CHAPTER TWO

FUNDAMENTAL ECONOMIC CONCEPTS

2.1 Equilibrium Analysis: Supply and Demand Relationship
Demand shows how buyers respond to changes in price and other variables that determine
quantities buyers are willing and able to purchase. Supply shows how sellers respond to changes
in price and other variables that determine quantities offered for sale. The interaction of buyers
and sellers in the market place leads to market equilibrium. Market equilibrium is a situation in
which, at the prevailing price, consumers can buy all of a good they wish and producers can sell
all of the good they wish.

Equilibrium Price: The price at which Qd= Qs

Equilibrium Quantity: The amount of a good bought and sold in market equilibrium
Excess Supply (Surplus): Exist when quantity supplied exceeds quantity demanded
(current price is above equilibrium price).
Excess demand (shortage): Exist when quantity exceeds quantity supplied (current price
is below equilibrium price).
Market clearing price: The price of a good at which buyers can purchase all they want
and sellers can sell all they want at that price. This is another name for the equilibrium
price.

Example: suppose the supply and demand equation for bread in Hawassa city on a given day
reveals the following
DD: P=1000-5q (-ve slope)
SS: P=200+3q (+ve slope)
a) Find the market equilibrium price and quantity
b) Plot the demand and supply equation on a graph

Solution
a) At the equilibrium DD=SS: 1000 - 5q = 200+3q
1000 - 200 = 5q+3q
Q= 100 units, at which the demand and supply for bread is equilibrium

Fundamental Economic Concepts Page 1

The price at the equilibrium can be calculated by making a substitution of equilibrium quantity in
the demand or supply function.

P=1000-5q

= 1000-5(q)

= 500 birr

We can also substitute with the supply function to find the equilibrium price

2.2 Marginal Analysis

Marginal analysis is one of the most useful concepts of economic decision making. Resource-
allocation decisions typically are expressed in terms of the marginal conditions that must be
satisfied to attain an optimal solution. The term ‘marginal’ refers to the change (increase or
decrease) in the total of any quantity due to a one unit change in its determinant. For example,
the total cost of production of a commodity depends on the number of units produced. The
familiar profit-maximization rule for the firm of setting output at the point where “marginal cost
equals marginal revenue” is one such example. Long-term investment decisions (capital
expenditures) also are made using marginal analysis decision rules. If the expected return from
an investment project (that is, the marginal return to the firm) exceeds the cost of funds that
must be acquired to finance the project (the marginal cost of capital), then the project should be
undertaken. Following this important marginal decision rule leads to the maximization of
shareholder wealth.

In the marginal analysis framework, resource-allocation decisions are made by comparing the
marginal (or incremental) benefits of a change in the level of an activity with the marginal (or
incremental) costs of the change. Marginal benefit is defined as the change in total benefits that
are derived from undertaking some economic activity. Similarly, marginal cost is defined as the
change in total costs that occurs from undertaking some economic activity. In summary,
marginal analysis instructs decision makers to determine the additional (marginal) costs and
additional (marginal) benefits associated with a proposed action. Only if the marginal benefits
exceed the marginal costs (that is, if net marginal benefits are positive) should the action be
taken.

Fundamental Economic Concepts Page 2

This analysis of marginal revenue equips us for the task of finding the maximum profit
equilibrium of the firm. Until that to maximize profits, the firm must find the equilibrium price
and quantity, which gives the largest profit or the largest difference between TR and TC. Some
reflections will tells us that this maximum profit will occur when output has expanded to just the
point where the firm’s MR is equal to MC, as it is shown by the data in table 2.1.

Table 2.1 Equating Marginal Cost to Marginal Revenue gives Firm’s Maximum-Profit

(1) (2) (3) (4) (5) (6) (7)

Quantity Price TR=p*q TC T profit MR MC
q P
0 $200 0 145 - 145 - MR>MC
1 $180 180 175 +5 +180 30
2 160 320 200 +120 +140 25
3 140 420 220 +200 + 100 20
4 120 460 260 +230 + 40 40 MR=MC
5 100 500 300 +200 +20 40
6 80 480 370 +110 - 20 70
7 60 - 460 -40 - 60 90
8 40 320 570 -250 - 100 110 MR<MC
MC= TCn-TCn-1

MR=TRn-TRn-1

Table 2:1 shows the optimal quantity and price that will maximize total profit. Column (5) tells
us that the optimal quantity, which is 4 units, requires a price of $ 120 per unit. This produces TR
of $ 480 and after subtracting TC of $ 250 we calculate total profit to be $230. At this level of
maximum profit MR equals to MC. Moreover as we understand from the table as long as MR is
greater than MC the firm's profit is increasing. So the firm would continue to increase output. By
contrast, suppose that at a give level of output MR is less than MC which means that increasing
output would lead to lower profit, so the profit maximizing firm should at that point get back on
cutting output.

Fundamental Economic Concepts Page 3

The decision Rule: The decision rule under the marginal principle is that a business activity
must be carried out so long as it is MR>MC. The necessary condition for profit maximization is
that MC must be equal to MR.

That is, profit is maximum where MR=MC

Marginal versus Incremental concepts:

The marginal concept is a key component of the economic decision-making process. It is
important to recognize, however, that marginal relations measure only the effect associated with
unitary changes in output or some other important decision variable. Many managerial decisions
involve a consideration of changes that are broader in scope. For example, a manager might be
interested in analyzing the potential effects on revenues, costs, and profits of a 25 percent
increase in the firm’s production level. Alternatively, a manager might want to analyze the profit
impact of introducing an entirely new product line, or assess the cost impact of changing the
entire production system. In all managerial decisions, the study of differences or changes is the
key element in the selection of an optimal course of action. The marginal concept, although
correct for analyzing unitary changes, is too narrow to provide a general methodology for
evaluating alternative courses of action.

The incremental concept is the economist’s generalization of the marginal concept. Incremental
analysis involves examining the impact of alternative managerial decisions or courses of action
on revenues, costs, and profit. It focuses on changes or differences between the available
alternatives. The incremental change is the change resulting from a given managerial decision.
For example, the incremental revenue of a new item in a firm’s product line is measured as the
difference between the firm’s total revenue before and after the new product is introduced.
Incremental Profits
Fundamental relations of incremental analysis are essentially the same as those of marginal
analysis. Incremental profit is the profit gain or loss associated with a given managerial decision.
Total profit increases so long as incremental profit is positive. When incremental profit is
negative, total profit declines. Similarly, incremental profit is positive (and total profit increases)
if the incremental revenue associated with a decision exceeds the incremental cost. The
incremental concept is so intuitively obvious that it is easy to overlook both its significance in

Fundamental Economic Concepts Page 4

managerial decision making and the potential for difficulty in correctly applying it. For this
reason, the incremental concept is often violated in practice.
2.3 Time Value of Money
Time perspective in business decision
To achieve the objective of shareholder wealth maximization, a set of appropriate decision rules
must be specified. We just saw that the decision rule of setting marginal revenue (benefit) equal
to marginal cost (MR = MC) provides a framework for making many important resource-
allocation decisions. The MR =MC rule is best suited for situations when the costs and benefits
occur at approximately the same time. Many economic decisions require that costs be incurred
immediately but result in a stream of benefits over several future time periods which necessitate
the time value of money concept.
All business decisions are taken with a certain time perspective. The time perspective refers to
the duration of time period extending from the relevant past and foreseeable future taken in view
while taking a business decision. All business decisions do not have the same time perspective.
Some business decisions have short run repercussions and, therefore, involve short run time
perspective. There are also large numbers of business decisions which have long run
repercussions (e.g., investment in plant, machinery, land, scale of production, introduction of
new product) and implication which makes a well worked out time perspective view an
immensely important aspect. The business decision makers must assess and determine the time
perspective of business proposition well in advance and make decisions accordingly.
Determination of time perspective is of a great importance especially where projections are
involved. The decision maker must decide on an appropriate future period for projecting the
value of a variable.
A dollar received in the future is worth less than a dollar in hand today because a dollar today
can be invested to earn a return immediately. Therefore, to compare a dollar received in the
future with a dollar in hand today, it is necessary to multiply the future dollar by a discount
factor that reflects the alternative investment opportunities that are available.

In summary, Present value recognizes that a dollar received in the future is worth less than a
dollar in hand today, because a dollar today could be invested to earn a return. To compare a sum
of money in the future with today, the future dollars must be discounted by a present value

Fundamental Economic Concepts Page 5

interest factor, PVIF = 1/(1+i), where i is the interest compensation for postponing receiving
cash one period. For dollars received in n periods, the discount factor is PVIFn = [1/(1+i)]n.
2.3.1 Simple Interest

If interest is paid on the initial amount of money invested or borrowed only and not on
subsequently accrued interest, it is called simple interest.

I = prt ….. ----------------------------------(1)

Where: I = Simple interest P = principal amount r = Annual simple interest rate t =

Future Value = PV (1 + rt) ………………………………………(2)

A
Present value = 1+ rt ……………(3); where A is future value

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

Solution:

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

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

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

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

Interest (I) = Prt = Br. 10, 450

= 10, 000 x 0.06 x ¾

= Br. 450

Fundamental Economic Concepts Page 6

2.3.2 Compound Interest

If the interest, which is due, is added to the principal at the end of each interest period (such as a
month, quarter, and year), then this interest as well as the principal will earn interest during the
next period. In such a case, the interest is said to be compounded. The result of compounding
interest is that starting with the second compounding period, the account earns interest on
interest in addition to earning interest on principal during the next payment period. Interest paid
on interest reinvested is called compound interest.

The sum of the original principal and all the interest earned is the compound amount.

The compound interest method is generally used in long-term borrowing unlike that of the
simple interest used only for short-term borrowings. The time interval between successive
conversions of interest into principal is called the interest period, or conversion period, or
Compounding period, and may be any convenient length of time. The interest rate is usually
quoted as an annual rate and must be converted to appropriate rate per conversion period for
computational purposes. Hence, the rate per compound period (i) is found by dividing the annual
nominal rate (r) by the number of compounding periods per year (m):

i = r/m

Example if r = 12%, i is calculated as follows:

Conversion period (m) Rate per compound period (i)

1. Annually (once a year) -------------------------------- i = r/1 = 0.12/1 = 0.12

2. Semi annually (every 6 months) --------------------- i = r/2 = 0.12/2 = 0.06

3. Quarterly (every 3 months) -------------------------- i = r/4 = 0.12/4 = 0.03

4. Monthly ------------------------------------------------- i = r/12 = 0.12/12 = 0.01

A = P (1 + i)n
………….* Compound amount formula.

Fundamental Economic Concepts Page 7

Where: A = amount (future value) P = Principal (present value)

i = r/m = Rate per compounding period. n = mt = conversion periods

t = total number of years m = no. of compounding/ periods per Year

r = annual nominal rate of interest

Example 1

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

Solution
P = Br. 10, 000

r = 12%

t = 1 year

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

i = r/m 12%/4 = 3%

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

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

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

= Br. 11, 255.088

Compound Interest = Compound amount – original principal

= 11, 225.088 – 10, 000

Fundamental Economic Concepts Page 8

 = Br. 1, 255.088

The present value

Frequently it is necessary to determine the principal P which must be invested now at a given
rate of interest per conversion period in order that the compound amount A be accumulated at the
end of n conversion periods. Under these conditions, p is called the present value of A. This
process is called discounting and the principal is now a discounted value of future income A. If:

A = P (1 + i)n then dividing both sides by (1 + i)n leads to

A
n
P = ( 1+i) = A (1 + i)-n
P = A (1 + i) -n
……… ………* Present value of compound amount.

Where P= present value

A= Future value

Example 4. How much should you invest now at 8% compounded semiannually to have

Br. 10, 000 toward your brother’s college education in 10 years?

Solution

A = Br. 10, 000 P = A (1 + i)-n

t = 10 years = 10, 000 (1.04)-20

m=2 = 10, 000 (0.456387)

n = mt = 20 = Br. 4563.87

r = 8%

i = r/m = 4% = 0.04

p=?

Fundamental Economic Concepts Page 9

2.3.3 ANNUITIES

An annuity is any sequence of equal periodic payments. If payments are made at the end of each
payment period, the annuity is called an ordinary annuity. If payment is made at the beginning
of the payment period, it is called annuity due. In this course we will discuss only ordinary
annuities.

The term of an annuity refers to the time from the beginning of the first payment period to the
end of the last payment period.

Ordinary Annuity

An ordinary annuity is a series of equal periodic payments in which each payment is made at the
end of the period. In an ordinary annuity the first payment is not considered in interest
calculation for the first period because it is paid at the end of the first period for which interest is
calculated. Similarly, the last payment does not qualify for interest at all since the value of the
annuity is computed immediately after the last payment is received.

Future value (Amount) of an ordinary annuity

The amount, or future value, of an annuity is the sum of all payments plus the interest earned
during the term of the annuity

A=R
[ (1 + i )n − 1
i ]
………………..* Amount of an ordinary annuity

Where: A = Amount (future value) of an ordinary annuity at the end of its term

R = Amount of periodic payment

i = interest rate per payment period

n = (mt) total no. of payment periods

Fundamental Economic Concepts Page 10

Example What is the amount of an annuity if the size of each payment is Br. 100 payable at the end of
each quarter for one year at an interest rate of 4% compounded quarterly?

Solution

Periodic payment (R) = Br. 100
Payment interval (Conversion period) = quarter
Nominal (annual rate) = r = 4%
Interest per conversion period (i) = r/m = 4%/4 =
1%
Future value of an annuity =?

A=
[
100 ( 1.01 )4 − 1
0.01 ]
= Br. 406.04

Example 2 A person deposits Br. 200 a month for four years into an account that pays 7%
compounded monthly. After the four years, the person leaves the account untouched
for an additional six years. What is the balance after the 10 year period?

Solution:

R = Br. 200 Amount after

t = 4 years
m = 12 4 years (A4)= 200
[(1 + 0 . 07/12)48 − 1
0 .07 /12 ]
n = mt = 4 x 12 = 48 = 200 (55.20924)

r = 7%
i = 7%/12 = 0.07/12

After the end of the fourth year, we calculate compound interest rate taking Br. 11, 041.85 as
principal compounded monthly for the coming 6 years.

p = 11, 041.85 A10 = 11, 041.85 (1 + 0.07/12)72

t = 6 years = 11, 041.85 (1.5201

Fundamental Economic Concepts Page 11

 m = 12 = Br. 16, 784.77

n = 6 x 12 = 72

r = 7% i = r/m = 7%/12 = 0.07/12 A10 = ?

Therefore, the balance after 10 years is Br. 16, 784.77.

Present value of an ordinary annuity

The present value of an ordinary annuity is the sum of the present values of all the payments,
each discounted to the beginning of the term of the annuity. It represents the amount that must be
invested now to purchase the payments due in the future.

The present value of an annuity can be computed in two ways:

 Discounting all periodic payments to the present (beginning of the term individually) or
 Discounting the future value (amount) of an annuity to the beginning of the term

P=R
[
1 − (1 + i)−n
i ] …………………..* Present value of an ordinary annuity.

R = periodic payment P = present value I = interest n = payment period

Example What is the present value of an annuity if the size of each payment is Br. 200 payable at the
end of each quarter for one year and the interest rate is 8% compounded quarterly?

Solution:

R = Br. 200

r = 8%, m=4 i = 2% n=4 p=?

R = Br. 200

r = 8%, i = 2%
P=R
[
1 − (1 + i)−n
i ]
m=4

t=4
= 200
[
1 − (1.02)−4
0.02 ]
Fundamental Economic Concepts = 200 (3.80773)
Page 12 761.56
Example What is the present value of an annuity that pays Br. 400 a month for the next five
years if money is worth 12% compounded monthly?

Solution:

R = Br. 400

t = 5 years P=R
[
1 − (1 + i)−n
i ]
[ ]
m = 12
1 − (1.01)−60
= 400 0.01
n = 12 x 5 = 60

r = 12% = 400 (44.955037)

i = 12%/12 = 1% = 0.01

p=?

• An annuity whose payments occur at the end of each period is called ordinary annuities. The
Formulas above are for ordinary annuities.
• If each payment occurs at the beginning of the period rather than at the end, then we have an
annuity due.

Fundamental Economic Concepts Page 13