Introduction to Economics

(Econ. 101)

By Eyasu kumera

April, 2010

1
Chapter 2: Micro Economics

2
Micro Economics: Major Topics

2.1. Theory of Demand and Supply

2.2. Theory of Consumer Behavior

2.3. Theory of Production

2.4. Theory of Cost

2.5. Analysis of Market Structure

3
Micro Economics: Major Topics

2.1. Theory of Demand & Supply

2.1.1. Demand Analysis

2.1.2. Supply Analysis

2.1.3. Market Equilibrium

2.1.4. Elasticities
4
2.1. Theory of Demand and Supply
2.1.1. Demand Analysis
Demand
one side of a product or factor market.

is a willingness and ability of a consumer to

purchase goods and services at specific
price within a set of possible prices at a
given period of time

Law of demand: price of a commodity and

its quantity demanded are inversely related,
ceteris paribus (Price is not the only factor that affects
supply of quantity demanded, however it is the major factor)
Ceteris paribus means keeping other factors constant. 5
 Quantity demanded of a commodity is the amount of
the commodity willing to be purchased at a given price level.

Demand Curve: shows the relationship between the

quantity demanded of the commodity at different price levels

Demand Curve
Birr
1. A decrease
in price...

Demand Schedule
2. ... increases quantity 6
demanded.
 2.1.1.1. Non- Price Determinants of Demand
These cause a right ward (left ward) shift of the
demand curve to indicate an increase (a decrease) in
demand. The factors are described as follows:
A) Change in Tastes and Preferences
What was once perceived as useful or useless,
stylish or ugly, healthy or dangerous now can become
its opposite & can affect demand
Ex: You currently drink a branded milk (protein) shake for breakfast
every day. Research indicates that ingredients in that shake cause cancer.
B) Change in income
Having more or less to spend affects individual
demand schedules.
Increase in income leads demands schedule to
shift rightward for normal goods and leftward to 7
inferior goods
Normal good: When income rises the demand
for the product will increase & when income falls the
demand for the commodity decreases, ceteris
paribus.
Ex. House, DVD players, Refrigerators etc
Inferior good: When income rises the demand
for the product will decrease, ceteris paribus.
Ex1. Shift from tea & bread to milk & burger
consumption as income rises
Ex2. Shift from using public bus to either Taxi, own car,

etc. as income increases

C) Change in Prices of Related Goods
If two goods are related, then the change in
price of one good affects demand for the other & the
relation could be “substitute” or “complementary”. 8
1. Substitutes --Two goods are considered
substitutes if they satisfy the same needs or desires
separately like, Pepsi cola and coca cola, Pork and
Beef and coffee and tea etc.
2. Complements -- if they are used or consumed
jointly to satisfy the needs of the consumer. Example:
Sugar and tea, car and petrol, etc.

9
 Substitute good •When price of its
substitute good (coffee)
increases (decreases)
demand for the commodity
(Tea) increases
(decreases), ceteris
paribus.
•Positive relation (upward
(Coffee)
sloping graph)

(Tea)
•As price of its
Complementary complementary good (Sugar)
increases (decreases)
demand for that commodity
good (Tea) decreases (increases),
ceteris paribus.
•Negative relation (downward
sloping graph)
(Sugar)

(Tea) 10
Factors Affecting …
D) Change in Number of Buyers
As population increases, the demand for
goods increases as well because each
member of the population has needs to be
filled.
Ex: Everybody wears clothes, the more people there
are the greater demand will be for clothes.
E) Expectation of Consumers:
Purchases may be postponed or rushed
dependent on the expectations of future price
changes
Ex: You want to buy a house but expect housing
prices in the area to keep falling for the next 18
months. Despite wanting to buy a house your effective
demand is currently zero. 11
2.1.1.2. Change in Quantity Demanded and
Change in Demand
•The demand curve is derived under the
A. Change in Quantity
Demanded assumption of Ceteris Paribus (other things
remain constant). In this case we observe
change in quantity demanded simply
because of change in the price of a
commodity, and the demand curve remained
unchanged (not shifted)

•Change in Quantity Demanded

(Movement along the same
demand line)

12
Example:
Price of
needle
A tax that raises the
price of needle results
Birr B
2.00 in a movement along
the demand curve.

1.00 A

D
0 4 8 Quantity of needle
13
B. Change in Demand (Shift in Demand
Curve)
If the price of a commodity (own price) remains
constant and one or more of those other factors
affecting demand (e.g., income, taste and
preference, prices of other goods, expectation and
number of consumers) change, then the demand
curve shifts from its position either to the right or to
the left.

Thus, when the demand curve changes its

position we call it change in demand (shift in
demand) 14
 Change in Demand
(Shift in Demand Curve)

Price of
Teff

Increase
in demand

Decrease
in demand
Demand
curve, D2
Demand
curve, D1
Demand curve, D3
0 Q1 Q0 Q2 Quantity of Teff
15
2.1.1.3. Individual and Market Demand Curve

Individual demand curve is the amount of

goods that a single consumer is willing and able
to buy at different price levels over certain time
period.

Market demand refers to the sum of all

individual demands for a particular good or
service.

Market Demand Curve is a horizontal

summation of individual demand curves.
16
Price Individual Demand Curves

Abebe Bekele
Qtty

Price

Qtty

Total
Market Demand Curve 17
 2.1.2. Supply Analysis
Is also one side of a product or factor market

Supply is the amount of goods and services

that businesses are willing and able to produce at
different prices during a certain period of time.

Law of supply: the quantity supplied of a

commodity varies directly with the price of that
commodity, ceteris paribus.

18
 Quantity supplied of a commodity is the amount of
commodity that a producer supplies to the market at a given
price level.
Supply Curve: shows the relationship between the
quantity supplied of the commodity at different price levels.
Example:

Birr
1. An
increase
in price ...

2. ... increases quantity of bread supplied.

Supply Schedule 19
Supply Curve
2.1.2.1. Factors Affecting Supply
A) Change in Prices of Production Substitutes
If price of a good increases other things remain constant, producers
decrease the production of its substitute. The vice versa is also true.
B) Change in Prices of Factor Inputs
Other things being constant, an increase (decrease) in the price of
factors of production causes an increase (decrease) in cost of
production.
C) Change in technology
The development of the new method of production or the invention of
efficient machines may make possible a big expansion of output at a
lower cost and so causes supply to increase.
D) Taxes and Subsidies
Taxes are a compulsory payment imposed on producers or consumers.
Subsidies are some amount of money given to producers or consumers to
supplement their expenditure. An increase (decrease) in tax, other thing being
constant, causes supply to decrease (increase), because producers feel as if their
cost of production were increased (decreased). If subsidy to producers increases
(decreases), then supply will increase (decrease) because producers feel as if
their cost of production were decreased (increased) thereby causing profit to
increase (decrease). 20
E) Number of Sellers/Producers
As number of firms producing a good increases more and more
goods will be supplied.
F) Expectation of Change in Price
Expectation of higher price in the future may cause decrease in
current supply as producers store their outputs to sell them later at a
higher price assuming other things being constant. Quantity of goods
kept in store is not considered as a supply. Goods are considered as a
supply only when they are brought to the market.
G) Market Organization
If a market for certain commodity is monopolized (i.e., there is only a
single producer) then a producer charges higher price by producing
few outputs, because, the producer faces no competition. If a market
for certain commodity is characterized by a perfect competition (many
producers and sellers), then producers produce more outputs,
because, there is no possibility of increasing price to increase revenue
H) Weather
For some products, especially agricultural products weather affects
the quantity to be supplied. Favorable (unfavorable) weather increases
(decreases) supply of agricultural outputs.
21
 2.1.2.2. Change in Quantity Supplied and
Change in Supply
A. Change in Quantity Supplied

Change in quantity supplied

(movement along the same supply curve caused by
price change) 22
B. Change in Supply

Change in Supply (Shift in the supply curve)

If we fix price of a commodity (own price) constant and vary any of those other
factors affecting supply (e.g. Prices of production substitute and inputs,
technological state, tax and subsidy, no of producers, producers' expectation
and weather) then the supply curve changes its position, i.e., the supply curve
shifts.
23
2.1.2.3. Individual and Market Supply Curve

Individual Supply Curve shows the quantity that a single producer is willing and able to
supply at each price level over certain period of time. Market Supply Curve shows the total
amount of particular commodity supplied by all producers at each price level.

Graphically,
individual supply
curves are summed
horizontally to obtain
the market supply
curve.

24
2.1.3. MARKET EQUILIBRIUM

Refers to a situation in which the price has

reached the level where quantity supplied
equals quantity demanded.

The prices at which both demand and supply

curves intersect is the equilibrium price.

Equilibrium price : The price that balances

quantity supplied and quantity demanded.

Equilibrium quantity : The quantity supplied

and the quantity demanded at the equilibrium
price.
25
 SUPPLY AND DEMAND TOGETHER
Demand Schedule Supply Schedule
Bread price Quantity
Bread price Quantity

•At $2.00, the quantity demanded is equal to the quantity supplied!

•From our demand and supply analyses, we know that consumers tend to buy
more of the goods as price falls while producers tend to sell more as price
increases. Thus, consumers need price to fall while producers need price to
(rise). Equilibrium point is the point where consumers and suppliers agree.
26
 MARKET EQUILIBRIUM

Price of
Bread Supply
Excess Supply

$2.50
Equilibrium Equilibrium
2.00 price

1.50
Excess Demand
Equilibrium Demand
quantity

0 4 7 10 Quantity of Bread
Quantity Quantity
demanded supplied
27
 2.1.3.1. Effects of Change in Demand or
Supply on the Market Equilibrium
1. Effects of an increase in Demand when Supply Remains Unchanged

An increase in demand (shift

of the demand curve from D0
D0 to D1D1) supply being
unchanged causes equilibrium
point to change from e to e1.
In this case the new
equilibrium point (point e1) is
attained both at a higher price
and quantity than the initial
equilibrium (point e).

28
2. Effects of an increase in supply when demand remains unchanged

An increase in supply (shift of

supply curve from S0S0 to S1
S1) assuming demand not to
change causes equilibrium
point to change from point e to
e1. As a result equilibrium
price decreases from P0 to P1
and equilibrium quantity sold
or bought increases from Q0
to Q1, i.e., the new equilibrium
is attained at a lower price but
higher quantity than before.

29
3. Effects of a decrease in supply when demand remains unchanged

Decrease in supply (shift of

the curve from S1 S1 to
S0S0) assuming demand
being unchanged causes
equilibrium point to change
from e1 to e. That is to say the
new equilibrium point e is
attained at higher price but
lower quantity level than
before.

30
4. Effects of increase in demand by more proportion than supply increase

If demand increases by more

proportion than the supply, the
new equilibrium (e1) is
attained at both higher
equilibrium price and quantity
than before. Thus, the new
equilibrium quantity (Q1) is
greater than the previous
equilibrium quantity (Q0) and
the new equilibrium price (P1)
is also greater than the
previous equilibrium price
(P0).

31
5. Effects of increase in supply by more proportion than demand increase

If supply increases by more

proportion than demand, then
the new equilibrium (e1) is
attained at a higher equilibrium
quantity (Q1) than previous
quantity (Q0) but at a lower
equilibrium price (P1) than the
previous price (P0).

32
6. Effects of increase in supply and demand by equal proportion

If both demand and supply

increases by an equal
proportion the new equilibrium
quantity is attained at a higher
level than the initial equilibrium
quantity. But equilibrium price
remains unchanged.

33
 Result of Shifts in Supply and Demand

Equilibrium Equilibrium
Demand Supply
Price Quantity

+   + +
-   - -
  + - +
  - + -
+ + ? +
- - ? -
+ - + ?
- + - ? 34
We can also represent the supply-demand curves
by SS & DD equations.

Ex1: if demand is given by : P = 60 – Q

and supply is given by: P = 10 + 4Q
to find the equilibrium price and quantity,
simply set both equations equal to each other
10 + 4Q = 60 – Q …..> Q= 10, P= 50

Ex.2. D = 100 - 6P, S = 28 + 3P ;

D =demand, S =supply, P = price, Q=quantity
100 - 6P = 28 + 3P
P= 8, Q= 52
35
2.1.4 Elasticity of Demand
 Elasticity is a measure of how much buyers and sellers
respond to changes in market condition.

 Elasticity of demand is defined as a measure of how

much the quantity demanded of a good responds to a
change determinants of demand including price of a
product.
 is the percentage change in quantity demanded given
a percent change in determinants of demand
including the price.

 3 types of elasticity of Demand

1. Price elasticity of demand
2. Income elasticity of demand
3. Cross-price elasticity of demand 36
2.1.4.1. Price elasticity of demand
 It is a concept that measures by how much
percent will quantity demanded changes when its
price changes by certain percent, i.e.,
Ep = Percentage change in quantity demanded = (Q/Q) x 100
Percentage change in price (P/P) x 100

but Q = Q2 - Q1 and
P = P2 - P1
Where Q2 and Q1 are quantity demanded of
a commodity at price level P2 and P1
respectively
37
 Ep = [(Q2 - Q1)/Q1] x 100
[(P2 - P1)/P1] x 100

Ep = (Q2 - Q1) x P1 = (Q2 - Q1) x P1

Q1 P2-P1 (P2- P1) Q1
Ex: Calculate 'point" price elasticity of demand

Demand schedule for barley Point Price Quantity

Demanded
A 15 20
B 10 30
C 5 40
1.Considering movement from point A to B, i.e.,
Ep = Q2 - Q1 x P1 = (30 - 20) x 15 = / -1.5 / = 1.5
P2 - P1 Q1 (10 - 15) 20

2. Considering movement from point B to A, i.e.,

Ep = Q2 - Q1 x P1 = 20 - 30 x 10 = / -0.67/ = 0.67
38
P2 - P1 Q1 15-10 30
One of the problems of using point price elasticity
is that it yields two different values of elasticity
depending on the direction of our movement.

To avoid this discrepancy in value of elasticity it is

better to use "arc" or" average" elasticity which
takes the average price and average quantity as a
base for computation.

Let's see mathematical derivation of arc elasticity of demand as follows:

(Q2  Q1 ) / Q2  Q1
ep 
2
( P2  P1 ) / P1  P2
2 39
 (Q2  Q1 ) / Q2  Q1
ep 
2
( P2  P1 ) / P1  P2
2

Ep = 2 (Q2 - Q1) x (P1 + P2)

(Q2 + Q1) 2(P2- P1)

Ep = (Q2 - Q1) x ( P1 + P2 )
(P2 - P1) (Q1 + Q2 )

This formula is an arc elasticity formula and it is widely used.

40
The Five Categories of Price Elasticity of Demand

1. Perfectly inelastic demand

Quantity demanded does not respond to price

changes at all. Ex : the demand of car-driver for a road in the
middle of inhabitant land, 41
2. Inelastic demand

Quantity demanded does not respond strongly

to price changes
42
Demand tends to be more inelastic. . .
if the good is a necessity.
the shorter the time period.
the fewer the number of close
substitutes.
the more broadly defined the market.

43
3. Elastic Demand

Quantity demanded responds strongly to changes

in price 44
4. Perfectly Elastic demand

Quantity demanded changes infinitely with any

change in price. Ex: paper clips
45
Demand tends to be more elastic. . .
if the good is a luxury.
the longer the time period.
the larger the number of close substitutes.
the more narrowly defined the market.
Ex: The broader the definition, the lower the elasticity. For example,
Company X's fried dumplings will have a relatively high elasticity, where as
food in general will have an extremely low elasticity.
46
5. Unitary Price Elasticity

Quantity demanded changes by the same

percentage as the price 47
Linear demand curve and price elasticity of demand
Elasticity Varies with Price Range—more
elastic toward top left; less elastic
at lower right

Elastic

Unitary Elastic

Inelastic

Point m is the mid point of straight-line demand curve DD1 (i.e. DM =

MD1). Above the mid point M to the left of M demand is elastic (i.e., ep >
1). At the mid point demand is unitary elastic with ep = 1. Below the mid
point to the left of M demand is in elastic with ep<1. 48
Factors Affecting Price Elasticity of Demand

A)Availability and number of substitute

B) Number of alternative uses of a commodity

C)The nature of a commodity (i.e. whether it is

luxury or necessity)

D)Other factors such as size of percentage

share of commodity's expenditure in total
expenditure of a consumer, time horizon of
consumption, durability of a good, etc can also
affect price elasticity of demand.
49
 Price Elasticity
The demand curve can be
Price a range of shapes each of
which is associated with
a different relationship
between price and the
quantity demanded.

Quantity Demanded

50
2.1.4.2. Income Elasticity of Demand
It measures percentage change in quantity
demanded due to certain percentage change in
income of the consumer

ey = (Qd/Qd ) x 100 Note

( y/y)x 100 If ey >0 = normal good

If ey b/n 0&1 = necessity
ey = [(Q2 - Q1)/Q1)] x 100
Ifey>1= luxury
[(Y2 - Y1)/Y1] x 100
If ey <0 = inferior good
 Q2  Q1   Y1 
ey =   x 
Y  Y   Q 
 2 1   1

where Q1 is quantity demanded at income level Y1

and Q2 is quantity demanded at income level Y2 51
For example:
Ey = - 0.6: Good is an inferior good but inelastic – a
rise in income of 3% would lead to demand falling
by 1.8%
Ey= + 0.4: Good is a normal good but inelastic –
a rise in incomes of 3% would lead to demand rising
by 1.2%
Ey= + 1.6: Good is a normal good and elastic –
a rise in incomes of 3% would lead to demand rising
by 4.8%
Ey = - 2.1: Good is an inferior good and elastic –
a rise in incomes of 3% would lead to a fall in demand
of 6.3%
52
Examples

53
 2.1.4.3. Cross Price Elasticity of Demand
Measures the percentage change in quantity
demanded of a commodity, (say X) due to
percentage change in price of the other
commodity, (say Y)

exy = (Qdx) / Qdx = Qdx, Py

 py/py py Qx
 Py1 
exy = x 
Q 
 x1 

where Note

Qdx is change in quantity demand of x. If exy >0 = substitute

py is change in price of commodity y If exy <0 = complementary

Qxd is quantity demanded of x at particular price If exy =0>>no relation

54
 Ex: Demand schedule for good X and Y
where
Points Px Py Qx Qy Px is price of x.
A 2 3 18 13 Py is price of y.
B 4 5 12 9 Qx is good/commodity x.
x
C 5 6 10 4 Qy is good/commodity y.

 Py1 
exy = x  
Q 
 x1 
from A to B
12  18  3 = 6 x 3
e xy    = -½
(5  3  18 2 18
from B to A
exy = 18  12 x
5
  = 6/-2 x 5/12 = -5/4
12
(3  5)  55
Arc cross - price elasticity
 In order to avoid the discrepancy, use arc cross
price elasticity

(Q x2  Q d x1 ) ( Py 2  Py1 )
(exy) = x
( Py 2  Py1 ) (Q d x 2  Q d x1 )
.

56
2.1.4.4. Application of Elasticity
 If demand for the product is elastic an increase in price results decrease in revenue as
small percentage change in price causes large decrease in quantity sold.

 If a producer faces an inelastic demand curve for his product he can increase his
revenue by increasing price because under this case large percentage increase in price
causes little percentage decrease in quantity demanded.

 If demand is unitary, change in price does not affect total revenue. In this case there is
no need of decreasing or increasing price, as it does not affect total revenue of the
producer.

E
l
a
s
t
i
c

57
Total Revenue Test for Elasticity
 Total Revenue is the amount the seller receives from the
buyer from the sale of a product; P x Q = TR

 Elasticity and total revenue are related; observe the effect

on total revenue when product price changes

58
2.1.5. Elasticity of Supply
2.1.5.1.Price Elasticity of Supply
 Measures percentage change in quantity supplied
due to certain percentage change in the price
of a commodity
 Is positive & it may vary from 0 to  (Law of Supply
tells us this number is generally positive).
Q s - p  Q2 s  Q1 s 
  x P1 (Point elasticity of supply)
es = = P  P  s
P Qs  2 1  Q1
Where es = Price elasticity of supply
Qs = Change in quantity supply
P1 = price of a commodity
Qs = quantity supplied at a particular price.

Arc cross - price elasticity (exy) = (Qx2d - Qdx1) x (Py2+Py1)

(Py2 - Py1) (Qdx2 + Qx1d)
59
 2.1.5.2. Categories of Price Elasticity of Supply
 If es = 0 it is called perfectly inelastic supply
Quantity supplied does not
respond to price changes at
all. Ex hotel rooms, Picasso
painting

 If es =  i.e p = 0 then it is called a perfectly

elastic supply
Quantity supplied
changes infinitely with
any change in price.
That means at any
price above the price
noted, Qs is
unlimited. Ex. supply
of tickets for sports or
musical venues. 60
 If 0 < es < 1, it is called inelastic supply

Quantity supplied does not

respond strongly to price
changes.

 If es = 1 it is called unitary elastic

Quantity supplied
changes by the same
percentage as the price.

61
 If es > 1, it is called elastic supply

Quantity supplied responds strongly

to changes in price.

62
 Few facts about elasticity of supply
 Generally, anything that can affect a firm’s ability to change
production easily will affect the elasticity of supply.

 the market period: occurs when the time immediately after a

change in price is too short for producers to respond with a
change in quantity supplied. The supply will be perfectly
inelastic.

 the short run implies that the plant capacity will be fixed, but
variable costs (labor, materials) can be added to increase
production if price rises.

 the long run is a time period long enough for the firm to adjust
both its fixed plant capacity as well as variable resources. The
ability to be responsive means that a smaller price rise can
bring forth a larger output increase than in the short run. 63
Importance of Elasticity
Relationship between changes
in price and total revenue
Importance in determining
what goods to tax (tax revenue)
Importance in analyzing time lags
in production
Influences the behavior of a firm

64