CHAPTER 2

The Basics of Supply and Demand

Supply and demand form the most fundamental concepts of economics. Being an academic,
farmer, manufacturer, or a consumer, the basic premise of supply and demand are integrated
into their daily actions. The model of demand and supply that we shall develop in this chapter
is one mostly in all economic analysis. We will first look at the definition of demand, tables,
graphs, and the variables that influence demand. Then we will turn to supply, and finally we
will put demand and supply together to explore how the model of demand and supply operates.
Whereas supply graphs are drawn from the perspective of the producer, demand is portrayed
from the perspective of the consumer.

2.1. DEMAND

2.1.1. Meaning

Desire refers to people's willingness to own a good. Demand is the amount of a good that
consumers are willing and able to buy at a given price. Demand is generally classified on the
basis of various factors, such as nature of a product, usage of a product, number of consumers
of a product, and suppliers of a product. The demand for a particular product would be different
in different situations.

2.1.2. The demand functions

The demand function relates the quantity demanded for a product and its different influencing
variables, which are of an economic nature (prices) as well as of a non -economic type (tastes
or structure of the population). In the simplest case, the demand function relates the quantity
demanded to the price of a particular product. This simple relationship is best represented by a
downward sloping curve connecting all the points of the demand schedule. These points show
the quantities demanded at each price, ceteris paribus, that is when all the other influencing
variables do not change.
2.1.3. Law of demand
The law of demand states that as price rises quantity that is demanded falls and as prices fall
more goods are demanded. The result is a downward sloping curve from the left to the right. A
demand curve has a negative slope. Suppose RICA is producin g and selling mangoes to the
community living nearby. If RICA were selling a Kilo of mangoes and offer it at Rwf 3000
very few people would be willing and able to buy them. Perhaps only 10 will buy it. If it was
to be lowered to Rwf 2500 a kilo. Perhaps 20 people will buy it. Still lowering the price to Rwf
2000 more would buy it. This time may be 30 people would demand the mangoes. At Rwf
1500, 40 people would demand it and at Rwf 1000 some 50 people would buy it. If lowered to
Rwf500 then number of people buying mangoes would increase to 60. If the market of the
mangoes is the community living around RICA; then the demand schedule is also the market
demand schedule for the people buying mangoes from RICA. Generally, a demand schedule is
a table showing the relationship of price and quantity demanded.

Table: Demand schedule

Price in RWF Quantity of Mangoes demanded

3000 40
2500 60
2000 80
1500 100
1000 120
500 140

2.1.4. Demand curve

The demand curve shows how much of a good consumer are willing to buy as the price per
unit changes.

Figure: Demand curve

More generally the demand curve is depicted as a smooth curve

P D

2.1.5. Determinants of demand

The amount of a good demanded depends on:

• the price of the good.

• the income of consumers.
• the demand for alternative goods which could be used (substitutes).
• the demand for goods used at the same time (complements).
• whether people like the good (consumer taste).

2.1.6. Shift in the demand curve

A change in price never shifts the demand curve for that good. In the figure below an increase
in price results in a movement up the demand curve. A movement refers to a change along a
curve. On the demand curve, a movement denotes a change in both p rice and quantity
demanded from one point to another on the curve. The movement implies that the demand
relationship remains consistent. Therefore, a movement along the demand curve will occur
when the price of the good changes and the quantity demanded ch anges in accordance to the
original demand relationship. In other words, a movement occurs when a change in the quantity
demanded is caused only by a change in price, and vice versa. The fall in the quantity demanded
from Q1 to Q2 is sometimes called a contraction in demand.

A demand curve shifts only if there is a change in income, in taste or in the demand for
substitutes or complements. A shift in a demand curve occurs when a good's quantity demanded
changes even though price remains the same. For instance, if the price for a kilogram of oranges
was Rwf2000 and the quantity of oranges demanded increased from Q1 to Q2, then there would
be a shift in the demand for oranges. Shifts in the demand curve imply that the original demand
relationship has changed, meaning that quantity demand is affected by a factor other than price.
A shift in the demand relationship would occur if, for instance, oranges suddenly became the
only type of fruits available for consumption. In the diagram below a decrease in demand has
shifted the demand curve to the left. The new demand curve is D1 D1.

Figure: Shift in demand curve

2.1.7. Types of demand

• Composite demand

It refers to the demand for a good that has multiple different uses. Examples include the
following:

• Milk is demanded because it can be used for cheese, yoghurts, cream, butter and other
products including fertilizer
 • People may demand wheat for producing bread, biofuels or feeding livestock.

• Land can be used for farming or building houses.

• Demand for smartphones is increasing because these can be used as a camera, access
the internet, and make phone calls.
• joint demand

Joint demand (sometimes referred as complimentary demand) occurs when demand for
two goods is interdependent. There are many types of commodities whose demand are
tied together. For instance, the demand for a car will necessitate the demand for tyres.
Since the demand for the products is highly related; a rise in the price of one lead to a fall
in the demand for the other and vice versa. For example, a rise in the price of cars will
bring a fall in their demand together with the demand for petrol and lower its price, if the
supply of petrol remains unchanged.

• Derived demand

Derived demand is an economic term that refers to the demand for a good or service that results
from the demand for a different, or related, good, or service. Demand is derived if it would not
arise had not the other commodities existed. Derived demand exists only when a separate
market exists for both related goods or services involved. A product or service's level of derived
demand has a significant impact on the market price of that product or service. Derived demand
differs from regular demand, which is simply the quantity of a certain good or service that
consumers are willing to buy at a given price at a certain point in time. Derived demand can be
broken down into three main elements:

Raw materials: Raw or “unprocessed” materials are the elemental products used in the
production of goods. The level of derived demand for a certain raw material is directly related
to and dependent on the level of demand for the final good to be produced. For example, wheat
flour is a raw material in production of bread, cakes, etc. Hence when the demand for bread or
cakes increase then, the demand for wheat flour will also increase.

Processed materials: are goods that have been refined or otherwise assembled from raw
materials. Paper, glass, gasoline, milled lumber, and peanut oil are some examples of processed
materials.
Labor: the production of goods and the provision of services requires workers—labor. The
level of demand for labor depends solely on the level of demand for goods and services. Since
there is no demand for a workforce without a demand for the goods it produces or the services
they provide, labor is a component of derived demand.

2.2. SUPPLY
2.2.1. Meaning

Supply is the quantity sellers are willing to offer in the market at a given price.

2.2.2. Law of supply

As prices rise quantity supplied also rises and as prices in the market fall the quantity sellers
are ready to offer decreases. A table showing the relationship is a supply schedule and the curve
slopes upwards from the left to the right. The slope of a supply curve is positive.

The supply curve labelled SS in the figure below shows the amount of a good one or more
producers are prepared to sell at different prices.

2.2.3. Determinants of supply

Supply depends on:

• the price of the good;

• the cost of making the good;
• the supply of alternative goods the producer could make with the same resources
(competitive supply);
• the supply of goods actually produced at the same time (joint supply);
 • Unexpected events that affect supply.

2.2.4. Shift in the supply curve

A change in price never shifts the supply curve for that good. In the diagram below; an increase
in price results in a movement up for the supply curve. A movement along the supply curve
means that the supply relationship remains consistent. Therefore, a movement along the supply
curve will occur when the price of the good changes and the quantity supplied changes in
accordance with the original supply relationship. In other words, a movement occurs when a
change in quantity supplied is caused only by a change in price, and vice versa. The increase
in quantity supplied from Q 1 to Q2 is sometimes called an expansion in supply.

A supply curve shifts only if there is:

• a change in costs.
• a change in the number of goods in competitive or joint supply; or
• Some unforeseen event which affects production.

In the diagram below an increase in supply shifts the supply curve to the right. A shift in a
supply curve occurs when a good's quantity supplied changes even though price remains the
same.
2.2.5. Types of supply

• composite supply

A composite supply means a supply comprising two or more taxab le supplies of goods or
services, or any combination thereof, which are naturally bundled and supplied in conjunction
with each other in the ordinary course of business, one of which is a principal supply. For
instance, supply of sugar is total supply of sugar for all uses. Sugar for medicine, for
confectionaries and manufactures of confectionaries and sugar for household use in tea and
coffee.

• joint supply

This is the case when supply of one good is tied to the supply of another or it occurs when two
goods are produced together from the same origin / raw material. Examples of joint supply
include:
• If one grows wheat, will get both wheat and straw.
• Producing refined flour creates bran as a by-product. Bran can be used as fibre
ingredient or using in compost or animal feeds
• If one increases the supply of beef (keeping more cattle) will also increase the
supply of leather (a by-product of beef)
• If one decreases the supply sheep, there will be a fall in both mutton and wool.
2.3. PRICE MECHANISM

2.3.1. Equilibrium price

The logic of the model of demand and supply is simple. The demand curve shows the quantities
of a good or service that buyers will be willing and able to purchase at each price during a
specified period. The supply curve shows the quantities that sellers will offer for sale at each
price during that same period. By putting the two curves together, we should be able to find a
price at which the quantity buyers are willing and able to purchase equals the quantity sellers
will offer for sale. The equilibrium price in any market is the price at which quantity demanded
equals quantity supplied

At prices above the equilibrium (P*) there is excess supply while at prices below the
equilibrium (P*) there is excess demand. The effect of excess supply is to force the price down,
while excess demand creates shortages and forces the price up. The price where the amount
consumers want to buy equals the amount producers are prepared to sell is the equilibrium
market price. All these situations are shown in the diagram below:

With an upward-sloping supply curve and a downward-sloping demand curve, there is only a
single price at which the two curves intersect. This means there is only one price at which
equilibrium is achieved. It follows that at any price other than the equilibrium price, the market
will not be in equilibrium.

Equilibrium quantity is when there is no shortage or surplus of a product in the market. Supply
and demand intersect, meaning the amount of an item that consumers want to buy is equal to
the amount being supplied by its producers. In other words, the market has reached a perfect
state of balance as prices stabilize to suit all parties. From the diagram above the equilibrium
quantity is Q*.

2.3.2. Shifts in demand and supply

This can be stated as follows. If demand is held constant a forward shift of the supply curve
will lower the equilibrium price. Like wise if supply is held as a constant a forward shift of the
demand curve will result in a rise in equilibrium price. The reverse should be true. A backward
shift of the supply curve when demand is held as a constant should raise equilibrium price and
a backward shift in the demand curve with supply held as constant should lower equilibrium
price.

In case of a shift of supply when demand is held as a constant think of the effect of a tax and/or
a subsidy to a firm producing say sugar. E.g. Kabuye sugar factory. What will be the effect on
equilibrium price.

In the figure below an indirect tax has been added to SS. This has the e ffect of shifting the
supply curve up vertically by the amount of the tax. Note in the diagram below that price does
not increase by the full amount of the tax. This suggests that part of the tax is paid by the firm.

In this figure a subsidy has been given to the firm. This has the effect of making firms willing
to supply more at each price and so shifts the supply curve downwards. The shift is
equivalent to the value of the subsidy. Note that price falls by less than the full amount of the
subsidy. This suggests that the firm keeps part of the subsidy.
2.3.3. Elasticity
Elasticity is an economics concept that measures the responsiveness of one variable to the
changes in another variable. Basically, it shows the ratio of the percentage change in one
variable to the percentage change in another variable. It is a tool for measuring the
responsiveness of a function to changes in parameters in a relative way. The knowledge about
elasticity is vital in agriculture as well.

%Quantity
Elasticity =
% Pr ice

Elasticity can be described as follows:

Elastic demand or supply curves indicate that the quantity demanded or supplied responds to
price changes in a greater than proportional manner.

An inelastic demand or supply curve is one where a given percentage change in price will cause
a smaller percentage change in quantity demanded or supplied. It is indicating low
responsiveness to price changes

Unitary elasticity means that a given percentage change in price leads to an equal percentage
change in quantity demanded or supplied

2.3.4. Price Elasticity of Demand

Price elasticity of demand measures the responsiveness of demand to a given change in price
and is found using the equation:

PED = Percentage change in quantity demanded/Percentage change in price

or

PED = P/Q x Q/P

Where P = the original price
Q = the original quantity
And = 'the change in'
In general, the most price elastic commodities are those food products that are relative luxuries
with close substitutes, such as beef, fruits and vegetables. Other products such as milk and
potatoes have no close substitutes and are characterized by a low-price elasticity of demand.
Consequently, the demand for a product tends to be more elastic the more numerous are the
substitutes for it. In developing countries, the price elasticity of demand for food tends to be
extremely low, particularly in the case of an increase in price. Since most of the calorie intake
in low-income countries originates already from cheap starchy staple foods such as cereals and
root crops, consumers have indeed little scope for shifting to less expensive foods in order to
offset a rise in food prices. Also, in the developing countries, rises in food prices would have a
stronger inflationary impact than in developed economies, given the predominant role of the
agricultural sector in their economy.

2.3.5. Income Elasticity of Demand

Income elasticity of demand (YED) measures the responsiveness of demand to a given change
in income. In the same vein, the sensitiveness of demand to income changes can be computed
using a similar formula. To understand the relationship existing between income and demand
for food products, let’s take the case of an individual i1 with a relatively low level of income,
so that his desired and optimal level of food consumption is not reached. Any increase in
income is therefore likely to be spent on extra food consumption. On another hand, an
individual i2 with a relatively high level of income is likely to have reached an optimal level of
food consumption. Compared with i1, consumer i2 spends a much smaller percentage of income
on food. Constrained by physical capacity, individual i2 may at best increase his food
expenditure by switching to better quality products. However, there will be a point in time at
which a further increase in i2’s income will lead to a less than proportional increase in his
expenditure on food. As a result, the increase in the demand for food in developed countries
tends not to keep pace with the increase in consumers’ incomes. This relationship between
income and demand for food products was first stated by 19th century German statistician Ernst
Engel. Known as Engel’s law, this simple relationship stipulates that food expenditure, as a
proportion of total expenditure, declines as income increases ceteris paribus, or that the income
elasticity of demand for food tends to decline as a country moves along the development path.
This is expressed as follows:
∆𝑄 ⁄𝑄
𝜀𝑦 = ∆𝑌
⁄𝑌

Generally, income elasticity of demand for food in general is higher in the developing countries
(around 0.6)

If YED is negative, then the good is inferior. People use an increase in income to buy less of
this good and more of a superior substitute.
If YED is positive then the good is normal. Consumers use an increase in income to buy
more of the good.

Cross Elasticity of Demand

Cross elasticity of demand (XED) measures the responsiveness of demand for one good (z) to
a given change in the price of a second good (w):

XED = Percentage change in quantity demanded of good z/Percentage change in the price of
good w

If XED is positive then the two goods are substitutes. If XED is negative then the two goods
are complements.

2.3.6. Price Elasticity of Supply

The price elasticity of supply (PES) is the measure of the responsiveness in quantity supplied
(QS) to a change in price for a specific good (% Change QS / % Change in Price). There are
numerous factors that directly impact the elasticity of supply for a good including stock, time
period, availability of substitutes, and spare capacity. The state of these factors for a particular
good will determine if the price elasticity of supply is elastic or inelastic in regards to a change
in price.

PES = Percentage change in quantity supplied/Percentage change in price

or PES = P/Q x Q/P

The price elasticity of supply has a range of values:

o PES > 1: Supply is elastic.

o PES < 1: Supply is inelastic.
o PES = 0: The supply curve is vertical; there is no response of demand to prices. Supply
is “perfectly inelastic.”
o PES = ∞∞ (i.e., infinity): The supply curve is horizontal; there is extreme change in
demand in response to very small change in prices. Supply is “perfectly elastic.”

Inelastic goods are often described as necessities. A shift in price does not drastically impact
consumer demand or the overall supply of the good because it is not something people are able
or willing to go without. Examples of inelastic goods would be water, gasoline, housing, and
food.
Elastic goods are usually viewed as luxury items. An increase in price for an elastic good has
a noticeable impact on consumption. The good is viewed as something that individuals are
willing to sacrifice in order to save money. An example of an elastic good is movie tickets,
which are viewed as entertainment and not a necessity.

2.3.7. Practical Importance of Elasticity of Demand

There are about eight important uses of elasticity of Demand as follows below:
1. Importance in taxation policy: The concept has immense importance in the sphere of
government finance. When a finance minister levies a tax on a certain commodity, he
has to see whether the demand for that commodity is elastic or inelastic. If the demand
is inelastic, he can increase the tax and thus can collect larger revenue.
2. Price discrimination by monopolist: If the monopolist finds that the demand for his
commodities is inelastic, he will at once fix the price at a higher level in order to
maximize his net profit. In case of elastic demand, he will lower the price in order to
increase his sales and derive the maximum net profit.
3. Importance to businessmen: When the demand of a good is elastic, they increase sale
by lowering its price. In case the demand is inelastic, they charge high er price for a
commodity.
4. Help to trade unions: The trade unions can raise the wages of the labor in an industry
where the demand of the product is relatively inelastic. On the other hand, if the
demand, for product is relatively elastic, the trade unions cannot press for higher wages.
5. Use in international trade: The terms of trade between two countries are based on the
elasticity of demand of the traded goods.
6. Determination of rate of foreign exchange: The rate of foreign exchange is also
considered on the elasticity of imports and exports of a country.
7. Guideline to the producers: The concept of elasticity provides a guideline to the
producers for the amount to be spent on advertisement. If the demand for a commodity
is elastic, the producers shall have to spend large sums of money on advertisements for
increasing the sales.
8. Use in factor pricing: The factors of production which have inelastic demand can
obtain a higher price in the market then those which have elastic demand. This concept
explains the reason of variation in factor pricing.
2.4. Consumer Behaviour
2.4.1. Utility

Utility is usefulness of a commodity. Utility depends on place. A glass of water may have more
utility than a glass full of alcohol. During the rainy season, a raincoat has more utility than in
the dry season. It also depends on culture. Beef is a good food in Rwanda, but it is not eaten
among the Hindus living in Rwanda.

Utility analysis and the desire to satisfy wants has been a challenge to philosophers and
economists. Jeremy Bentham in the nineteen-century talked of the happiness for the greatest
number. Later Edgeworth and Pareto in the first part of the twentieth century developed a more
detailed analysis of utility. The theory was developed so that analysis of economic choices
could be based upon preferences which can be observed and compared or ordinal utility, rather
than the older concept of utility which was based on the unrealistic assumption that the
satisfaction derived from economic choices could be measured or cardinal utility.Utility
analysis leads us to understanding how demand is derived after the relevant analysis of
indifference curves developed by the two economists and others.

Diagram: Total Utility and Marginal Utility

TU MU

Time Time
2.4.2. Law of Diminishing Marginal Utility
The law of diminishing marginal utility follows the diagram in the section above. Th e more
one consumes the higher is the level of satisfaction. Two glasses of milk have a higher capacity
of satisfying wants than on glass. Three glasses can satisfy wants more than two. Total utility
increase progressives with successive consumption of goo ds. But according to the law of
diminishing marginal utility the incremental rise is not uniform. It declines at every marginal
unit consumed.

The first glass of milk has very high utility. It will quench your thirsty. The second has less
utility because you are satiated by the first. So, you may drink it to fill the stomach. The third
is less desirable. You have quenched the thirst and filled your stomach. Yet you may choose to
drink it. The fourth may be even uncomfortable and your belly may start aching. Therefore, the
marginal utility curve always slopes down wards. It means the marginal utility of consuming
an additional unit will always be less tan the previous one consumed.

2.4.3. Indifference curve

In microeconomics, an indifference curve is a graph showing combinations of two goods to
which an economic agent (such as a consumer or firm) is indifferent, that is, it has no
preference for one combination over the other. They are used to analyse the choices of
economic agents.

For example, if a consumer were equally satisfied with 1 apple and 4 bananas, 2 apples and 2
bananas, or 5 apples and 1 banana, these combinations would all lie on the same indifference
curve.
Indifference curves are typically assumed to have the following features:

• An Indifference curve slopes downward from left to right (negative slope). The negative
slope is a consequence of the fact that the demand for one commodity (X) increases
while the demand for another commodity (Y) decreases (because of diminishing
marginal utility of Y), which is necessary to maintain the total satisfaction.

• Indifference curves do not intersect. This is a consequence of the assumption that

consumers will always prefer to have more of either good than to have less.

• The curves are convex which is a consequence of the assumption that as consumers
have less and less of one good, they require more of the other good to compensate
corresponding to the law of diminishing marginal utility.

• The Indifference curves are ubiquitous throughout an indifference map. In other words,
there exists an indifference curve through any given point on an indifference map.

The slope of an indifference curve, known as the marginal rate of substitution which shows the
rate at which consumers are willing to give up one good in exchange for more of the other
good. For most goods the marginal rate of substitution is not constant so their indifference
curves are curved. The curves are convex to the origin indicating a diminishing marginal rate
of substitution.
4.6 Budget constraint and line

Budget line for Commodity A and B

A consumer would have wanted to locate his or her consumption at the highest possible
indifferent curve. However, there is always a budget constraint. There is always limited amount
of money to satisfy every need. The consumer has to choose that combination which
maximises his or her utility and at the same time be within his or her means

Á budget line represents such a constrained maximisation problem. A consumer can choose
either to spend all the money on good A or all the money on good B. joining the two extremes
gives a budget line. This means he or she can spend some money on commodity A and some
money on commodity B. At 1 a consumer is having more of commodity A relative to B. At 2
a consumer is using his budget to purchase more of commodity B relative to commodity A.
4.7 Consumer equilibrium

From the first diagram above the point of equilibrium is tenable where the budget line is tangent
to the highest possible indifference curve. This is point R It is a point where some amount of
Y i.e. Yo and some amount of commodity X i.e. Xo satisfy the wants of the consumer.

In the second diagram the price of A has changed instead of B as in the previous case. A new
equilibrium point that maximises utility is arrived at c. In both cases, the consumer attempts
to maximise utility, and the level of satisfaction from two commodities constrained by the
budget or income available. Of course, the problem is more difficult in reality since there are
not only two goods that have to satisfy human wants under conditions of scarce monetary
resources.

2.5. An Overview of Demand and Supply: The Circular Flow Model

Implicit in the concepts of demand and supply is a constant interaction and adjustment that
economists illustrate with the circular flow model. The circular flow model provides a look at
how markets work and how they are related to each other. It sh ows flows of spending and
income through the economy.

A great deal of economic activity can be thought of as a process of exchange between

households and firms. Firms supply goods and services to households. Households buy these
goods and services from firms. Households supply factors of production—labor, capital, and
natural resources—that firms require. The payments firms make in exchange for these factors
represent the incomes households earn.

The flow of goods and services, factors of productio n, and the payments they generate is
illustrated in the figure below "The Circular Flow of Economic Activity". This circular flow
model of the economy shows the interaction of households and firms as they exchange goods
and services and factors of production. For simplicity, the model here shows only the private
domestic economy; it omits the government and foreign sectors.
Figure 1: The Circular flow Spending
MARKETS FOR
Revenu GOODS AND SERVICES
e • Firms sell
• Households buy
Goods &
Services
Goods Bought
&
Services
Firms Sold Household
• Produce and sell goods • Buy and consume goods
and services and services
• Hire and use factors of
• Own and sell factors of
production production

Inputs for Land, Labor,

production & Capital
MARKETS
FOR
FACTORS OF PRODUCTION
• Households sell

Wages, • Firms buy Income

Rent &
Profit
= Flow of Goods
& Services

= Flow
of
Income

The figure above presents a visual model of the economy, called a circular-flow diagram. In
this model, the economy has two types of decision makers—households and firms. Firms
produce goods and services using inputs, such as labor, land, and capital (buildings and
machines). These inputs are called the factors of production. Households own the factors of
production and consume all the goods and services that the firms produce. Households and
firms interact in two types of markets. In the markets for goods and services, households are
buyers and firms are sellers. Particularly, households buy the output of goods and services that
firms produce. In the markets for the factors of production, households are sellers and firms
are buyers. In these markets, households provide firms the inputs that the firms use to produce
goods and services. The circular-flow diagram offers a simple way of organizing all the
economic transactions that occur between households and firms in the economy.
The inner loop of the circular-flow diagram represents the flows of goods and services between
households and firms. The households sell the use of their labor, land, and capital to the firms
in the markets for the factors of production. The firms then use these factors to produce goods
and services, which in turn are sold to households in the markets for goods and services. Hence,
the factors of production flow from households to firms, and goods and services flow from
firms to households. The outer loop of the circular-flow diagram represents the corresponding
flow of dollars. The households spend money to buy goods and services from the firms. The
firms use some of the revenue from these sales to pay for the factors of This diagram is a
schematic representation of the organization of the economy. Decisions are made by
households and firms. Households and firms interact in the markets for goods and services
(where households are buyers and firms are sellers) and in the markets for the factors of
production (where firms are buyers and households are sellers). The outer set of arrows shows
the flow of dollars, and the inner set of arrows shows the corresponding flow of goods and
services.

2.6. Central problems of an economic system

What to produce?

This is the determination of the product mixes in the economic system. The product mix is the
combination of different types of goods and services in the economy. Goods are of different
types. Capital goods are produced so that they can be used to produce other goods. If you buy
a car and use it to generate money as a taxi, it is capital. If it is for final use such as moving
around with your friends then it is not capital. It is a consumer good. Capital goods are also
called investment goods.

Capital and consumer goods can be durable or non-durable. Durable goods are hard and
tensile. They cannot be easily destroyed. Tables, fridges, cars and chairs are durable goods.
Non-durable goods are not hard they can be broken or destroyed. Non -durable goods are like
milk, fruit and food items. They can be consumed and perish in production or consumption.

Services are either economic or social. Roads and provision of electricity are economic
services. Health and education are social services. Collective services are services that are used
by the public without discrimination. These are like market places. These are different from
services such as medical attention that are received at individual level.

The product mix differs from one economy to another. In developed industrialised countries
like the U.S more capital goods or industrial goods are produced. In poorer countries like
Rwanda more consumer goods are produced. These are mainly agricultural products. Goods
from the agricultural and extractive sectors are called primary goods. Most goods from the
industry are manufactured or form secondary production. The tertiary sector produces services.

How to produce?

How to produce is about techniques of production. In production we use more of capital

relative to less of labour or use more labour relative to capital. Using more capital relative to
labour is called a capital-intensive technique of production. Using more labour relative to
capital is labour - intensive technique of production.

At RICA it is possible to choose between two of the techniques of production when wanting to
cut grass on campus. They can employ 40 labourers to cut grass using ‘slashers”. The choice
would be a labour-intensive technique. Alternatively, the University can purchase one
motorised lawn mower, buy some petrol, and hire one driver. The latter will be a capital-
intensive technique. The first choice may be important because it will employ people and does
not need skills or machinery. The latter may be more efficient where capital is available and
relatively cheaper.

Ideally poorer countries like Rwanda prefer labour intensive techniques because they have
labour in abundance and capital is scarce. Sometimes industries in poor countries are capital
intensive because of the types of technologies that are available on the market or because those
who choose the techniques prefer capital-intensive methods. It is believed engineers even in
developing countries like capital-intensive techniques. Capitalist oriented managers prefer
capital-intensive techniques as well because they say ‘machines do not go on strike’

For whom to produce?

This problem of the economic system is about distribution. Who gets what in the economy? If
production is biased towards production of goods that meet the needs of the rich, then the
economic system favours the upper stratum of society. If a larger proportion of resources are
directed to producing wine instead of food, then distribution in the economy will be skewed in
favour of the rich.

Distribution may also between men and women. In many societies including Rwanda, women
have often been discriminated in production, employment, and consumption. Girls may be
denied going to secondary and universities, while most boys have unlimited access to
education. Unequal and inegalitarian income distribution in society may bring tension in
society and is not desirable in many societies.

In the economy income disparities may also be by regions. The economic system would
normally try to minimise wide differences between provinces or in provinces between districts.
It may be important to promote rural industries to reduce the gap between urban and rural
sectors. Some poorer provinces of Rwanda may need to be helped in order to allow its residents
realise decent standards of living.

Income and distribution policy as well as taxation can be used to reduce disparities between
incomes of different categories of people. A wide gap between the highest and lowest pay is a
problem that the economic system should address. Likewise, disparities may be between
different age groups.

2.7. Production possibility curve

A production possibilities frontier, or PPF, defines the set of possible combinations of goods
and services a society can produce given the resources available. It is used to show the tradeoffs
associated with allocating resources between the production of two goods. The PPC can be
used to illustrate the concepts of scarcity, opportunity cost, efficiency, inefficiency, economic
growth, and contractions. It shows how the economic system can be simplified and how the
different questions can be answered using diagrams and simple arithmetic. Gen erally, it
illustrates the variations in the amounts that can be produced of two products if both depend
upon the same finite resource for their manufacture. It is a method that is also used to explain
the concept of scarcity, choice and opportunity costs that were considered in Chapter one.

The PPC is an ideal method using hypothetical cases to show how an economic system works
and particularly how the choice is made while allocating scarce resources. It is based on the
following assumptions
 • Factors of production are fixed in total supply. The resources can be allocated among
different types of production
• Technology is constant
• Economy operates efficiently and resources are fully employed
• Only two products are produced

It is a model that captures scarcity and the opportunity costs of choices when faced with the
possibility of producing two goods or services. Points on the interior of the PPC are inefficient,
points on the PPC are efficient, and points beyond the PPC are unattainable. The opportunity
cost of moving from one efficient combination of production to another efficient combination
of production is how much of one good is given up in order to get more of the other good.

In business analysis, the PPF operates under the assumption that the production of one
commodity can only increase if the production of the other commodity decreases, due to limited
available resources. Thus, PPF measures the efficiency with which two commodities can be
produced simultaneously.

This information is of importance to managers seeking to determine the precise mix of goods
that most benefits a company's bottom line. The PPF assumes that technological infrastructure
is constant and underlines the notion that opportunity costs typically arise when an economic
organization with limited resources must decide between two products. However, the PPF
curve does not apply to companies that produce three or more products vying for the same
resource.

Let us start explaining the concept of Production Possibility Frontier as represented by a

hypothetical schedule of producing food and clothing

Table 1: Production Possibility Schedule

Choices Food (000s kg) Clothing (000s m)

A 1000 0
B 750 125
C 500 250
D 250 375
E 0 500

A-E are possible choices of production. Suppose an economy produces only two types of
goods, food items and clothes. Even if it put all of its resources (land, labour, capital and
enterprise) into making food items, there must be a maximum number of goods that can be
produced; from the table it’s 1,000,000Kgs. Now because all the resources are used in
producing foods; there are none left for clothes, hence the output for clothes will be zero.
Alternatively, resources may be used to produce 500,000 tons of clothing and no food. Neither
of these two extreme cases are likely choices. Society will choose to produce some food and
some clothing. Choices will differ from one society to another. Line AE represents a set of
such choices and is what is called the Production Possibility Frontier.

Food

1000 A

750 B

500 C

250 D

0 125 250 375 500 E

Clothing

But most likely then shape of the possibility frontier will not be linear. Instead, the PPF is
graphically depicted as an arc, with one commodity represented on the X-axis and the other
represented on the Y-axis. Each point on the arc shows the most efficient number of the two
commodities that can be produced with available resources. The shape of the PPC also gives
the information on the production technology (in other words, how the resources are combined
to produce these goods). The bowed out shape of the PPC in figure below indicates that there
are increasing opportunity costs of production.
Diagram: What to produce?

1000

Food 750 A

500 B

250 C

125 250 375 500

Clothing

It is now possible to answer some of the central questions of the economic system using the
PPC. What to produce can be illustrated by any PPC and is represented by all points on the
curve. Any choice on the curve represents a mix of different commodities. Thus, if the diagram
is retained but goods are changed to represent clothing and food, then any choice represents
different combination of clothing and food. According to the PPF, points A, B, and C on the
PPF curve represent the most efficient use of resources by the economy. Point blue in the
diagram represents an inefficient use of resources, while the curve beyond points A, B and C
represents a goal that the economy simply cannot attain with its present levels of resources.

Therefore, the PPC is a simplified way of showing how the economic system works. In reality
it is more complex. Societies do not produce two goods only. They produce thousands.
Technology cannot be held as constant. It also changes. But in a simplified way it shows us the
central problems of any economic system. The choices would differ between a capitalist and
socialist economy.

2.8. The supply and demand relations in Agriculture

From a demand and supply perspective, agricultural products fall into three broad groups: food,
raw materials and non-food consumer goods such as cut flowers, trees and shrubs etc. The
concepts of demand and supply can be applied both at the level of an individual unit (the
consumer or the firm) and at the level of the industry or market. As every market co mprises a
large number of individual consumers interacting with suppliers, the market demand curve is
the sum of all quantities demanded by individual consumers, for any price level.
Supply is a term that describes the number of goods or services that all producers are ready to
offer on the market at a given period and price. On the other hand, demand refers to the number
of goods or services that customers are ready to buy at a given period and for a certain price.

In a highly competitive market, every f armer is chasing his/her own opportunity for success.
Not only are farmers striving to produce high yield and deliver quality crops to the market but
also, sell their goods and finally, achieve higher profit. Farmers are therefore faced with a
challenge to survive on the market.

Regarding the relation between supply and demand, a farmer should know two important
things:

1. The relation between supply and demand will determine the market price of goods or
services

This has huge implication. Suppose a farmer that is growing watermelon decides to set a low
price, obviously the demand for his/her watermelon will increase sharply, because it’s
relatively cheap. Alternatively, if a farmer sets a price for watermelon which is too high, the
demand will decrease.

2. The market price will determine the supply and demand of products or services

From the example above, if the market price for watermelon is high, the interest of the same
farmer will increase. In other words, the supply will increase. Also, if the market price is low,
the interest of consumers increases, which means that demand increases.

3. Equilibrium point

Supply and demand, as well as market prices, will rise and fall until they achieve a balance,
which is called market equilibrium. For example, if orange prices are too high, most consumers
will choose another fruit (let say mangoes) at a more affordable price. As a response to
declining sales, farmers will have to lower the prices until the demand for oranges increases
again. When the demand for oranges is balanced with the supply, the market is at its
equilibrium.