Microeconomics I

(NrEp 2081)

Biruk J. (MSc)
Introduction
 Economists has one more Eye to see the future
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 BASIC CONCEPTS OF
ECONOMICS
 Economics is a social science whose purpose is to
understand the working of the real-world economy
that is how people choose to use scarce resources
such as time, land, knowledge and others, and how
to combine them to create useful products and
services.
 It is called “social” because it deals with the aspects
of human behavior. It is called “science” since it
studies social problems from a scientific point of
view.
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Definition of economics
 Different scholars define economics differently in
connection with the subject matter of economics. These
are broadly divided in to: Wealth, Welfare, Scarcity and
Growth definition

Wealth definition
 Father of Economics Adam Smith in his book “Wealth of
Nations 1776” defined economics as a science which
inquired into the nature and cause of wealth of nations

 In this definition wealth is given first place, man has

given second place
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Contd…
 According to this definition:
 Economics is a science of study of wealth
only;
 This wealth centered definition deals with the
causes behind the creation of wealth, and
 It only considers material wealth which deals
with production, distribution and consumption

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Contd…
 Criticismsof this definition:
(a) Wealth is of no use unless it satisfies human
wants.
(b) This definition is not of much important to man
and welfare.

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Welfare definition
 According to Alfred Marshall “Principles of
Economic Science-1890”, “Economics is the study of
man in the ordinary business of life”

 It examines how a person gets his income and how

he invests it. Thus on one side it is a study of wealth
and on the other most important side, it is a study of
well being

 He defined economics as a science of human welfare

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Contd…
Welfare definition-points
 Mainly concerned with the study of man in relation
to wealth. The study enquires how an individual gets
his income and how he uses it
 First place to man, second place to wealth
 It studies man not in isolation but as a member of a
social group
 Definition considered only material welfare, ignored
immaterial welfare
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Contd…
Scarcity definition
 Scarcity definition is raised by Lionel Robbins in his book ‘Nature
and Significance of Economic Science-1932
 Economic is a science which studies human behavior as a relationship
between ends/wants and scarce means which have alternative uses.
Scarcity Definition-main Points
 Unlimited wants: Human wants is unlimited b/c of its recurrence and
hierarchal nature
 Scarce resources: is a Situation in which the amount of something
available is insufficient to satisfy the desire for it
 Efficient use of scarce resources
 Need/choice for optimization: Trade-off

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Contd…
 When there is scarcity of resources, we are unable to
have everything we desire so we must make choices
on how we will use our resources

 Therefore, there is always suffering of the other

which to forgive in need of the other known as an
opportunity cost

 In economics we will study the choices of

individuals, firms, and governments, consequences
of choices and the indirect effect of choice in the
society Biruk J.
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Contd…
 The scarce resources (factors of production) are:
 Land/Natural resources: it is a free gifts of nature
such as land, minerals, oil, forests, air, and timber
it explained by Rent.

 Capital Resources: these are manufactured things

used in producing goods and services. It can be
human capital or capital stock which explained as
an interest rate. Example tools, machines,
equipment, and factories.

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Contd…
 Human Resources (Labor): it is mankind’s physical
and mental talent. These are the skills people have
that are used to produce goods and services.
 It is the work time and effort that people devote to
producing goods and services It is measured as wage

 Entrepreneur: it is the individual who combines the

factors of production in order to produce a good or
service. These are risk takers, policy makers, and
innovators. This production factor is explained in
terms of profit
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Contd…
 In general:
 Economics is a science of scarcity which looks at
the behavior of people in market place to satisfy
their unlimited need and want

 Economics is NOT about what to think, but it is

rather HOW to think!

 "Economics is not a body of concrete truth, but an

engine for the discovery of the truth
Biruk J.
Obstacles and Pitfalls in Economics
 Economists cannot easily do experiments

 To isolate the effect of interest, economists use

the logical device called ceteris paribus, or “other
things being equal.”
Economists try to isolate cause-and-effect
relationship by changing only one variable at a
time, holding all other relevant factors unchanged.
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Economic Assumptions and Goals

Assumptions
 Society’s wants are unlimited, but all resources are
limited (scarcity).
 Due to scarcity, choices must be made. Every choice
has a cost (a trade-off).
 Everyone’s goal is to make choices that maximize their
satisfaction. Everyone acts in their own “self-interest.”
 Everyone acts rationally by comparing the marginal
costs and marginal benefits of every choice
 Real-life situations can be explained and analyzed
through simplified models and graphs.
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Contd…
Goals
 Economic Growth (Increase in GDP or GNP)
 Employment creation
 Economic Efficiency – “obtaining the maximum
output from available resources” or “maximum
benefits at minimum cost from our limited
resources.” It is doing the best with what we have.
 Price Level Stability – sizable inflation or
deflation should be avoided

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Contd…
 An Equitable Distribution of Income: One group
shouldn’t have extreme luxury while another is in
stark poverty

 Economic Freedom – guarantee that businesses,

workers, and consumers have a high degree of
economic freedom.

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Contd…
 Economic Security – provision should be made for
those not able to take care of themselves –
handicapped, disabled, old age, chronically ill,
orphans. Protection from lay-offs [unemployment
insurance] and also no discrimination

 Balanceof Trade: it is the difference between the

value of goods and services exported out of a
country and the value of goods and services
imported into the country

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Three Fundamental Concepts of Economic Thinking

 Opportunity Cost
 Marginal and Utility Concept
 Information

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Opportunity Cost
 Theopportunity cost of something is that which
we give up when we make that choice or decision.

 The implication is that all decisions involve trade-

offs.

 “There’sno such thing as a free lunch!!/ there is

no as such free lunch as possible”

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Margins and Utility

 Utility is the ability of something to satisfy needs or wants.
 It is a representation of preferences over some set of goods
and services.
 Utility is an important concept in economics because it
represents satisfaction experienced by the consumer of a
good.
 One cannot directly measure benefit, satisfaction or
happiness from a good or service, so instead economists
have devised ways of representing and measuring utility in
terms of economic choices that can be counted.
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Contd…
 Economists consider utility to be revealed in people’s
willingness to pay different amounts for different
goods.
 Total utility is the aggregate sum of satisfaction or benefit
that an individual gains from consuming a given amount
of goods or services in an economy.
 Usually, the more the person consumes, the larger his or
her total utility will be. But it is expected to decline
 Marginal utility is the additional satisfaction, or amount
of utility, gained from each extra unit of consumption.
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Contd…
People make choices at the margin, which means that
they evaluate the consequences of making incremental
changes in the use of their resources.

The benefit from pursuing an incremental increase in an

activity is its marginal benefit.

The opportunity cost of pursuing an incremental

increase in an activity is its marginal cost.

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INFORMATION
 Every decisions in economics made according to
the information or data we have.
 This data enables us to forecast the future
 Present and past economic decisions have an
enormous influence on the character of life in a
society.
 The state of our physical environment, the level of
material well-being, and the nature and number of
jobs are all products of the economic system.
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Branches of Economics
 In modern approach, economics can be classified as :
(i) Micro-economics
(ii) Macro-economics

Both branches of economics answer the basic

questions of economics what to produce?, how to
produce? and for whom to produce?
Their difference is the scope of the concern.

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Microeconomics
• Micro Economics comes from the Greek word mikros,
meaning “small”

• It Studies about small economic units such as individuals,

firms, and industries (competitive markets, labor market,
personal decision making, choice and their interaction in
specific markets, and the influence that governments exert
on them.

• It focuses on individual parts of an economy.

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Macroeconomics
Macro Economics also comes from the Greek word makros,
meaning “large”

Itstudies the behavior of the overall economy that focuses on

big picture like National Economic Growth, Government
Spending, Inflation, Unemployment, etc. and it ignores fine
details.

Itstudies the effects on the national and global economy of the

choices that individuals, businesses, and governments make.
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Contd…
EXAMPLES OF MICROECONOMIC & MACROECONOMIC CONCERNS
Production Prices Income Employment

Microeconomics Production/Output in Price of Individual Distribution of Income Employment by

Individual Industries and Goods and Services and Wealth Individual Businesses &
Businesses Industries
Price of medical care Wages in the auto
How much steel Price of gasoline industry Jobs in the steel industry
How many offices Food prices Minimum wages Number of employees in
How many cars Apartment rents Executive salaries a firm
Poverty Number of accountants
National Aggregate Price Level National Income Employment and
Production/Output Unemployment in the
Macroeconomics Consumer prices Total wages and salaries Economy
Total Industrial Output Producer Prices Total corporate profits
Gross Domestic Product Rate of Inflation Total number of jobs
Growth of Output Unemployment rate

Biruk J.
Positive vs Normative economics
 Economics can be analysed from two perspectives

 Positive economics: it is concerned with analysis

of real facts and informations
It attempts to describe the world as it is.
It tries to answer the questions what was; what is; or
what will be? It does not judge a system as good or
bad, better or worse
 Contd…
 Normative economics: it evaluates the desirability
of alternative outcomes based on one‘s value
judgments about what is good or what is bad.
 It deals with the questions like, what ought to be? Or
what the economy should be?
 The employees should have to be fairly taxed as
traders
 Economic and political involvement of women's
ought to be based on their competency.
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Theories of absolute and comparative

advantage

 Thesetheories enable to answer one of the basic

economic questions “what to produce?”
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Theory of Absolute Advantage

 The Scottish economist Adam Smith developed new economic
theory called the theory of absolute advantage with the slogan
of “free trade”.
 Absolute advantage is defined as the ability to produce more
of a good or service than competitors, using the same amount
of resources.
 Smith’s theory of absolute advantage stated that if two
countries have an absolute advantage in the production of two
different commodities, it is more advantageous to buy from
one another than to make what does not belong to their
particular trade.
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Contd…
 In his argument the wealth of nations depends upon the
goods and services available to their citizens, rather than
the gold reserves held by the nation.
 Maximizing this availability depends primarily on fuller
utilization of resources and then, on the ability
 to obtain goods and services from where they
are produced most cheaply (because of “natural”
or “acquired” advantages), and
 to pay for them by production of the goods and
services produced most cheaply in the country
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Contd…
 The case for absolute advantage implies each
country produces more of something per unit of
resources used than the rest of the world.
 According to this assumption the theory can be
illustrated with the following example.
 Suppose there are two countries Ethiopia and
Brazil both produces Coffee and Camera. But
Ethiopia produces coffee cheaply than Brazil and
in reverse Brazil does it in the case of Camera.
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Contd…
  Ethiopia Brazil
Coffee 80 40

Camera 40 80

 Here we assume that, Ethiopia produced 80 quintals of

coffee or pieces of 40 cameras, or any combination of these
in between per unit of labor. And 40 quintals of coffee or 80
pieces cameras for Brazil.
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Contd…
 In this case it is clear that Ethiopia specializes in production
of coffee to get a twofold of labor gain and similarly Brazil
is able to generate a double of camera within a given
resource.
 Shortly, Ethiopia has absolute advantage in Coffee and
Brazil in Camera.
 The problem of the theory of absolute advantage is that it
cannot answer the question: what if either Ethiopia or Brazil
doesn’t have absolute advantage in both goods while the
other has? Do they participate in trade in such condition?
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Comparative Advantage
 This theory is developed by David Ricardo in 1817.
 According to this theory, nations might participate in trade
while a given country produces both commodities with
less resource than the other.
 Comparative advantage is the ability of a firm or
individual to produce goods and/or services at a lower
opportunity cost than other firms or individuals.
 It gives an ability to sell goods and services at a lower
price than its competitors and realize stronger sales
margins.
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Contd…
  Ethiopia Brazil
Coffee 40 80

Camera 30 80

As the above figure shows that Brazil has an

absolute advantage in production of both coffee and
camera. But still there is a possibility for trade.
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Contd…
 If Brazil produces camera it enables to produce
more than two fold camera than Ethiopia within a
given resource, but in coffee it is only two fold.
 Although Brazil has an absolute advantage in the
production of both products, Brazil has a
comparative advantage only in the production of
camera.
 This is because its advantage in camera is
comparatively greater than its advantage in coffee.
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Contd…
 In the case of comparative advantage:
 Consumers react to price differences and buy from lower
price foreign producers for the goods in which their
country does not have comparative advantage (gains from
exchange).
 Producers react to price differences and allocate resources
to industries where relative productivity is higher,
exporting those goods (gains from specialization).
 Every country always has an industry in which it has
Comparative Advantage and it is competitive in world
markets for that industry.
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Production possibilities curve (PPC)

 A production possibility curve measures the
maximum output of two goods using a fixed
amount of input
 The model shows an alternative ways that how an
economy can use its scarce resources or
 It shows a combinations of goods and services that
can be produced efficiently from a fixed amount or
resources in a given period of time

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Contd…
 PPF is the boundary between the goods and
services that can be produced and from those that
cannot
 Because resources (factors of production) are
limited we are only able to use little of them to
produce certain goods.
 This model graphically demonstrates Scarcity, Trade-
offs, Opportunity costs and Efficiency.

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Contd…
 4 Key Assumptions
 Only two goods can be produced
 Full employment of resources
 Fixed Resources (Ceteris Paribus)
 Fixed Technology

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Illustration in ppc

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Contd…

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Contd…
 The PPF curve divides production space into 3
distinct areas,
 points on the PPF curve (points like A, B, C, D, E,
and F),
 points on the inside of the curve (points like X), and
 points outside the curve (points like Y)
 Points either on or inside the frontier are attainable
with the current level of resources and technology.

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Contd…
 Points outside the frontier are unattainable with the
economy's current level of resources and technology.
 We need more than the available resources and technology to
reach there.
 Because scarcity forces the society to give up one choice for
another, the slope of the PPF will always be negative,
reflecting the concept of trade off.
 Because of the law of opportunity cost i.e. as we produce
more and more product the opportunity cost per unit of
additional output increase, PPF curve is concave to the origin

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Contd…
 Possibility A shows that all resources are devoted
to producing machines and no resources are
available to produce food.
 Possibility B shows that if some of the resources
are assigned to produce 2 tons of food, the
production of machines would be reduced to 4
machines.
 Because the resources used to produce the 5th
machine were transformed to food production.
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Contd…
 The pattern continues on to the possibility F,
where all resources are in the production of food
and no resources available to produce machines.
 This results in 5 tons of food and zero machines
 Points on the PPF represent the maximum
production (output) we can get when all resources
are fully employed.

Biruk J.
Theory of Supply and Demand
 How buyers react for change in price of a good?
 How sellers react for change in price of a good?
 How a transaction (selling and buying) of
commodities is takes place in the market
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Types of goods
 Types of Goods - Related to Income:
 inferior good: goods for which demand decreases as
consumer income rises. Thus, it’s “income elasticity”
will be negative.
Example: Inter-city bus service and inexpensive foods
 normal good: goods for which demand increases as
consumer income rises. Thus, it’s “income elasticity”
will be positive. But its effect is not that much
significant
Most goods are normal goods.
Example: salt and food oil
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Contd…
 superior good: goods that will tend to make up a
larger proportion of consumption as income rises.
As such, they are an extreme form of normal good.
Thus, a superior good’s “income elasticity” will be both
positive and greater than 1
A superior good might be a luxury good that is not
purchased at all below a certain level of income, such as
a luxury car
luxury good: a more colloquial term that is synonymous
with “superior good.”

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Contd…
 Types of good- related to demand schedules
 Complementary goods: this are goods which are used
together.
 Example: TV and DVD player

 Substitute goods: goods which are alternatives to each

other.
 Example: Pepsi and Coca-cola or Tea and Coffee

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Contd…
 Types of Goods - Related to Price:
 Ordinary good: goods for which quantity demanded increases
as the price for the good drops; conversely, quantity demanded
decreases as the price for the good increases, ceteris paribus
(all other things being equal).
 Mostly common for many goods
 Giffen good: a rare type of good which will experience an
increase in quantity demand in response to an increase in price
due to budgetary constraints.
 In order to be a true Giffen good, price must be the only thing
that changes to prompt a change in quantity demand.
 Conspicuous consumption (such as found with Veblen goods)
is not a factor.
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Contd…
 The classic example is of inferior staple foods, whose demand is
driven by poverty that makes their purchasers unable to afford
superior foodstuffs
 As the price of the cheap staple rises, consumers can no longer
afford to supplement their diet with superior foods, and must
consume more of the staple food.
 Veblen good: often confused with Giffen goods, Veblen goods are
goods for which increased prices will increase quantity demanded
 However, this is not because the consumers are forced into
buying more of the good due to budgetary constraints (as in
Giffen goods).

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Contd…
 Rather, Veblen goods are high-status goods such as
expensive wines, automobiles, watches, or
perfumes.
 The utility of such goods is associated with their
ability to denote status.
 Decreasing their price decreases the quantity
demanded because their status denoting utility
becomes compromised.

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Contd…
 Types of Goods - Related to Consumption Ability:
 rival good: goods whose consumption by one
consumer prevents simultaneous consumption by other
consumers. For example, food, cars, and clothing.
 Non-rival good: goods that may be consumed by one
consumer without preventing simultaneous
consumption by others.
 Most examples of non-rival goods are intangible goods.
For example, television and radio are non-rival goods.

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Contd…
 excludable good: goods or service that enable a
seller to prevent non-paying customers from
enjoying the benefits of it.

 Market allocation of such goods is feasible.

Examples: public transportation, haircuts, movie
theatre, food, clothing, housing, rental
accommodations.

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Contd…
 non-excludable good: goods or service whereby it is
impossible to prevent an individual who does not pay for
that thing from enjoying the benefits of it.
 Market allocation of such goods is not feasible. Examples:
beautiful scenery, fresh air.
 public good: goods that are non-excludable as well as
non-rival. This means it is not possible to exclude
individuals from the good's consumption.
 Fresh air may be considered a public good as it is not
generally possible to prevent people from breathing it.
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Contd…
 private good: goods that are both excludable and rival.
Example: bread (eaten by a given person cannot be
consumed by another [rival], and a baker can refuse to
sell [excludable]).
 club good: goods that are excludable but non-rival, at
least until reaching a point where congestion occurs.
 Examples of club goods would include cinemas, cable
television, access to copyrighted works, and the services
provided by social or religious clubs to their members.

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Contd…
 common-pool resource: goods that are non-excludable
but rival.
 Examples of common-pool resources include irrigation
systems, fishing grounds, pastures, and forests.
 A pasture, for instance, allows for a certain amount of
grazing to occur without the core resource being
harmed. In the case of excessive grazing, however, the
pasture may become more prone to erosion and
eventually yield less benefit to its users.

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Contd…
 Thus, the core resource is vulnerable to the
problems of congestion, overuse, pollution, and
potential destruction unless harvesting or use
limits are devised and enforced.

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Contd…

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Theory of Demand
 Demand

 Demand is a process of seek or want of a good or

service which can be afforded and then planned to
buy it.

 It is not only about the willingness of buying

rather it is also about the ability to buy it.

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Contd…
 The relationship between price of a good and
quantity demand of the good which is the amount
consumers plan to buy during a particular time
period and at a particular price is known as
quantity of demand

 This relationship when all other influences on

consumers’ planned purchases remain the same is
explained by Demand Curve

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Contd…

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Contd…
 The above demand curve figure illustrates the
distinction between a change in demand and a change
in the quantity demanded
 When the price of the good changes and everything
else remains the same, the quantity demanded changes
and there is a movement along the demand curve
 The curve is downward sloping which shows as it has
a negative slope cause quantity demand and price of
the product have an inverse relation

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Movements along vs. Shifts in

Demand

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Contd…
 A movement along the demand curve occurs as a result
of change in price of the good keeping other variables
constant
 Given the law of demand, a fall in the price of a good
would cause a movement to the right and downward
along the demand curve
 Conversely, a rise in price would cause a movement to
the left and up along the demand curve.
 Changes (or shifts) in demand occur when the other
factor we’ve been holding constant change. It occurs
when we change things other than the price of the good.
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Contd…
 There are five main factors that shift the demand
curve (though other possibilities exist)
1. Changes in income (or wealth)
2. Changes in the number of consumers
3. Changes in the prices of related goods or services
4. Changes in tastes
5. Changes in expectations

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Contd…
 Changes in income
 Changes in income have different impact for
different types of good.
 For a normal goods and luxury goods, we would
expect that an increase in income would result in an
increase in the quantity demanded of the good at any
given price.
 On the other hand, for some goods, known as inferior
goods, demand decreases as income increases.
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Contd…
 Changes in number of consumers
 The larger the population, the greater is the demand
for all goods. Therefore demand curve will change
due to change in number of consumers.

 It may increase (i.e., shift to the right) as the

number of consumers increases or it may decrease
due to its inverse function.

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Contd…
 Changes in consumers test and preference
 People with the same income have different demands if
they have different preferences.
 Therefore demand curve may change due to change in
preference of the consumers.
 It may increase (i.e., shift to the right) as the tastes change
in favor of the good or service or it may decrease due to
change in taste in favor of other substitute goods.
 Example the demand for boots and cotton wears in
summer and winter season or the demand for recreational
sites before and after honeymoon.
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Contd…
 Change in price of related goods
 Demand will also shift with a change in the price of
other goods.
 In this case the demand will increase when the price
of a substitute good increases and it will decrease
when the price of a complementary good increases.
 Example: The demand for chip wood increases when
the price of MDF product increases and the demand
for Wabishebele lodge decreases when the safety cost
of traveling to the area increases
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Contd…
 Change in price expectation
 Consumers will adjust their current spending in
anticipation of the direction of future prices in
order to obtain the lowest possible price.
 The future expectation of a product price either
increases or decreases the demand of that product
depending on the type of good whether it is an
ordinary or Veblen good.
 Example: the demand of wears before and after
holidays.
Biruk J.
 78 05/26/2023

Contd…
 The law of demand
 The law of demand states: other things remaining
the same;
 The higher the price of a good, the smaller is the
quantity demanded;
 The lower the price of a good, the larger is the
quantity demanded.
 Therefore the demand curve always slopes
downward
Biruk J.
 79 05/26/2023

Contd…
 The law of demand results from
  Substitution effect
 When the relative price (opportunity cost) of a good or
service rises, people seek substitutes for it, so the
quantity demanded of the good or service decreases
  Income effect
 When the price of a good or service rises relative to
income, people cannot afford all things they previously
bought, so the quantity demand of a good or service
decreases.

Biruk J.
 80 05/26/2023

Theory of Supply
 Supply
A firms quantity supplied of a good (or service)
are the specific amount firms would choose to sell
over some time period with in a particular price

 It represents a choice by firms in terms of the

quantity they would be willing to sell at a given
price

Biruk J.
 81 05/26/2023

Contd…
 Itis a relationship between the price of the good
and quantity supplied of the good which is the
amount that producers plan to supply during a
particular time period and at a particular price
 This relationship when all other influences of
suppliers’ remain the same is explained by Supply
Curve
 The supply curve is positively sloped; i.e., the
quantity supplied increases with price. This is the
law of supply
Biruk J.
 82 05/26/2023

Contd…

Biruk J.
 83 05/26/2023

Contd…
 The law of supply
 Other things remaining the same, the higher the
price of a good, the greater is the quantity supplied;
and the lower the price of a good, the smaller is the
quantity supplied
 The law of supply results from the general tendency
for the marginal cost of producing a good or service
to increase as the quantity produced increases
 Producers are willing to supply a good only if they
can at least cover their marginal cost of production

Biruk J.
 84 05/26/2023

Movements along vs. Shifts in Supply

Biruk J.
 85 05/26/2023

Contd…
 A movement along the supply curve occurs due to a
change in the price of a good

 A rise in price would cause a rightward movement

along the supply curve and a fall in price would
cause a leftward movement along the supply curve

 Shifts in supply occur when factors other the current

price of the good change
Biruk J.
 86 05/26/2023

Contd…
 There are five main factors that shift the supply
curve (though other possibilities exist)
1. Changes in input prices
2. Changes in the number of producers
3. Changes in the prices of related goods or services
4. Changes in technology
5. Changes in expectations

Biruk J.
 87 05/26/2023

Contd…
 Changes in input prices
 An input is any good or service used to produce any
other goods or services.
 An increase in an input price makes it more costly to
produce a good, resulting in reduced supply (i.e., a
leftward shift in the supply curve).
 Changes in the number of producers
 An increase in the number of producers will lead to an
increase in supply (i.e., a shift of the supply curve to the
right). And also decrease in number of producers will
lead to have decrease in supply.
Biruk J.
 88 05/26/2023

Contd…
 Changes in the price of related goods at citrus
paribus condition
 The impact of a change in the price of related goods
will vary depending on the type goods whether it is
substitute or complementary.
 If the related good is a substitute in production (i.e., a
potential output for the firm that it can produce
instead), then an increase in the price of this related
good will cause a decrease in supply (i.e., a shift to
the left).
Biruk J.
 89 05/26/2023

Contd…
 If the related good is a complement in production
(i.e., an output that the firm produces along with
the good in question), then an increase in the price
of this related good will cause an increase in
supply (i.e., a shift to the right).

Biruk J.
 90 05/26/2023

Contd…
 Changes in technology
 Technology is the knowledge to produce a given product
at a lower cost; i.e., how we produce a given good or
service.
 A technological innovation makes sellers willing to offer
more at a given price, or sell the same quantity at a lower
price because it lowers costs of production and increases
supply.
 Cost-saving technological advances increase the supply of
a good therefore it shifts the supply curve to the right.
 Example: the effect of Agricultural machineries.
Biruk J.
 Contd…
 Changes in technology of related goods
 The impact of a change in technology of related goods
will vary depending on the type goods whether it is
substitute or complementary.
 If the related good is a substitute in production (i.e., a
potential output for the firm that it can produce instead),
then an improvement in technology of this related good
will cause a decrease in supply (i.e., a shift to the left)
 If the related good is complementary, then an
improvement in technology of this related good will
cause increment in supply
 92 05/26/2023

Contd…
 Changes in price expectations
 If the firm can alter when it sells its output,
changes in price expectations can cause a shift in
the current supply curve.
 For example, if the firm expects prices to increase
in the future, it will cause a reduction in the
amount the firm willing to supply today (i.e., a
leftward shift in the current supply curve).
 Example: fuel storage

Biruk J.
Market demand and Supply
 Market demand is the horizontal sum of all
individual demands for a particular good or service
 Market demand is derived from individual
demands and thus depends on all those
factors that determine individual demand (income,
expectations, etc)
 In our case, market demand curve shows the
variations in the quantity demanded of a good as
price change
 Contd…
 Assuming there are only two households in the
market, market demand is derived as follows:
 Contd…
 Market supply is the sum of all the quantities of a
good or service supplied per period by all the
firms
selling in the market for that good or service
 Any change that varies the quantity supplied at a
given price shifts the supply curve
 Changes in price that varies the quantity supplied
in the market is represented as a movement along
the supply curve
 Contd…
 Aswith market demand, market supply is the
horizontal summation of individual firms’
supply curves
 97 05/26/2023

Market Equilibrium
 In competitive markets, demand and supply play a key
role in coordinating the decisions of consumers and
producers.
 Changes in price drives quantity demanded and supplied
to a point of stability, known as market equilibrium,
where the demand and supply curves intersect.
 Whenever the market is out of equilibrium, quantity
supplied cannot keep up with quantity demanded.
 A competitive market is said to be at equilibrium when
price has moved to a point where the quantity of a good
or service demanded equals the quantity of the good
supplied.
Biruk J.
 98 05/26/2023

Contd…
 The price at which this occurs called the
equilibrium price or the market-clearing price and
the quantity at which this occurs is called the
equilibrium quantity

 For the equilibrium market graph below, the

equilibrium point is reached at a price level Pe
(clearing price) and the quantity demanded and
supplied intersects at a point Qe (equilibrium
quantity).
Biruk J.
 99 05/26/2023

Contd…
P Demand curve

Pe

Supply curve
Q Biruk J.
Qe
 100 05/26/2023

Contd…
 When the market is not in equilibrium, you get either excess
supply or excess demand, and a tendency for price to change.

 Excess supply – a surplus, the quantity supplied is greater

than quantity demanded
 In this case prices tend to fall.

 Excess demand – a shortage, the quantity demanded is

greater than quantity supplied
 And in this case prices tend to rise.

Biruk J.
 101 05/26/2023

Shifts in Demand and supply

 Shifts in either supply or demand change equilibrium
price and quantity.
 Shift in demand:
 An increase in demand creates excess demand at the
original equilibrium price.
 The excess demand pushes price upward until a new
higher price and quantity are reached.
 a decrease in demand creates lower demand at the
original equilibrium price.
o The lower demand pulls the equilibrium price down ward
until the new equilibrium price is reached.
Biruk J.
 102 05/26/2023

Contd…
p

Q
Biruk J.
 103 05/26/2023

Contd…
 Shift in supply:
 A decrease in supply creates excess demand at the original
equilibrium price.
 The excess demand pushes price upward until a new higher
price and lower quantity are reached.

 An increase in supply creates excess production which

exceeds the equilibrium quantity and price.
o It pulls the demand downward until a new lower price and
lower quantity reached.
Biruk J.
 104 05/26/2023

Contd…

P1

P2

Q1 Q2 Q
Biruk J.
Summary of Market Equilibrium
DEMAND/ No change in Increase in Decrease in
SUPPLY Supply supply supply

No change in P same P down P up

demand Q same Q up Q down

P
Increase in P up P up
ambiguous
demand Q up Q ambiguous
Q up

P down
Decrease in P down P ambiguous
Q
demand Q down Q down
ambiguous
 Elasticity
 Theory of demand and supply discuss about the
relationship(direction) of price and supply
 But is that possible to determine the rate of change
in supply and demand which arise due to change in
price?
 How the demand for your product would change
when you changes the price?
 Elasticity
 What is Elasticity?

it is a measure of how much buyers and sellers

respond to changes in market conditions

 it allows us to analyze supply and demand with

greater precision
 Elasticity vs Slope
 Both the price elasticity of demand/supply and
slope of demand/supply curve shows how much
quantity demanded responds to the price

 Butinstead of looking at unit change, elasticity

looks at percentage change
 109 05/26/2023

Price Elasticity of demand

 Law of demand tells us that consumers will respond to
a price drop by buying more, but it does not
tell us how much more
 The degree of sensitivity of consumers to a change in
price is measured by the concept of price elasticity of
demand
 Price elasticity of demand is relative responsiveness of
consumers to price changes which gives information
about the exact quantity response to a price change.

Biruk J.
 Contd…
 It is defined as the percentage change in quantity
demanded relative to a percentage change in Price.
 The value of ε is always negative and this sign
indicates that price & quantity moving in opposite
directions.
 ε=%∆Q/%∆P
 Contd…
 Exercise

1. If the price of perfume increases from ETB 200 to

ETB 350 and the amount you buy per year falls from
3 to 2. Then, what is your elasticity of demand?
2. If the demand function is Q = 245 – 3.5 P, find the
price elasticity of demand when the price is 10.
 112 05/26/2023

Contd…
 Here we have two different demand curves.
 Let’s pretend that they possibly represent the demand
behavior of consumers in the antacid market.
 For the demand curve of DA then raising the price
from P1 to P2 will cause quantity demand to drop
from QA1 to QA2.
 However, if the real curve is DB then demand falls
from QB1 to QB2 which have low elasticity of demand.

Biruk J.
 113 05/26/2023

P
Contd…
P2
Price

P1

DB DA

Q Biruk J.
QB,2 QA,2 QB,1 QA,1
 114 05/26/2023

Contd…
 Changes in price may lead to change the demand in
three ways either changing the demand at equal rate
of price change or at a larger (elastic) or small
percentage (inelastic) which leads to have /ε d/ =1,>1
and <1 respectively.

 Perfectly inelastic curves are vertical curves in which

quantity does not change at all in response to an
enormous proportional change in price (/ε d/ =0).
Biruk J.
 115 05/26/2023

Contd…

Biruk J.
 116 05/26/2023

Contd…
 Perfectly elastic curves are flat curves in which
quantity changes enormously in response to a
proportional change in price (/εd/=∞).
Price

0
Quantity Biruk J.
 117 05/26/2023

Contd…
 Numerical example for elasticity of demand
 Calculate the price elasticity of demand if in
response to an increase in price from 5 to 7 ETB,
the quantity demanded decreases from 60 to 40
units.

Biruk J.
 Determinants of Price Elasticity of
Demand
 Various factors influence the price elasticity of
demand.

1. Number of Substitutes:
 If a product can be easily substituted, its demand is
elastic, If a product cannot be substituted easily, its
demand is inelastic,
 Contd…
2. Luxury Vs Necessity:
o Necessity's demand is usually inelastic because
there are usually very few substitutes for
necessities.
o Luxury product, such as leisure/travel by water,
are not needed in a daily bases.
o There are usually many substitutes for these
products. So their demand is more elastic
 Contd…
3. Price/Income Ratio:
 The larger the percentage of income spent on a
good, the more elastic is its demand.
 A change in these products' price will be highly
noticeable as they affect consumers' budget with a
bigger magnitude.
 Consumers will respond by cutting back more on
these product when price increases. On the other
hand, the smaller the percentage of income spent
on a good, the less elastic is its demand.
 Contd…
4. Time lag:
The longer the time after the price change, the more
elastic will be the demand.
It is because consumers are given more time to carry
out their actions.
 122 05/26/2023

Summary of Price Elasticity of

Demand

Biruk J.
Cross elasticity of demand
 Cross elasticity (Exy) shows the relationship
between two products X & Y.
 it measures the sensitivity of quantity demand
change of product X to a change in the price of
product Y.
 It is a percentage change in quantity demanded of
X / percentage change in Price of Y.
 Exy=%∆Qx/%∆Py
 Contd…

Where
Q1 = initial Qdd of X, and Q2 = new Qdd of X and,
P1 = initial Price of Y, and P2 = New Price of Y
 Characteristics of Exy
If Exy > 0, Qdd of X and Price of Y are directly related.
i.e. X and Y are substitutes.

If Exy approaches 0, Qdd of X stays the same as the

Price of Y changes.
i.e. X and Y are not related.

If Exy < 0, Qd of X and Price of Y are inversely related.

i.e. X and Y are complements.
 Exercise
1. If the price of Product A increased by 25% and
then the quantity demanded of B increases by 15 %.
Then what is the coefficient of cross elasticity of
product A and B? what type of product are they?
2. If the price of Product A increased by 10%, the
quantity demanded of B decreases by 5 %. Then,
what is the coefficient of cross elasticity of product A
and B? what type of product are they?
Income Elasticity of Demand(EI)
 It is (% change in quantity demanded) / (% change in
income)
 Income elasticity shows sensitivity of quantity
demanded to changes in income.
 EI=%∆Qdd/%∆I
 Normal goods have EI > 0.
 Inferior goods have EI < 0.
 Luxury items have high income elasticity of demand,

while necessities have low income elasticity of demand

 128 05/26/2023

Price elasticity of supply

 Price elasticity of supply is the relative responsiveness
of suppliers to price changes which gives information
about the exact quantity response to a price change.
 It is defined as the percentage change in quantity
supplied relative to a percentage change in Price.
 The value of εss is always positive and this sign
indicates that price & quantity moving in the same
directions.
 εss =%∆Qss/%∆P

Biruk J.
 129 05/26/2023

Contd…
 Let we have two different supply curves SA and SB which
represents the supply curves of your firm in the market
 For the supply curve SA raising the price from P1 to P2 will
cause quantity supplied to rise from QA1 to QA2
 However, for the case of SB, the supply increases from QB1
to QB2
 Think what happens to profits if you get it wrong
 Either your costs rise faster than your revenues or
 Your revenues do not expand due to increased opportunity

Biruk J.
 130 05/26/2023

Contd…
SA
SB

P2
Price

P1

Biruk J.
QB,1 QB,2 QA,1 QA,2
 131 05/26/2023

Contd…
 In a common sense with price elasticity of demand:
 A price inelastic of supply means that quantity doesn't
change much with a change in price. Or the percentage
change in quantity is less than the percentage change in
price (ε < 1).
 Perfectly price inelastic means the quantity supplied
does not respond at all to price changes (ε= 0).
 A price elastic supply means that the change in quantity
supplied exceeds than the cause that is the change in
price of the commodity. Or it is the percentage change in
quantity exceeds the percentage change in price (ε >1).
Biruk J.
 132 05/26/2023

Contd…
 Perfectlyprice elastic means the quantity supplied
responds enormously to price changes (ε=∞)

 A unit elastic means that the effect of price change

is the same or equal with the change of quantity
supplied. It means the percentage change in
quantity supplied is the same as the percentage
change in price (ε = 1)

Biruk J.
 Determinants of Price Elasticity of
Supply
1. Time lag: How soon the cost of increasing production
rises and the time elapsed since the price change
influence the Es.
 The more rapidly the production cost rises and the less
time elapses since a price change, the more inelastic the
supply.
 The longer the time elapses, more adjustments can be
made to the production process, the more elastic the
supply
 Contd…
 2. Storage possibilities: Products that cannot be
stored will have a less elastic supply.
 For example, produces usually have inelastic
supply due to the limited shelf life of the vegetables
and fruits.
 THEORY OF CONSUMER
BEHAVIOR
 What determines consumer behavior?
 How to attract consumers?
 How consumers generate their maximum
satisfaction?
 136 05/26/2023

Understanding consumer behavior

 Consumer is an individual who purchases products
and services from the market for his/her own
personal consumption.

 The term consumer describes two consuming

groups: final consumer (an individual, a family or
a household) and organizational consumers (a
business, governmental or non-profit oriented
organizations).
Biruk J.
 137 05/26/2023

Contd….
 Consumer behavior is the behavior that consumers
display in searching for, purchasing, using,
evaluating, and disposing of products and services
that they expect will satisfy their needs.

 In order to understand consumer behaviour, it is

necessary to have a complete picture regarding to
all his psychological, social and economic aspects.

Biruk J.
 138 05/26/2023

Contd….
 Understandingconsumers’ behaviour will help you
become better marketers as it is the foundation for:

 Segmenting markets and Targeting

 Positioning products
 Developing an appropriate marketing

Biruk J.
 139 05/26/2023

Contd….
 Market Segmentation: determining distinct groups of
buyers (segments) with different needs,
characteristics, or behavior.

 Targeting: selecting one or more of the segments to

pursue

 Positioning: developing a distinct image for the

product in the mind of the consumer
Biruk J.
 140 05/26/2023

Factors Determining 
Consumers Behavior

Biruk J.
 141 05/26/2023

External factors
 Cultural factors
Culture is the learned values, perceptions, wants, and behavior
from family and other important institutions
 Basic Culture

Influence of culture on buying behaviour varies from country to

country. Marketers must analyze the culture of different groups,
regions or even countries.
 Subculture

Each culture contains different subcultures such as religions,

nationalities, geographic regions, racial groups, etc. Marketers can
design their strategies according to these subcultures.
Biruk J.
 142 05/26/2023

Contd…
 Social class
Social classes are society’s relatively permanent and
ordered divisions whose members share similar
values, interests, and behaviors
It is determined by income, wealth, education,
occupation, etc.
Buying behaviour of people in a given social class is
similar and marketing activities could be tailored
according to different social classes.
Biruk J.
 143 05/26/2023

Contd….
 Reference Groups
Reference groups include opinion leaders (persons who
influence others because of their special skills,
knowledge, or other characteristics)
Reference groups have potential in forming a person’s
attitude or behaviour.
The impact of reference groups varies across products and
brands.

Biruk J.
 144 05/26/2023

Contd….
 Family
Buyer behaviour is strongly influenced by the member of a family.
So marketers should try to find out the roles and influences of
husband, wife and children.
 Roles and Status

Each person possesses different roles and status in the society

depending upon the groups, clubs, family, organization etc. to
which he belongs.
The buying decisions will be influenced by these roles and status.

Biruk J.
 145 05/26/2023

Personal factors
 Age
 Family life-cycle consists of different stages such as young
singles, married couples, unmarried couples, etc., which help
marketers to develop appropriate products for each stage.
Consumers change the purchase of goods and services with
the passage of time.
 Occupation
 Consumers also buy products according to the demands of
their occupations. For example, a marketing manager of an
organization will try to purchase business suits, whereas a
low level worker in the same organization will purchase
rugged work clothes.
Biruk J.
 146 05/26/2023

Contd…
 Economic situation
If the income and savings of a consumer are high, he will
purchase more expensive products, and vice versa.
 Lifestyle

Lifestyle refers to the way a person lives in a society and is

expressed by the things in his/her surroundings.
It is determined by consumer interests, opinions, activities, etc.
 Personality

Personality is the totality of the behaviour of a man in different

circumstances.
It has different characteristics such as dominance, submission,
extroversion, introversion, etc., which determine the consumer
behaviour for a particular product or service. 
Biruk J.
 147 05/26/2023

Psychological Factors
 Motivation

A motive is a hidden need of consumers that is

sufficiently pressing to direct the person to seek
satisfaction

 Perception

It is the process by which people select, organize, and

interpret information to form a meaningful picture of the
world from three perceptual processes

Biruk J.
 Contd…
 Selective attention
It is the tendency for people to screen out most of the
information to which they are exposed
 Selective distortion

It is the tendency for people to interpret information in a way

that will support what they already believe
 Selective retention

It is the tendency to remember good points made about a

brand they favor and forget good points about competing
brands
Biruk J.
 149 05/26/2023

Contd….
 Learning
It is the change in an individual’s behavior arising from
experience and occurs through interplay of reinforcement
 Belief

It is a descriptive thought that a person has about

something based on Knowledge, Opinion and Faith
 Attitudes

It describe a person’s relatively consistent evaluations,

feelings, and tendencies toward an object or idea
Biruk J.
 150 05/26/2023

Consumer purchase decision process

 A consumer goes through several stages before purchasing a
product or service in the following manner:
NEED
↓
INFORMATION GATHERING/SEARCH
↓
EVALUATION OF ALTERNATIVES
↓
PURCHASE OF PRODUCT/SERVICE
↓
POST PURCHASE EVALUATION
Biruk J.
 151 05/26/2023

Contd….
 Need: Need is the catalyst which triggers the buying decision of
individuals.
 Information gathering: When an individual recognizes his need for a
particular product/service, he tries to gather as much information as he can.
Sources of information:
 Personal sources: Friends, family members, co-workers and other
acquaintances.
 Commercial sources: Advertisements, salespeople, packaging of products,
and displays (props, mannequins, etc.)
 Public sources: TV, radio, newspapers, magazines, and internet.
 Experiential sources: Individual’s own experience, prior handling of a
particular product.

Biruk J.
 152 05/26/2023

Contd….
 Evaluation of alternatives
It is evaluating various alternatives available in the market.
An individual after gathering relevant information, tries to choose the
best option available as per his need, taste, and pocket
 Purchase of product/service

After going through all the above stages, the consumer finally
purchases the product.
  Post purchase evaluation

Post purchase evaluation refers to a customer’s analysis whether the

product was useful to him or not, whether the product fulfilled his
need or not.
Biruk J.
 153 05/26/2023

Contd….
 Ways of influencing consumer behavior
 Awareness creation: In this respect, advertising and other
communications may be used to build and maintain a high
level of brand awareness and to provoke sufficient interest in a
proportion of consumers that will lead them to try the product.

 Trial: the most obvious means of encouraging trial is to ensure

that there is a sufficient stock of the brand available to ensure
that every customer can find the shape and size that they
require.

Biruk J.
 154 05/26/2023

Contd….
 Here close attention should be paid to the setting
and in particular towards estimating the extent to
which the setting can be controlled or closed.

 Reinforcement:Choice is not only the outcome of

internal mental deliberation but is simply a
behavior.

Biruk J.
 Properties of consumer preference
 Completeness

When facing a choice between any two bundles of

goods, a consumer can rank them so, one of the
following relationships is true:
The consumer prefers the first bundle to the
second,
Consumer prefers the second bundle to the first, or
 Consumer is indifferent between them
 Contd…
 Transitivity

A consumer’s preferences over bundles is consistent

in the sense that,
• if the consumer weakly prefers bundle A to bundle
B and weakly prefers bundle B to bundle C, then the
consumer also weakly prefers bundle A to bundle C
 Contd…
 More Is Better
All else being the same, more of a commodity is
better than less of it (always wanting more is
known as non-satiation)
Good-a commodity for which more is preferred to
less, at least at some levels of consumption
Bad-something for which less is preferred to more,
such as pollution
 Basic assumption of consumer
behavior
1. An economic agent behaves rationally
2. Constrained maximization
3. Each individual has many wants
4. To each individual, some goods are scarce
5. Scarce goods are substitutable
6. The law of diminishing MRS
 Contd…
 Marginal rate of substitution (MRS): is the
maximum amount of good Y that an individual is
willing to forgo for an additional unit of good X

 MRS is defined as the number of units of good Y

that must be given up if consumer is to receive an
extra unit of good X and to maintain a constant
level of satisfaction
Number of units of Y given up
MRS X ,Y 
Number of units of X gained
 The concept of utility
 Utility is a hypothetical unit used to measure how
much satisfaction a person obtains from consuming
a good
 Utility measures the satisfaction or enjoyment a
person obtains from consuming a good
 Therefore, utility reflects preference /happiness/
satisfaction / social welfare
 There are two major approaches of measuring
utility: Cardinal and ordinal approaches
 Contd…
 Cardinal approach believes as that utility can be
measured & added;
The difference between the numbers assigned is
meaningful
 Ordinal approach holds that utility cannot be measured
but can be ordered according to consumers’ preferences.
Different product combinations may be viewed as having
same utility, the difference between the numbers assigned
is meaningless
 Contd…
 The concept of utility is characterized with the
following properties:
 ‘Utility’ and ‘Usefulness” are not synonymous. For
example, paintings by Picasso may be useless
functionally but offer great utility to art lovers.
 Utility is subjective: The utility of a product will
vary from person to person. That means, the utility
that two individuals derive from consuming the
same level of a product may not be the same. For
example, no-smokers do not derive any utility from
cigarettes.
 Contd…
 The utility of a product can be different at different
places and time. For example, the utility that we
get from meat during fasting is not the same as any
time else.
 Assumptions of Cardinal Utility
theory
 Rationality of Consumers: The main objective of the
consumer is to maximize his/her satisfaction given
his/her limited budget or income.
Thus, in order to maximize his/her satisfaction, the
consumer has to be rational.
 Utility is Cardinally Measurable: The utility or
satisfaction of each commodity is measurable as utils.
Money is the most convenient measurement of utility.
In other words, the monetary unit that the consumer is
prepared to pay for another unit of commodity measures
utility or satisfaction.
 Contd…
 Constant Marginal Utility of Money: According
to assumption number two, money is the most
convenient measurement of utility.
However, if the marginal utility of money changes
with the level of income (wealth) of the consumer,
then money can not be considered as a measurement
of utility
 Limited Money Income: The consumer has
limited money income to spend on the goods and
services he/she chooses to consume.
 ContD…
 Diminishing Marginal Utility (DMU):The utility
derived from each from each successive units of a
commodity diminishes.
In other words, the marginal utility of a commodity
diminishes as the consumer acquires larger quantities
of it.
 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, the total utility is given by:
TU=f (X1,X2,…Xn )
 Total and marginal Utility
 Totalutility: is the aggregate pleasure gained from
a consumption of a given product

 Marginal utility: is the satisfaction gained from

one more consumption of a product.
 168 05/26/2023

Contd…
Q consumed Total Utility Marginal Utility
0 0
1 10 10

Diminishing Marginal
2 18 8
3 6

Utility
24
4 28 4
5 30 2
6 30 0 Biruk J.

7 28 -2
Contd…
Contd…
The relationship between Total and
Marginal Utility:
 As the consumer consumes more of a good per
time period, the total utility increases, at an
increasing rate when the marginal utility is
increasing
 Then increases at a decreasing rate when the
marginal utility starts to decrease and,
 Total Utility reaches its maximum at the point
where Marginal utility equals to zero and then it
begins to decline for one more consumption of the
product.
Equilibrium of a consumer
A consumer that maximizes utility reaches his/her
equilibrium position when allocation of his/her
expenditure is such that the last birr spent on each
commodity yields the same utility.
 For example, if the consumer consumes a bundle
of n commodities i.e x1,x2,…,xn, he/she would be
in equilibrium or utility is maximized if and only
if:

 Where: MUm –marginal utility of money

Example of single commodity
Marginal
Quantity utility per Margina
Total Marginal Birr(Mux l utility
of Price
utility utility /P) of
Orange
(price=2 money
birr)
0 0 - 2 - 1
1 6 6 2 3 1
2 10 4 2 2 1
3 12 2 2 1 1
4 13 1 2 0.5 1
5 13 0 2 0 1
6 11 -2 2 -1 1
 Utility schedule for two
commodities
Orange, Price=2birr Banana, Price=4birr
Quan TU MU MU Quant TU MU MU/P
tity /P ity
0 0 - - 0 0 - -
1 6 6 3 1 6 6 1.5
2 10 4 2 2 22 16 4
3 12 2 1 3 32 10 2.5
4 13 1 0.5 4 40 8 2
5 13 0 0 5 45 5 1.25
6 11 -2 -1 6 48 3 0.75
 Limitation of the Cardinalist
approach
 The Cardinalist approach involves the following
three weaknesses:
 The assumption of cardinal utility is doubtful
because utility may not be quantified.
 Utility can not be measured absolutely
(objectively). The satisfaction obtained from
different commodities can not be measured
objectively.
 The assumption of constant MU of money is
unrealistic because as income increases, the
marginal utility of money changes
 Ordinal approach

 In the ordinal utility approach, utility cannot be

measured absolutely but different consumption
bundles are ranked according to preferences.
 The concept is based on the fact that it may not be
possible for consumers to express the utility of
various commodities they consume in absolute
terms
 It is practically possible for the consumers to rank
commodities in the order of their preference as
and so on
 Assumptions of Ordinal Utility
theory
1. Consumers are rational-they aim at maximizing
their satisfaction or utility given their income and
market prices.
2. Utility is ordinal, i.e. utility is not absolutely
(cardinally) measurable. Consumers are required
only to order or rank their preference for various
bundles of commodities.
3. Diminishing Marginal Rate of Substitution
(MRS):
 Contd…
4. The total utility of the consumer depends on the
quantities of the commodities consumed
i.e., TU=f (X1,X2,…Xn )

5. Preferences are transitive or consistent

 Contd…
 The ordinal utility approach is expressed or
explained with the help of indifference curves
 An indifference curve (IC, is a line joining all the
points (representing different baskets of goods)
giving the same utility to an individual.
 It is a locus of points representing different
bundles of goods and services, each of which
yields the same level of total utility
 Contd…
 Good
X

U=40

Y
 Contd…
 Theslope of an indifference curve at any point of
any two commodities X and Y is MRS

y
 MRS X ,Y
x
 Contd…
 An indifference map is a set of ICs showing the preference of an
individual
X
increase in satisfaction

U=50

U=40
U=30
Y
Properties of Indifference Curves of
Two Goods
 ICs of two goods are negatively sloped
 Indifference curves are continuous
 Indifference curves can never intersect
 Indifference curves of two goods are convex to the
origin
 Special Indifference Curves
 Perfect substitutes
If two commodities are perfect substitute, the
indifference curve becomes a straight line with a
negative slope.
MRS for perfect substitutes is constant
 Perfect complements

The indifference curve takes the shape of a right

angle
MRS for perfect complements is zero
 A useless good

The indifference curve is vertical

 185

Theory of Production
 A production function relates physical output of a
production process to physical inputs or factors of
production.

 In particular, the production function tells us the

maximum quantity of output the firm can produce
given the quantities of the inputs that it might employ
in which it depends on exogenous technological
conditions.
 186

Contd…
 We will write the production function this way:
Q= f (L, K, X)
 Where Q is the quantity of output, L is the quantity
of labor used, K is the quantity of capital employed
and X is other factors of production.

 This expression tells us that the maximum quantity

of output the firm can get depends on the quantities
of factors of production it employs.
 187

Contd…
 The production function can have various uses. It can
be used to:
 Compute the least cost factor combination for a given
output or
 The maximum output combination for a given cost.

 Knowledge of production function may be helpful in

deciding on the value of employing a variable factor
in the production process.
 188

Contd…
 When discussing production, it is important to distinguish
between two time frames.

 Short-run: it describes the maximum quantity of good or

service that can be produced by a set of inputs, assuming
that at least one of the inputs is fixed at some level.
 Long-run: it describes the maximum quantity of good or
service that can be produced by a set of inputs, assuming
that the firm is free to adjust the level of all inputs.
 189

Contd…
 When discussing production in the short run, some
definitions are very important.
 Total product (TP) is another name for total amount of
output.
 The marginal product (MP) of a variable input is the
change in output (or TP) resulting from a one unit change
in the input. It tells us how output changes as we change
the level of the input by one unit at citrus paribus.
, while keeping other inputs constant
 190

Contd…
 The average product (AP) or average physical product
of labor of an input is the total product divided by the
level of the input.
 It tells us, on average, how many units of output are
produced per unit of input used, while keeping other inputs
constant

Diminishing Returns: As additional units of a variable input

are combined with a fixed input, at some point the
additional output (i.e., marginal product) starts to diminish.
 191

Contd…
 In order to easily understand about production
function it is better to see the function with only
one input labor which is called Total production
function.

 Total product function is a production function

with a single input which shows how total output
depends on the level of the input.
 192

Contd…
 Figure: the production function
 193

Contd…
 The figure depicts this possibility by showing the
production function for a single input, labor: Q= f(L).

 Points on or below the production function shows the firm’s

production set which is the set of technically feasible
combinations of inputs and outputs.

 Points such as A and B in the production set are technically

inefficient (i.e., at these points the firm gets less output
from its labor than it could).
 194

Contd…
 If we invert the production function, we get a function
L= g(Q), which tells us the minimum amount of labor
L required to produce a given amount of output Q.

 This function is the labor requirements function. If, for

example, Q= L2 is the production function, then L= is
the labor requirements function; thus, to produce an
output of 36 units, a firm will need at least units of
labor.
 195

Production in short run

 196

Contd…
 In the short run, let Y=2. The row highlighted
below represents the firm’s short run production
function.
 Contd…
Calculation of MP and AP
Input (X) TP MP
0 0
1 8 8
2 18 10
3 29 11
4 39 10
5 47 8
6 52 5
7 52 4
8 52 -4

197
 Contd…
 Assuming the input X as a labor, first when L=0, Q=0. That is,
nothing can be produced without using some labor.

 Second, between L=0 and L=3, output rises with additional

labor at an increasing rate (i.e., the total product function is
convex). Over this range, we have increasing marginal returns to
labor.

 When there are increasing marginal returns to labor, an increase

in the quantity of labor increases total output at an increasing
rate.

198
 Contd…
 Increasing marginal returns are usually thought to occur
because of the gains from specialization of labor.

 In a plant with a small work force, workers may have to

perform multiple tasks.

 For example, a worker might be responsible for moving

raw materials within the plant, operating the machines,
and inspecting the finished goods once they are produced.

199
 Contd…
 As additional workers are added, workers can
specialize: some will be responsible only for moving
raw materials in the plant; others will be responsible
only for operating the machines; still others will
specialize in inspection and quality control.

 Specialization enhances the marginal productivity of

workers because it allows them to concentrate on the
tasks at which they are most productive.

200
 Contd…
 Third, between L= 3 and L=7, output rises with additional labor
but at a decreasing rate (i.e., the total product function is concave).
Over this range we have diminishing marginal returns to labor.

 When there are diminishing marginal returns to labor, an increase

in the quantity of labor still increases total output but at a
decreasing rate.

 Diminishing marginal returns set in when the firm exhausts its

ability to increase labor productivity through the specialization of
workers.

201
 Contd…
 Finally, when the quantity of labor exceeds L=7, an increase in
the quantity of labor results in a decrease in total output.

 In this region, we have diminishing total returns to labor.

When there are diminishing total returns to labor, an increase
in the quantity of labor decreases total output.

 Diminishing total returns occur because of the fixed size of

the fabricating plant: if the quantity of labor used becomes too
large, workers don’t have enough space to work effectively.

202
 Contd…
 Also, as the number of workers employed in the plant grows,
their efforts become increasingly difficult to coordinate.
The three stages of production
 Stage I
From zero units of the variable input to where AP is
maximized
 Stage II
From the maximum AP to where MP=0
 Stage III
From where MP=0

203
Contd…

204
Contd…

205
 Relationship Between Marginal, Average And Total
Product
 When average product is increasing, marginal product is greater
than average product. That is, if AP increases, then MP>AP. In
this case the slope of AP>0

 When average product neither increases nor decreases in labor

because we are at a point at which AP is at a maximum, then
marginal product is equal to average product.

 When average product is decreasing, marginal product is less

than average product. That is, if AP decreases, then MP<AP. In
this case the slope of AP<0

206
 Contd…
 If Marginal Product is positive then Total Product
is increasing.
 If Marginal Product is negative then Total Product
is decreasing.
 Total Product reaches a maximum when Marginal
Product = 0

207
 Long run production
 In the long run, all inputs are variable
 There are no fixed costs
 The long run cost structure of a firm is related to
the firm’s long run production process.
 If all inputs of production are variable, then it
means there is a possibility to have a combination
of different inputs which yield the same output
called isoquant
 Contd…
 Isoquant :represents combinations of inputs that
yield the same level of output
Contd…
 Contd…
 Where MRTS indicates the rate of input substituted by
other factor of production to produce the same yield

 The firm’s long run production process is

described by the concept of returns to scale

 A firm’s long-run production function may exhibit at

first increasing returns, then constant returns, and
finally decreasing returns to scale
 Contd…
If all inputs into the production process are
doubled, three things can happen:
output can more than double

increasing returns to scale (IRTS)

output can exactly double

constant returns to scale (CRTS)

output can less than double

decreasing returns to scale (DRTS)

 Contd…
 Economists hypothesize that a firm’s long run
production function may exhibit at first
increasing returns, then constant returns, and
finally decreasing returns to scale
 Theory of cost of production
 How to calculate costs in two different time
frames (long run and short run production)?
 Contd…
 Cost of production can be alienated to Social and
Private cost
 Social cost

It is the cost of producing an item to the society

This cost is realized due to the fact that most

resources used for production purpose are scarce and
some production process brings environmental
pollution
 Contd…
 Private cost
 This refers to the cost of producing an item to the
individual producer
 It can be either Economic or Accounting cost

Economic costs include the cost of all inputs used

for the production of the item
 It can be the cost of purchase from owns pocket
i.e. Explicit cost
 Eg: Buying/renting land for operating business
 Contd…
 Cost of production that not spent from own pocket
i.e. Implicit cost
 Eg: using own land for operating business
 Economic cost: Explicit cost + Implicit cost
 Contd…
Accounting Cost
It is the cost of production that includes only the cost
of purchased inputs

It is the explicit cost of production only

 Short run vs Long run cost
 Short run costs are the costs over a period during
which at least some factors of production are fixed

 Long- run costs are the cost over a long period to

permit the change of all factor of production
Fixed cost in the long-run is equal to 0, why?
 Contd…
 In the short run production because there is at least one
fixed cost, total cost is expected to be the sum of both
fixed and variable inputs cost.
 i.e.: TC= TFC+TVC
 Where:

fixed cost is a cost that is constant, regardless of the

number of outputs produced either zero or more production.
These costs are unavoidable or can be avoid if and only if
the business stops operation/shut down
 Contd…
 Variable cost is a cost that is incurred with each
unit of production
 It varies with the level of output produced
 Contd…
 But in the case of long run production all inputs
are variables so there is no fixed cost.
TC=TVC
 Or

MC=MVC and AC=AVC

 223 05/26/2023

Market structure

 Markets may classified in to many streams on the

basis of different dimensions.
 In economics the common way of classifying
market is market structure
 Classification by market structure:
 Market Structure refers to the relative number and
size of firms in an industry and characteristics of the
market that significantly affect the behavior and
interaction of buyers and sellers.
Biruk J.
 224 05/26/2023

Contd…
 FourMain Characteristics:
 Number and size distribution of sellers
 Number and size distribution of buyers
 Product Differentiation
 Conditions of entry and exit
 Flow of information

Biruk J.
 225 05/26/2023

Contd…
 Based on market structure, markets are classified
in to:
 Perfect markets and;
 Imperfect markets (monopoly, duopoly, oligopoly,
monopolistic competition).

Biruk J.
 226 05/26/2023

Contd…
 Perfect markets: A perfect market is one in which the following
conditions hold good:
1) There are a large number of buyers and sellers;
2) All the buyers and sellers in the market have perfect
knowledge and information about demand, supply and prices;
3) Products are homogenous
4) Prices at any one time are uniform over a geographical
area, plus or minus the cost of getting supplies from surplus to
deficit areas;

Biruk J.
 227 05/26/2023

Contd…
5) The prices are uniform at any one place
over periods of time, plus or minus the cost
of storage from one period to another; and

6) The prices of different forms of a product are

uniform, plus or minus the cost of converting the
product from one form to another.

Biruk J.
 228 05/26/2023

Contd…
 As a result of its characteristics, perfectly competitive
market has the following outcomes:
 The actions of any single buyer or seller in the market have
a negligible impact on the market price
 Each buyer and seller takes the market price as given. Thus,
each buyer and seller is a price taker
 No individual firm can affect the market price
 Demand curve facing each firm is perfectly elastic
 The price of this market is lower than other market
structures
Biruk J.
Bonus
 Habtamu Kindu (0029/10) +2
 Eshetu Aragaw (0023/10) +2
 Zewudu Mossie (0056/10) +1
 Tafete Cherkos (0046/10) +0.5
 230 05/26/2023

Contd…
 Imperfect markets: is the market in which the
conditions of perfect competition are lacking.

 Based on the degree of imperfection they may be

classified as monopoly, duopoly, oligopoly, or
monopolistic competitive markets.

Biruk J.
 231 05/26/2023

Contd…
 Monopoly market:
Monopoly is a market situation in which
there is only one seller of a commodity. That
body exercises sole control over the quantity or
price of the commodity.
 Characteristics of monopoly market:
 A single seller producing a product with no close
substitutes
 Effective barriers to entry into the market, this due
to three sources:
Biruk J.
 232 05/26/2023

Contd…
 Ownership of a key resource
 The government gives a single firm the exclusive right to
produce some good
 Costs of production make a single producer more efficient
than a large number of producers
 The firm is a price maker (price setter)
 In this market, the price of a commodity is generally higher
than in other markets.
 Demand curve for a monopolist is the market demand curve
and it is downward sloping
Biruk J.
 233 05/26/2023

Contd…
 Duopoly market: A duopoly market is one which has
only two sellers or buyers of a commodity.

 They may mutually agree to charge a common price

which is higher than the price in a common market.

 The market situation in which there are only two

buyers of a commodity is known as the duopsony
market.
Biruk J.
 234 05/26/2023

Contd…
 Oligopoly market: A market in which there are
more than two sellers but still a few sellers of
a commodity.
 In this case the firms may agree on what price to
sell the product which is higher than market price
but finally they violate it in order to get greater
market share.
 Firms Decisions To keep To violate
(A,B)
To keep 50,50 40,60

To violate 40,40 60,40

Biruk J.
 235 05/26/2023

Contd…
 Monopolistic competition: When a large
number of sellers deal in heterogeneous and
differentiated form of a commodity, then the
situation is called monopolistic competition.

 The difference is made conspicuous by different

trade marks on the product and different prices
prevail for the same basic product

Biruk J.
 237 05/26/2023

National income accounting

 National-income accounting refers to the
measurement of aggregate economic activity,
particularly national income and its components
 Why do we study the national income accounts?
 National income accounting provides
structure for our macroeconomic theory
models
 Production/supply vs consumption/
demand side of the economy
 Introduces statistics that characterize the
economy Biruk J.
 238 05/26/2023

Measuring GDP
 GDP is a good indicator of nations’ output
 Output typically measured as GDP i.e.: a value of
all final goods and services that is produced
within a country over a particular period of time
 Output can be measured via demand or production
side which is equal in equilibrium, or income
expenditure approach
1. Production side: output = payments to workers
in wages, capital in interest and dividends
2. Demand side: output = purchases by different
sectors of the economy
Biruk J.
 239 05/26/2023

Contd…
 The income approach:
 A method of computing GDP by measuring the
income—wages, rents, interest, and profits—
received by all factors of production in
producing final goods.
 It look at who’s being paid to produce it (the
supply side)
 Thesefactors are broken up into employee
compensation, rent, interest, and profits
Biruk J.
 240 05/26/2023

Contd…
 The expenditure approach:
 A method of computing GDP that measures the
total amount spent on all final goods during a given
period.
Expenditure categories:
 Personal consumption expenditures (C)—
household spending on consumer goods.
 Gross private domestic investment (I)—spending
by firms and households on new capital: plant,
equipment, inventory, and new residential
structures.
Biruk J.
 241 05/26/2023

Contd…
 Government consumption and gross investment
(G)
 Net exports (EX – IM)—net spending by the rest
of the world, or exports (EX) minus imports (IM)

 The expenditure approach calculates GDP by

adding together the four components of spending.
In equation form:
 GDP= C+G+I+(EX-IM)

Biruk J.
 GDP
 To avoid double counting in calculation of GDP.
Either we should:
 Compute the value of the final output or
 Count only the value added at each stage of production.
 Ex. Would not include the full price of MDF
bed, nails and timber bought by the
manufacturer for the production of bed 
nails and timber are intermediate goods
 Ex. The added values in each stages
production, painting and etc.
 243 05/26/2023

Contd…
 Only count goods and services currently produced
(in the time period being considered) & exclude
transactions involving used goods
 Ex. Include the construction of new homes in
current GDP, but not the sale of existing homes
(real-estate-agent fees are included as services!)
 Only count goods and services produced within a
country, regardless of the ownership/nationality of
the producing firm
 Ex. Include the sale of a flower produced by a
Holland floriculture located in the Ethiopia in
Ethiopia GDP Biruk J.
 244 05/26/2023

Contd…
 There are three major problems with measuring
GDP:
 Omits non-market goods and services
 Ex. Work of stay at home not included
in GDP
 Government services not always
evaluated at market-clearing prices

Biruk J.
 245 05/26/2023

Contd…
 No accounting for “bad things” such as crime
and pollution
Ex. Crime and pollution are detrimental to
society, but there is no subtraction from GDP to
account for it
 No correction for quality improvements
 Ex. PC are cheaper at present than 20
yrs ago despite being much faster and
more powerful
 Despite these drawbacks, GDP is still considered
one of the best economic indicators for
estimating growth in an economy Biruk J.
 246 05/26/2023

GDP Vs GNP
 Gross National Product (GNP) is the aggregate
final output of citizens and businesses of an
economy in one year
 It measures the economic activity of the citizens
and businesses of a country
 Gross Domestic Product (GDP) is the total market
value of all final goods and services produced in
an economy in a one-year period.
 It is the single most-used economic measure
 GDP measures the economic activity that occurs
within a country Biruk J.
 247 05/26/2023

Real Vs Nominal GDP

 Nominal GDP is the value of final output
produced in a given period, measured in the prices
of that period

 Real GDP is the value of final output produced in

a given period, adjusted for base period price
 The base period is the time period used for
comparative analysis

Biruk J.
 248 05/26/2023

Tools of Macroeconomic Policies

 Because the government is so large and has such
an impact on business, the decisions it makes has a
huge influence on the economy

 There are two macro economic policies:

 Fiscal policies
 Monetary policies

Biruk J.
 249 05/26/2023

Fiscal Policy
 Refers to changes in government expenditures
and/or taxes to achieve particular economic goals,
such as low unemployment, price stability, and
economic growth

 Fiscalpolicy influences saving, investment, and

growth in the long run

 Inthe short run, fiscal policy primarily affects the

aggregate demand Biruk J.
 250 05/26/2023

Contd…
 Government expenditures is the sum of
government purchases and transfer payments

 The total level of government spending can be

changed to help increase or decrease the output of
the economy

Biruk J.
 251 05/26/2023

Contd…
 Expansionary Policies: refers to increases in government
expenditures and/or decreases in taxes to achieve
macroeconomic goals
 This is a policies that try to increase the output of the
economy
 During a contraction or recession of the economy, the
government can do two things:
1. Decrease Taxes
Or
2. Increase Spending
Biruk J.
 252 05/26/2023

Contd…
 Contractionaryfiscal policy: attempts to
decrease government expenditures and/or
increases in taxes to achieve
macroeconomic goals

 Thispolicies tries to decrease the output of

the economy
Biruk J.
 253 05/26/2023

Contd…
 During a period of excessive inflation (during a
period of expansion), the government can do
two things:

1. Increase Taxes
Or
2. Decrease Spending

Biruk J.
 254 05/26/2023

Problems with fiscal policy

1. It is unpopular to raise taxes or cut government
spending
 This because the government worries to win an
election
2. If the government cuts taxes, they have less money
to spend or they go into debt

Biruk J.
 255 05/26/2023

Monetary policy
 Monetary policies are regulations which
implemented by the government to control the
supply and demand of money in the economy

 The goal of monetary policy is to assist the

economy in achieving a full-employment,
noninflationary level of total output

Biruk J.
 256 05/26/2023

Contd…
 Based on instruments which initiate policy
monetary policy can be categorized by four
characteristics

 Instruments that initiate monetary policy:

 Open Market Operations
 The Discount Rate
 Reserve Ratios

Biruk J.
 257 05/26/2023

Open market operation

 It is the buying or selling of bonds by the
government in the open market
 It is the most often used instrument
 Expansionary- the government buys bonds (injects
reserves)
 Contractionary- the government sells bonds
(drains reserves)

Biruk J.
 258 05/26/2023

The Discount Rate

 It is defined as the rate of interest charged to
banks that borrow from the Federal
Reserve
 Expansionary- the government lowers
discount rate.
 Contractionary- the government raises
discount rate
Biruk J.
 259 05/26/2023

Reserve Ratios
 It is designed to change the amount of required reserves
 Expansionary Policy -- government lowers reserve
ratios
 Contractionary Policy – government raises reserve
ratios
 To raise the level of reserve
• Banks must hold more reserves
• Banks decrease lending
• Money supply decreases
Biruk J.
 260 05/26/2023

Contd…
 To lower the reserve ratio
 Banks may hold less reserves
 Banks increase lending
 Money supply increases

Biruk J.
Market Failure and Governments Role
 Economic freedom refers to the degree to which private
individuals are able to carry out voluntary exchange
without government involvement

 It is necessary and also linked to standards of living

 Inthis case the invisible hand market is required to control

every thing
 Contd…
To be economically efficient:
1. All actions generating more benefits than costs
should be undertaken

2. No actions generating more costs than benefits

should be undertaken

 But due to some reasons market failure may occurs

 Contd…
oMarket failure – the invisible hand pushes in such
a way that individual decisions do not lead to
socially desirable outcomes

oSo in such cases, some action by the government is

sometimes necessary to ensure that the market does
work well
 Causes of market failure
1. Externalities

2. Lack of Competition

3. Public goods

4. Lack of information
 Externalities
 Private costs and benefits are costs and benefits that are
borne solely by the individuals involved in the transaction

 An externality is a cost or benefit that accrues to someone

who is not the buyer (demander) or the seller (supplier)

 Externalities are the effect of a decision on a third party

that is not taken into account by the decision-maker
 Contd…
 Externalities can be either positive or negative

 A positive externality occur when the effects of a

decision not taken into account by the decision-
maker is beneficial to others

 A negative externality occur when the effects of a

decision not taken into account by the decision-
maker are detrimental to others
 Contd…
 If externalities exist, it means that those involved
in the demand and supply in the market are not
considering all the costs and benefits when making
their market decisions

 As a result, the market fails to yield optimal

results.
 Contd…
 When there is a negative externality, marginal
social cost is greater than marginal private cost

 Therefore, the competitive price is too low and

equilibrium quantity too high to maximize social
welfare
A Negative Externality
Cost S1 = Marginal social cost
S = Marginal private cost
Marginal cost from
P1 externality
P0

D = Marginal
benefit
0
Quantity
Q1 Q0
 Contd…
 In the case of positive externalities, producer
bears the cost and everybody gains the benefit

 With a positive externality, the demand curve

does not reflect all the benefits of the good

 As a result, the demand that is given is less

than it would be if demanders received the
external benefits
Positive Externalities
 The role of government
 Role of government is internalizing the costs and
benefits, so that the market can work better

 i.e.:
 Subsidizing positive externalities and
 Incurring additional cost for the producer like
pollution tax, commanding and introduction of
marketable pollution permits
 Lack of Competition
 With the absence of competition, a firm can hold
back production and raise price

 So the government should have to refrain from

activities that reduce competition like licenses

 It should have also work on motivating new

entrants in to the business
 Public goods
 Public goods have two characteristics:

Non-rival in consumption: making the good

available to one consumer does not reduce its
availability to others

Non-excludable: it is impossible (or incredibly

costly) to exclude nonpaying customers from
receiving the good
 Contd…
Free-rider: A person who receives the benefit of a
good without paying for it
This will cause the good to become under- supplied
In such cases, the government forces people to pay
through taxes
 Information
 This is one source of market failure

 When purchasing a good, consumers may not have

the information necessary to make an informed
choice

 The government provide information through

regulations
 277 05/26/2023

------------ The End ----------

THANK YOU

 GOOD LUCK
Biruk J.