Chapter One:

Introduction to Economics

1.1. Definition and scope of Economics

Economics is the study of how humans make decisions in the face of scarcity. These can
be individual decisions, family decisions, business decisions or societal decisions. If you
look around carefully, you will see that scarcity is a fact of life. Scarcity means that
human wants for goods, services and resources exceed what is available. Resources,
such as labor, tools, land, and raw materials are necessary to produce the goods and
services we want but they exist in limited supply. Of course, the ultimate scarce
resource is time- everyone, rich or poor, has just 24 expendable hours in the day to earn
income to acquire goods and services, for leisure time, or for sleep. At any point in time,
there is only a finite amount of resources available.

Think about it this way: In 2015 the labor force in the United States contained over 158
million workers, according to the U.S. Bureau of Labor Statistics. The total land area
was 3,794,101 square miles. While these are certainly large numbers, they are not
infinite. Because these resources are limited, so are the numbers of goods and services
we produce with them. Combine this with the fact that human wants seem to be
virtually infinite, and you can see why scarcity is a problem.

The word economics comes from the Greek word ‘Economicous’ meaning, one who
manages a household. There are two fundamental facts that provide the foundation for
the field of economics: Human or society’s material wants are unlimited and Economic
resources are scarce or limited in supply Society’s material wants refers to the desire of
consumers, businesses, and government to get those things that help them realize their
respective goals. Note that goal of consumers is to get maximum satisfaction, the goal of
businesses is to produce goods and services and get profit, and the goal of the
government is to satisfy the collective wants of its citizens. All of these wants are not
only numerous but also multiply through time. An economic resource refers to

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anything natural or manmade that can be used in production of goods and services. By
economic resources, we refer the various types of labors, minerals, buildings, trucks, oil
deposities, communication facilities, etc., that can be used in production of goods and
services. And all these resources are scarce or limited in supply. So, on the one hand,
society’s material wants are unlimited; on the other hand, economic resources are
limited. These contradictory facts lay the foundation for the field of economics.

The scope of economics is broad, encompassing various aspects of human life related to
resources, wealth, and decision-making. Economics studies how individuals,
businesses, governments, and societies allocate scarce resources to satisfy their
unlimited wants and needs. Here’s a breakdown of the major areas within the scope of
economics: Micro economics, macro, developmental, international, public,
environmental, health and like.

Generally, the Economics is, thus, defined as a social science, which studies
how societies allocate scarce resources in the production and distributes of
goods and services so as to attain the maximum fulfillment of society’s
material wants.

Activity one: dear, learner to what extent is the scope of Economics? Please, refer more.

1.2. Branch of Economics

Generally, Economics can be divided into two main branches:-macroeconomics and
microeconomics, where ‘macro’ means big and ‘micro’ means small.

A. Microeconomics: is the concerned with economic behavior (action) of individual

economic units, well-defined groups of individual economic units, and how markets of
individual commodities function: These individual economic units can be households
or a firm. It studies the interrelationships between these units in determining the
pattern of production and distribution of goods and services. It is concerned with the
decisions taken by individual consumers and firms and with the way these decisions
contribute to the setting of prices and output in various kinds of market. For example,

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questions like how does a particular person or household maximize satisfaction, how
does a particular business enterprise strive to get maximum possible profit by
producing and selling a product, .etc are studied in microeconomics.

B. Macroeconomics: is the branch of economic analysis that studies economy as whole

and sub aggregates of the economy: It does not deal with household, firm, or industry.
It deals with magnitudes such as the total output level in an economy, national income
of a country, the overall level of prices, total output and total employment in the
economy, general price level of goods and services in the economy, etc. For example, in
microeconomics we can study why the price of ‘teff’ increase or decrease in Addis
Ababa. But this increase or decrease in the price level of ‘teff ’is not the concern of
macroeconomics. Macroeconomics rather concerned with whether the average level of
prices of goods and services in the economy as whole is increasing or decreasing. In
short, in microeconomics we study a tree in a forest; but macroeconomics we study the
forest, not a tree. Remember that, like macroeconomics, microeconomics also uses
aggregates. For example, we talk of the total market demand for wheat, total market
demand for maize…etc. In microeconomics, we aggregate over homogenous product,
but in macroeconomics, the aggregation is at the economy level. In microeconomics we
cannot aggregate the total market demand for wheat and maize together. In
macroeconomics we can aggregate the total of several products and talk about the total
level of outputs currently produced in a country this year.

1.3. Methods in Economics

In order to solve the basic economic problems (What, how and for whom to produce)
economists design policies based up on principles or theories. This principles or
theories can be derived from facts. Economic theories/analysis are drawn from facts
through induction (from particular to general) and deduction (from general to
particular) methods.
Both methods come from science, viz., Logic. The deductive method involves reasoning
from a few fundamental propositions, the truth of which is assumed. The inductive

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method involves collection of facts, drawing conclusions from them and testing the
conclusions by other facts.

Deduction:

i. Starts from the general and moves to the particular.

ii. Begins with general assumptions and moves to particular conclusions.
iii. Develops a theory, and then examines the facts to see if they follow the
theory.

Induction:

i. Starts from the particular and moves to the general.

ii. Begins with particular observations and moves to general
explanations.
iii. Collects observations, then develops a theory to fit the facts.

Positive and Normative Economics

Positive economics deals with specific statements that are capable of verification by
reference to the facts about economic behavior. It deals with facts or relationships which
can be proven or disproven.
Examples of positive economic statements are:
 The 2000 fiscal year deficit of Ethiopia exceeded $5 billion.
 When the value of Birr falls, imported products into our country become more
expensive.
 If investment rises, national income will increase.
A normative economics is someone’s opinion or value judgment about an economic
issue. Such a statement can never be proven. It has a moral or ethical aspect and goes
beyond a science can say.
Examples of normative economic statements are:
 The government should raise taxes and lower government spending to reduce
the budget deficit.

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  We need to try to lower the value of Birr in order to discourage the importation
of foreign goods into this country.

 Families with income below birr $3,500 per year should be exempted from
1.4. Economic problems and Economic system
1.4.1. Economic problems
Scarcity of resources created three major problems that every society faces. These
economic problems are what, how and for whom to produce.

What to produce: It refers to those goods and services and the quantity of each that the
economy should produce. Since resources are scarce or limited, an economy cannot
produce as much of every good and service as desired by all members of society. For
this reason, more of one good or service means less of others. Therefore, every society
must choose exactly which goods and services to produce and in what quantities. In
other words, what to produce refers to the problem of allocation of scarce resource
between their alternative uses.
How to produce: It refers to the choice of the combination of factors and the particular
technique to use in producing a good or service. Different techniques of production can
be used to produce goods and services. Even if resources are generally scarce, some
resources may be relatively abundant than others in a country. For instance, in Ethiopia
labor is relatively abundant than capital. If the country uses more of labor and less of
capital it minimizes cost of production.

For whom to produce: This question refers to how the total output produced is to be
divided among different consumers. In every economy, due to scarcity no nation is
capable of satisfying all the needs of its society. As a result, the nation has to choose
how to distribute the output. For example, in market economy the distribution of goods
and services depends on the distribution of money income. That means, those who have
more income can enjoy more of the goods and services and those who have less income
can enjoy less of the goods and services.

1.4.2. Economic system

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One important difference between societies is in the degree of government control of
the economy. Based on this we have three types of economic systems:

Free market economy; command or planned economy and mixed economy. It is useful
to analyze the extremes, in order to put the different mixed economies of the real world
into perspective.

Free market economy is an economy where all economic decisions are taken by
individual households and firms and with no government intervention at all.
Households decide how much labor and other factors to supply, and what goods to
consume. Firms decide what goods to produce and what factors to employ. The pattern
of production and consumption that results depend on the interactions of all these
individual demand and supply decisions.

Command or centrally planned economy is an economy where all economic decisions

are taken by the central authorities/government.

Mixed economy is a market economy where there is some government intervention.

Because of the problems of both free-market and command economies, all real-world
economies are a mixture of the two systems. Government intervention can be used to
rectify various failings of the market. Note, however, that governments are not perfect
and their actions may bring adverse as well as beneficial consequences.

1.5. Scarcity; choice and opportunity cost

Scarcity: What is the crucial ingredient that makes a problem an economic one? The
answer is that there is one central problem faced by all individuals and all societies and
from this problem all the other economic problems stem. This central economic problem
is the problem of scarcity. At any one time the world can only produce a limited
amount of goods and services. This is because the world only has a limited amount of
resources. The reasons for scarcity economic resource is human wants are virtually
unlimited, whereas the resources available to satisfy these wants are limited. We can

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thus define scarcity is the excess of human wants over what can actually be produced.
Because of scarcity, various choices have to be made between alternatives

Economics is the study of scarcity-the study of the allocation of scarce resources to

satisfy human wants. People’s material wants, for the most part, are unlimited. Output,
on the other hand, is limited by the state of technology and the quantity and quality of
the economy’s resources. Thus, the production of each good and service involves a cost.
A good is usually defined as a physical item such as a car or a hamburger, and a service
is something provided to you such as insurance or a haircut.

Scarcity is a fundamental problem for every society. Decisions must be made regarding
what to produce, how to produce it, and for whom to produce. What to produce
involves decisions about the kinds and quantities of goods and services to produce.
How to produce requires decisions about what techniques to use and how economic
resources (or factors of production) are to be combined in producing output. The
economic resources used to produce goods and services include: land: (the economy’s
natural resources-such as land, trees, and minerals.); labor (The mental and physical
skills of individuals in a society); capital (Goods-such as tools, machines, and factories-
used in production or to facilitate production). The for whom to produce involves
decisions on the distribution of output among members of a society.

Economics helps to solve the three important questions of what to produce, how to
produce it, and for whom to produce. These decisions involve opportunity costs. An
opportunity cost is what is sacrificed to implement an alternative action, i.e., what is
given up to produce or obtain a particular good or service.

Choice and opportunity cost

Choice involves sacrifice. The more food you choose to buy, the less money you will
have to spend on other goods. The more food a nation produces the fewer resources
will there be for producing other goods. In other words, the production or consumption
of one thing involves the sacrifice of alternatives. This sacrifice of alternatives in the

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production (or consumption) of a good is known as its opportunity cost. Opportunity
cost is the cost of any activity measured in terms of the best alternative forgone.
Example; if the workers on a farm can produce either 1000 tons of wheat or 2000 tons of
barley, then the opportunity cost of producing 1 tons of wheat is the 2 tons of barley
forgone.

Activity two: define and explain the following term

1. What is economics?
2. What are the foundations of economics?
3. What is the central aim of economics?
4. What is micro economics?
5. What is macroeconomics?
6. What is positive economics?
7. What is normative economics?
8. Which kind of economic system does Ethiopia flow? Why? Explain.
9. Is any difference between Scarcity; choice and opportunity cost? How?

Chapter Two

Theory of Demand and Supply

Pre tests
 What is meant by demand and supply?

2.1. Definition and law of demand

Meaning of Demand

In our day-to-day life, we use the word demand in a loose sense to mean the desire of a
person to purchase a commodity or service. But in economics it has specific meaning.
Demand implies more than a mare desire to purchase a commodity. It states that the
consumer must be willing and able purchase the commodity, which he desire. His
desire should be backed by purchasing power. A poor person is willing to buy a car; it
has no ability to pay for it. On other hand, his desire to buy the care must be backed by

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the purchasing power constituting demand. Demand thus, means the desire of
commodity the consumer for commodity backed by the purchasing power. These two
factors are essential. If consumer is willing to buy but is not able to pay, his desire will
not become demand. If consumer is ability to pay but is not willing to pay, his desire
will not be called demand. Demand refers to the amount that consumers are willing and
able to purchase at a alternative price over a given period (e.g. a week, or a month, or a
year). Quantity demanded refers to the amount that consumers are willing and able to
purchase at a given price over a given period (e.g. a week, or a month, or a year). They
do not refer to what people would simply like to consume.

Law of Demand
Law of demand states that there is an inverse relationship between price of a
commodity and its quantity demand in the markets, keeping other factors constant. It
means that it shows us an inverse relationship between the above two variables. The
quantity of a good demanded per period of time will fall as price rises and will rise as
price falls, other things being equal (ceteris paribus). The two explanations to the law of
demand are income effect and substitution effect.
The reasons for law of demand are:
 People will feel poorer. They will not be able to afford to buy so much of the
good with their money. The purchasing power of their income (their real income)
has fallen. This is called the income effect of a price rise.
 The good will now cost more than alternative or ‘substitute’ goods, and people
will switch to these. This is called the substitution effect of a price rise.
But the above law operates only under the assumption that “other things remain
constant”. The above phrase implies that when we state the law of demand, we assume
the determinants of demand constant, these are
 Tastes and preference remain constant
 The number and price of substitute goods
 The number and price of complementary goods.
 Income of consumer

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  Distribution of income.
 Expectations of future price changes.
 Advertisement
 Past demand
 Consumer future price and income
The demand curve slopes downward from left to right. The downward slope of
demand curve reflects the law of demand. In the next section you will elaborate the law
of demand in terms of curve, equations and tables.
Demand schedule

A demand schedule is defined as a table which presents the quantity demanded at each
price level during a specific time period. Assuming that all other factors are constant by
varying the price of the goods itself, we get an individual demand schedule for the
good (see Table 2.1). Table shows how many kilograms of potatoes per month, would
be purchased at various prices. Columns (2) and (3) show the demand schedules for
two individuals, Tracey and Darren. Column (4) by contrast, shows the total market
demand schedule. This is the total demand by all consumers. To obtain the market
demand schedule for potatoes, we simply add up the quantities demanded at each price
by all consumers: i.e. Tracey, Darren and everyone else who demands potatoes.
Table 2.1 The demand for potatoes (monthly)

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

Price Tracey's Darren's Total market
(pence per demand demand demand
kg) (kg) (kg) (tonnes: 000s)

A 20 28 16 700
B 40 15 11 500
C 60 5 9 350
D 80 1 7 200
E 100 0 6 100

Demand schedule for an individual is refers to a table showing the different quantities
of a good that a person is willing and able to buy at various prices over a given period
of time.

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Market demand schedule is defined as a table showing the different total quantities of
a good that consumers are willing and able to buy at various prices over a given period
of time.

Demand curve:
The demand schedule can be represented graphically as a demand curve. Demand
curve is graph showing the relationship between the price of a good and the quantity of
the good demanded over a given time period. Price is measured on the vertical axis;
quantity demanded is measured on the horizontal axis. A demand curve can be for an
individual consumer or group of consumers, or more usually for the whole market. It
slopes downward from left to right: they have negative slope. This indicate the lower
the price of the product, the more is the person likely to buy.

Figure 2.1 shows the market demand curve for potatoes corresponding to the schedule
in Table 2.1. Point E shows that at a price of 100p per kilo, 100 000 tones of potatoes are
demanded each month. When the price falls to 80p we move down the curve to point D.
This shows that the quantity demanded has now risen to 200 000 tons per month.
Similarly, if the price falls to 60p we move down the curve again to point C: 350 000
tones are now demanded. The five points on the graph (A–E) correspond to the figures
in columns (1) and (4) of Table 2.1.
P r ic e ( p e n c e p e r k g )

Market demand for potatoes (monthly)

E
100

D
80

C
60

B
40

A
20
Demand

0
0 100 200 300 400 500 600 700 800
Quantity (tonnes: 000s)

Fig 2.1 Market demand for potatoes (month)

2.2. Determinants of Demand

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The extent of the demand for a good is determined by two factors. These factors are:
1. Price factor
2. Non price (The condition of demand) factors
Price factor (The conditions of demand remain constant)
Price is the most important factor that determines how much of a good people will buy
(demand), while the condition of demand is remain constant.

The condition of demand (price is assumed to be constant or given)

Price is not the only factor that determines how much of a good people will buy.
Demand is also affected by the following.
 Tastes: the more desirable people find the good, the more they will demand.
Tastes are affected by advertising, by fashion, by observing other consumers, by
considerations of health and by the experiences from consuming the good on
previous occasions.
 The number and price of substitute goods (i.e. competitive goods or goods
considered by consumers to be alternatives to each other e.g. Coffee & Tea): the
higher the price of substitute goods, the higher will be the demand for this good as
people switch from the substitutes.
 The number and price of complementary goods. Complementary goods are
those that are consumed together: cars and petrol, shoes and polish. The higher the
price of complementary goods, the fewer of them will be bought and hence the less
will be the demand for this good.
 Income. As people’s incomes rise, their demand for most goods will rise. Such
goods are called normal goods. There are exceptions to this general rule, however.
As people get richer, they spend less on inferior goods, such as cheap margarine,
and switch to better quality goods. N.B Normal goods whose demand increases as
consumer incomes increase. Inferior goods whose demand decreases as consumer
incomes increase.
 Distribution of income. If national income were redistributed from the poor to the
rich, the demand for luxury goods would rise. At the same time, as the poor got

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 poorer they might have to turn to buying inferior goods, whose demand would
thus rise too.
 Expectations of future price changes. If people think that prices are going to rise
in the future, they are likely to buy more now before the price does go up.

2.3. Movements along and shifts in the demand curve

A demand curve is constructed on the assumption that ‘other things remain equal’
(ceteris paribus). In other words, it is assumed that none of the determinants of
demand, other than price, changes. The effect of a change in price is then simply
illustrated by a movement along the demand curve: for example, from point B to point
D in Figure 2.1 when the price of potatoes rises from 40p to 80p per kilo.

What happens, then, when one of these other determinants does change? The answer is
that we have to construct a whole new demand curve: the curve shifts. If a change in
one of the other determinants causes demand to rise – say, income rises – the whole
curve will shift to the right. This shows that at each price more will be demanded than
before. Thus in Figure 2.2 at a price of P, a quantity of Qo was originally demanded. But
now, after the increase in demand, Q1 is demanded. (Note that D1 is not necessarily
parallel to D0.) If a change in a determinant other than price causes demand to fall, the
whole curve will shift to the left.
An increase in demand

P
P r ic e

D0 D1

O Q0 Q1
Quantity

Fig 2.2 shift in demand curve

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To distinguish between shifts in and movements along demand curves, it is usual to
distinguish between a change in demand and a change in the quantity demanded. A
shift in the demand curve is referred to as a change in demand, whereas a movement
along the demand curve as a result of a change in price is referred to as a change in the
quantity demanded.

Demand function
We can represent the relationship between the market demand for a good and the
determinants of demand in the form of an equation. This is called a demand function. It
can be expressed either in general terms or with specific values attached to the
determinants. Simple demand functions. Demand equations are often used to relate
quantity demanded to just one determinant. Thus an equation relating quantity
demanded to price could be in the form:
q d=a−bp (1)
For example, the actual equation might be: Qd=10, 000 - 200P. More complex demand
functions. In a similar way, we can relate the quantity demanded to two or more
determinants. For example, a demand function could be of the form:

q d=a−bp +cY −d P s+ e Pc . (2)

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Where Qd = quantity demanded; p = price of the good; Y= income; Ps= price of substitute good;
Pc= price of complement

2.4. Definition of Supply

Supply refers to the various quantities of a product that sellers (producers) are willing
and able to provide at various prices in a given period of time, citrus paribus. Note that
quantity supplied and supply are two different concepts. Quantity supplied refers to a
specific quantity that a supplier is willing and able to provide at a specific price. But
supply refers to the whole relationship between possible prices of a product and the
corresponding quantities supplied.

Law of Supply

Law of supply states that, other things remain unchanged, as price of a product
increases quantity supplied of the product increases, and as price decreases, quantity
supplied of the product decreases. From law of supply, we understand that sellers are
motivated to sell more at higher prices than at lower prices.

The Supply Curve, Schedule and Function

The amount that producers would like to supply at various prices can be shown in a
supply schedule. Table 2.2 shows a monthly supply schedule for potatoes, both for an
individual farmer (farmer X) and for all farmers together (the whole market). The
supply schedule can be represented graphically as a supply curve. A supply curve may
be an individual firm’s supply curve or a market curve (i.e. that of the whole industry).
Take the same definition for supply schedule and supply curve as we defined for
demand.
Table 2.2 Individual producer’s supply of potatoes per monthly

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 The supply schedule:
c: of potatoes (monthly)
The supply

Price of Farmer X's Total Market

potatoes supply supply
(pence per kg) ( tonnes) ( tonnes: 000s)

a 20 50 100

b 40 70 200

c 60 100 350

d 80 120 530

e 100 130 700

From the above table we notice that as price rises, the respective quantity supplied rises,
and as price decreases, the respective quantity supplied decreases. The direct
relationship between price of a product and quantity supplied, holding other things
constant, is called the law of supply.
Law of supply states that, other things remain unchanged, as price of a product
increases quantity supplied of the product increases, and as price decreases, quantity
supplied of the product decreases. From law of supply, we understand that sellers are
motivated to sell more at higher prices than at lower prices

Market supply of potatoes (monthly)

100 e
P ric e (p e n c e p e r k g )

Supply
d
80

c
60

b
40

a
20

0
0 100 200 300 400 500 600 700 800
Quantity (tonnes: 000s)

Fig 2.3 Market supply of potatoes (monthly)

Figure 2.3 shows the market supply curve of potatoes. As with demand curves, price is
plotted on the vertical axis and quantity on the horizontal axis. Each of the point’s a–e
corresponds to a figure in Table 2.2. Thus, for example, as price rise from 60p per

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kilogram to 80p per kilogram will cause a movement along the supply curve from point
c to point d: total market supply will rise from 350 000 tons per month to 530 000 tons
per month. Not all supply curves will be upward sloping (positively sloped).
Sometimes they will be vertical or horizontal or\ even downward sloping. This will
depend largely on the time period over which firms’ response to price changes is
considered.

2.5. Determinants of Supply

Like demand, supply is not simply determined by price. The other determinants of
supply (supply shifter) are as follows.
 The costs of production (price of inputs); the higher the costs of production, the
less profit will be made at any price. As costs rise, firms will cut back on
production, probably switching to alternative products whose costs have not
raised so much.
 The profitability of alternative products (substitutes in supply); If a product
which is a substitute in supply becomes more profitable to supply than before,
producers are likely to switch from the first good to this alternative. Supply of the
first good falls. Other goods are likely to become more profitable if: their prices
rise; their costs of production fall.
 The profitability of goods in joint supply; Sometimes when one good is
produced, another good is also produced at the same time. These are said to be
goods in joint supply. An example is the refining of crude oil to produce petrol.
Other grade fuels will be produced as well, such as diesel and paraffin. If more
petrol is produced, due to a rise in demand and hence its price, then the supply of
these other fuels will rise too.
 Nature, ‘random shocks’ and other unpredictable events; In this category we
would include the weather and diseases affecting farm output, wars affecting the
supply of imported raw materials, the breakdown of machinery, industrial
disputes, earthquakes, floods and fire, etc.

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  The aims of producers; A profit-maximizing firm will supply a different quantity
from a firm that has a different aim, such as maximizing sales. For most of the time
we shall assume that firms are profit maximizes.
 Expectations of future price changes; If price is expected to rise, producers may
temporarily reduce the amount they sell. Instead they are likely to build up their
stocks and only release them on to the market when the price does rise. At the
same time they may install new machines or take on more labour, so that they can
be ready to supply more when the price has risen.
 The number of suppliers; If new firms enter the market, supply is likely to increase.

2.6. Movements along and shifts in the supply curve

The principle here is the same as with demand curves. The effect of a change in price is
illustrated by a movement along the supply curve: for example, from point d to point e
in Figure 2.3 when price rises from 80p to 100p. Quantity supplied rises from 530 000 to
700 000 tons per month. If any other determinant of supply changes, the whole supply
curve will shift. A rightward shift illustrates an increase in supply. A leftward shift
illustrates a decrease in supply. Thus in Figure 2.4, if the original curve is S0, the curve
S1 represents an increase in supply (more is supplied at each price), whereas the curve S2
represents a decrease in supply (less is supplied at each price).
Shifts in the supply curve
P
S2 S0 S1

Decrease Increase

O Q

Fig 2.4 shifts in supply

A movement along a supply curve is often referred to as a change in the quantity
supplied, whereas a shift in the supply curve is simply referred to as a change in
supply.

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Supply Function

The simplest form of supply equation relates supply to just one determinant. Thus a
function relating supply to price would be of the form:
q s=c+ dp…………………………………………………. (1)
Thus an actual supply equation might be something like:
Qs = 500 + 1000P (2)
More complex supply equations would relate supply to more than one determinant.
q s=c+ dp−e a1−f a2 + gj…….………………………. (3)
Where P is the price of the good, a1 and a2 are the profitability’s of two alternative goods
that could be supplied instead, and j is the profitability of a good in joint supply.
Explain why the P and j terms have a positive sign, whereas the a1 and a2 terms have a
negative sign.

2.7. Market equilibrium approaches

This will show how the actual price of a product and the actual quantity bought and
sold are determined in a free and competitive market. Equilibrium is the point where
conflicting interests are balanced; only at this point is the amount that demanders are
willing to purchase the same as the amount that suppliers are willing to supply. It is a
point that will be automatically reached in a free market through the operation of the
price mechanism. The price where demand equals supply is called the equilibrium price
and the quantity where demand equals supply is called the equilibrium quantity. Let us
return to the example of the market demand and market supply of potatoes, and use the
data from Tables 2.1 and 2.2. These figures are given again in Table 2.3.

Table 2.3 The market demand and supply of potatoes (monthly)

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 Equilibrium price and output:
The Market Demand and Supply of Potatoes (Monthly)

Price of Potatoes Total Market Demand Total Market Supply

(pence per kilo) (Tonnes: 000s) (Tonnes: 000s)

20 700 (A) 100 (a)

40 500 (B) 200 (b)
60 350 (C) 350 (c)
80 200 (D) 530 (d)
100 100 (E) 700 (e)

Equilibrium price and output :

The Market Demand and Supply of Potatoes (Monthly)

Price of Potatoes Total Market Demand Total Market Supply

(pence per kilo) (Tonnes: 000s) (Tonnes: 000s)

20 700 (A) 100 (a)

40 500 (B) 200 (b)
60 350 (C) 350 (c)
80 200 (D) 530 (d)
100 100 (E) 700 (e)

The determination of market equilibrium

(potatoes: monthly)
P ric e (p e n c e p e r k g )

E e
100
Supply
D SURPLUS d
80
(330 000)

60

b SHORTAGE B
40
(300 000)
a A
20

Demand
0
0 100 200 300 Qe 400 500 600 700 800
Quantity (tonnes: 000s)

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Fig 2.5 the determination of market equilibrium (potatoes: monthly)

The determination of equilibrium price and output can be shown using demand and
supply curves. Equilibrium is where the two curves intersect. Figure 2.5 shows the
demand and supply curves of potatoes corresponding to the data in Table 2.3.
Equilibrium price is Pe (60p) and equilibrium quantity is Qe (350 000 tones).

At any price above 60p, there would be a surplus. Thus at 80p there is a surplus of 330
000 tones (d-D). More is supplied than consumers are willing and able to purchase at
that price. Thus a price of 80p fails to clear the market. Price will fall to the equilibrium
price of 60p. As it does so, there will be a movement along the demand curve from
point D to point C, and a movement along the supply curve from point d to point c.

At any price below 60p, there would be a shortage. Thus at 40p there is a shortage of
300 000 tonnes (B-b). Price will rise to 60p. This will cause a movement along the supply
curve from point b to point c and along the demand curve from point B to point C.
Point Cc is the equilibrium: where demand equals supply. In fact, only one price is
sustainable – the price where demand equals supply: namely, 60p per kilogram, where
both demand and supply are 350 000 tones. When supply matches demand the market
is said to clear. There is no shortage and no surplus.

Movement to a new equilibrium

The equilibrium price will remain unchanged only so long as the demand and supply
curves remain unchanged. If either of the curves shifts, a new equilibrium will be
formed. A change in demand; If one of the determinants of demand changes (other
than price), the whole demand curve will shift. This will lead to a movement along the
supply curve to the new intersection point.

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 Effect of a shift in the demand curve
P
S

i New equilibrium at
Pe2 point i

g h
Pe
1

D2
D1
O Qe1 Qe2 Q

Fig 2.6 Effect of a shift in the demand curve

A Change in Supply

Likewise, if one of the determinants of supply changes (other than price), the whole
supply curve will shift. This will lead to a movement along the demand curve to the
new intersection point. For example, in Figure 2.7, if costs of production rose, the
supply curve would shift to the left: to S2. There would be a shortage of g j at the old
price of Pe1. Price would rise from Pe1 to Pe3. Quantity would fall from Qe1 to Qe3. In
other words, there would be a movement along the demand curve from point g to point
k, and along the new supply curve (S2) from point j to point k.
Effect of a shift in the supply curve
P
S2

S1

k
P e3

j g New equilibrium at
P e1 point k

D
O Q e3 Q e1 Q

Fig 2.7 Effect of a shift in the supply curve

To summaries: a shift in one curve leads to a movement along the other curve to the
new intersection point. Sometimes a number of determinants might change. This might

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lead to a shift in both curves. When this happens, equilibrium simply moves from the
point where the old curves intersected to the point where the new ones intersect.
2.8. Elasticity’s of Supply and Demand

We have seen that the demand for a good depends on its price, as well as on consumer
income and on the prices of other goods. Similarly, supply depends on price, as well as
on variables that affect production cost. For example, if the price of coffee increases, the
quantity demanded will fall, and the quantity supplied will rise. Often, however, we
want to know how much supply or demand will rise or fall. How sensitive is the
demand for coffee to its price? If price increases by 10 percent, how much will demand
change? How much will demand change if income rises by 5 percent? We use
elasticity’s to answer questions like these.

Elasticity is a measure of the sensitivity of one variable to another. Specifically, it is a

number that tells us the percentage change that will occur in one variable in response to
a 1 percent change in another variable.

The concept of elasticity is used to measure the amount by which the quantity demanded/supply
changes when its determinants/supply change. There are as many elasticities of demand as there
are its determinants. The most important of these elasticities are:
A. The price elasticity of demand/supply
B. The income elasticity of demand/supply
C. The cross-elasticity of demanded/ supply

A. The Price Elasticity of Demand

The price elasticity is a measure of the responsiveness of demand to changes in the commodity’s
own price. If the changes in price are very small, we use as a measure of the responsiveness of
demand the point elasticity of demand. If the changes in price are not small, we use the arc
elasticity of demand as a relevant measure. The point elasticity of demand is defined as the
proportionate change in the quantity demanded resulting from a very small proportionate change
in price. Symbolically, we may write as:

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It tells us what the percentage change in the quantity demanded for a good will be
following a 1 percent increase in the price of that good. Let’s look at this in more detail.
Denoting quantity and price by Q and P, we write the price elasticity of demand as

(% ∆ Q)
ε p=
(% ∆ P)

where %∆ Q simply means "percentage change in Q" and % ∆ P means "percentage

change in P."~ But the percentage change in a variable is just the absolute change in the
variable divided by the original level of the variable. (If the Consumer Price Index were
200 [he beginning of the year and increased to 204 by the end of the year, the percentage
change-or annual rate of inflation-would be 4/200 = .02, or 2 percent.) So we can also
write the price elasticity of demand as

∆ Q/Q P ∆Q
ε p= =
∆ P/ P Q ∆ P

The price elasticity of demand is usually a negative number. When the price of good
increases, the quantity demanded usually falls, so ∆ Q /∆ P Q (the change in quantity for
a change in price) is negative and therefore ε p is negative. When the price elasticity is
greater than 1 in magnitude, we say that demand is price elastic because the percentage
decline in quantity demanded is greater than the percentage increase in price. If the
price elasticity is less than 1 in magnitude, demand is said to be price inelastic. In
general, the elasticity of demand for a good depends on the availability of other goods
that can be substituted for it. When there are close substitutes, a price increase will
cause the consumer to buy less of the good and more of the substitute. Demand will
then be highly price elastic. When there are no close substitutes, demand will tend to be
price inelastic. The price elasticity of demand is the change in quantity associated with a
change in price (∆ Q /∆ P Q) times the ratio of price to quantity (P/Q). But as we move
down the demand curve, (∆ Q/∆ P) may change, and the price and quantity will always
change. Therefore, the price elasticity of demand must be measured at a particular point

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on the demand curve and will generally change as we move along the curve. This is
easiest to see for a linear demand curve, that is, a demand curve of the form

Q=a−bP

For this curve,∆ Q /∆ P is constant and equal to -2 (∆ P of 1 results in a,∆ Q of -2).

However, the curve does not have a constant elasticity. Figure 2.8 as we move down the
curve, the ratio P/Q falls, and therefore the elasticity decreases in magnitude. Near the
intersection of the curve with the price axis, Q is very small. so ε p= -2(P/Q) is large in
magnitude. When P = 2 and Q = 4, ε p = -1. And at the intersection with the quantity axis,
P = 0 so ε p = 0. Because we draw demand (and supply) curves with price on the vertical
axis and quantity on the horizontal axis, ∆ Q /∆ P = (I/slope of curve).

FIGURE 2.8 Linear Demand Curve.

Given this graphical measurement of point elasticity it is obvious that at the mid-
point of a linear demand curve ep = 1. At any point to the right of ep=1 the point
elasticity is less than unity (ep < 1); finally, at any point to the left of ep=1, ep > 1.
At point D, the ep , while at point D’ the ep = O. The price elasticity is always
negative because of the inverse relationship between Q and P implied by the law of
demand. However, the negative sign is omitted when writing the formula of the
elasticity.
The range of values of the elasticity is O  ep  .
(1) If ep = O, then the demand is perfectly inelastic
(2) If ep = 1, then the demand is unitary elastic

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 (3) If ep = , then the demand is perfectly elastic
(4) If O< ep < 1, then the demand is inelastic
(5) If 1 < ep < , then the demand is elastic.

B. Income Elasticity of Demand

The income elasticity is defined as the proportionate change in the quantity demanded resulting
from a proportionate change in income.

∆ Q/Q Y ∆ Q
ε y= =
∆ Y /Y Q ∆ Y

 If e y > o, then the commodity is normal.

 If e y <0, then the commodity is inferior
 If e y >1, then the commodity is luxury
 If 0<e y <1, then the commodity is necessity

The main determinants of income elasticity are

i. The nature of the need that the commodity covers: the percentage of income spent on
food declines as income increases.
ii. The initial level of income of a country. For example, a TV set is a luxury in
underdeveloped countries while it is a necessity in a country with high per capital
income.
iii. The time period, because consumption patterns adjust with a time lag to changes in
income.
C. The Cross- Elasticity of Demand

The cross elasticity of demand is defined as the proportionate change in quantity demand of X
resulting from a proportionate change in the price of Y.

∆Q x
∆ Q x /Q x ∗P y
ε xy = = ∆Py
∆ P y /P y
Qx

If 𝑒𝑥𝑦 < 𝑜, then X & Y are complementary goods. If 𝑒𝑥𝑦 > 𝑜, “ “ substitute goods.

Activity two:

26
 1. What is demand and supply? And what factors can determine both demand and supply?
2. Suppose a 3 percent increase in the price of corn flakes causes a 6 percent decline in the
quantity demanded. What is the elasticity of demand for corn flakes?
3. Consider a competitive market for which the quantities demanded and supplied (per year)
at various prices are given as follows:

a. Calculate the price elasticity of demand when the price is $80. What about when the price is
$100.
b. Calculate the price elasticity of supply when the price is $80. What about when the price is
$100.
c. What are the equilibrium price and quantity?
d. Suppose the government sets a price ceiling of $80. Will there be a shortage, and if so, how
large will it be?

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