from the Mu curve is based on the equilibrium of the consumer,
which is Mux = Px.
Mux Px The demand curve Qx= f(Px), all other
factors remaining constant
Marginal utility curve for X
MU1 P1
*

P2 *
MU2

P3 *
MU3

P4 *
MU4

0 x1 x2 x3 x4 x5 Qx 0 X1 X2 X3 X4 X5 X6 Quantity
MUx

❖ The rationale for the downword slope of the demand curve, accordiing to the caridanl
apporach, is that since MUx diminshes as x increases, the person would be willing to buy the
successive units of x only at a successively decreasign prices.

3.1.2. The Ordinal Utility Approach

This approach is also known as the indifference curves theory (analysis). Before we set out to discuss this
approach, let us first of all state the basic assumptions underlying the analysis.

1. The consumer is assumed to be rational: the consumer aims at the maximization of his utility, given
his/her income and market prices.
a. Rationality assumption1: a complete binarry ordering. For any bundle A and B in a consumption
possiblity set, eaither A is atleast as good as B, B is at least as good as A, or A is exactly as good as B.
when A is exactly as good as B we say that our agent is indifferent between A and B.
b. Rationality assumption 2: Reflexibity. For any bundle A  A , any bundle is atleast as good as itself.
c. Rationality assumption 3: consistency and transtivity of choice. Consistency and transitivity of choice:
It is assumed that the consumer is consistent in his choice, that is, if in one period he chooses bundle
A over B he will not choose B over A in another period if both bundles are available to him. The
consistency assumption may be symbolically written as follows: If A>B, then B < A
Similarly, it is assumed that consumer’s choices are characterized by transitivity : if bundle A is preferred
to B, and B is preferred to C, then bundle A is preferred to C. Symbolically:If A > B, and B>C, then
A>C.
2. Utility is ordinal : the consumer can rank his/her preferences according to the satisfaction of each
basket of goods. He/she need not know presisely the amount of satisfaction derived from the
consumption of the commodities. The ranking of goods according to his/her preference is all that is
needed.

49
 3. Diminishing marginal rate of substitution: the slope of the indifference curve, which depicits
the rate at which the consumer is willing to substitute one good for another, declines. The
indifference-curve analysis is, thus, based on the axiom of diminishing marginal rate of
substitution.
4. The total utility (U) of the consumer depends on the quantities of the commodities consumed:
U = f(q1,q2,….qn)
5. The non-satiation assumption (more is better): this assumption implies that the consumer always prefers
the bundle with at least one more commodity in it.
For example , the first bundle A consists of 4 units of X and 1 unit of Y while the second bundle B consists
5 units of X and 1 unit of Y. According to the above assumption, the consumer strictly prefers the bundle
B to the A one.
6. The consumer is assumed to have all relevant information.

3.1.2.1 Indifference Curves

We can show a consumer’s preferences graphically with the help of indifference curves. An indifference
curve is the locus of bundles which provide the same level of satisfaction (utility) to the consume ( that are
all exactly as good as each other in the eye of consumer or agent). The consumer is therefore indifferent
(equally happy) among the bundles represented by the points on the curve.

In order to draw the indifference curves which depict the consumer’s preferences, let us assume there are only
two goods, say X and Y, available for consumption. The vertical axis in fig.1 measure the quantity of good
Y and the horizontal axis measures the quantity of good X. Thus, every point on the curves represents some
combination of X and Y.

Good Y

Iindiffrence curves further

I3 further from orgion
Fig.1 *E represent higher utility
Indifferenc curves level. Bundle E is must be
10 * B I2
*A *D preferred to bundle A b/c it
* C contains more of both
goods.
5
I1

Good X
2 4
0

The consumer’s preferences for X and Y are represnted by the indifference map in fig.1 where I1,I2 and I3
are three of the indifference curves. Thus, an indifference map is a set of indifference curves that describes
the preferences of the consumer. It should be noted here that there exists an indifference curve passing
through every possible combination of X and Y. That is, through every point on the graph. This means that,
although we have only drawn three of them in the above figure, there are an infinite number of indifference
curves making up the indifference map.
In the above diagram, the consumer is said to be indifferent between combinations B and C, since both
combinations are on the same indifference curve. In other words, both combinations yield the same utility
to the consumer. Combination D, however, is on a higher indifference curve than B or C. We say that the
consumer prefers D to either A or C. Similarly, the consumer prefers combination E to A,B,C or D.

50
3.1.2.2. Properties of Indifference Curves
There are four basic atributes (properties) of indifference curves.
1. An indifference curve has a negative slopes down-ward from left to right). This means that if the quality
of one commodity, say Y deceraases, the quantity of the other(X) must increase, if the consumer is to
stay on the same level of satisfaction.
2. The further away from the origin an indifference curve lies, the higher the level of utility it denotes:
bundle of goods on a higher in difference curve (such as bundle E in fig 1) are preferred by the rational
consumer.
3. Indifference curves do not intersect. If they did, the point of intersection would imply two different
levels of satisfaction, which is impossible. To show this, consider fig.2, which shows two intersecting
indifference curves.
Good Y

y2 *A
*
B

y1 *
C I2

I1
x1 good X
Since both combinations A and C are on the same indifference curve, the consumer must be indifferent
between them. Combinations B and C, however, are also on the same indifference curve, so the consumer
must be indifferent between them as well. If the consumer is indiffderent between A and C, and between
B and C, he/she must (by the rule of transitivity) be indifferent between A and B. This however, is absured
because A contains more Y and the same amount of X as B and so must be preferred to it. We conclude,
therefore, that indifference curves can never interest each other.
4. The indifference curves are convex to the origin. This implies that the slope of an indifference curve
decreases (in absolute terms) as we move a long the curve from left downwards to the right. In other
words, as more and more units of one good, say y, are given up, successively bigger quantities of x
must be obtained to compensate the consumer for the loss and leave him/her at the same level of
utility. Consider fig.3 to illustrate this proposition.

Y Fig.3: Convexity of indifference curves

11
*A

B
7 *
4 C
2 * D
*
1 X
1 2 3 4
As X increases, Y decreases showing that the slope of the indifference curve decreases as x increases.
In moving from A to B, B to C, C to D, change in Y decreases from 11to 7, 7 to 4, 4 to 2 and then 2 to 1
respectively.

3.1.2.3. Marginal Rate of Substitution

51
 One essential feature of the indifference curve analysis is that different combination of commodities can
give rise to the same level of satisfaction. Therefore, one commodity can be substituted for another in the
right amount so that the consumer remains just as well off as before, or remain on the same indifference
curve. An important concept in the indifference curve approach is the rate at which a consumer is willing
to substitute one commodity for another in consumption.

Consider fig.4 . An indifference curve is represented by I where the consumer is indifferent between bundle
R, containing 2 units of X and 14 units of Y, and bundle P, containing 7 units of X and 4 of Y.
Fig.4 The marginal rate of substitution

Good Y

14 -- R As the agent is given bundles

containing more and more of good x,
she values individual unit of good x less
and less.
Y N
T
P
4 S *
X T'
0 2 7 good X

At point P, the consumer is willing to give up 5 units of X for 10 more units of Y. At point R, the consumer
is willing to give up 10 units of Y for 5 more units of X. The rate at which the consumer is willing, on
average, to substitute X and Y is therefore:
Y RS 4  14 10
    2
X SP 7  2 5

This ratio measures the average number of units of Y the consumer is willing to forego (sacrifice) in order
to obtain one additional unit of X (over the range of consumption pairs under consideration, i.e over the
range of RP). The consumer is willing to give up 2 units of Y inorder to gain one more unit of X. Stated
alternatively, the ratio measures the amount of Y that must be sacrificed (2 units) per unit of X gained to
remain at precisely the same level of satisfaction. We define this rate of substitution as:-
Y 10
  2
X 5
The negative sign is included to allow the rate of substitution to be a positive number. The rate of sustitution
given by the ratio above is obiously the negtive of the slope the broken straight line joining R and P. The ratio
could be quite different between two alternative points, say N and P. But, as point R moves along I toward
P, the ratio RS/SP approachs closer to the slope of the tangent TT1 at P. In the limit, for extremely small
movements in the neighborhood of P, the negative of the slope of I, which is the negative of the slope of its
tangent at P, is called the marginal rate of substitution of X for Y. Thus, the marginal rate of substitution of
X for Y hereafter, written as MRSx for y, measure the number of untis of Y that must be sacrificed per unit
of X gained so as to maintain a constant level of satisfaction. Stated differently, the MRSx for y is the
maximum amount of Y that a consumer is willing to give up to obtain one additional unit of X.
Y
MRS 
X
x for y

To reamin on the same level of satisfaction, the increase in total utility ( U ) because of the increase in X
must be equal to the dcecrease in total utility .

52
In our earlier discussion of the properties of indifference curves, we noted that the marginal rate of
substitution (which is the negative of the slope of an indifference curve) diminishes as we move along an
indiference curve from left down ward to the right. And this is clearly illustrated by fig.3, above. The axiom
of diminishing marginal rate of substitution expresses the observed behavioural rule that the number of units
of Y the consumer is willing to sacrifice inorder to obtain an additional unit of X decreases as the quantity
of Y decreases (or as the quantity of X increases).

We can now easily relate the concept of marginal utility to the marginal rate of substitution along an
indifference curve. Always keep in mind that marginal utility can be:

a) the increase in utility due to a small increase in the rate of consumption of a commodity,
holding the level of consumption of all other commodities constant; or

b) the decrease in utility attributable to a small decrease in the rate of consumption, under the
same assumption.

To remain on the same level of satisfaction, the increase in total utility (U ) because of the increase in X
must be equal to the decrease in total utility (U ) because of the decrease in Y.

i.e.  U  U
U
but MUx   U  MUx * X
X
U
and MUy   U  MUy (  Y )
 Y
U  U implies that
Y .MUy  X * MUx
Regarding the terms, we have
 Y Mux

X Muy
 Y
Therefore, the MRS which is the negative of the slope of an indifference curve ( ) is equal to the ratio
X
of the marginal utilities of the commodities involved in the utility function. Specifically, the MRS x for y is
equal to the ratio or the marginal utility of X to that of Y.
Mu x
Thus, MRS x for y =
Mu y
3.2 The Budget Line
What we have discussed in the preceeding sections is only what a consumer is willing to do or wishes to
do. In other words, indifference curves only tell us about the consumer’s preferences for a the two goods.
By themselves, they can not tell us which combinations will be chosen.

We know that aconsumers have limited income, and, as a result, they are compeled to determine their
behaviour in light of limited financial resources. For the theory of consumer behaviour, this means that each
consumer has a maximum amount of income that can be spent per period of time. The consumer’s problem
is to spend this amount of income in the way that yields maximum satisfaction. Thus, in addition to the
consumer’s preferences, we need to consider his/her income and the prices of the goods prevailing in the
market.

53
 In order to draw the budget line facing the consumer, let us assume that there are only two goods, X and
Y, bought in quantities x and y. Each consumer is confronted with market determined prices, Px and Py,
of X and Y respectivley. Finally, the consumer in question has a known and fixed money income (M). M
is the maximum amount the consumer can spend, and we assume that it is all spent on X and Y. The
amount spent on X(i.e X*Px ) plus the amount spent on Y (i.e. Y*Py) is equal to the stipulated money
income Algebraically,
M= Px. X + Py . Y
This equation can be expressed as the equation for a straight line. Solving for the quantity of y. (since y is
generally plotted on the vertival axis), we have:
Px
Y= M  .x
Py Py
Assigning successive values to X(given the income M and the commodity prices, Px and Py) we may find
the corresponding values of y. Thus, if X=0 (i.e. if the consumer spends all his/her income on Y) the
consumer can buy M/Py units of Y. Similarily, if Y=0 (i.e, if the consumer spends all his/her income on X)
the consumer can buy M/Px units of X. If we join therre two points with a line, we obtain the Budget line.
Fig. 5: The budget line
Good Y
M/Py A

Px
Y= M  .x
Py Py

B
0 M/Px good X

✓ M/Py, mathematically speaking, is the y-intercept and m/px is the x - intercept.

✓ In the above equation, -Px/Py ( the negtive of the price – ratio), is the slope of the budget
line. That is:
M
0A Py Px
Slope =  
0B M
Px Py
The negative sign in the price ration ( Px Py )indicates that the budget-line slopes down-ward from left to the
right.The budget line is, thus, the locus of combinations or bundle of goods that can be purchased if the
entire money income is spent.

Let us now see what will happen to the budget line when income (M) and price change. Consider first the
effect of a change in M, prices of X and Y remaining constant.

If a consumer has an increase in money income at the original set of commodity prices, the amounts of the
commodities (in our case, X and Y) which the consumer can purchase must increase. And since the increase
in money income allows the consumer to buy more goods(of X and Y), the budget line is pushed out ward
(shifts outward). Since prices are not changed, the slope of the budget line doesnot change. Therefore, an
increase in money income (prices of commodities remaining constant) caused an outward parallel shift in
the budget line, as indicated in fig.6 below.
Fig.6. Varying income (income of consumer is increased)

As the agent’s income rises, his budget

line shifts 54
outward from AA’ to BB’
and so on
 M1/Py B

M/Py A where M’ > M

A’ B’
0 M/Px M1/Px X
Similarly, a decrease in money income, the price ratio held constant, cause a parallel inward shift in the
budget line. In fig.7, budget line CD is associated with a lower income than is budget line AB.
Fig.7 : Income of agent is decreased
A
M/Py

M1/Py

Here M’ < M

P M/Px
0 M1/Px B X

Fig. 8 shows what happens to the budget line when price ratio changes with money income held constant.
Hold money income (M) and the price of Y (Py) constant, then let the price of X (Px) increases. Since Px
increases, Px/Py increases also. The budget line becomes steeper, in this case the line BB”.
Figure 8: varying prices (price of X is decreased)
Y
B • As the price of X decrease while price of Y
M/Py remains constant, the budget line become
flatter, rotating around its point of
intersection with the vertical axis (point B)
• Note that price of Px1> Px2

B’ B” good X
M/Px1 M/Px 2 X

Since the y-intercept (M/Py) is constant, the consumer can purchase the same amount of Y by spending the
entire money income on Y regardless of the price of X. We can show from fig.9 that an increase in the price
of X rotates the budget line back-ward, the Y-intercept remaining fixed. Similarly, a decrease in the price of
X, money income and price of Y held constant, pivots the budget line outward, in fig.9 from BB’ to BB”.

3.3 Optimum of the Consumer (Consumer Equilibrium)

55
The principal assumption on which the theory of consumer behavior is built is that the consumer aims at the
maximization of utility, given his/her income and market prices of the commodities available for
consumption. Therefore, to determine the equilibrium (optimum) of the consumer, we have to bring together
the indifference map and the budget line facing the consumer on the same diagram. Stated differently, we
need to consider both what the consumer is willing (wishes) to do and what he/she can do. Fig.9 depicts the
indifference curves and the budget line facing the individual consumer under consideration.
Fig. 9: The consumer optimum
Good Y
✓ Consumer equilibrium is
D achieved when the budget is
exhausted and the last dollar
* spent on each good yield the
same marginal utility.
✓ The consumer reallocates
Y1 E I4 spending until the last dollar
I3
* C spent on each product yields
* the same marginal utility.
I2
I1

X1 Good X

The indifference map describes the preferences of the consumer (what he/she wishes) while the budget line
specifies the different combinations of X and Y the consumer can purchase with the limited income (M).

The consumer cannot purchase any bundle lying above and to the right of the budget line and, therefore,
cannot consume any combination lying on indifference curves I4. However, some points on indifference
curves I1 I2 and I3 are attainable. The question then arises as to which combinations of X and Y the rational
consumer will purchase to optimize its choice.
Suppose the consumer chooses the combination at D. Without experimenting, the consumer cannot know for
certain whether D represents a maximum position or not. Let the individual consumer experimentally move
to the left and right of combination D. Moving to the left from D, obviously, lower his/her level of satisfaction
to some indifference curves below I2. But moving to the right from D puts the consumer on a higher
indifference curve. The consumer will, accordingly, return to the point E.
Similarly, if a consumer were situated at a point such as C, experimentation would lead him to substitute Y
for X, there by moving the consumer in the direction of E. The consumer would not stop short of E, because
each successive substitution of Y for X brings him to a higher indifference curve. Therefore, the position of
maximum satisfaction or the point of consumer optimization is attained at E, where an indifference curve
is just tangent to the budget line. The person will consume X1 units of X and Y1 units of Y.
It will be recalled that the slope of the budget line is the negative of the price ratio, the ratio of the price of X
to the price of Y. It is also stated earlier that the slope of an indifference curve at any point is called the MRS
of X and Y. Therefore, the point of consumer equilibrium is defined by the condition that the marginal rate
of substitution of X for Y must equal the price ratio.
The interpretation of this condition is very straight forward. The MRS shows the rate at which the consumer
is willing to substitute X for Y. The price ratio shows the rate at which market prices permit substitution of X
for Y. Unless these rates are equal, it is possible to change the combination of X and Y purchased to attain a
higher level of satisfaction. In general, unless the MRS and the price ratio are equal, some exchange can be
made to move the consumer to a higher level of satisfaction. Therefore, at equilibrium,
Px
MRS x for y =
Py

56
Recall from our earlier discussion:
Mu x
MRS x for y =
Mu y
We can thus have the equilibrium condition as:
Mu x Px Mu x Mu y
 Or 
Mu y Py Px Py
This relation provides an alternative view of the condition for consumer equilibrium, which is exactly the
same as the equilibrium condition arrived at in the cardinalist approach.

3.4. Income Consumption Curve and Engle

Having developed the concept of utility maximization (or consumer’s equilibrium), we are now prepared to
analyze the effect of changes in two important determinants of quantity demanded (or also consumer
equilibrium). These are the consumer’s income and the price of the good. We will first consider the effect of
change in income, all other things remaining constant, on the equilibrium of the consumer. And, in the next
section, we will deal with the effect of change in price.
In our earlier discussion, we noted that an increase in the consumer’s income (all other things held constant)
results in an upward parallel shift in his/her budget line. And when the consumer’s income falls ceteris
paribus, the budget line shifts downward, remaining parallel to the original one. To analyze graphically the
effect of changes in money income, we will use the figure below that depicts the equilibrium of the consumer
at different levels of money income.

Fig. 10: Income expansion path

Y Y ICC

ICC
C

D B
Y4
C
Y3
Y2 B A
A
Y1

X X
X3 X2 X3 X4

(a) Both X and Y are Normal goods (b) If X only is an inferior good

From our earlier discussion, it is clear that the equilibrium of the consumer, with an income of M, is
established at point A. At this point the consumer buys X1 units of X and Y1 units of Y.

57
 What happens if the consumer’s income is increased to M1? The consumer’s budget line then shifts outward
parallel to the original budget line, allowing him/her to attain the utility level associated with indifference
curve I2. Equilibrium is now at B, where the consumer buys X2 units of X and Y2 units of Y. An income of
M2 causes the consumer to purchase X3 units of X and Y3 units of Y, which is represented by point C. Finally,
if income is increased to M3, the budget line is tangent to I4 at D where X4 and Y4 units of X and Y are
purchased.

This exercise could be continued to include all possible changes in income. The point, however, is the point
of consumer equilibrium changes as income changes. The line connecting the successive points of equilibrium
is called the income-consumption curve. This curve shows the equilibrium combinations of X and Y at various
levels of money income prices of the commodities remaining constant.

The locus of points showing consumer equilibria at various levels of money income with constant prices is
called the income consumption curve.

Engel curve, derived from the income consumption curve in fig.10, is shown in fig. 11. Here the quantity of
good X is plotted along the horizontal axis, and money income along the vertical axis. Point E in fig.11
indicates that with an income of M, the consumer purchases, X1 units of X. And this is associated with point
A in fig.10. It follows that at a point F, X2 units of X at an income of M2, is associated with point B in fig.10.
Likewise, G and H in fig.11 are equivalent to C and D in fig.10, respectively. Thus, an Engel curve is a locus
of points relating equilibrium quantity of some good to the level of money income.

Income
Fig 11: Engle’s curve

M3 H
*
* Engel’s curve if X is
G normal good

M2 * *

F
*
M1 * *
Engel's curve if X is inferior
E good
*
*
M

X1 X2 X3 X4

Looking at fig.10 and fig. 11, we can see that the relation between money income and the amount of good X
consumed is such that, as income increases, the amount of X consumed increases (the prices of X and Y held
constant). That is, in this case, the income consumption curved does not bend backward and the Engle curve
slopes up-ward. Such a good is called a normal good over the relevant income levels. Because more X is
purchased as money income increases, the income consumption curve and the Engle curve are positively
sloped for a normal good. Normal goods are given that name because economists in the past believed that an
increase in income usually caused an increase in the consumption of a good-they believed this was the
“normal” situation. However, an increase in income may well cause a decrease in the consumption of certain

58
commodities at certain price ratios. These commodities are called inferior goods. As shown in fig 13, the
Engel curve is negatively slopped and the income consumption curve is also downward slopping (fig 10.b)

3.5 Price Consumption Curve and Demand Curve

The effect of price on the consumption of good is even more important to economists than the effect of
changes in income. Here, we hold money income constant and let price change to analyze the effect on
consumer behavior. Consider the following figure to illustrate the effects of a price Change.
Suppose the consumer has a money income of M, and the prices of X and Y are Px and Py, respectively. Given
these, the consumer’s budget line is AB. We know by now that the consumption bundle represented at P,
where. AB is tangent to indifference curve I1, is optimal. The consumer purchases x1 units of X and y1 units
of y.
Fig 12: Price Consumption Curve

Y A
m
PCC
py
S
Y4 R *
Y3 Q *
P * I4
Y2 I3
* I2
Y1
I1
X

B C D E
Assume that the price of X falls to Px1 from PX. Now, if the consumer wishes to spend all income on X,
M
P
X Px
he/she can purchase units. The budget line at the new price is AC, with slope of 1
rather than
PX 1 PY Py
. The new equilibrium point of tangency is designated by Q, where the individual consumes X2 units of X

and Y2 units of Y. If Px further falls to Px 2 , other things remaining constant, the new budget line is AD, with
Px2
a slope of . At equilibrium point R, the consumer purchased X3 units of X and Y3 units of Y. Finally,
Py

when the price of X falls to P , the new budget line AE is tangent to indifference curve I4 at point S. The
X 3

consumer maximizes utility when he/she consumes X4 units of X and Y4 units of Y. Therefore, each price
decrease causes the consumer to purchase more units of X. The line joining points P, Q, R and S is called the
price consumption curve. The price consumption, curve is a locus of equilibrium points resulting from
changes in the price ratio, money income remaining constant.
The individual’s demand curve for a commodity can be derived from the price consumption curve, just as an
Engle curve is derivable from the income-consumption curve. The horizontal axis is the same (units of X),
but the vertical axis now shows the price of X.

Fig 13: Demand curve can be derived from PCC

Price

59
 Px P

Q
PX1

R
PX2

S
PX3 Demand
Curve for X
X
X1 X2 X3 X4

At point P, the consumer buys X1 quantity of X at price Px. At point Q, the price PX1is lower than Px, and the
quantity demanded has increased to X2. Similarly, when the price of X falls to PX2, quantity purchased
increases to X3 and so on. When we plot the price quantity pair defined by the points of equilibrium (on the
price-consumption curve), we obtain a demand curve, as shown in fig.16. The demand curve of an individual
for a particular commodity relates the equilibrium quantity purchased to market price, all other factors
affecting demand held constant. The slope of the demand curve illustrates the law of demand which states
quantity demanded varies inversely with price, ceteris paribus.

3.6 Substitution and Income Effects

We will now turn to a more complete analysis of why demand curves slope downward. Recall from our earlier
discussion that there are two effects of a price change. If price falls (rises), the good becomes cheaper (more
expensive) relative to other goods; and consumers substitute toward (away from) the good. This is the
substitution effect. Also, as price falls (rises), the consumer’s purchasing power increases (decreases). Since
the set of consumption opportunities increases (decreases) as price changes the consumer changes the mix of
his or her consumption bundle. This effect is called the income effect. Let us analyze each effect in turn, and
then combine the two in order to see why demand is assumed to slope downward.

A. Substitution Effect

The substitution effect of a price change is the consumption of a good resulting from price change while
the consumer stays on the same indifference curve. Consider fig.13 to illustrate this. Assume AB is the
original budget line, giving an equilibrium point at point E on indifference curve I; the equilibrium quantity

P
of X is X1. From here let the price of X decrease to X 1 from Px so that the new budget line is AC. We
know from our theory that the consumer will now move to a new equilibrium tangency, on the new budget
line AC.

60
 Good Y
Fig. 14: Substitution Effect

A
E
R
F
I1
*

Good X
X1 X2 B S C

But suppose we place the following restriction on the consumer: after the decrease in the price of X, we
reduce the consumer’s money income M just enough to force a tangency to the original indifference curve
I1. That is, at the new price ratio given by the slope of AC, reduce income so that a budget line with the
same slope (same price ratio) as Ac is tangent to I1.This new budget line is shown as RS, parallel to AC and
tangent to I1. This new budget line RS showing the new price ratio, the consumer maximizes utility at point
F, consuming X2 units of X. The consumer is neither better nor worse off, being on the same indifference
curve as before. The movement from E to F or the change in consumption from X1 to xX2 is the pure
substitution effect. Considering the impact of price along an indifference curve, a decrease in a price leads
to increased consumption of the good.

From our discussion above, it should be noted that income is adjusted to show the pure substitution effect
due to price change. This adjustment in income, called compensating variation, is shown, in fig.14, by a
parallel shift of the new budget line until it becomes tangent to the original indifference curve I1. In fig.14,
the dotted budget line RS shows the adjustment made in the money income of the consumer when price
falls.

At this point one may wonder as to why this adjustment is necessary? The answer is very simple if we recall
what a change in price would bring about. Earlier we noted that a change in price causes two things:
i. Consumers would be induced to substitute goods, that is, they will substitute the relatively cheaper
good for the more expensive ones, and
ii. Consumers experience change in their purchasing power, i.e. change in their real income.

Thus, in order to single out the substitution effect of a price change from its total effect, income should be
adjusted so as to keep the real purchasing power of the consumer the same as before. In other words, the
purpose of the compensating variation is to allow the consumer to remain on the same level of satisfaction
as before the price change. The dotted lines, in fig.14, drawn for this purpose, are called compensated
budget lines.

B. Income Effect
While we have established the direction of the substitution effect, we cannot be as certain about how the
income effect influences the quantity of X purchased. Stated differently, we cannot tell whether the income
effect, for instance, of a decrease in price causes a decrease or as increase in quantity of the good consumed.
In the case of income effect (unlike substitution effect), a fall in the price of a commodity may cause a
decrease or an increase in its consumption, depends on the type of commodity under consideration.

61
The income effect from a price change is defined as the change in consumption of a good resulting strictly
from a change in purchasing power, i.e., a change in real income. We will illustrate the income effect with
the help of fig.15 below.
Starting from budget line AB, the consumer is in equilibrium at point E on indifference curve I1where the

PX 1
consumption level is x1 units of X. Let the price of X falls from Px to . This causes the budget line to
rotate outward to AC.

Fig. 15: Substitution and income effect for a decrease in the price of normal good X

Good Y
A

R*
E
*
G
F * I2
*

I1

Good X
X1 X2 X3 B S C
We can isolate the substitution effect by reducing money income and forcing the new budget line at the
new price ratio to move back until a new line with the same slope as AC is just tangent to I1. Such a budget
line is RS, and is tangent to I1, at F, where the consumer chooses X2 unit of X. In this case, the substitution
effect of the price decrease shows an increase in the consumption of X from X1 to X2.

Now that we have isolated the substitution effect, let us return the money income to the original level by
shifting the budget line from RS back to AC. Assuming that good X is normal, the increase in money
income from the level shown by RS to that shown by AC causes the consumption of X to increase. This
result is shown by the movement from F on indifference curve I1 to G on indifference curve I2, or the
increase in X from X2 to X3.This is the income effect. The income effect shows that the consumption of X
increases from X2 to X3. Whenever the income effect causes more X to be consumed (as price decreases)
and, therefore, reinforces the substitution effect, we know the good is normal. The total effect of the
decrease in price that rotated the budget line from AB to AC is the increase in consumption of X from X 1
to X3. The total effect is broken up into the substitution effect (the distance X1 to X2) and the income effect
(the distance X2 to X3).

We will now consider income and substitution effects in the case of an inferior good. In fig.16 below, let
us begin with budget line AB and equilibrium P, with X1 units of X being consumed.

62
 Fig. 16: Substitution and income effects for an inferior good

Good Y
A

G
R
E
I2

I2

Good X

X1 X3 X2 B S C

The decrease in the price of X, as before, rotates the budget line AB to AC; and, as before, the substitution
effect of the decrease in price is the increase from X1 to X2, or the movement from E to F. Next, let the
income be returned for good X. As the budget line shifts from RS back to AC, the consumption of X is
reduced from X2 to X3 by the return of the money income. The income effect is the movement from F back
to G. The total effect is the change in X from X1 to X3. But the total effect is less than the substitution effect
alone. This is because the income effect, to some extent, offsets the substitution effect. Thus, X here is an
inferior good, because the shift in the budget line from RS back to AC caused a reduction in the consumption
of X from X2 to X3

SUMMARY

Considering the substitution effect alone, an increase in the price of a good cause less of the good to be
demanded; while a decrease in the price of a good causes more of the good to be demanded. However, in the
case of income effect, we need to differentiate between normal and inferior goods. For a normal good, the
income effect adds to (reinforce) the substitution effect, in which case the total effect becomes greater than
the substitution effect. But the income effect for an inferior good off sets (takes away from) the substitution
effect to some extent, in which case the substitution effect alone is more than the total effect.

We therefore conclude that the demand curve for a normal good slope down ward because both income and
substitution effects for such a good change in the same direction. In other words, since, for a normal good,
the income effect must add to the substitution effect, demand must be negatively sloped.

In the case of an inferior good, the income effect does not move in the same direction as the substitution effect.
In fact, it offsets the substitution effect on a certain extent. However, as long as the substitution effect
dominates (i.e. is greater than the income effect), demand is downward sloping.

It is only when the income effect dominates the substitution effect that price and quantity demanded are
directly related, causing demand to slope upward. This is the case of the Giffen Goods, which are inferior
and their demand curve has a positive slope. Giffen good, however, is very rare in practice.

63
 CHAPTER FOUR
THEORY OF PRODUCTION AND COSTS
Introduction
In the previous discussions, we spent some time looking at the theory of consumer behavior
in which consumer behavior shaping the demand curve. This chapter explores the producer
behavior shaping the supply curve. You have some idea how firms operate. They will have
the same goal- either they try to maximize profit or minimize cost. This chapter introduces
the production and cost side of the firm. Topics to be discussed include:
➢ The law of diminishing marginal return
➢ Production technologies
➢ Optimal combination of inputs
➢ Explicit and implicit costs
➢ Economic and normal profit
➢ Short run and long run costs
➢ Economies and diseconomies of scale
Learning objectives:
At the end of this chapter, you will be able to:
✓ Discuss the law of diminishing return
✓ Describe production functions
✓ Discuss the marginal rate of technical substitution and elasticity of substitution
✓ Explain returns to scale of technology
✓ Analyze optimal combination of inputs in the long run
✓ Explain expansion path
✓ Differentiate between economic and accounting profits
✓ Discuss the relationship between marginal and average cost
✓ Analyze the relationship between marginal product and marginal cost
✓ Discuss short run and long run costs of a firm
✓ Explain economies and diseconomies of scale

4.1 The Theory of production

Firms vary in size and internal organization; however, they all take inputs and transform
them into things, which have demand. In economics, the process by which inputs or factors
of production (such as labor, equipment, etc…) are combined, transformed, and turned in
to outputs is called production. An input is any god or service such as labor, capital, land,
and entrepreneurship that contributes to the production of a product or service-an output.
An automobile plant, for instance, uses steel, labor, plastic, electricity, machines, and other
inputs to produce cars. Also, a trip from Addis Ababa to Debre Zeit can be produced with
a bus, 50 minutes of a driver's labor, some gasoline, and so forth. Note that activities in
transportation, storage, the wholesale, and retail trade and other services are considered as
production.

Most outputs can be produced by a number of different techniques. Hundreds of farmers

with small shovels and their hands could harvest a 5 hectare of wheat land; this would be
a labor-intensive technology-a technology that relies heavily on human labor rather than
capital. On the other hand the same 5 hectare of wheat land could be harvested only by 3

64
farmers with different harvesting machines such as harvesting car; this would be a capital-
intensive technology-a technology that relies heavily capital rather than human labor. In
choosing the most appropriate technology, firms choose the one that minimizes the cost of
production.

In production activity there is a certain kind of relationship between inputs and outputs. And the
relationship between any combination of input services and the maximum output obtainable from
that combination expressed numerically or mathematically or tabular or graphically is called a
production function. It shows units of total product as a function of units of inputs.

1. Mathematical production function:

Q= f (L, K, Lan, M, e)
Where: Q = output
M= Material
L= labor
e= other factors
K= capital
Lan = Land

2. Production schedule:
Example:

Labor units (Employees) Total product (units per hr.)

0 0
1 10
2 25
3 35
4 40
5 42
6 42

3. Graphical production function

The above tabular example can also be seen graphically as:

Fig 4.1 Production Function

Total 40 *
output
Q (Total output)
30

20

0 1 2 3 4 5 6
10

65 Labor units
(Number of employees)
A specific technology gives rise to a specific production function and when a given technology
changes the production function changes as well.

Short run and Long run:

A firm uses various inputs (factors of production) in a production process. Depending on the
duration of the time considered, inputs are categorized as fixed and variable inputs:

Fixed inputs are those factors of production the supply of which can't be changed over a short
period. Thus, fixed inputs are inputs, which do not change in quantity when output changes, in a
given short period. Example: The size of building, machines, managerial personnel.

Variable inputs are inputs the supply (quantity) of which changes in response to the desired change
in output in a short time. These inputs change (vary) in quantity to effect change in output.
Example: Labor and material

The distinction as to which inputs are fixed and which are variable is primarily dictated by time
and the state of technology. And to account for the role of time in production and costs, we
distinguish two different time periods short run and long run.
Short run:
The short run is a period of time for which the firm is operating under a fixed factor of production.
It is a period of production during which the firm is confined to a fixed plant. In the short run,
production can be changed by changing variable inputs, but not fixed inputs. Therefore, the short
run refers to that period of time during which the set of inputs available to an enterprise is not
wholly adjustable. The firm's plant capacity is fixed in the short run, but output can be varied by
applying larger or smaller amounts of variable inputs. In effect, in the short run there is a limit to
production because there is only limited plant capacity available.
➢ At least a factor of production is fixed in short run. Output in short run can be changed by
adjusting variable resources, but the size or the scale of the firm is fixed in the short run.

Long run:
The long run is a period extensive enough for firms for firms to change the quantities of all
resources or inputs employed, including plant capacity. It is a period of time for which there are
no fixed factors of production. From the industry's view point, the long run also encompasses
enough time for new firms to enter and existing firms to exist the industry.

While the short run is a "fixed plant" period, the long run is "a variable-plan" period and produces
have more flexibility in the long run than they do in the short run. Note that the short run and the
long run are conceptual rather than specific calendar time periods. The actual period of time
encompassing the long run is likely to vary from industry to another because nature of production
differs. For example, some producers might be able to increase all of their inputs in a month and
some might take years to increase the capital inputs (such as refineries) required to produce more
output.

The theory of production can better be understood if we first emphasize production in the short run
(a production process where a firm can change its output by changing variable resources or inputs
to a fixed plant) and then treat production in the long run, which is a more complex production
process where a firm changes its output by changing all type of inputs.

66
Short run Production
Recall that in the short run a firm can change its output by adding variable inputs (not fixed inputs)
to the existed fixed input or plant. So, in this topic we will examine how does output change as
more and more variable inputs are added to the firm's fixed inputs.

To begin the analysis, we will examine the relationship between the quantity of one variable input
used and the quantity of output, given a fixed input. To illustrate the situation and grasp the
essential principles of production more clearly it will be easier to focus on the simplest model: i.e.
the case of one fixed input, say land, and one variable input, say labor.

In the following table column 1, 2 and 3 provides a hypothetical producer's short run production
schedule:

Yearly Output of Wheat (in quintals) production

(1) (2) (3) (4) (5)

Land(fixed input) Labor (variable input) TP,Q AP= TP  L) MP = TP  L

1 0 0 - -
1 1 10 10 10
1 2 25 12..5 15
1 3 35 11.7 10
1 4 40 10 5
1 5 42 8.4 2
1 6 42 7 0
1 7 41 5.9 -1

The first column in the above table shows the fixed input (land) in hectare and the second column
shows the number of employees (variable input) involved in the production process. And the
maximum possible output (called total production) that can be produced with the given variable
input and the given fixed input (land) is given in column 3. These three columns represent
production schedule. The last two columns show average products and marginal products, which
are defined as follows.

Total, Average and Marginal Products:

Total Product (TP) is defined as the total quantity of a product produced during some period of
time by all the factor of production (or inputs) employed over that period of time. That is, TP refers
to all goods and services produced using a certain quantity of inputs. For instance, in the above
table, the total product produced using 3 laborers (3 employees) and 1 unit (hectares) of land is 35
units (quintals) of output (wheat).

One way of presenting production functions is using graph. The total product curve describes the
relationship between the variable input and output, with fixed amounts of other inputs and under
current technology. The total product curve, using columns 2 and 3 in the above example, can be
sketched as shown below:

67
 TP
Fig 4.2: Total product Curve

*
40 * Total product
curve
30 *

20
*

10 *
Labor

1 2 3 4 5 6 7

The above graph generally illustrates the traditional production curve. The traditional production
curve is a cubic function of the variable input which first increases at an increasing rate and then
increases at a decreasing rate.

Average product (AP) of a variable input is the average amount of output produced by each unit
of the variable input (factor of production). It is calculated by dividing a firm’s total output by the
number of units of the variable input that produced it. For instance, in our wheat product example
above, average product of labor (i.e. column 4) is computed as:
Total product total product TP
Averageproduct of labor   , APL  L
Total unit of labor total labor hour L

Thus, the average product of labor when 3 workers are employed is 11.7 (35  3)
The average product curve describes the relationship between the average product and the variable
input used. The average product curve, using columns 2 and 4 the above example, can be shown
as:

Fig 4.3: AP curve

12.5 MP is the change in total product that

occurs when the use of the particular
resource increases by one unit, all other
10 Average Product curve resources are constant.

1 2 Labor
Marginal product (MP) of a variable input is the additional output that can be produced by
adding the variable input by a small change (i.e. by one unit- for practical purposes). In our wheat
example, the marginal product of labor (i.e. column 5) is computed as:

68
 Change in Total Pr oduct
Marginal Product =
Change in Amount of labor used
TP
MP =
L
Such as, the marginal product of labor when 4 workers are employed is 5 (i.e.
TP  40  35  5 and L  4  3  1 and MP  TP  L  5  1  5)

The marginal product curve describes the relationship between the marginal product and the level
of variable input used. The marginal product curve, using columns 2 and 5 of the above example,
is sketched below:

MP Fig 4.5 MP Curve

15
Marginal Product curve

10

0 1 2 6
Labor

Derivation of Average and Marginal Product curves from Total Product curve.
Since both the average product and marginal product are defined in terms of total product, the
average and marginal product curves can be derived from the total product curve. The following
figure illustrates the situation:

Fig 4.6: Derivation of AP & MP curves from TP curve

TP
D
Q4 * T4
c*
Q3
TP

B
Q2

T2
T3
Q1
A
T1
0
L1 L2 L3 L4 Labor

69
Using the figure above:

▪ The average product of L1 units of labor is :

OQ1
AP  , This is the slope of the ray OA
QL1
▪ The average product of L2 units of labor is similarly:
 OQ2 
 AP   , This is the slope of the ray OB
 OL2 
▪ What is the average product of L3, & L4 units of labor?

This shows that geometrically, average product of a variable input is represented by the
slope of a ray drawn from the origin to the point on the total product (TP) corresponding
to the given amount of the variable input.

Slope, by definition, measures the change in the value of a variable in the vertical axis as a
result of a change in the value of a variable in the horizontal axis. And the slope of a
straight line is constant while slope of a curve differs from one point to another on the same
curve. The slope of a curve at a particular point on the curve is the slope of the tangent line
to the curve at that point. Therefore, the marginal product of the variable input is measured
by the slope of the tangent line to the total product curve corresponding to the given amount
of the variable input because by definition the marginal product of a given amount of input
is the change in output as the input changes by small amount (by one unit).

For instance:
✓ The marginal product of L1 units of labor is measured by the slope of T1,
✓ The marginal product of L2 units of labor is measured by the slope of T2, etc.
The above illustration is very helpful to understand the behaviors of AP and MP, and their
relationship.

The illustration shows that marginal product increases as labor input increases up to point
B (i.e. the slope of the tangent line become steeper and steeper). However, at point B it
achieves its maximum value (i.e. the slope of the tangent line at point B is maximum) and
starts to decline as more and more variable input (labor) is used point B is called the point
of inflection. At point D, marginal product become zero (slope of the horizontal tangent
line is zero) and become negative beyond point D.

The illustration also shows that average product rises between point O and C as more
variable input (labor) is used (i.e. the slope of the rays become steeper and steeper). And
it starts to decline beyond point C. However, average product will never decline up to it
becomes zero (Why?).

Another very important illustration of the above graph is that the slope of the tangent line
and the ray at point C are equal, which implies that marginal product and average product
become equal at point C, where the average product achieve its maximum while the
marginal product already started to decline. And we also see between points O and C that
at any point on the curve, the tangent line is steeper than the ray while the other way around

70
beyond point C. This shows that marginal product is greater than average product between
O and C while average product is greater than marginal product beyond point C.

Total, Average and Marginal product curves

Using the above illustrative discussion, the relationship between total, overage and
marginal product can be graphically shown as:

Output
* TP
Fig 4.7: TP, AP & MP Curves

Phase I Phase II Phase III Labor

Output

AP

L2 L3 L4 Labor
MP
Relationships between total, marginal, and average product

The above graph helps you understand the relationships between total, marginal, and average
product:
▪ First note that total product goes through three phases: It rises initially at an increasing rate
(phase I), then it increases but at a decreasing rate (phase II), it finally reaches a maximum and
declines (phase III).
▪ The three phases of total product are also reflected in marginal product. Where total product is
increasing at an increasing rate, marginal product is rising (phase I). In this phase extra workers

71
 are adding larger and larger amounts to total product. Thus, this phase is known as the phase
of increasing marginal returns. Similarly, where total product is increasing at a decreasing
rate, marginal product is positive but falling (phase II). Each additional worker adds less to
total product than did the preceding workers. Thus, phase II is known as the phase of
diminishing marginal returns. Where total product is at a maximum, marginal product is
zero. And finally, where total product declines, marginal product become negative (phase III).
In this phase the addition of each worker decreases total product. Thus, this phase is known as
the phase of negative marginal returns.

▪ As does marginal product, average product also reflects the same generally "increasing -
maximum-diminishing" relationship between variable inputs of labor and output.

In general, the following relationships exist between average and marginal product of the variable
input (you may refer the above graph to help you understand the following generalizations):

➢ Where marginal product exceeds average product, average product will rise. This actually
is a mathematical necessary: if you add a number to a total which is greater than the current
average of that total, the average must rise. That is, so long as the amount an additional worker
adds to total product exceeds the average product (productivity of all workers already
employed) average product will rise.

➢ Where marginal product is less than average product, average product must be declining.
This is also a mathematical necessity: you may similarly argue.

➢ It follows that when marginal product is equal to the average product, the average product
is at a maximum, it neither increases nor decreases.

The Law of Diminishing Returns

We recall that in the short run a firm can change its output by adding variable inputs (resources) to
a fixed plant. The above discussion provides the answer for the question of how does output change
as more and more variable resources are added to the firm's fixed input. As we discuss above both
average and marginal product reflect the common or general "increase-maximum-diminishing"
characteristics. That is, they at first increase, reach their maximum and then decrease. In fact so
far as the study of economics is concerned, the fact that the rate of increasing in total product slows
down, or that marginal product declines is an inevitable physical phenomena, under a given set of
assumptions. That is why economists treated this diminishing nature of marginal product as a law
and called it the law of diminishing returns also called the "law of diminishing marginal product"
or the "law of variable proportions."

➢ The Law of Diminishing Returns states that as successive units of a variable input (resource)
are added to a fixed input, after a certain point the extra, or marginal, product of the variable
input declines.

In our wheat product example, this law refers that: if additional labor (workers) are applied to a
constant size of land, output will eventually rise by smaller and smaller amounts as more labor
(workers) are employed.
As far as the law of diminishing returns is concerned two important points must be clear:
➢ The law is relevant in the short run when at least one input is fixed. In which case the ratio at
which inputs are combined varies as the variable input changes in quantity.
➢ The law applies to a given level of production technology. Thus, the law should not be
misapplied in situations in which technology conditions are changing.

72
 Production function with two variable inputs

It is assumed that the two inputs used for producing a good are labor and capital and that they are
substituted for each other. The firm should use the combination of capital and labor that will
produce the greatest amount of product for a given outlay.

A production with two variable inputs can be represented by a family of Isoquants. The word
"Isoquants" simply means equal quantities. They are also known as equal product curves or
isoproduct curves. Isoquant is defined as the locus or path indicating different combinations of the
two inputs, labor (L) and capital (k) which yield a specific level of output.

Example: Suppose that a firm can produce a given level of output of 100 tons of sugar by
employing any one of the alternative combinations of the two inputs, labor and capital as shown.

Combination Units of labor Units of capital Total product

(tons)
A 1L 20K 100
B 2L 15K 100
C 3L 11K 100
D 4L 8K 100

The above table indicates that an output of 100 tons of sugar can be produced either by one unit of
labor and 20 units of capital, 2 units of labor and 15 units of capital or by any of four combinations
mentioned in the table in the specified period of time.
Y
Capital ❖ Note:
(K) Fig 4.8 ✓ Isoquant (IQ) is the locus of capital-labor
A combination yielding the same level of output.
20 ✓ All combination of inputs along the same
isoquant yields the same output.
B
15

11 C IQ2 (200 tons)

D
8 IQ1 (100 tons)

0 Labor (L)
1 2 3 4 X

Here, we assume that technical production conditions are constant. Thus, an isoquant shows
various combinations of the two inputs in the existing state of technology which produce the same
level of output.

73
 The question that wheat farmer inventively asks himself is: if I want to produce 100 tons of wheat,
what is the least cost combination that I can use? Clearly the answer to this question depends on
the cost of inputs. If labor is relatively cheaper than capital certainly the farmer wants economize
the use of the capital. Be informed that we will provide mathematical proof to such questions when
we deal with optimal combination of inputs.

Properties of Isoquants

1. Isoquants are down-ward sloping and convex to the origin

2. The further away an isoquant is from the origin, the larger is the output represented. IQ2
denotes larger output in fig 4.8 above. Note that for a given production function, each point on
the specified Isoquants is a maximum output that can be achieved with that input combination.
3. Isoquants don’t intersect. Because, if they did, we would have different outputs with the same
input combinations which violates the definitions
4. Isoquants are represented as continuous curves which imply that inputs are perfectly
divisible; or inputs come in any fraction of a unit.
5. Factor intensity of the production technique could be measured by the slope of a straight line
through the origin to any point on the isoquant. Factor-intensity is simply the capital-labor
ratio.
K
Fig 4.9

At A, factor intensity is given by 12

K1 12 *A
  12 10
L1 1
K2 8 *B
  4. 8
While at B, it is given by
L2 2
6 *C
Hence, the production process at point A
is more capital intensive than at point B 4 *D Q
K1 K 2 2 *E
 )  (12  4)
(i.e
L1 L2 0
1 2 3 4 5 L

The equation of an isoquant can be represented by:  K *MPK +  L * MPL=0

In other words, as we move from one point to another along the isoquant, the reduction in output
from using less of K must be just offset by the addition to output from more of L. It implies that
loss in output equal to gains in output.

Types of Isoquants
a) Convex Isoquants: Traditional economic theory mostly adopts convex Isoquants. This form
of isoquant assumes substitution between K & L is possible but only over a certain range.
b) Linear-Isoquants: This type assumes perfect substitute ability of factors of production. That
is a given output may be produced by using only capital or only labor or by an infinite
combination of K & L (see b).
c) Input-output Isoquant (Leontief technology): assumes strict complementarily of the inputs.
The possibility of substitution between factors of production is zero. There is only one method
of production for any one commodity. Alternatively, any level of output requires fixed
proportions of inputs (see C). In Leontief production function moving from point A to point B

74
 by adding more unit of labor does not increase output. This behavior must mean that the
marginal product of labor along the portion of the isoquant from A to B is constant and equal
to zero. Similarly when we move from point A to point D, the marginal product of capital is
zero. We can therefore conclude that no substitution is available in the technology unless we
must use inputs in the proper proportion. The Leontief technology at least gives us a rough
approximation of constraints involved in producing output.

Fig 4.10: Production functions

(a) (b) (c)
K K
Capital
(k)

3 d*

2 IQ3
IQ3
IQ2
IQ3 B
1 A*
IQ2 IQ2 * IQ1
IQ1
IQ1

0 0 6 8
L L
Rate of Technical Substitution
The slope of an isoquant shows how one input can be traded for another while holding output
constant.
The marginal rate of technical substitution of labor for capital (MRTS L,K) is the amount by which
the capital input can be reduced when one extra unit of labor is used, so that output remains
constant. More precisely, we can express this rate as follows:

MRTS L,K = - (slope of Isoquant)

K MPL  dk Q * L
1
−𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛𝑝𝑢𝑡
=    
K Change in labor input L MPK dL Q * 1
K

✓ Note that the absolute value of the

K1 slope of the isoquant at any point
*A measures the MRTS.
✓ As shown in the figure, the MRTS
is diminishing as we move from
left-to right along the IQ.
K2 *B
✓ MRTS is the rate at which one input
IQ
can be substituted for another while
L keeping the output constant

L1 L2
75
 L
Notice that for a high ratio of K to L, the MRTS is large positive number indicating that a great
deal of capital can be given up if one more unit of labor is employed to produce the same level of
output.
Elasticity of Substitution

The MRTS has a serious limitation in serving as a measure of the degree of substitution between
factors. This is because it depends on the units of measurement of the inputs. A better, measure of
the case of substitution is provided by elasticity of substitution.

The elasticity of substitution is defined as the percentage change in the capital labor ratio divided
by the percentage change in the rate of technical substitution. It measures how freely we can vary
our inputs as their relative prices change but the amount of output produced remains constant.
Basically, the elasticity of substitution measures the percentage change in the ratio of input used
as the producer experiences a given percentage change in the ratio of the prices of the inputs.

Elasticity of Substitution: LK = Percentage change in K/L

Percentage change in MRTS

Why would firms ever want to substitute capital for labor or labor for capital? Why not use the
same ratio of capital to labor to produce any level of output, as in the Leontief technology? Because
the relative prices of capital and labor may vary, producers sometimes want to change the
combination of inputs they use to produce output so that they can continue to operate in the least-
cost way. For example, if capital becomes very expensive and the labor is cheap, a producer will
want to use more labor and fewer unit of capital if the technology permits this substitution.

Returns to Scale

In the long run, output can be increased by changing all factors of production. Output can be
increased.
a) by changing all factors by the same proportion
b) by changing all factors by different proportions

However, traditional theory of production focuses on the first case; that is the study of output as all
inputs change by the same proportion. Thus, the term returns to scale refers to the changes in output
as all factors change by the same proportion.

Alternatively, how does the output of the firm change as its inputs are proportionately increased is
answered by the laws of returns to scale.

The returns to scale of a certain production function could be any of the following:
1) Constant Returns to Scale: if a doubling of all inputs results in a precise doubling of output.
2) Decreasing Returns to Scale: if a doubling of all inputs yields less than doubling of outputs.
1) Increasing Returns to Scale: if a doubling of all inputs results in more than doubling of output.
Homogeneous Vs non-homogeneous Production Function
Both homogeneous and non-homogeneous production functions may exhibit constant, increasing
or decreasing returns to scale as all inputs are increased by the same proportion.
Homogenous production function: is defined as a function such that if each of the inputs is
multiplied by  , then  can be completely factored out of the function.
Let Qo = f (L,K)

76
 If all inputs are increased by  , then
Q=f (  L,  k)
And if  can be factored out and Q1 can be expressed as a function of  as:
Q1=  vf(L, K)

Thus, such a production function is called homogenous and v indicates the degree of homogeneity
or the scale of returns to scale.
V = 1  constant returns to scale
V < 1  decreasing returns to scale
V >1  increasing returns to scale

Consider the following three production functions:

a) Q  f K , L   K 1 / 2 L1 / 2
1 1
b) Q  f  K , L   K L 4 4

C ) Q  f K , L   K 2 L2
Demonstrate that the first function has constant, the second has decreasing and the third has
increasing return to scale.

When all inputs are multiplied by the same proportion, say  , and if  cannot be factored out as
above, then the production function is non-homogeneous. Note that, however, a non-homogenous
production may exhibit constant, decreasing or increasing returns to scale.

Product lines and Isoclines

The product line describes the technically possible alternative paths of expanding output as we
change either factors or a single factor. This is shown as a movement from one Isoquant to another.
Case I: when only one factor is variable, ceteris paribus, the product line is parallel to the axis of
the variable factor. The capital-labor ratio diminishes when labor is the variable input. (See the
following figure)

̌
𝐾 Product line (expansion path)

Consider the following Cobb-Douglas production function of the form:

Q=zLaKb
Where Q= output, L =labor, K =capital and z,a,b are parameters.
If Q=1.10L0.75K0.25, the linear logarithmic form is:
Log Q = log 1.10 + 0.75 log L +0.25 log K.
A. If the labor input were increased by 1 %, output would increase 0.75%.Hence, a=0.75
represents the increase in output with respect to labor. Alternatively, a= (0.75) is the
elasticity of output with respect to labor input.

77
 B. If the capital were increased by 1%, output would increase by 0.25%. Hence, b=0.25
represents the response in output with respect to capital. In other words, b= (0.25) is the
elasticity of output with respect to capital input.
C. If both labor and capital were increased by 1%, a 1% increase in output would result
because v = a+b = 0.75+0 %+0.25 % =1%. Thus, this is the case of constant returns to
scale.
Case II: when both factors are variable, the product line passes through the origin. If the production
function is homogeneous, we can show the expansion path by drawing a straight line also called as
isoclines. An Isocline is a special product line. It is the locus of points of different Isoquants at
which the MRTS of factors is constant. Along any one isocline, the capital-labor ratio is constant.
But on different Isoquants both the MRTS and the capital-labor ratio are different.

K IS1 * All along the IS1, the K/L is constant. But the

K/ L on IS1 is greater than the K/L on the IS2

IS2.
Likewise, the MRTS on IS1 is different from that
of IS2 as shown by the steeper slopes of the
former. But the parallel lines on each IS indicate
that MRTS is equal along an Isocline.

0 L

Graphical Presentation of Returns to Scale

The returns to scale of a homogeneous production may be shown by the distance on the isoclines-
that is the distance between successive multiple level- of output Isoquants. For instance, if Q is the
base level output, then the multiple levels of outputs would be 2Q, 3Q, etc.

A) Constant Returns to Scale:

As the Isocline indicates, both labor and capital are increased proportionately. Here, output is
increased by the same proportion inputs are increased. Thus this is the case of constant returns
to scale. Doubling or trebling inputs results in doubling or trebling outputs, respectively.

Isocline

K2 Q2= 360

K1 Q1= 180

0 L1 L2 L

B) Decreasing Returns to Scale:

78
An expansion in inputs results in a less than proportionate rise in output.
K
Isocline The distance between consecutive multiple Isoquants
increases. By doubling the inputs, output
increases by less than the original output level.
D Q2= 300 For instance, when L and K are doubled, output
K2 c is less than double.

Q1= 180
L
L1 L2

C) Increasing Returns to Scale:

The distance between consecutive multiple Isoquants decreases.

K
Isocline
Q2= 400 A doubling of inputs is more than
K2 sufficient to double output. In this case,
the isoquant gets closer as input expands.
Doubling both L and K from 1 to 2 units
K1 Q1 = 180 results a more than double output which
is greater than 360 = 2Q)

0 L
L1 L2

The inequality means that additional output (marginal product) per dollar of labor is greater than
the marginal product per dollar of capital. Hence, the producer can reduce his cost by reallocating
his dollar outlay until eventually the contribution per dollar of each inputs will be in balance; i.e.
MPL MPK

w r

Choice of Optimum Combination of Inputs

In addition to the knowledge of physical production possibilities, the economist is concerned with
economic efficiency. By economic efficiency we mean the least-cost combination of resources to
produce a given output. Both knowledge of production possibilities and input prices are required
to identify economically efficient resource combinations. Resource (input) price information is
represented by an isocost. An isocost is a locus of points which represent the same cost outlay (C).
An isocost of a firm that used labor and capital given by:
C  wL  rK
Where, w = price of labor (wage rate) and r = price of capital ( rental price ).
In general, the least cost of producing a given output (a point on a given isoquant) lies at a point
where the isoquant is tangent to the isocost representing the smallest possible out- lay. For instance,
consider the following figure.

79
K
A''

A'
'a

A
e
K1
'b Q

L1B B' B''

L

At any point other than the point of tangency, the isoquant intersects higher isocost lines; thus away
from the point of tangency, greater cost will be incurred in producing a given output (Q). The point
that fulfills the cost minimizing objective is the point where the slope of isocost = the slope of
isoquant can be given by:
MPL MPK w MPL
  
w r r MPL

The meaning of this equation can be better understood if we look at a situation where
MPL MPK
➢  The rational producer would react by substituting labor input for capital input
w r
and/or

MPL MPK
➢  The rational producer would react by substituting capital input for labor input.
w r

The highest level of output attainable with given level of cost is produced by using L1units of labor
and K1 units of capital. At point e the firm produces highest possible output at the minimum
possible cost. Point a & b represent higher cost to produce given output (Q). The Optimum factor
combination is represented by a point of tangency between the given output (Q) and the lowest
possible isocost line, at point e.

The Expansion Path

In determining the equilibrium point, we have assumed firm's resources or total outlay to be
constant. But if there is a change in its total outlay, the firm has to establish a new equilibrium
point. The firm may produce highest level of output if the total outlay has increased (assuming
input price to be constant).

The isocost line or the factor price lines will make a parallel shift following every change in the
cost out lay, as the ratio of input prices has been assuming to be constant.

80
 M2
Capital
(k) P
M1 Expansion Path

M
E2
E1 IQ3
E0
IQ1 IQ2
Labor (L)
N N1 N2

The above figure indicates a family of three Isocost lines. Every increase in cost outlay will enables
the firm to raise the level of employment of both inputs and thus produce higher levels of output.
The equilibrium points of input combinations will be E0, E1 and E2. If we join these equilibrium
points with help of a curve, then this curve is known as the expansion path of a firm. Hence an
expansion path indicates different points of least cost combinations of labor and capital required to
produce different level of output.

The expansion path of linear homogeneous production function (the constant return to scale) is
always a straight line through the origin.

The expansion path of a general production function (where constant returns are absent will not be
a straight line; in that case an increase in the total outlay will be followed by varying proportions
of capital and labor.

4.2 Theory of Cost

Cost exists because resources are scarce and have alternative uses.

Economic Cost is the monetary value of all inputs used in a particular activity or enterprise over
a given period to make goods or services available to users. The idea behind economic cost of any
resource in producing a good is that it must reflect the value of those resources in their best
alternative uses, i.e. opportunity cost.

Economic costs may be either explicit or implicit. Implicit costs are the value of inputs which are
owned by the businessmen (i.e. use of company owned buildings, self -owned and self -employed
resources could have earned in their best alternative employments). Alternatively, explicit costs of
a firm are opportunity cost of using resources owned by the firm. The way costs are currently
measured according to standard accounting practices these implicit costs are not accounted for.
That is, accounting cost measure the explicit cost of operating a business. Explicit costs consist of
the monetary payments or cash expenditures a firm makes to "outsiders" who supply labor services
materials, fuel, transportation services, and power in the production process. Explicit costs are
payments to non-owners of the firm for the resources they supply.

81
One important point to rise in relation to the concept of economic cost is the day to day practice
that economists and accountants use the term "profits" differently.

Accounting profit of a firm is total revenue minus its explicit costs

➢ Accounting profit = total revenue - explicit costs while;
Economic profit is a firm’s total revenue minus its explicit and implicit costs
➢ Economic profit = total revenue - Economic cost or opportunity cost of all inputs (explicit
and implicit),or
➢ Economic profit= Accounting profit- implicit costs

Cost Function of a firm

The cost function expresses the relationship between cost and the corresponding output. In
general, a cost function can be written as: C  f Q 
Where, Q represents the quantity of output
C represents the corresponding total cost
f represents a function relating quantity of output to total cost

The function above implies the market value of the minimum quantity of inputs required to product
Q quantity of output and C (cost) consistent with the prevailing technology.

Cost in the Short run: Total, Average and Marginal costs

We recall that in the short run some resources are fixed and others are variable. This implies that
in the short run costs can be classified as either fixed or variable.

Fixed costs are those costs that do not vary with changes in output. Fixed costs are associated
with the very existence of a firm's plant and therefore are independent of the level of output. That
is, the total fixed cost is the same both at zero level of output and all other levels of output. Costs
such as interest on a firm's bonded indebtedness, rental payments, apportion of depreciation on
equipment and buildings, insurance premium, and the salaries of top management and key
personnel are generally fixed costs. An important thing to remember about fixed costs is that firms
cannot avoid or change them in the short run. Firms have no control over fixed costs in the short
run and hence they are sometimes called sunk costs.

Variable costs are those costs that change with the level of output in the short run. That is the
total variable cost is the market value of the minimum quantity of the variable inputs, consistent
with the prevailing technology and factor prices required to produce the various quantities of
output. They include required to produce the various quantities of output. They include payments
of materials, fuel, power, transportation services, most labor, and other variable resources. Variable
costs can be controlled or altered in the short run by changing production levels.

In the short run, fixed costs and variable costs together make up total costs.

Total cost is the sum of the value of all inputs used over any given period to produce goods and
services. It is the sum of fixed and variable costs at each level of output.
TC = TFC + TVC

Where, TC denotes total costs, TFC denotes total fixed costs, and TVC denotes total variable costs.
Oftentimes, the short-run total cost function can be written as:

82
C = Co + V (Q)
Where, C is the total cost
Co is the total fixed cost
V (Q) is the total variable cost which is a function of output

Given the price of input, the cost function is derived from the associated production function.
To illustrate this and the above discussion we will use the data we earlier used for production (i. e.
the yearly output of wheat production). Assuming that the one hectare of land is rented Birr 1000
per year and the annual payment per employee is Birr 5000 (i.e. assuming rent and salary are the
only payments the firm incur), total fixed, total variable and total costs schedule for the wheat
producer in the SR would be:
Derivation of Cost function from production function

(1) (2) (3) (4) (5) (6)

Output Land Labor Total fixed Total Total cost
(Q) (fixed input Variable cost (TFC) variable cost (TC = TFC
in hectares) inputs (no. of (TVC )` + TVC)
employees)
0 1 0 1000 0 1,000
10 1 1 1000 5,000 6,000
25 1 2 1000 10,000 11,000
35 1 3 1000 15,000 16,000
40 1 4 1000 20,000 21,000
42 1 5 1000 25.000 26,000
42 1 6 1000 30.000 31,000
41 1 7 1000 35.000 36,000

The cost figures and the corresponding quantities of output constitute the cost of production in the
form of schedule.
The information in the schedule above can be presented graphically by plotting total fixed cost,
total variable cost and total cost against output.

Total fixed cost curve

Total fixed cost curve is a graph that shows the relationship between total fixed cost and at the
level of a firm's output. Since total fixed cost, by definition, is constant, it is always a horizontal
straight line. In column 4 of the above table we assume that the total fixed costs are Birr 1000 at
all levels of output, including zero. Thus, as shown below, the fixed cost curves a horizontal line
at cost is equal Birr 1000.

Total Variable Cost Curve

It is a graph that shows the relationship between total variable cost and the level of a firm's output.
Since more output costs more in total than less output, total variable costs curve has a positive
slope, i.e., total variable cost change directly with output. In particular, the total variable cost curve
always starts at the origin and rises to the right first at a decreasing rate and then at an increasing
rate. The reason for this is the law of diminishing returns- in the short run, as the firm increases
production, larger and larger additional amounts of variable inputs (and hence larger and larger

83
 variable costs) are needed to product each successive unit of output. The total variable cost curve
of the above example is drawn below using column 1 and 5.

Total Cost Curve

It is a graph that shows the relationship between total cost and the level of a firm's output. At
zero units, of output total cost is equal to the firm's fixed cost. And then for each unit of output
total cost varies by the same amounts as does a variable cost. As a result the total cost curve
begins from the level of the fixed cost and moves parallel with the total variable cost curve.

Costs
(birr ) TVC
TC
40

30

Total Fixed Cost

20

Total Variable cost

10
Total
*
cost TFC
*
1
10 20 30 40 Q

The total cost (TC) of any output is the vertical sum of the fixed cost (TFC) and
variable cost (TVC) of that output.

Average and Marginal Costs

The concepts of average cost and marginal cost are very crucial concepts for producers. Producers
are certainly interested in their total costs, but they are equally concerned with per unit, or average,
costs and marginal costs.

Average Costs
Average-cost data are more meaningful for making comparisons with product price, which is
always stated on per unit basis. Since total cost, by definition, is the sum of total fixed cost and
total variable cost, we have three averages that must be defined - average fixed cost, average
variable cost and average total cost.

Average fixed cost (AFC)

Average fixed cost for any output is found by dividing total fixed cost by that output. That is,
TFC
AFC =
Q
See, the table below, how AFC (column 5) is derived from TFC (Column 2) &output (Column 1).

84
Since the total fixed costs are by definition, constant or independent of output, average fixed cost
will continuously declines so long as output increases. This is commonly referred to as "spreading
the overhead". You find in the figure below that AFC graphs as a continuously declining curve as
total output is increased. Column 5, in the table below, also shows that AFC declines as more
output is produced.

Average variable cost (AVC)

Average variable cost is the per unit variable cost incurred by the firm. The average variable cost
for any out is obtained by dividing total variable cost by that output. That is,
TVC
AVC =
Q
See, the table below, how AVC (col. 6) is derived from TVC (Column 3) and output (Column 1).
Since total variable cost reflects the law of diminishing returns, so must the average variable cost
because AVC is derived from total variable cost. That is, due to increasing returns, initially it takes
fewer and fewer additional variable resources (and hence average variable cost per unit declines)
to produce each of the first few units of output. After AVC hits a minimum it will start to rise as
diminishing returns require more and more variable resources (and hence AVC rises) to produce
each additional unit of output. In short, AVC declines initially, reach a minimum, and then
increases. As a result the AVC curve, as show in the figure below, is a U - shaped or Saucer-
shaped. Column 6 in the table also shows that the AVC initially declines and reaches its minimum
(i.e. 400) and then rises as output is increased.

Average total Cost (ATC):

Average total cost for any output is total cost divided by the number of those units of output. That
TC
is ATC =
Q
Column 7 in the table below shows ATC which is the result of dividing the total cost (TC) in
column 4 by the quantities of output (TP) in column 1.
Another, more revealing, way of deriving average total cost is to add average fixed cost and average
variable cost together. That is:

TC TFC  TVC TFC TVC

ATC =     AFC  AVC.
Q Q Q Q
Thus, in the table below, you can also get column 7 by adding column 5 and column 6.
Graphically average total cost (ATC) curve is therefore, found by adding vertically the AFC and
AVC curves, at all levels of output as shown in the figure below. Since average fixed costs falls
with output, an ever-declining amount is added to AVC. Thus, AVC and ATC get closer together
as output increases, but the two curves never cross as AFC never be equal to zero.

85
 Cost per
unit

ATC
AVC

AF
C Units of output

Marginal Cost (MC)

The concept of marginal cost is the most important cost concepts. Marginal cost is the increase in
total cost that results from producing one more unit of output. In short, it is the extra, or additional,
cost of producing one more unit of output. MC is the ratio of change in total cost to a small (a one
unit, for practical purposes) change in the level of output. That is:
changeinTC TC
MC = =
ChangeinQ Q

Column 8 in the table below shows MC which is calculated from the data on TC (column 4) and
output (column 1). For example, the marginal cost when output changes from 35 to 40 is 1000,
because TC  21000  16000  5000 & Q = 40 - 35= 5, and hence,
MC= TC  Q  5000  5  1000.
Note that marginal cost depends only on changes invariable cost. This is because fixed cost doesn't
change as output changes. This means that MC can also be calculated from the total variable cost.
That is:
TC (TFC  TVC) TVC
MC    , because TFC  0
Q Q Q
Marginal cost is influenced only by variable cost. For example, in the table below, fixed cost is
1000. As output increases, fixed cost remains 1000. Only variable cost increases as output
increases. So change in TC is only as a result of change in TVC.
Since variable cost, and therefore total cost, increase first by decreasing amounts and then by
increasing amounts, marginal cost (which is a function of total cost) declines sharply, reaches a
minimum, and then rises rather abruptly (see the figure below). This marginal cost curve's shape
is a reflection of, and the consequence of the low of, diminishing returns.

Relationship between MC, ATC and AVC

➢ The marginal cost curve intersects both the AVC and ATC curves at their minimum points.
This relationship is a mathematical necessity. If marginal cost is below average total cost,
average total cost will decline toward marginal cost; if marginal cost is above average total

86
 cost, average total cost will increase, i.e. AC always moves towards MC. As a result marginal
cost intersects average total cost at ATC's minimum point. By the same reason marginal cost
intersects average variable cost at AVC's minimum point (See the figure below). No such
relationship exists for the MC curve and the AFC curve, because the two are not related. MC
includes only those costs which change with output, and FC and output are independent.
➢ Average variable cost reaches its minimum before the average total cost because of the
inclusion of fixed cost.
Costs The distance between average
MC variable cost and the average
total cost curve is average fixed
ATC cost curve, which gets smaller as
the rate of output increase. (Why
* does average fixed cost curve gets
AVC smaller?)
*

Quantity
AFC Q
We may use the following table to illustrate the various average cost and marginal cost concepts
and their interrelationships. The table shows, using our previous wheat production example, the
derivation of Average cost and Marginal cost.

Units of Total Cost data Average Cost data Marginal

Output cost data
(1) Q (2) TFC (3) TVC (4) TC (5) AFC (6) AVC (7) ATC (8) MC

0 1000 0 1000 - - - -
10 1000 5000 6000 100 500 600 500
25 1000 10000 11000 40 400 440 333.33
35 1000 15000 16000 28.57 428.57 457.14 500
40 1000 20000 21000 25 500 525 1000
42 1000 25000 26000 23.81 595.24 619.05 2500
42 1000 30000 31000 23.81 714.29 738.1 ?

Relationship between costs and production

The following figure shows the relationship between cost and production curves; assuming labor
as a variable input:

87
Output
*

MP AP

Labor

Cost
MC

AVC

*
*

Output

You recall that the average total cost and marginal cost curves are U-shaped, while the average
product and marginal product curves are inverted U-shapes. The additional cost of production of
a good is lowest, at the output level where the additional product of the variable input is maximum.
Similarly, the average variable cost is lowest where the average product of the variable input is
maximum. Thus, the marginal cost (MC) and average variable cost (AVC) curves are mirror images
of the marginal product (MP) and average product (AP) curves, respectively. That is, cost curves
are inverted replicates of product curves.

Mathematically: suppose labor (L) is the only variable input used and wage (W) is variable cost.
TVC
Step 1: MC 
Q
TVC= WL
TVC  W .L
TVC W .L L 1
MC   W( ) W  Shows the inverse relationship
Q Q Q MPL
between marginal cost and marginal product of variable input in the short run

In similar way, we can proof the inverse relationship between AVC and AP.

88
 ATC = TC/Q
ATC = W*L/Q
ATC = W (L/Q)
APL = Q/L Recall, L/Q = 1/APL

ATC = W/APL

What Shift the cost curves?

Changes in either resource prices or technology will cause cost curves to shift:

➢ If a more efficient technology were discovered, the cost curves would shift down because
productivity of all inputs would increase.

➢ For instance, if fixed costs had been higher, then AFC & hence ATC would shift at a higher
position (Why?). However, the positions of the AVC and MC curves would be unaltered
(why?)

➢ For instance, if the price of a variable input, such as wage of labor rose, the AVC, ATC and
MC curves would shift upward (why?), but AFC would remain unchanged (why?).

Production costs in the long-run

Recall that so far we have talked only about short-run costs. The curves we have drawn are
therefore short-run cost curves. The shape of these curves is determined by the assumption that in
the short-run some fixed factors of production lead to diminishing returns. Given this assumption,
marginal costs eventually rise and average costs curves are likely to be U-shaped.

However, in the long-run there is no distinction between fixed and variable inputs. This does not
lead to diminishing returns because all resources are variable, and therefore all costs, are variable
in the long run.

Derivation of long run average cost

In the long run all factors are assumed to become variable. The long run AC curve is derived from
short run cost curves. Each point on the LAC corresponds to a point on a short run cost curve,
which is tangent to the LAC at that point.

Assume that the available technology to the firm at a particular point of time includes three methods
of production, each with a different plant size: a small, medium and large plant size. The small
plant operates with costs denoted by the curves SAC1; the medium size plant operates with the
costs on SAC2, and the large size plant gives rise to the costs shown on SAC3. If the firm plans to
produce output Q1 it will choose the small plant. If it plans to produce Q2, it will choose the
medium plant. If it wishes to produce Q3 it will choose the large plant size.

If the firm starts with the small plant and its demand gradually increases, it will produce at lower
costs up to level Q1. Beyond that point costs start increasing. If its demand reaches the level Q1
"the firm can either continue to produce with the small plant or it can install the medium size plant.
The decision to this point depends not on costs but on the firm's expectations about its future

89
demand. If the firm expects that the demand will expand further than Q1" it will install the medium
plats, because with this plant outputs larger than Q1" are produced with a lower cost.

Similar considerations hold for the decision of the firm when it reaches the level Q2"If it expects it
the demand increase more than Q2, the firm install the large plant, given that it involves a larger
investment which is profitable only if demand expands beyond Q2"
When the firm install the large plant size, simultaneously it become difficult to manage the firm
activity. As a result the unit cost increase when additional output increase.
Cost
Cost

LMC
SATC3
curve
C1 SATC1 LAC
SATC2 curve

C2

C3

0 Output, Q
Out put 0
Q1 Q2 Q3 Q

Fig A Fig B

If we assume that there is a very large number of plants, we obtain continues curve, which is the
planning LAC curve of the firm. Each point of this curve shows the minimum (Optimal) cost of or
producing the corresponding level of output. The LAC curve is the locus of points denoting the
least cost of producing the corresponding output.
In the traditional theory of the firm the LAC curve is U-shaped and it is often caused the 'envelope
curve' because it envelopes' the SRC curves. This shape reflects the laws of returns to scale.
According to this law the units costs of production decrease as plant size increases, due to the
economies of scale which the larger plant sizes make possible. This theory assumes that economies
of scale exist only up to a certain size of plant, which is known as the optimum plant size, because
with this plant size all possible economies of scale are fully exploited. If the plant increases further
than this optimum size there are diseconomies of scales, arising from managerial inefficiencies. It
is argued that management becomes highly complex, overworked, and the decision-making process
becomes less efficient. The turning up of the LAC curve is due to managerial diseconomies of
scale.

❖ The LMC is derived from the SRMC curves but does not envelope them as LAC curves
envelope STAC.

Economies and Diseconomies scale

The long run average total cost curve described a situation where the firm can expand out its inputs
both its capital and labor when all inputs increase, we say that the scale of the increases.

For example, if the number of workers at the firm doubles, the number of trucks doubles, the
number of terminal doubles and so on, then we would say the scale of the firms doubles. Thus, the
long run average total cost curve describes what happen to the firms average total cost when its
scale increases.

90
Economies of scale
When long run average total cost decrease in the initial stages of production, a firm is experiencing
economies of scale. This means that the larger size (scale) of the operation permits the business to
produce each unit of output in less cost compare to a small size operation. There are a number of
causes for economies of scale. Few of them are the following:

1. Worker often takes longer to accomplish a given task the first few times they do it, as they
become familiar, they spend less to accomplish the same task.
2. Manager learn to schedule the production process more effectively, from the flow of material
to the organization of the manufacturing itself,
3. Better and more specialized tools and plant may also lower costs.

Diseconomies of scale

When per unit of costs increase in the latter stage of long run production, a firm is said to be
experiencing diseconomies of scale. In this case, the size or scale of the operation has become so
large that the cost per unit of output increases. The major reason for diseconomies of scale is the
following.
1. As the organization growth and the chain of command lengthens and becomes more complex,
it might be necessary to hire more mangers at all level, thereby increasing the cost of output.
2. Due to lack of accountability or poor control.
3. Cost may also be affected by the amount of time required to pass information and command
through such a large organization.

The Expansion path and Derivation of Long run total cost

Expansion path is defined as the locus of tangency points between isocost line and Isoquant lines.
It shows the least cost combinations of labor and capital needed to produce different level and
output, with given factor prices (w, r) and productive function, the optimal path is determined by
the points of tangency of successive isocost lines and successive Isoquants.
K
C3
r

Expansion Path
d
C1
Q4
r c
b Q3
a Q2
Q1

L1 L2
C1 C2
𝑪𝟑 L
W W 𝑾

91
TC

LTC
TC3 c

b
TC2

a
TC1

Q2 Q
Q1 Q3
Example: if W =20 and r=20 suppose the firm uses 3 units of labor and 4.5 units of capital to
produce one tone of output. The total cost is now 3 X 20 + 4.5 X 20 =150.

For given level of output we have the fixed total cost. Then as shown from figure below the
expansion path is a line from the origin to the successive optimal combination of factor input.

As shown form the figure to produce Q1 level of output, we need the TC1. When rate of output is
Q2, the minimum total cost to produce it is TC2 and when the output opened to Q3, the minimum
total cost for its production rises to TC3. Let assume the firm operate with the assumption of
increasing return to scale, constant and decreasing return to scale accordingly form the initial. Now
plotting TC1, TC2 and TC3 against output level S Q1, Q2 and Q3 respectively in panel 6 of above
figure we get the long run total cost curve (LTC).

92
 CHAPTER FIVE
MARKET STRUCTURE

Introduction
In the discussion of the theory of production and costs, it was shown that in the short run in
production, some inputs are fixed and others are variable. As the result, a distinction was made
between fixed and variable costs for a firm. In the market, producers face, on the one hand, a given
cost function that is determined by technology and the input market, and on the other hand, a given
revenue function that is determined by demand. Taking those two functions (Revenue and cost)
into account, producers choose a level of output that will accomplish their objective- the goal of
profit maximization. The level of output which maximizes profit however, differs depending on
the market structure, i.e., on whether the firm is operating in a perfectly competitive market or in
imperfectly competitive once.
Chapter objectives:
After completing this chapter, you should be able to:
✓ Identify the characteristics of perfectly competitive markets which explain the horizontal
(perfectly elastic) demand curve that the firm faces.
✓ Determine the profit of a firm from its revenue and cost functions which you may use to base
your decision for the choice of output.
✓ Use the total revenue total cost and marginal analysis to explain how the firm chooses the
profit-maximizing level of output.
✓ Understand how the market price of the good affects its profitability and explain the conditions
under which the firm provides positive output and it ceases production.
✓ Show how the supply curve of a firm can be derived from the profit maximizing conditions of a
competitive firm.
✓ Identify the characteristics of imperfectly competitive markets which explain the down ward
sloping demand curve which firms face in such markets.
✓ See how the choice of the profit-maximizing level of output differs in such markets from that of
the perfectly competitive ones.

4.1 Perfectly Competitive Markets

A perfectly competitive market is a market, which has the following characteristics.
1. There are many sellers in the market: In a perfectly competitive market the number
of sellers is so large that each firm has a very small share in total sales. This means that, perfect
competition is a market in which every seller is so small, relative to the market as a whole and can’t
exert any influence on price by changing his level of output.
2. The products sold in the market are homogeneous: The product of each seller in a
perfectly competitive market must be identical to the product of every other seller in an industry.
Thus, buyers are indifferent as to the firm from which they purchase the product.
3. Independence behavior: No seller in the market regards competing sellers as a threat to
its market share. Firms therefore are unconcerned about their competitors marketing or production
decisions (Hyman: 1991, 268).
4. Perfect information: Sellers and buyers have perfect information or knowledge
concerning the market. I.e. prices, technology and profits.

5. Free entry and exit: All sellers have complete freedom of entry into and exit from an
industry. This means that there is no legal, social or financial restrictions that would prevent a
seller from entering an industry. There is no patent that grants monopoly right to a seller in a

93
 perfectly competitive market. There is no taboo. Neither there is financial difficulty that can
bar entry.
The existence of large number of sellers in the market and the homogeneity of products imply that
the individual firm in a perfect competition is a price taker. That is it can sell any quantity it wishes
to sell at the market price, without affecting the price of the good. Thus, it is not necessary for the
competitive firm to reduce its price below the market price. Moreover, it will be unable to sell a
single unit if its asking price is above the market price as buyers will shift to the products of other
firms. That behavior of the competitive firm, that it is a price taker means that it faces a horizontal
(infinitely elastic) demand curve.
The market for ‘standardized’ agricultural products is considered perfectly competitive. Most
agricultural products are produced by too many small farms. Further what are called standardized
products is perfectly substitutable to one another, and hence homogeneous.

4.1.1 Demand, Total, Average and Marginal Revenue

The demand curve, which a firm faces in a market, is used to derive its total, average and marginal
revenue.
Total revenue: as given earlier, is the product of the quantity of a good sold and its price. If we
denote total revenue by TR, price by P and quantity by Q:
TR = PQ
Average revenue: on the other hand, is the quotient of total revenue divided by the quantity of the
product that is sold.
 P .......... .. 4 .1
TR
AR  Where, AR is average revenue
Q
By implication, price is always equal to average revenue in the absence of price discrimination.
Marginal revenue: is the ratio of change in total revenue to a small change in quantity sold.
Denoting marginal revenue by MR:
TR
MR  .......... ....... 4 . 2
Q
For practical purposes, marginal revenue can be considered as the additional revenue that results
from an additional unit of sale.
Table 4.1 illustrates the derivation of total, average and marginal revenue from the demand curve
that is faced by a competitive firm.

Table 4.1: The Derivation of Total, Average and Marginal Revenue of Competitive Firm
P (Birr) Q(units) TR(Birr) AR(Birr) MR(Birr)
(1) 2 3=2x1 4 = 32 5 =3/2

2 0 0 - -
2 1 2 2 2
2 2 4 2 2
2 3 6 2 2
2 4 8 2 2
2 5 10 2 2

In Table 4.1., the first two columns contain the price and quantity values, that is, the demand
schedule. Column 3 gives total revenue (TR), which is the product of columns 1 and 2. Column 4
provides the average revenue (AR), which is computed by dividing column 3 by column 2. Column
1 and 4 are identical except where Q = 0. That is not a coincidence. In the absence of price

94
discrimination (the practice of charging different price for the same good) price is always equal to
average revenue. Column 5 gives marginal revenue, computed by dividing successive differences
of column 3 by the corresponding differences of column 2. When the price of a good is constant
(case of perfect competition), average revenue and marginal revenue are equal.
In the case of constant prices, we can see that the horizontal straight-line demand curve is the same
as the average revenue and marginal revenue curves (Figure 4.1). Where the demand curve, the
average revenue curve and the marginal revenue curve comprise the same horizontal straight line,
the total revenue curve is a straight line which starts from the origin and rises by a fixed amount
for each additional unit of the good sold.
Figure 4.1: The relationship between Total, AR & MR & Demand; For the Competitive Firm
Birr

10 -

8 - TR
6 -
P = AR= MR
4-
2
1 2 3 4 5
Units of Quantity Sold (Q)

4.1.2 Determination of profit Maximizing level of output of a competitive Firm in the Short
Run

In the short run, as we have already shown in the theory of production and costs, some inputs are
fixed and some are variable. Corresponding to the fixed inputs are fixed costs which represent their
market values and corresponding to the variable inputs are variable costs which are derived by
multiplying the quantities of the variable inputs used in production by their prices. In the short run,
the number of firms in an industry is also fixed.
In the market, producers face on the one hand, a given cost function that is determined by
technology and the input market, and on the other hand, a given revenue function that is determined
by demand. Taking the two functions, as their data, producers choose the level of output which
maximizes their profit.
In a perfectly competitive market, the cost functions of all firms in industry must be identical. This
is so because products are homogeneous in that market which implies the use of homogeneous
inputs. Because of this we will talk of the typical (representative) firm. All theoretical results
derived for the representative firm will therefore be applied to all firms in an industry.
A firm under perfect competition is a price taker. Hence price is given to it by the market. In
maximizing its profit, the firm can only choose (adjust) the quantity to be produced and sold at the
given price. Since in the short run, a firm uses both fixed and variable inputs, it can adjust its output
(increase or decrease it) by increasing or decreasing the use of the variable input. Further, when the
representative firm adjusts its production level, the quantity of product in the industry will be
adjusted accordingly because all other firms are assumed to follow suit.
For a given cost, a firm’s adjustment in the quantity produced for various market prices, on the
basis of the principle of profit maximization will yield the supply curve of a firm from which the
supply curve of an industry can be derived.
How does the typical firm choose the output level at which it maximizes profit?

95
Profit Maximization: Total Revenue Total Cost Approach

The firm, in the short run, will choose the level of output which maximizes its profit, denoted as.
Profit of a firm is defined as the difference between total revenue (TR) and total cost (TC), i.e.
 = TR – TC …… ( 4.3 )

Since profit is defined as the difference between total revenue and total cost, the easiest way to
demonstrate the relationship between profit and output is by comparing total revenue (TR) and total
cost (TC) for each and every level of output. To give a clear picture of the profit maximizing output
choice we shall use both numerical examples and the corresponding graphs to illustrate the logic
of total revenue- total cost approach.

Table 4.2: Choice of the profit- Maximizing Level of Output: Total Revenue Total Cost Approach
Q TFC TVC TC P1 TR1 1 P2 TR2 2 P3 TR3 3
1 10 5 15 6 6 -9 4 4 -11 3 3 -12
2 10 9 19 6 12 -7 4 8 -11 3 6 -13
3 10 10 20 6 18 -2 4 12 -8 3 9 -11
4 10 13 23 6 24 1 4 16 -7 3 12 -11
5 10 17 27 6 30 3 4 20 -7 3 15 -12
6 10 23 33 6 36 3 4 24 -9 3 18 -15
7 10 30 40 6 42 2 4 28 -12 3 21 -19
8 10 39 49 6 48 -1 4 32 -17 3 24 -25
9 10 49 59 6 54 -5 4 36 -23 3 27 -32
10 10 60 70 6 60 -10 4 40 -30 3 30 -40

Column Q shows the quantity produced; each of columns TR1, TR2 and TR3 respectively provide
the corresponding total revenue when price is 6 birr, 4 birr and 3 birr. Columns TFC, TVC and TC
respectively show the total fixed cost, total variable cost and total cost of production of the various
levels of output. Each of 1, 2 and 3 respectively shows the profit for a given level of output
when price is 6, 4 and 3 birr.
Given a market price of 6 birr per unit it can be seen that the maximum profit occurs when the
output is either 6 or 5 units. Hence, the quantity that maximizes profit is not unique. This is due to
the fact that we have used discrete data in the hypothetical example. If continuous data had been
used the output level that maximizes profit would have been unique. At any rate if the firm produces
6 units at a market price of 6 birr per unit, it will obtain a maximum profit of 3 birr.
On the other hand, if the market price were 4 birr per unit, the total revenue would be as shown in
column TR2, and the corresponding profit figures for the same cost data would be as given in
column 2. As can be seen from column 2, the profit is negative for all quantities produced, i.e.,
the firm makes loss at all levels of output. The minimum loss is 7 birr and occurs at either 5 or 4
units of output. Since the minimum loss of 7 birr is less than the TFC of 10 birr (which cannot be
recovered anyway), the firms loss will be minimized if it produces 5 units of output.
If we now further reduce the market price to 3 birr per unit, total revenue would be as shown in
column TR3 and the corresponding profit figures for the same cost data are given in column 3. As
can be seen from that column, the profit is not only negative for all quantities produced but is also
greater than the TFC of 10 birr in absolute terms. Under such a condition, if the firm continues to
produce a positive output, its loss would include additional expense from the variable cost. Since
to do nothing is always a feasible alternative, the firm will shut down

96
The two cases (P=6 and P=4) represent positive maximum profit and negative maximum profit
with a positive output. The third case (P=2), however, represents a condition where zero output
results in a minimum loss.
Table 4.2 is plotted in Figure 4.2. In the range, where total revenue lies above the total cost curve,
the vertical distance between the two measures the total positive profit which can be realized at
each level of output. To maximize profit, the firm chooses the level of output for which the distance
between the two is the maximum. Between A and B, in Figure 4.2, TR1 lies above the total cost
curve, indicating the range of output for which profit will be positive. If the firm chooses either
the fifth or sixth unit of output the distance between the two will be maximum.
TR2 lies below the total cost curve at all levels of output. The vertical distance between the two
however is minimum at either the fourth or the fifth unit of output. And that distance is less than
the level of total fixed cost which indicates that the firm will minimize its loss by producing either
of the two levels.

Figure 4.2: Total cost and Total Revenue Curves

C, R
Birr
TR1 TC
70 B

60

50 TR2
A
40
TR3
30

20
TFC
10

0 1 2 3 4 5 6 7 8 9 10 Quantity (Q)

As in the case of TR2, TR3 also lies below the total cost curve at all levels of output. The minimum
distance between the two obtained at Q=3 or at Q=4 units of output is greater than the level of the
TFC. Under this condition the firm should cease production to minimize its loss.

Profit Maximization: The Marginal Approach

The total approach to profit maximization is straight forward and easy to understand. But it does
not lead to an important analytical result. The terms marginal product (MP), marginal cost (MC)
and marginal revenue (MR) are, however, important analytical concepts. In section 4.1.1, it was
shown that under perfect competition, the market price is equal to the average revenue (AR) and
marginal revenue (MR) of the firm.

97
Using the same data, we used for the total approach, we may construct Table 4.3 to show how the
marginal revenue and marginal cost concepts are used in the choice of the profit maximizing level
of output.
Table 4.3: Choice of the Profit-Maximizing Level of Output, the Marginal Approach
Q P1=MR1 MC 1 P2=MR2 2 AVC ATC

0 - - -10 - -10 - -
1 6 5 -9 4 -11 5.- 15.-
2 6 4 -7 4 -11 4.50 9.50
3 6 1 -2 4 -8 3.33 6.67
4 6 3 1 4 -7 3.25 5.75
5 6 4 3 4 -7 3.40 5.40
6 6 6 3 4 -9 3.80 5.50
7 6 7 2 4 -12 4.30 5.70
8 6 9 -1 4 -17 4.90 6.13
9 6 10 -5 4 -23 5.40 6.60
10 6 11 -10 4 -30 6.00 7.00

Since both the total and the marginal approach are based on the same data, the profit figures for the
various output levels at a given market price are identical. For example, for a market price of 6 birr
per unit, the profit is 1 when Q=4 and 3 when Q=6, whereas for a market price of 4 birr per unit,
the profit is –7 birr for Q=5 and –9 birr for Q=6. Both tables also indicate that profit is maximum
at Q=6 or 5 when price is 6 birr per unit and at Q=5 or 4 when price is 4 birr per unit. However,
there is a peculiar phenomenon in the marginal table. In both cases, i.e., when the price is 6 birr
per unit or 4 birr per unit, price or marginal revenue is equal to MC at maximum profit. This does
not happen by chance and the phenomenon has a considerable theoretical importance. Figure 4.3
has been constructed with the objective of showing the significance of that relationship in choosing
the profit maximizing level of output.
The horizontal straight lines, in Figure 4.3, at P1=6 and P2=4 are the marginal revenue curves for
the two prices respectively. MC is the marginal cost curve, AVC and AC represent the average
variable and the average total cost curves respectively, and 1 and 2 are the profit curves for P1
and P2 respectively.
It can be seen that when MR=MC, the profit curves reach their maximum values for both P 1 and
P2. The graph also shows that P2=MC at two points; Q=2 and Q=5. This is very significant. Under
perfect competition, a firm’s profit will be maximized when the firm chooses a level of output for
which (a) MR=MC and (b) MC is increasing. The two are referred to as the necessary and
sufficient conditions for profit maximization.

Why do we say that profit will be maximized when the above conditions are satisfied? The reason
can be understood if one examines whether it is profitable to produce any given level of output by
comparing the additional revenue secured from selling an additional unit (MR) with the additional
cost of producing that unit of output (MC). If the additional revenue (MR) exceeds the additional
cost (MC), producing that level will be profitable because it adds more to revenue than it adds to
cost as the result profit increases. Thus, whenever marginal revenue exceeds marginal cost
producers will increase their profit by expanding production, i.e., by producing more.

98
To reinforce the understanding of the marginal principle which we stated in the preceding
paragraphs, consider the case where P = 6 in Table 4.3 and Figure 4.3. When the market price is 6
birr per unit, both the values in the table and the curves show that the first unit of output generates
revenue of 6 birr but costs only 5 birr, that is MR>MC. The first unit by itself brings in an additional
profit of 1 birr. Thus, it must be produced. Similarly, the second unit by itself brings in a net profit
of 2 birr, the third an additional profit of 5, and so on. Until the fifth unit of output, each additional
unit brings in a profit. Therefore 5 units should be produced. The sixth unit by itself does not bring
in a profit nor does it result in a loss. In this case, the firm is indifferent as to whether or not to
produce the sixth unit. At any rate, examination of the seventh unit shows that it generates
additional revenue of 6 birr, whereas the additional cost of producing it is 7 birr. Thus, if the
seventh unit is produced the total profit will be lowered. In Figure 4.3, this is shown in the fact that
total profit (1) declines to the right of the sixth unit. In the figure it can also be seen that
MC=P1=MR at Q=6. For any increase in production above 6 units, the additional cost exceeds the
additional revenue, and hence profit will decrease. Conversely, the revenue brought in by
producing any unit below the total of 6 units is greater than the cost. Therefore, any cut in
production to less than 6 units will cause a reduction in profit. In other words, when MR=MC at
Q=6, profit will be maximized, and any change in the level of output will cause profit to be reduced.
Put differently, for a competitive firm maximum profit occur when output has been adjusted to the
point at which P=MC. Any output below this level will mean that the firm can increase profits by
producing more. Any output above the point at which marginal cost equals the product price
implies that the firm can increase profits by producing less.

But, the equality of price or marginal revenue and marginal cost though necessary for-profit
maximization is not confined to that situation. It may also occur where profit is minimum. That
situation is illustrated in the case where P=4 birr. As we have mentioned earlier, MR=MC at both
Q=2 and Q=5 at that price. When Q=2, we can observe that the total profit curve reaches a local
minimum in the sense that profit increases as we move to either the right or the left. As we may
see it, the third unit results in a net profit of 3 birr, and therefore profit increases as we move from
the second to the third unit. Similarly, since the first unit by itself results in a net loss of 1 birr, it
follows that if the first unit were not produced, profit would again increase. This implies that profit
must be a minimum at Q=2. Further elaboration of this point will prove beneficial. From the
marginal figure, it can be seen that the marginal cost (MC) curve is declining at Q=2. A small
increase in quantity above 2 units generates additional revenue which exceeds the additional cost
of production; consequently, a small increase in quantity will result in greater profit. On the other
hand, for a small decrease in quantity the reduction in cost is greater than the cut in revenue.
Therefore, a decrease in quantity will also result in an increase in profit. Thus, either an increase
or a decrease in output from Q=2 will result in an increase in profit. This indicates that profit must
be a minimum at Q=2.

The above results can be concluded as follows:

1. Profit will be maximum if:
a) MR=MC
b) MC is increasing or rising
2. Profit will be at a local minimum if:
a) MR=MC
b) MC is decreasing

The profit maximizing level of output may or may not result in a positive profit. In fact, the
maximized profit may take any value; positive, zero or negative economic profit1. For a given cost
function, the level of profit actually depends upon the market price.

99
When the market price is greater than the average cost of production at the profit maximizing
output, as is the case in Figure 4.3 for P=6, the firm earns positive economic profit. When the
market price is just equal to the minimum average total cost the firm will obtain zero economic
profit or normal profit. The firm, under that condition, is said to break-even. When price falls
short of average total cost, the total cost of production exceeds the total revenue obtained from the
sale, and hence the firm incurs loss (the case where P=4 in Figure 4.3). However, the firm provides
positive output and continues in production, if the market price is greater than the minimum average
variable cost of production at the profit maximizing output. When the market price falls to the
level of the minimum average variable cost, the firm covers its total variable cost and its loss would
be equal to the total fixed cost. The firm would be indifferent as to whether or not to produce that
level of output. Any price that is less than the minimum average variable cost of production at the
profit maximizing output results in a loss of the variable cost which the firm can avoid by ceasing
production. Hence the minimum average variable cost is called the shutdown point.
Figure 4.4: A competitive Firm Earning Positive and Zero Economic Profit and incurring loss
MC
ATC
A B
P4 P4= MR
D C AVC

P3 P3= MR3

P2 P2 = MR2
P1
B P1 = MR1

Q1 Q2 Q3 Q4 Quantity (Q)

Figure 4.4 summarizes the profit position of the competitive firm for varying prices. When
market price is P4, the firm maximizes profit by producing Q4 units of output. Note that Q4 is the
level of output for which MC= P4 and MC is rising. At that level of output, the average total cost
is less than P4. The difference between P4 and ATC (BC) measures profit per unit. Multiplying
it by total output, we arrive at the total economic profit given by the area of rectangle ABCD.
When price declines to P3, the firm maximizes profit by producing Q3 units of output; the level
of output for which P3=MC. The price P3 however is equal to the average total cost of production
of Q3. The firm will earn zero profit. At P2, the firm’s profit maximizing level of output is Q2.
For that level of output, the firm’s average total cost of production exceeds P2 by EF. That excess
represents the per unit loss. Thus, the area of rectangle P2P3EF represents the total loss. Since
that area does not cover the whole area between ATC and AVC, the loss is less than the total
fixed cost. When price falls to the level of P1, the profit maximizing level of output is Q1. The
firm covers the average variable cost of production. Its loss per unit, GE is just equal to the
average fixed cost. G, which corresponds to the minimum average variable cost, is called the
shutdown point.
As shown above, Figure 4.4, the competitive firm always adjusts output to a level for which price
is equal to marginal cost so as to maximize profit. The marginal cost curve therefore gives the
relationship between price and quantity supplied by a competitive firm. For all prices above the
minimum average variable cost the firm provides a unique level of output but the quantity

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 supplied by the firm falls down to zero, for all prices below the minimum average variable cost.
Thus, the rising portion of the marginal cost curve of the competitive firm above the minimum
average variable cost represents its short run supply curve. In Figure 4.4 the marginal cost
curve above G represents the supply curve.
The supply curve is positively sloped because the additional cost of production of an additional
unit of output eventually increases as output increases. This is caused by the law of diminishing
returns. Thus to stimulate additional output market prices should rise.
4.2 . Theories of Imperfect Competition

Basically the distinction between perfect and imperfect competition emanates from their
characteristics which determine each of the two categories of the demand curves.
The existence of many sellers, product homogeneity independence of behavior of sellers, free entry
and exit and perfect information characterize perfectly competitive markets. Given its
characteristics, suppliers are price takers. They exert no influence on prices and therefore prices
are taken as fixed parameters in decision making. The firm in this case faces a horizontal demand
curve, i.e., a perfectly elastic demand curve. Those characteristics of that market which have
resulted in the price taking behavior of producers have been crucial to most of the analyses.
What will happen if we drop the price taking behavior for the suppliers of goods? In other words,
what will be the consequence of the supply of a good by one seller? What will happen to our results
if differentiated products are supplied by many sellers? In all those cases sellers will have a certain
degree of control over prices. Markets in which sellers have a control over prices of goods they
sell are called imperfectly competitive markets.
A complete discussion of the imperfectly competitive markets includes monopoly, monopolistic
competition and oligopoly. In this course, however, we will confine our discussion to the most
extreme one, monopoly and provide a brief characterization of the other markets.

4.2.1 Monopoly
Pure monopoly refers to that form of market organization in which there is a single firm selling a
good for which there are no close substitutes. Changes in prices and outputs of other goods sold in
the economy must leave the monopolist unaffected. Conversely, change in the monopolist price
and output must leave other sellers in the economy unaffected. In technical language, monopoly
exists if the cross-price elasticity of demand for the output of a firm with respect to the price of all
other firms is small.
The reason for the existence of a single seller of a good in the market is that other firms find it
unprofitable or impossible to enter the market. Barrier to entry are therefore the sources of all
monopoly power. If other firms were able to enter a market, a market can no more be a monopoly
by definition. What might be these barriers to entry which form the sources of monopoly power?
Broadly these may be classified into three as technological, legal and artificial entry barriers.
1. Technological barriers emanate from the nature of the technology of some industries. The
nature of some industries may be such that the production of the good in question may exhibit
decreasing marginal cost over a wide range of output levels. The technology of production in this
case, is such that relatively large-scale firms are low cost producers. A market which is most
cheaply served by a single firm is called natural monopoly. Most of such industries lie in the
public utilities sector like electricity, gas, telephones. Let us try to see these more closely.
Take water supply. Here, the technology involves very large fixed costs for creating and
maintaining the water delivery pipes. Once the main pipes are laid, it costs very little to supply
more water to additional households. Thus, a very small marginal cost is required to provide extra
units of water. Hence both marginal cost and average cost decline with an increase in production.
The supply of electricity involves a very large fixed cost for providing the wires and the switching
network. Once that is provided, the additional cost of supplying additional units is very small.

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If such markets are left to the private sector and are initially competitive, one firm may find it
profitable to derive others out of the industry by price cutting. Had a single firm been the supplier
of the good initially, entry will be difficult because any new firm must produce at a relatively low
level of output and therefore at a relatively high average cost. Barrier to entry in that case is the
result of technology itself.
Most governments usually run the supplies of such goods because it is expected that if they are left
to private suppliers, the firm may increase prices by reducing supply. Currently new developments
in telecommunication and electric power generation are changing the situation.
2. Legal barriers are created by means of law. Patents, franchise and copyrights fall in this
category.
In the case of patents, the government provides the innovator of a production technique an exclusive
right over the patented material. No other firm can use the technique to produce goods and sell in
the market except the innovator. The rationale for providing patent rights is that the protection
provided, it is believed, would give an incentive to technical progress by making inventions more
profitable.
The same argument lies behind copyright. It is a sole legal right held by the author of a book,
music, etc., to print, publish, sell, broadcast, film or record his work (or a part of it) for sale or for
use. This is protected by law because it is believed that it gives stimulus for invention.
Franchise is a little bit different. It is a special right provided by public authorities to a company
or an individual to supply a good. One rationale for franchise is the argument of natural
monopolies. Since the cost of a good decline with the increase in output, the government may give
a right to a single company to supply the good. Such rights, however, may be provided in many
other markets, outside natural monopolies. Franchise prevents anyone but a government licensed
firm from doing business. For instance, a local government may give an exclusive right for a
restaurant to give services for tourists visiting a park.
3. Barriers created by a firm against entrants: The two broad categories of barriers which we
have discussed so far are independent of the firm’s own activities; one is the result of technology
and the other of government’s activity. However, barriers to entry may come about directly from
the activities of the firm itself.
Firms may assume a monopoly position by controlling resources to prevent potential entry. The
most usually cited example is The De Beers Diamond Miners’ which controls about 80 percent of
the world supply of raw diamonds.
Control over technology is another means by which firms assume a monopoly position. Firms in
some cases may develop unique products or technologies and try to keep them secret from others
(competitors) and remain the sole producer of a good.
Still more, firms producing similar goods may form associations, called cartels to avoid
competition. The cartel may act as a single seller of the good and assume a monopoly position.
Demand and Revenue
The analysis or monopoly pricing begins with statements about the monopolist’s demand curve. In
fact, the essential difference between perfectly competitive firm and a monopoly is the nature of
the demand curve that each faces.
A perfectly competitive firm, as we have shown in the preceding section, faces a horizontal demand
curve. In chapter 2, it was shown that both the individual consumers’ demand curve and the market
demand curve (derived as a horizontal sum of many individuals demand) are negatively sloped.
Since a monopolist is the only firm selling in the market, the market demand curve is the
monopolist’s demand curve. Thus, the monopolist faces a negatively sloped curve. Where the
demand curve is a negatively sloped one, the demand curve is always the average revenue curve,
but the corresponding marginal revenue curve will lie below the demand curve or the average
revenue curve. This relationship between price, total revenue, average revenue and marginal
revenue that a monopolist faces can be illustrated using the following data and the corresponding
figure.

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Table 4.4: The Relationship between Total, Average and Marginal Revenue of the Monopolist
Price Quantity Total Average Marginal
(Birr ) (units ) Revenue Revenue Revenue
1 2 3 =1x2 4 = 3/2 3
5 
2
10 0 0 - -
9 1 9 9 9
8 2 16 8 7
7 3 21 7 5
6 4 24 6 3
5 5 25 5 1
4 6 24 4 -1
3 7 21 3 -3
2 8 16 2 -5
1 9 9 1 -7
0 10 0 0 -9

Figure 4.5: Total, Average and Marginal Revenue curves of the Monopolist

Birr
25

20

15

10 TR
5 D= AR

0 1 2 3 4 5 6 7 8 9 10 Quantity (units)
MR

Both the table and the figure lead to the following conclusions about the relationships that exist
between the revenue curves.
Where the demand curve faced by a firm is a negatively sloped one, total revenue initially increases
at a decreasing rate, reaches maximum and then declines.
In the range where total revenue increases, marginal revenue decreases but is positive, reaches zero
when total revenue is maximum and is negative where total revenue declines. Note that marginal
revenue is the slope of the total revenue.
Marginal revenue at different levels of sales must be less than the average revenue (price) at those
sales levels. This is because; the monopolist must decrease its price in order to sell more. And
since the new price, which is lower, applies to all his sales (previous and additional) the monopolist

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incurs loss from all previous sales. The net change in total revenue (i.e., marginal revenue) is the
new (lower) price from selling the additional nth unit minus the loss the firm incurs from selling
previous units.

To see that more closely, consider Table 4.4. If the monopolist decides to sell only 1 unit, both the
additional revenue and the price that he obtains will be 9 birr. If he decides to sell 2 units, he needs
to decrease price from 9 to 8 birr. But the additional revenue (MR) will not be 8 birr. Because
when he decreases price, he has incurred a loss of 1 birr from the sale of the first unit. Hence
marginal revenue will be equal to 8-1=7. To add one more example, if the monopolist decides to
sell 3 units, he should fix prices at 7 birr. Assume that he now wants to increase sales to 4 units,
and reduces his price to 6 birr. His marginal revenue = 6-3 birr. The 3 birr subtracted from the new
price represent the loss from the previous 3 units of sales.

Thus we see that in a pure monopoly market, it is always the case that marginal revenue lies below
the demand (average revenue) curve. What then is the specific relationship between the two? The
mathematical relationship between demand and marginal revenue depends on the nature of the
demand curve.

When the demand curve is linear, the marginal revenue curve is also linear with the slope twice
that of the demand curve and having the same price axis intercept. Mathematically, that
relationship can be shown as follows. Suppose that the linear demand curve in a general form is
given as: P = a - bQ

Where, P is the price is quantity, a and b are constants

To determine the total revenue, we multiply price by quantity i.e.:

TR = PQ = (a-bQ) Q

TR = aQ-bQ2…………. (4.4)

Marginal revenue is the slope of total revenue or is the first derivative of the total revenue with
respect to output i.e.:

 a  2bQ ........ 4.5 

dTR
MR 
dQ

Comparison of price and marginal revenue functions show that both of them have the same vertical
axis intercept; namely a. As far as their slopes are concerned, while the slope of the demand curve
is –b that of the marginal revenue curve is –2b. Thus, the marginal revenue curve is twice as steep
as the demand curve.

The above given general demand and marginal revenue relationship can also be given in terms of
specific numerical example. Suppose that the demand curve facing a monopolist is given by P=10-
Q, then determine the marginal revenue function.

Given, P = 10-Q ……………………..(4.6)

TR = P.Q = (10-Q) Q

TR = 10Q-Q2

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  10  2Q .......... .4.7 
dTR
MR
dQ

A comparison of (4.6) and (4.7) shows that while both have the same vertical axis intercept equal
to 10, the slope of the demand curve is –1 while that of the marginal revenue curve is –2.

The relationship that we have derived mathematically makes it quite easy to draw in the marginal
revenue curve corresponding to any linear demand curve. In order to draw the marginal revenue
curve corresponding to the demand curve you may proceed as follows.

1) Choose any point on the demand (AR) curve.

2) Connect the point by a horizontal line segment with the price axis.

3) Find the mid-point of this horizontal line segment between the price axis and the demand
(AR) curve.

4) Connect this mid-point and the point at which the demand (AR) curve intersects the price
axis by a straight line. This straight line is the derived marginal revenue curve.

The cost Function of the Monopolist

The cost curves of the monopolist are assumed to be like those of the perfectly competitive firm.
In other words, the monopolist seller of a product is the competitive buyer of resources and hence
has no effect on resource price. Monopoly output is also subject to the law of diminishing returns,
and therefore, the average and marginal cost curves are U-shaped.

Profit Maximization and Output Choice under Monopoly

We are assuming that monopolists are unregulated and free to pursue their goal, that is, profit
maximization. To achieve that objective, they will choose the output or the corresponding price.
The monopolist, of course cannot choose both. Assuming the objective of the monopolist is to
choose the level of output which will maximize its profit, how is that point to be determined? We
will employ Table 4.5 to show the principle of profit maximization.
From the table, it is obvious that our monopolist will choose to produce and sell either 2 or 3 units
of output at a price of either 45 or 40 birr per unit. The highest possible total profit which the
monopolist can make, i.e., 40 birr occurs at either 2 or 3 units.
Table 4.5: Choice of Profit Maximizing Level of Output under Monopoly
Price Units of Total Marginal Total Marginal profit
(Birr ) Output Revenue Revenue Cost Cost
1 2 3 = 1x2 3 5 5 7 = 3-5
4 6
1 1
55 0 - - 5 - -
50 1 50 50 25 20 25
45 2 90 40 50 25 40
40 3 120 30 80 30 40
35 4 140 20 112 32 28
30 5 150 10 158 46 -8
25 6 150 0 208 50 -58
20 7 140 -10 278 70 -138
15 8 120 -20 378 100 - 258

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The same result can be obtained using graphs. As we showed earlier, graphically the distance
between the total revenue and the total cost curve represent the total profit or the total loss. When
total revenue curve lies above the total cost curve, the profit is positive, whereas when the total
revenue curve is below the total cost curve, profit is negative.
Where the total revenue curve lies above the total cost profit will be maximized at that level of
output for which the distance between the two is largest.
The profit maximization problem of the monopolist can be equivalently or better answered in terms
of the marginal cost instead of the total revenue and total cost.
Table 4.5, indicates that at the third unit of output marginal revenue is equal to marginal cost and
that at this level of output profit is also at maximum the marginal approach results in a unique
solution. Taking that table, we can employ common sense reasoning to prove that profit is indeed
maximized when marginal revenue is equal to marginal cost. The marginal revenue is greater than
marginal cost up to the third unit of output inducing the monopolist to increase the level of output.
This is because any additional unit brings in more additional revenue than it costs. Thus, if
production stops short of 3 units, profits cannot be at maximum because each additional unit can
still bring in additional profit. Conversely, for any output level greater than 3 units, marginal cost
is greater than marginal revenue, which means that any additional unit costs the monopolist more
than it adds to total revenue. When this is the case, profit can obviously be increased by cutting
output back to 3 units. If profit neither can nor be at maximum above or below 3 units of output, it
must be at a maximum when output is at 3 units. This proves our assertion that profit will be
maximum when marginal revenue and marginal cost.
The condition marginal revenue is equal to marginal cost is a necessary but not a sufficient
condition for maximum profit. As in the case of the perfectly competitive firm, the equality of
marginal revenue and marginal cost may result in either maximum or minimum profit. In order to
avoid the confusion in the case of perfectly competitive firm, we argued that profit will be
maximized when (i.) MR=MC and (ii) MC is rising. The latter under the perfectly competitive
market is a sufficient condition because the slope of the marginal revenue curve is zero.
In the case of monopoly, however, we have similar but more complicated condition for maximum
profit to exist. The necessary condition still remains the same, i.e., MR = MC. But at the point of
equality of the marginal revenue and marginal cost, the slope of the marginal cost must be greater
than the slope of the marginal revenue curve. Since the slope of the marginal revenue curve is
negative, the marginal cost curve must either be rising or horizontal or even declining at slower
rate than the marginal revenue.

Profit or Loss in the short run

Earlier, we argued that, profit would be maximized if (i.) MR=MC, and (ii) the slope of MC is
greater than the slope of the MR curve. In the context of economic theory, however, maximum
profit does not always imply positive profit. Like a perfectly competitive firm a monopolist can
make either positive, zero or even negative profit at the profit maximizing level of output in the
short-run. This is because the monopolist is constrained both by demand and the input market.
A monopolist can’t freely set both its price and its quantity at any level to maximize profit for it
has no control over demand. Once the monopolist set the price, he/she must adjust output in
response to the market demand for the product. Besides demand, the input market and technology
also limit the operation of the monopolist. These constraints may result in any one of the three
outcomes. Figure 4.7 shows the case of a monopolist that makes a positive profit.

106
 Figure 4.7: A positive Profit Monopolist

Birr

P B SMC

SATC
C E

O Q MR D(AR) Quantity

Profit we argued will be maximized at the level of output and price for which marginal revenue
(MR) and marginal cost (MC) are equal. On the figure the two are equal at point E. Q represents
the profit maximizing level of output. It is determined by dropping a perpendicular from point E
to the quantity axis. P represents the corresponding profit maximizing price. It is determined by
extending the perpendicular up to the demand or average revenue curve, point B, and reading its
value on the price axis.
Total revenue obtained from the sale of Q units of output is by definition OQ multiplied by OP
i.e., the product of price and quantity. The area of rectangle OP BA provides the total revenue of
the monopolist. Total cost of production of the profit maximizing level of output is O Q multiplied
by OC, the product of quantity and average cost of production. The area of rectangle OCE Q
measures the total cost. Total profit of the monopolist in this case, is given by the area PBEC.
Since total revenue exceeds total cost profit is positive.
In this case of a monopoly, price is set above the marginal cost of production. Thus consumers are
paying more than the true cost of production. Possession of an enormous degree of monopoly
power, as we said earlier, does not always ensure a positive economic profit. The state of market
demand, or of costs, or of both, may force a zero profit on the monopolist.
Figure 4.8: A zero Profit Monopolist

Birr SMC

SATC

P A

 D(AR)
0 Q MR Quantity

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The tangency of the average cost and average revenue or price at point A in the figure shows that
the maximized total economic profit is zero. Any other price would result in a negative profit.
Note that, the expression zero profit does not mean that the monopolist receives no returns. The
cost curves contain the required normal profit.
A monopolistic zero profit has some features in common with the competitive zero profit solution.
(See Figure). In both cases, the short run average total cost curve (SATC) is tangent to the average
revenue or the demand curve. This indicates that the average revenue (price) is equal to the average
cost; hence, consumers pay no more than the true cost of production. But a monopolistic zero profit
solution has some important aspects that distinguishes it from perfect competition.

Since the demand curve under monopoly, is a negatively sloped one, the average total cost can be
tangent to it at the range where its slope is negative. This means that the plant cannot be operated
at its lowest cost of production. Since tangency, when it does occur, must be to the left of the
minimum point of the short run average total cost, there is an inefficient operation of plants which
takes the form of underutilization. A monopolist may have to accept losses in the short run.
If the short run average variable cost curve was to lie entirely above the average revenue curve, the
firm would be unable to cover not only the fixed cost but also part of its variable cost and would
improve its financial position by closing.

4.3. Other Imperfect Market structures: Monopolistic Competition

and Oligopoly

In between the two extremes, perfect competition and monopoly; we have two other market model,
monopolistic competition and oligopoly.
Monopolistic Competition:
It refers to that market organization in which there are many sellers producing differentiated
products which are close substitutes to one another. This market organization has a number of
important characteristics.
Product differentiation is an important characteristic of monopolistically competitive markets.
Where products are differentiated they are not homogeneous as in perfect competition, they are
heterogeneous. Neither are the goods remote substitutes like in monopoly. Products in this case
are not identical that consumers remain indifferent about which particular firm’s product they
purchase. There exists difference in the products (which may be genuine or nominal) to make
consumers prefer the product of one producer to those of others. But, the products of
monopolistically competitive group of firms are not so different that consumers regard them as
quite separate products. The goods are close substitutes to each other. Example may be the
different pairs of shoes with different brand names.
Large number of sellers and freedom of entry & exit: In a monopolistically competitive market,
there are large numbers of firms and there is the same freedom of entry and exit as in perfect
competition.
None Price Competition: Since the products are differentiated, the various firms try to use the
difference in their products in order to increase their sales. This can be done in various ways such
as advertising the difference in their products or by supplying other services attached to the sale of
the product, like providing transport services.
Independent behavior: The economic impact of the decision of any firm is spread sufficiently
evenly across all firms in the group. As the result the effect of the decision of that firm would not
be noticed by other firms. This means that conscious rivalry is missing or that competition is
impersonal and firms act independently.

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 Monopolistic competition as the name indicates is a combination of monopoly and competition. It
is monopoly in the sense that product is differentiated and each seller has a certain degree of control
over the price he/she charges. It is competitive because there are large numbers of sellers whose
products are close substitutes to each other. Thus, the demand curve is negatively slopped but
highly elastic. Given the cost curves, the determination of profit maximizing level of output is
similar to that of monopoly.

Oligopoly
In the real world, often there are a number of competitors in the market, but not so many as to
regard each of them as having a negligible effect on other sellers. According to Gravelle & Ress
(1992; 298), if a firm believes that the outcome of its decision depends sufficiently on the decision
taken by one or more other identifiable sellers, then we have the market situation known as
oligopoly. It has been the case that oligopoly has been defined as a market with few sellers.
However, if there exist no competitive relationships between these few firms, the market cannot be
called oligopoly. Thus, it is now thought of oligopoly as competition among the few.
Like in all the other markets, we still assume that the objective of the firm is one of maximizing
profit. Under oligopoly, however, the firm can’t make a free decision to achieve its profit
maximization objective. It has to know or at least to hypothesize about the reaction of its
competitors in order to decide upon his profit maximizing level of output. Since one can make
several hypotheses about the reaction patterns which are possible each with different solutions, we
have several possible theories with different solutions.
Oligopoly is a market structure or industries in which there are only a few firms (usually large)
producing either differentiated or homogeneous products. In general, entry of new firms into an
oligopolistic industry is difficult but possible, i.e. limited. Oligopolies behave somewhat
unpredictably in a sense that competing firms control over their price but execute strategies that
anticipate counter strategies. That is, in oligopoly, one firm sets the price of its product by taking
into account the reaction of the firms in the industry.

Summary: Characteristics of the Different Market Structures

market Products Firms have Free entry Distinguishing
Number differentiated or price-setting characteristics
of firms homogeneous power
Non-
Perfect Many Homogeneous No Yes Price competition
competition only

Monopolistic Many Differentiated Yes but Yes Price and quality

competition limited competition
Limited Strategic behavior
Oligopoly Few Either Yes
A unique, No Still constrained by
Monopoly One single product Yes market demand

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 CHAPTER FIVE

NATIONAL INCOME ACCOUNTING (NIA)

The question of measuring national income or output comes under the heading NIA.
National income accounting is an activity or an accounting system which aims at providing
a statistical description of the main economic activities that have taken place over a given
period in an economy. For instance, it gives us regular estimates of aggregate output and
income of an economy.

Like all scientists economists rely on both theories and observation. Since our goal is to
understand how the economy functions, observing the economy provides the bases for our
theories. Once we have developed theories, we turn again to observation to test them.
Economic statistics provides systematic and objective source of information.
The government regularly surveys households and firms to learn about their economic
activity how much they are earning, what they are buying, and what price they are charging.
From these surveys, various statistics are computed that summarizes the state of the
economy. Policy makers also use these data to monitor economic development and
formulate appropriate policies.
Therefore, the premier objective of this chapter is to introduce the concepts and
measurements used most often by economists and policy makers.

5.1. Importance of NIA

In general, National Income Accounting (NIA) has the following importance.

The NIA helps to:

(i) Evaluate the national wealth and standard of living of a nation.

(ii) Compare the level of economic development of a nation with other countries.
(iii) Compare growth performance of a country in different years. (Comparing different
years GDP/GNP.
(iv) Plan the economy as a whole and design policy measures to tackle national
economic problems.
From an analytical point of view, economic processes are characterized by the following
main aspects:
i) The production of goods and services, resulting in output as well as income
ii) The distribution of the income over primary factors of production, as well as
over sectors/institutions
iii) The re-distribution of income between sectors/institutions
iv) The allocation of the re-distributed income over final consumption expenditure
and savings
v) The investment processes

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NIA generally presents data related to the above mentioned economic processes/
categories. In addition to giving data on such aggregates as total output, consumption,
savings, investment, etc, it may also give data at a disaggregated level, i.e. that of various
sectors and sub-sectors (e.g. enterprises, households, government, Agriculture, Industry,
Services, etc).

5.2 National Product

1. National product is the flow of goods and services that become available during a year.
It is a flow variable, which is measured during a given period of time, usually one year.
2. It is the sum total of only final goods & services produced in an economy (raw materials
and intermediate goods are not included in the national product). This is to avoid
double/multiple counting. Thus, the precautions needed in measuring GNP/GDP are:

(a) Avoiding double counting by either considering final goods only

Or by using Value Added Method (net
output added)
(b) Adjustment for Net Factor Income from Abroad
Factor Income from abroad - Factor Payment to abroad = NFIA.
(c) Adjustment for Indirect Taxes and Subsidies.

Indirect taxes and subsidies are transfers from one's pocket to another. Thus, they have
to be adjusted to net out the realistic market value of goods and services received by
producers.

3. National Product is measured in monetary terms by assigning monetary value to the

different final goods and services produced with in a year (usually its market price or
imputed values for non-marketable goods)
4. The different goods produced in an economy will find their use either in consumption
(consumption goods) or in investment (investment goods).
5. All goods in a given year may not be sold but added to inventories. Nevertheless, the
increase in inventories must be included in GNP (GDP) determination since National
product measures all current production regardless of whether or not it is sold.
6. It excludes transactions in existing commodities (used goods such as houses, cars… etc
that are produced in the previous years). But includes realtor's (brokers') fees in the
transaction of existing goods because the realtor's service is current service).
7. It should include the imputed values of non-marketed goods and services. These are
goods and services that are not sold in the market. Since some of them may not have
market price, we estimate their value by the cost incurred to produce them. These
include
▪ Service rendered by the police, the parliament, the defense-force, etc (estimated
by the wages and salaries paid to them)
▪ Meal produced and served at home, etc
Because of the difficulty to get the imputed value of such services, imputations
might not be possible for such goods and services as:
▪ Meals served at home

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 ▪ Goods sold at the underground economy
8. Market price: National Product is valued at market prices. When it is valued at market
prices, it should be adjusted for Indirect Business Taxes and Subsidies.
The market price of many goods might have been distorted by indirect taxes (such as
sales tax, excise taxes…) and subsidies.
Why Adjustment?
▪ Sellers normally add Indirect Business Taxes (IBT) to the selling prices of their
products. This increases the market price and overstates the real value of the
product. Thus, it has to be deducted from market prices to bring the amount
down to the real value of the product.
▪ Subsidies are given by the government to producers so that they can sell the
product at a price lower than its real value. This tends to understate the real
value of the product. Thus, it has to be added to market prices to bring the value
up to the real one.
In such a way, we calculate the price net of Indirect Business Taxes and Subsidies.
That is:
Net Price = Market Price - Indirect Business Taxes + Subsidies
When national product is calculated at this net price, we call it national product at factor
cost, which is equivalent to summing up the cost of acquiring the primary factors of
production (labor, land, capital and entrepreneurial ability).

5.3 GNP Vs GDP

Definitions:
GNP: gross national product is the total market value of all final goods and services
produced by citizens of a given country over a given period of time (usually one year).
✓ Takes in to account nationality (citizenship). That means it includes output
produced by citizens of the country where ever they are (regardless of boundary).

GDP: gross domestic product is the total market value of all final goods and services
produced within the geographical territory of a given country within a given
period of time (usually one year).

➢ Takes in to account geographical territory. That is it includes output produced with

in the geographical territory of the country by whomever it is produced (regardless
of their nationality).Hence,

GNP- includes factor income from abroad and excludes factor payments to abroad.
GDP- includes factor payments to abroad and excludes factor income from abroad.
For example, income earned by Indians working in Ethiopia is part of Ethiopians GDP
but not GNP. On the other hand, it is part of India's GNP but not India’s GDP.
Income earned by Ethiopians working in the USA is part of Ethiopia's GNP and
America's GDP.
Thus, the difference between GNP and GDP is the difference between factor income
received from abroad by residents/citizens (FIA) and Factor income payable to
foreigners/non citizens (FPA). This difference is what is known as Net Factor Income from
Abroad (NFIA), i.e. NFIA = FIA - FPA

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Given this,
a. If FIA = FPA; then GNP = GDP
b. If FIA > FPA; then GNP > GDP
c. If FIA < FPA ; then GNP < GDP

Therefore, GNP = GDP + NFIA,

GDP is commonly regarded as a better measure than GNP (or has some advantages over
GNP) because:
1. International comparison becomes easier with GDP
2. The measurement of GDP is relatively easier than that of GNP. This is because it
is difficult to know the exact amount of income earned by factors of production
owned by the country but that are working abroad. For example, income earned by
Ethiopians living abroad is beyond the records of Ethiopian Authorities.
3. GDP is a better indicator of the job creating capacity of the economy than GNP.

5.4. Approaches to GNP/GDP/ Measurement

5.4.1. Output (Product) Approach

In production method, so as to avoid the double counting of the intermediate goods in the
production process, value-added system is customarily used. Let us take the notes of
Dornbusch and Fischer (1994) which states that at each stage of the manufacture of a good,
only the value added to the good at that stage of manufacture is counted as part of GDP.
The value of the wheat produced by the farmer is part of GDP. Then the value of flour sold
by the miller minus the cost of the wheat is the miller’s value added. If we follow this
process along, we will see that the sum of the value added at each stage of processing will
be equal to the final value of the bread sold.
Taking this example as base of our argument, we can say that GDP is the sum of the value
added in all production process units. To make it clear, let us take four stages of production
process to produce bread. In such production process, in the initial stage, the farmer
produces wheat and sells it to crop dealer at the price of birr 250. The crop dealer sells the
wheat to the miller at the cost of 300 birr and gained 50 birr gross profit which will be
distributed as wage, rent, interest and profit. Like before, the miller sells the floor to the
bakery at 375 birr and gains birr 75 which is distributed among the agents participated in
the production process. The bakery finally sells the bread to the consumers at the price of
Birr 450.00. Here, if we count all goods sold without distinguishing whether it is final or
intermediate product, these processes will generate a total of birr 1375. It is really
exaggerated and does not represent what the economy does. But if we take the price of the
final good (bread), it values only birr 450 which has conformity with our definition of GDP.
Alternatively, adding the value added in each stage of production gives similar result of
birr 450.00. Therefore, the sum of value added in all stages of production and service in
economy gives the GDP of the economy in the given year. Practically, it has a lot of
difficulties in obtaining and in measuring the value-added in each stage of production. The
problem gets higher intensity in developing countries.

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In this approach, GDP can be measured using the final output method (which is the sum
total of the market values of all final goods and services) or the sum of the value added in
all production process units.

GDP = ∑ Pi(Gi) + Pi(Si) + [imputed values of non-marketable goods and services]

Where P = Market price, G = All Final goods, and S = Services

Example: Suppose country A produces only three goods Autos, Bread and clothing.

Table 1: Output of Country A, Final Output Method.

Value of raw materials and intermediate The value of Final goods
goods (Billions of Birr p.a.)
(in Billion of Birr p.a)

Ore, Coal  20 Steel80

Autos 200

Rubber 10, Tire 20

Wheat 10, Flour 35, Bread 100

Cotton 50 Clothing 90

GDP 390 Bill, Birr

In practice double counting can be avoided by working with value added method. See the
following table.

Table 2: Value added method

Industry Industry Sales Purchases from… Value added
(Billion of Birr) (Billion Birr) (Billion Birr)
(net output)
Ore, Coal 20 0 20
Steel 80 20 60 Value of resources
Rubber 10 0 10
Tyre 20 10 10
Automobile 200 100 100
Wheat 10 0 10 Value of Resources
Flour 35 10 25
Bread 100 35 65
Cotton 50 0 50 Value of Resources
Cloth 90 50 40
GDP 390 Bill. Birr

➢ Money Vs GDP

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Money is any commodity commonly accepted in exchange for goods and services. We
have defined GDP as the money value of goods and services in a given year. In measuring
the Birr (money) value of goods and services, we use the market prices of the different
goods and services. But market prices change over time (increase or decrease). The change
in prices results in a change in GDP output being unchanged. Following this problem, we
have two measures of GDP.

(a) Nominal GDP: GDP at current market price. Nominal GDP measures the money
values of output (GDP) in a given year at the market prices of that year (current market
price).
Nominal GDP1990 = P1990 * Q 1990 + P1990 * S 1990

In this case any change in GDP could occur due to:

a) Change in market prices (output being constant)
b) Change in output (Mkt. prices being constant.)
c) Simultaneous change in both prices and output.
Therefore, Nominal GDP would not clearly indicate the real growth in output between two
periods. This makes comparison of GDP between two different years difficult.

(b) Real GDP: GDP at constant (base year) prices. Real GDP measures the real changes
in physical output in a given economy between two different periods. All goods and
services are valued at a constant (base year) price. It tells us the change in the real
productive capacity of a nation.
▪ A base year is a year in the past in which prices were generally stable. Once it is
chosen, its prices are used to calculate real GDP in subsequent years and may stay
for many years until another base year is chosen. One possible problem with the
use of base year prices is that it doesn't take in to account an increase in prices
because of an improvement in the quality of the product.

Table 3: Output, Price and National Product

Name of Output Price Output Price GDP in 1998
commodity in 1990 in in 1998 in
(unit) 1990 (Unit) 1998 At At constant
(Birr (Birr GDP in current (base year)
/unit) /unit) 1990 price Price of 1990
(NGDP) (Real GDP)
(1) (2) (3) (4) (5) (2) X (3) (4) X(5) (4) X(3)
A 2,000 10 2,000 15 20,000 30,000 20,000
B 3,000 7 3,000 14 21,000 42,000 21,000
C 1,000 15 1,000 20 15,000 20,000 15,000
56,000 92,000 56,000

From table 3,
92,000  56,000 36
% Increase in NGDP = X 100 = X 100 = 64.28%
56,000 56

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 56,000  56,000
% Increase in RGDP = X 100  0
56,000
Given the weakness in using base year prices for very long period of time, Real GDP is a
better measure of the change in the physical output of a country.

GNP Deflator: is the ratio of NGNP to RGNP, which measures the change in prices that
has occurred between the base year and the current year.

NomimalGDP
G DP Deflator = X 100
Re alGDP
=
 Pc .qc X 100 . It is also called Paasche’s, or
 po .qc
Current weighted price Index.

92,000
= X 100  164.28%
56,000
i.e. The rate of inflation = 164.28% - 100%
= 64.28%
Form this we have

NGDP 92,000
RGDP = X 100  X 100  56,000 .
GDPDeflator 164.28

56,000X 164.28
NGDP = RGDP X GDP Deflator   92,000
100

2.4.2 Expenditure Approach

To determine GDP through expenditure approach, we add up all types of spending (total
national spending (GNE) on finished (final) goods and services. These expenditures are
made by households, businessmen, government and foreigners. Now, let's see each
component one by one.

(a) Personal consumption expenditure (c)

It represents the total expenditure by households on durable goods (TV, Car,
refrigerator etc), non-durable goods (Bread, soft drink, etc) and services (taxi, doctor’s
service, barber, etc).
All the spending shall be on currently produced goods and services

(b) Gross Private Domestic Investment expenditure (I)

➢ Investment implies additions to stock of capital by business firms which includes:
✓ All final purchases of new machinery, equipment and tools.
✓ All constructions - Non residential (new offices, apartments, factories, stores)

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 ✓ Residential (new owner-occupied homes.)
✓ change in inventories (Ending inventory minus beginning inventory)

➢ It excludes portfolio investment (the exchange of ownership on existing capital such

as houses, vehicles etc.)
➢ In economics, investment mean additions to, or replacement of physical productive
assets: spending by business firms on new job-creating & income producing goods.
Such expenditures contribute to GDP. But when a firm buys a used machine, or an
existing factory, it merely exchanges money asset for physical assets. The purchase
itself creates no additional GNP. But when a firm buys new machines or new
buildings, it creates jobs and income for steel workers, carpenters, bricklayers, and
other workers, thereby contributing to the nation's GDP.
➢ Net private domestic investment, represents a net addition to the total stock of
capital. (I.e. gross private investment minus depreciation)
➢ Changes in inventories are counted as investment because an increase in inventories
is unconsumed output. We have defined that GDP measures total output produced
in a given year. The amount of Teff produced in 1990 by peasants and consumed
and sold must be included in 1990's GDP. The amount of Teff produced in 1989
but sold in 1990 has to be counted in 1989's GDP. Hence, to reconcile this, we have
to simply add the change in inventory. It can be simply stated as the difference
between ending inventory and beginning inventory. The sign of it is either positive
or negative.
➢ Investment is defined as "gross “, "domestic" and private. It is gross in the sense
that depreciation is not deducted.
➢ The term domestic means that spending by domestic residents but is not necessarily
spending on goods produced within this country. The word private explains it
excludes investment spending by government.

(c) Government Expenditure (G)

Government purchases include all government spending (Federal, regional & local) on
goods and services such as expenditure on national defense, road, health, education, water,
etc facilities and infrastructures. Usually government services are measured at the cost of
supplying them rather than at the cost of selling them. Because some of the government
services are not marketable: example defense, education etc, does not have market price.
It excludes all government transfer payments. (Such as pension, unemployment
compensation etc)

(d) Net export of Goods and Services (X- M)

For an open economy, GDP cannot be accurately measured without adding in the nations
exports (X) and subtracting out the nations imports (M) of goods and services (X-M) which
is net export.
Before defining what net export is, we must look and consider export and import
independently. Export indicates the amount of goods which are sold in abroad.

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Consider export first. If Ethiopian business concerns produce Birr 300 million of good for
export and sold it abroad, we must add that amount in determining of GDP by expenditure
method.
On the other hand, we know that part of consumption; investment and government
purchases are imports, goods and services produced abroad. This spending does not reflect
production activity in Ethiopia. The value of import has to be subtracted to avoid
overstating total production in Ethiopia.

In short, the amount of goods and services exported should be added to GDP and imports
should be excluded from GDP. To make it simple, rather than adding and subtracting
export and import separately, we can take the difference between them.
The difference between export and import (Exports - Imports) is known as net export
(Trade balance). It takes either positive or negative sign.
Thus, using the total expenditure approach GNP is measured using the following
mathematical formula.
GDP = C + I + G + (X - M)
GNP = C + I + G + NX + NFIA
GNP = GDP + NFIA

Example: Table 4. GDP by final expenditure (in Billions of Dollars) of a hypothetical

country
Expenditure Amount
Category
1. Personal Consumption Expenditure 1858
• Durable goods 232
• Non-durable goods 743
• Services 883
2. Gross Private Domestic Investment 450
• Non-residential structures 125
• Equipment 202
• Residential structures 105
• Inventory Investment 18
3. Government purchase of goods and services 590
• Federal government 229
• State and local government 361
4. Net export 24
GDP = C + I + G + (x - m) = 2,922 Bill. Dollar

5.4.3 Income Approach: Gross National Income (GNI)

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GNI is the sum total of incomes accruing to the different productive resources: Labor,
Land, Capital and Entrepreneurship. The components in this approach are:
(a) Income components
i. Compensation to employees (W): Wages and salaries which are the largest
component in this approach.
ii. Rents (R): Rental income to person's (payments made to land)
iii. Interest (I): Payment made to capital
iv. Profit (P): Payment made to entrepreneurs

Profit includes the following sub components:

(i) Proprietors income: the profit earned by sole proprietors and partners
(ii) Corporate profit: the profit earned by corporate business (treated as a legal
person).
Corporate income (profit) is further divided into three parts.
✓ Corporate income tax- that part of the corporate profit which goes to the
government.
✓ Dividends- that part of the corporate profit to be divided among stake holders.
✓ Undistributed corporate profits (retained earnings)- for further expansion of the
corporate business.

b) Non -Income components

i.Depreciation (D): allowance to capital equipment, machines, buildings etc to replace

their used up part in the year.
ii.Indirect Business Taxes (IBT): are cost to business firms and increase prices of such
products. Examples excise tax, sales tax, service tax etc. Since GNP is calculated
at market price which includes indirect business taxes, we have to include indirect
business taxes to GNI calculation so that GNP = GNE = GNI holds.
iii.Subsidy: it is a negative tax.

Hence, GDP = W + R + I + P + D + IBT - S, Where

W = Wages and salaries (compensation to employees.
R = Rent
I = Interest
P = Profit
D = Depreciation
IBT = Indirect Business tax
S = subsidy

Consider the following example.

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Table 5: GDP by type of Income of a hypothetical country
Amount
Type of Income (Bill. Of Dollars) %
Compensation to employees (W) 1,772 60.6*
Proprietor's income (PI) 134 4.6
Rental income to persons (R) 34 1.2
Corporate Profits (P) 189 6.5
Net interest (I) 215 7.4
Depreciation (D) 322 11.0
Indirect B. Taxes (TBT) 256 8.7
GDP 2,922 100.0

5.5 Other measures of National product (income)

(1) Net National Product/Income/ (NNI /NNP)

(a) NNP = GNP - Depreciation or
(b) NDP = GDP - Depreciation or

(2) National Income(NI):It can be calculated in two ways

(a) NI = GDP + NFIA - Depreciation - Indirect business taxes + Subsidies
= GNP - Depreciation - Indirect business taxes + Subsidies
= NNP - Indirect business taxes + Subsidies
That is National Income is Domestic product produced by domestically located factors
of production (GDP which is also income)
▪ less income paid to foreigners working in Ethiopia (FPA)
▪ plus, Factor income earned by Ethiopians working aboard (FIA)
▪ less depreciation (as it is not part of any income but wasted due to wear and tear of
capital)
▪ Less IBT plus subsidies (Recall that IBT and subsidies are adjustments made to get
the real value of output or GDP or real income).

(b) NI = W + PI + R + I + P + NFIA

That is, national income is the sum of income earned by labor, proprietors, owners of land,
owners of capital, entrepreneurs, all located in Ethiopia regardless of citizenship,
▪ less factor payments to non-citizens of Ethiopia but working in Ethiopia (FPA) (that
is any income that is earned by domestically located factors of production that do
not belong to Ethiopians)
▪ Plus, any factor income earned by factors of production that belong to Ethiopian
nationals but located in foreign countries.

(3) Personal Income (PI): It refers to the amount of income that households received
actually in the given year.

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 PI = NI- Corp income taxes -Retained earnings-social security contributions + transfer
payments received (such as Gifts, pension, unemployment compensation etc).

(4) Personal Disposable Income (PDI)

PDI = PI - Personal taxes (personal income tax, personal property tax &inheritance tax
etc.)
Hence personal disposable income (PDI) is the amount of income that households have
available to spend or save after satisfying all their tax obligations to the government.

Table 6: From GNP to Personal Disposable Income

Item Amount
(Bill. Of Dollars)
Gross National Product (GNP) 2,922
Less Depreciation
-321
Net National Product (NNP) 2,601
(less Indirect business taxes plus
government subsidies) -257

National Income (NI) 2,344

less corporate taxes, undistributed corporate
profits, social security contributions -273
Plus transfer payments.
+333
Personal Income (PI) 2,404
Less personal taxes -389
Personal Disposable Income (PDI) 2,015

Additional Note:
GDP at market price = C + I + G + NX (from expenditure side)
= W+ PI+ R + I + P + D + IBT - S (from income side)
GDP at factor cost = GDP at market price -IBT + Subsidies, or
GDP at market price = GDP at factor cost + IBT - Subsidies

GNP at market prices= GDP at market prices + NFIA, or

GDP at market prices = GNP at market prices - NFIA
GNP at factor cost = GNP at market prices - IBT + Subsidies
= GDP at market prices + NFIA - IBT + Subsidies
NDP at market prices = GDP at market prices - Depreciation
NDP at factor cost = GDP at factor cost - depreciation
= GDP at market price - IBT + Subsidies - Depreciation
NNP at market prices = GNP at market prices - Depreciation
NNP at factor cost = GNP at factor cost - depreciation
= GNP at market price - IBT + Subsidies - Depreciation

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 = GDP at market price + NFIA - IBT + Subsidies-Depreciation.
Example:
Look at the following example taken from the national accounts of Ethiopia, as
downloaded from the internet.
National Accounts of Ethiopia, 2004 CSA (in million birr) for the year 2000/2001.

1. GDP at current factor cost 49, 186.7

2. Net Factor Income From Abroad (NFIA) (426.4)
3. GNP at current factor cost (1 + 2) 48,760.3
4. IBT (net of subsidies) 5,024.0
5. GNP at current market price (3+4) 53, 784.3
6. GNP per capita at current market price 834.9
7. Annual Rate of Growth in real GDP at 1980/81 price 7.7 %

Personal Consumption Expenditure (C) 41,894.7

Government Purchases (G) 10,882.1
Gross Domestic Private Inv't * (I) 9,646.0
Exports (X) 7,981.5
Imports (M) 16,193.6
GDP at current market prices 54,210.7
Net Factor Income From Abroad (NFIA) (426.4)
GNP at current market prices 53,784.3

*It is also known as gross fixed capital formation

GNP and Social Welfare

1. Welfare, broadly speaking, refers to better living standard of human beings.

(a) economic -By availability of more and better material objects and services for
Component consumption. Economic welfare is one component of welfare and
is usually measured by monetary measures.)

(b) non-economic -Healthy and pleasant environment, family affections & love,
Component political stability, etc. It can not be measured by monetary measures.

2. A country with higher level of National Income and Per capita income (National
Income  Total Population) will be considered as more advanced and developed
3. An increase in the national income of a country implies that there is increasing
availability of goods and services in the country.
4. More goods and services mean higher level of consumption and standard of living or
economic welfare. It is, therefore believed that economic welfare depends upon
national Income.

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Limitations of National Income as a good indicator of social welfare: [GNP or GDP]

1. Increase in National income may be followed by a more than increase in population size,
which means decline in per capita income and hence lower economic welfare. -
GNP/GDP calculation fails to include population growth.
2. Increase in National income may be illusionary but not real, i.e., Output being constant,
national income may increase due to inflation, which means lower purchasing power
(real income) and lower economic welfare. NGNP fails to account inflation or deflation.

3. National income may increase as a result of prolonged working hours (loss of leisure)
and increased employment of children in production, in unhealthy and polluted working
atmosphere. Such an increase in national income will not promote economic welfare.
Moreover, if people choose more leisure GDP may decrease but welfare increases.
Hence, GDP fails to account leisure and underestimates welfare of the society. GNP
fails to account environmental degradation and overestimates social welfare.

4. National income may increase by changing the composition of national output either to
more of capital good or war goods, which will not increase economic welfare. On the
other hand it fails to account for non-marketable transactions. (e.g. cooking meals,
washing your clothes, repairing your home etc.)
5. If the national income increases, and yet if it is not fairly distributed or it is concentrated
in a fewer hands, it will not promote economic welfare unless the distribution of
national income changes in favor of the poor.
6. National income accounting fails to measure improvements in quality of goods and
services (e.g. computer)

7. Unless the poor get better job opportunities, good education and other facilities so that
economic uplift will create a sense of confidence and change their habits of spending
the increased income may be spent on such foolish things as drinking, gambling and
things of that sort which will result positive loss of satisfaction and hence declining
economic welfare.

8. National income accounting fails to include the goods and services produced in the
underground economy.

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