Wollo University; Department of AE, Agricultural Economics Program

Lecture Notes on Microeconomics-I (AgEc211)

CHAPTER ONE: INTRODUCTION TO ECONOMICS

1.1 An Introductory Remark
In this chapter, students will learn about the basic principles, theories, models of economics
discipline; definition of economics, nature of economics, main branches of economics,
usefulness and significance of studying economics, opportunity costs, and the nature of choice
and scarcity of resources.

Besides, you will learn about methods, types and levels of economic analysis and you will
differentiate the positive economic analysis from the normative one; deductive economic
reasoning from inductive one; and microeconomics from macroeconomics. Then, you will learn
about the fundamental (basic) economic problems; what to produce? How to produce? When to
produce? and for whom to produce? You will also learn how to distinguish and evaluate different
elements of economic systems how to solve the above problems.

Lastly, you will be introduced to the production possibility frontier (PPF), decision-making unit
and circular flow model, business enterprises and economic functions of governments.
Economics uses verbal explanation, mathematical equations and graphs. The PPF is the first
curve that you will encounter in this course.

For additional reading, you may use any standard text-book in economics or principles of
economics, or you may use the list of references given at the end of this course.

1.2 Definition of Economics

The word economics comes from the Greek word for “one who manages a household”. The
subject matter of economics continues to grow and expand in scope, size and character right
from the days of its founders, Adam Smith- generally know as the father of economics- to date.
Economics is a branch of social sciences. Human beings require various goods and services.
Economy is a system which provides people with the means to work and earn a living. living.
Economics as a science and /or discipline can be defined as in a number of ways.
 On the one hand, human wants are unlimited on the other, economic resources available to
satisfy all these wants are scarce or limited. Therefore, economics is a science that tries to
balance (reconcile) the unlimited nature of human wants and the limited nature of
economic resources.
 Economics is the study of how people allocate their limited resources to their alternative
uses to produce and consume goods and services to satisfy their endless wants or to
maximize their gains.
 Economics is a study of problems regarding choices that must be made due to scarcity of
resources. The insatiable nature of human material wants and the corresponding scarcity of
resources lead to the need for making choices. These Choices are how to allocate scarce
resources to maximize the satisfaction of human wants.
 Economics is the study of choosing among alternative ways in which scarce resources may
be allocated to maximize the satisfaction of human wants.

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Wollo University; Department of AE, Agricultural Economics Program
Lecture Notes on Microeconomics-I (AgEc211)

 Economics as a discipline therefore gives rise to a way of reasoning on how to allocate

scarce resources efficiently.
 It can also be defined as a branch of social science that is concerned with the efficient
utilization and management of limited productive resources for attaining maximum
satisfaction of human material wants. Besides, many economists have forwarded their own
definition of economics, some are:
 Economics is a study of how society manages scarce resources.
 It is the study of constrained maximization
 It is the study of choice or it is the science of choice.
 It is the study of how a society chooses to use its limited resources to produce,
exchange, and consume goods and services.
 It is a science that studies how to people use the things they have, to try to get the
most of what they want.
 It is the study of how scarce resources are allocated among competing ends

1.3 The Nature of Economics

Should economics be treated as a science or an art? We have observed that the variety in the
definition of economics reflects the changing views of economists over time. Some economists
have treated economics as a science, and others consider it to be an art.

1.3.1 Economics as a Science

The basic function of a science is to study a certain kind of natural and social phenomenon.
Science produces a systematic and organized knowledge that correlates causes and effects. This
knowledge can be called knowledge of “what is”. In economics, various facts are systematically
collected, classified, analyzed and interpreted to make prediction for the future, and it is in this
sense that economics can be considered to be a science.

1.3.2 Economics As An Art

Art is a technique or a way of doing or achieving something. While dealing with problems like
unemployment, poverty and inflation, economics presents principles and methods by which these
problems can be solved. Thus, economics is not only investigates the nature and causes of an
economic problem but also sets guidelines for its solution. On this basis, we can consider
economics to be an art.

1.4 Branches of Economics /Scope of Economics

By scope of economics, we mean coverage or major areas of study. The field and scope of
economics is expanding rapidly and has come to include a vast range of topics and issues. Many
new branches of the subject have developed, including development economics, welfare
economics, environmental economics, and so on. But, the core modern economics when

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Lecture Notes on Microeconomics-I (AgEc211)

developed in to a discipline comprises two main branches called microeconomics and

macroeconomics.

1.4.1 Microeconomics
Microeconomics is a branch of economics that studies the economic decision making of firms
and individuals in a market. It is the study of the economy in the small. It is concerned with the
economic activities of individual consumers and producers or group of consumers and producers.
In other words, it is concerned with the specific economic units and a detailed consideration of
the behavior of these individual units.
In Microeconomics, we talk in terms of individual industry, firm, or household and concentrate
up on the functioning of individual industries and the behavior of individual decision-making
units, i.e., single firm (business) and household. Microeconomics is useful in achieving a worm’s
eye view of some of the very specific components of an economy. Microeconomics examines
individual trees in a forest.

1.4.2 Macroeconomics
Macroeconomics is the branch of economics that studies the economy at large or the economy as
a whole. It is also the concern of macroeconomics to deal with the sub-aggregates (sub-divisions)
of the economy such as the government, total households in the economy, the whole industry,
and business sector, which make up the economy.
In dealing with aggregates, macroeconomics deals with obtaining general outline or overview of
an economy. In macroeconomics no attention is given to the specific units, which make up the
various aggregates, only the aggregates are a matter of concern. Macroeconomics entails
discussion on such magnitudes as national aggregates like national income and output, saving
and investment, total employment, general price level, etc. It considers the overall performance
of the economy with regard to the above variables and hence it is sometimes called aggregate
economics.
Note: Microeconomics also deals with aggregates. For example, we may talk of the total
production, total employment, total market demand (which is an aggregate) of Toyota, Nissan,
Mazda, etc of Japanese firms. It is the concern of microeconomics to study the total level of
employment in this single automobile industry (which is an aggregate of Toyota, Mazda, Nissan,
and others).

Let’s compare Microeconomics and Macroeconomics as follows.

follows

No Microeconomics Macroeconomics
1 It studies the behavior of It studies an economy as a whole
individual economic units of an and its aggregates.
economy.
2 Is concerned with output, price, Entails detail consideration of total

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income, employment, and output, total income, total

consumption determination in employment and general price level
individual household, firm or in the economy at large.
industry.
3 Is with the objective of efficient Is with the objective of maintaining
resource allocation and price high employment, maintaining
determination. stability of an economy, facilitating
growth and controlling inflation
4 Its main tools are the demand and Its main tools are aggregate
supply of particular commodities demand and aggregate supply of an
and factors economy as a whole.
5 It helps to solve the central It helps to solve the central problem
problem of ‘what, how, and for of ‘full employment of resources in
whom to produce’ in an economy. the economy’.
6 It discusses how the equilibrium of It is concerned with the
a consumer, a producer or an determination of equilibrium levels
industry is attained. of income and employment.
7 It is known as price theory or the It is known as the theory of income
theory of value and employment or simply income
analysis.
8 It studies aggregates that do not Studies aggregate and sub-
relate to the entire economy such aggregate items such as national
as individual income, individual income, national savings, general
savings, individual prices, price level, national output,
individual firm’s output, individual aggregate consumption and
consumption, individual expenditure, and aggregate
expenditure etc. employment etc at economic level.

1.5 Usefulness and Significance of Economics

Basic question: - why study economics? Economics is an important discipline and its importance
increased in recent years in response to worldwide economic problems. Nowadays, even counties
that have made rapid progress in areas like medicine, engineering, technology, electronics, and
information technology are not free from economic problems. Problems like poverty,
unemployment, inflation, economic recession, population explosion, global warming and so on
are worldwide today. Thus, to understand such problems and find solutions to them, an adequate
knowledge of economics is required. Some of the advantages of studying and knowledge of
economics are:

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 Economics helps us to understand certain problems and questions affecting individuals and
families (e.g. the types of jobs available, the level of wages in industries, the effects of
price rises on peoples’ standard of living )
 Economics explains problems and questions that affect society and the state as a whole, and
it suggests suitable solution for them (e.g. what are the causes of unemployment and how
can we reduce it, what causes price rises, what policies should the government adopt to
control inflation).
 Economics examines the actions and behaviors of different types of people under different
circumstances (e.g. employees, investors and speculators).
 Economics explains the causes of fluctuations in economic activity and helps us to
understand business trends.
 Economics helps us to understand and solve crucial problems like poverty and
unemployment.
 The study of economics is useful for economic planning and economic development.
 Economics helps us to understand and participate in international trade by examining the
theory and practice of exports, imports, comparative costs etc.
 Economics helps us to understand how different economic systems function.
The study of economics helps us to understand how social welfare can be achieved through
material means. Generally, the study of economics develops logical thinking and analytical
attitudes, and it enhances our faculties of observation and judgment.

1.6 Foundations of Economics

The following are the most fundamental facts with which the foundation of economics can be
built on.

1.6.1 The Economic Problem ( the problem of unlimited human wants )

Human wants are unlimited, and productive resources such as land, raw materials,
capital, and equipment that are used to produce goods and services to satisfy these
wants are scarce. With wants being unlimited and resources being limited, we
cannot satisfy all of our wants. This gives rise to the problem of how to use scarce
resources to attain maximum satisfaction. This is generally called the economic problem.
problem. We
may say, the economic problem is concerned with the uses of scarce resources among alternative
human wants and in using these resources towards the end of satisfying wants as fully as
possible.” Since all wants cannot be satisfied, due to scarcity of resources, we have to make
choices. The economic problem is also called the problem of choice.
choice.

Human wants refer to all the goods, services, and the condition of life that individual desire.
Human wants vary among different people, over different periods of time and in different
locations.
locations. However, human wants are always insatiable or unlimited, which greater than the

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goods and services available. Human wants continue to increase without meeting their end
because:
a. People have insatiable desire to raise their standard of living, comforts and efficiency;
b. Human tendency is to accumulate things beyond their present need;
c. Human wants increase with increase in knowledge, inventions and innovations;
d. Satisfying one want (e.g. buying a car) creates want for many other things (e.g. petrol,
driver, parking place, safety locks, spare parts, insurance, etc.);
e. The moment one want is satisfied, other wants come up from nowhere;
f. Biological needs (e.g. food, water, etc) are repetitive; and
g. In modern time, advancements influence consumer’s taste and preferences and create
new kind of wants. So, the end of wants for an individual comes only with the end of
his/her life.

1.6.2 The Principle of Scarcity

Resources are said to be scarce when they are not available in sufficient quantity to satisfy all
human wants. In other words, resources are scarce when the demand for them exceeds their
availability. The scarcity of resources is, in fact, the mother of all economic problems. It is the
scarcity of resources in relation to human wants which forces people to make choices.
Furthermore, the problem of choice arises also because resources have alternative uses and
alternative uses have different returns or earnings.

Generally, economics is needed to deal with the problem of unlimited human want and the
principle of scarcity. If human wants were limited and resources were unlimited, there would be
no scarcity and there would be no need to study economics. Nevertheless, naturally since
material want is unlimited and economic resources are limited, the discipline of economics is
needed to deal with.

Scarcity vs. Shortage: these two words are often used interchangeably, but they mean different
concepts in Economics. Scarcity means that society has limited resources and therefore, can not
produce all the goods and services people wish to have. Scarcity is a universal problem that faces
all societies because there are not enough resources to produce everything people want. A
shortage is a situation in which the quantity demanded is greater than the quantity supplied.
Shortages occur when producers are not or can not offer goods or services at the current price.

1.6.3 Choice
With limited resources, we cannot satisfy all our wants, and thus we make choices. Like an
individual, a society also must make choices between various alternatives. The economic
problem is called a problem of choice because the economy has to make choices between various
types of goods that can be produced with the given resources. For example, it might choose
between goods for civil use or military use, or might make a choice between luxury goods and

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necessity goods.
Choice, in turn, implies cost or, we may say, it involves sacrifice. Because of the scarcity of
resources, our choice of one thing means the sacrifice of another. Thus, when we make a choice
for one thing, it is at the cost of some other thing. This leads us to another concept in economics,
known as opportunity cost.

1.6.4 Opportunity Cost

The opportunity cost of a commodity is the amount of other commodities that must be forgone in
order to produce the first. In this context, the cost of producing a quantity of a commodity is
measured in terms of the quantity of some other commodity that could have been obtained
instead. The opportunity cost arises because of the problem of scarcity of resources and the fact
that resources have alternative uses. Hence, when we use resources in the production of one
commodity, we must forgo some amounts of other commodities that could have been produced
with these same resources. For example, given resources may be used for the production of cloth
or of bread. If a given amount of resources can produce either 1 metre of cloth or 20 loaves of
bread, then the cost of 1 metre of cloth is the 20 loaves of bread that must be sacrificed in order
to produce the metre of cloth.

1.6.5 Efficiency (Economizing of Resources)

Efficiency is the condition that exists when society gets the most that it can from scarce
resources. Economizing resources means making the best use of available resources or it implies
optimum utilization of existing resources. The need to economize resources arises because
resources are scarce and have different uses. Usually the demand for a resource exceeds, its
availability, and this compels the economy to utilize its available resources in the most efficient
manner in order to get maximum production and satisfaction.
The problem of efficiency in the use of resources exists in all economies. At times, certain forces
build up as a result of which the full utilization of available resources is not possible. The unused
capacity to produce goes to waste. The economy must identify such forces and take remedial
action.
Full utilization of available resources has taken place when no re-allocation of resources for
increasing the production of some goods can be made without reducing the production of other
goods.

1.7 Methods in Economics

Every science develops hypotheses, generalizations, principles, laws and theories that explain the
phenomena it studies. In order to develop these generalizations and theories, the science must
have a methodology. Thus, economic methodology refers to the system practiced by economists
in the study of their discipline or profession.

1.7.1 The Mostly Used Methods

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A. Positive versus Normative Economic Science

B. Deductive versus Inductive Reasoning
Before we are going to discuss the above methods, let’s see the definition of following
terminologies:
 Assumptions-
Assumptions- an unrealistic representation of reality
 Hypothesis-
Hypothesis- a tentative assumption made in order to be tested
 Theory- a general statement showing plausible and coherent explanation how certain facts
are related
 Model- is the formal statement of a theory in a mathematical form or;
-is an abstraction of the real world.
Example: - distinguish what they represent the following statements.
 Assume the world is flat --- Assumption
 Assume there are only two goods/products in our world --- Assumption
 Assuming that there are only two goods, what would happen to the price of ‘A’ when price
of ‘B’ increased? --- Hypothesis
 The theory of demand, which states that when the price of a good fails, its demand rises ---
Theory
 Q = f (p) or Qss = 20-P --- Model

A. Positive versus Normative Economic Science

Positive economics deals with analysis of how the economy operates, whereas normative
economics deals with analysis of the benefit of economic policies to society. Robbins
emphasized that economics should be treated as a positive science only, and he contended that it
should not become normative in character. In contrast, Professor Pigou argued that economists
should not refrain from making value judgments.
According to [Link],”...a
[Link],”...a positive science is a body of systematized knowledge concerning
what is and a normative or regulatory science is a body of systematized knowledge relating to
criteria of what ought to be and is concerned therefore with the ideal as distinguished from
actual.”

1. Positive Economic Science:

It is the study of what is actually happening in the economy. It develops theories and laws to
explain absorbed economic phenomena. It establishes cause and effect relationship among
economic variables. Answer the questions ‘what was’, ‘what will be’, and ‘what is’. It studies
facts and relationship. Friedman has defined as “the ultimate goal of a positive science is the
development of a ‘theory’ or ‘hypothesis’ that yields valid and meaningful predictions about the
phenomena not yet absorbed.” Here, the word ‘positive’ does not mean that the theoretical
statements are positively true: it means that it has a great possibility to occur if conditions are
fulfilled. Example:
1) Minimum wage laws cause unemployment.

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2) The USA economy is the strongest in our world.

3) What will happen to our economy if we continuously build our human capacity?
4) One dollar is nowadays exchange for about 20 birr.

2. Normative Economic Science:

It is the study of ideal or not actual or imaginary economic world. For example, production and
sale of harmful goods like alcohol and cigarettes may be a very profitable business. But, ‘is
production and sale of these goods desirable for the society?’ is a normative question-a question
in public interest. Consider another microeconomic problem; the growth of population and
supply of houses in Ethiopia. ‘Should house rents be allowed to increase depending on the
market demand and supply conditions or be controlled and regulated to protect the interest of
tenants?’ is a normative question-a question in public interest. It establishes value judgment
whether an outcome is good or bad, better or worse, right or wrong, desirable or undesirable. It
is the study of what ought to be or should be in the economy. Example:
1) The government should raise the minimum wage.
2) It is necessary to subsidize our textile industry.
3) Should the government reduce taxes?
4) What would happen to our economy if our population were 10 million?

Activities: identify whether the following statements are positive or normative economic science.
1) Ethiopia is among the fastest growing counties of our continent.
2) The birr-dollar exchange rates during the Derg was five birr.
3) Taxes should be eliminated
4) What is the trend in car prices in Ethiopia?
5) Why are car prices stable despite increase in demand for cars
6) What will be the demand for cars if prices go up?

B. Deductive versus Inductive Reasoning

1. Deductive Method/Reasoning
It is a method of reasoning or analysis which enables one to reach at a particular conclusion or
fact from general theory or assumption. It is a descending or down word process. Most economic
theories have been constructed through this method. The principal steps involved are:
a) Identifying the problem and its variables-
variables- the analysis must have a clear idea of the problem
to be investigated and the significant variables that interact relative to the problem.
b) Defining technical terms and making assumptions;
assumptions;
c) Developing hypotheses through logical deduction- the hypotheses propose cause-and-effect
relationships between the variables that are related to the problem identified. In this process
the analyst uses logical reasoning to derive the hypotheses from the assumptions defined.

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d) Testing or verifying hypotheses before they can be established as theories of economics . On

the basis of a hypothesis, economists make predictions. To verify the hypotheses, these
predictions are tested.
e) Comparing predictions with facts-if
facts-if the predictions of a hypothesis are found to be in
agreement with relevant facts in the real world, then a useful and correct theory has been
constructed and developed. However, if these are found to be in conflict with the facts- (i) the
theory is discarded in favor of a superior alternative; (ii) the process of constructing a theory
is re-started by modifying the assumptions.

2. Inductive Method / Reasoning

It is an ascending or going upward process where reasoning goes from a particular or specific
fact to a general theory. It develops economic theories on the basis of observations and
experiments. The principal steps involved are: first, to identify the problem; second,
second, defining
technical terms and variables related to the problem; third, collecting data about the variables
related to the problem; fourth, processing the collected data and determining which of the
relationships considered in the previous step holds true. Next, develop hypotheses and refined
and tested statistically. After creating hypotheses, the analyst bases predictions on it and tests the
predictions under real-life economic conditions. If the predictions agree with the actual behavior
of the economy, then a new reliable theory has been developed.

3. Integrated Deductive and Inductive Methods

Which of them are more appropriate for developing economic theories and principles? The
modern viewpoint is both deductive and inductive methods are needed for the proper
development of scientific economic theories. Indeed, the two are complementary rather than
competitive. Modern economists begin by developing economic hypotheses through logical
deduction and then empirically test them through statistical or economic methods.

1.7.2 Model Building in Economics

A model is a simplified theory or a simplified picture of what something is like or how something
works.
works. Simple models can often be constructed that reduce complex situations to their most basic
elements. Economic models include function, schedule and graph.
One of the most important strategies of economists is the economic model. Economists construct
analytic economic models to help explain the behavior of an individual consumer, producer or
industry or of the economy as a whole. An economic model usually consists of a set of equations
that express relationships between variables that are relevant to the problem under investigation.
Each equation attempts to explain the behavior of one variable, seeking to establish cause and
effect relationships regarding it.
For instance, consumption depends upon income, and also consumption influences income
through its participation in aggregate demand. Because of this mutuality in economic systems,

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the values of different variables are determined simultaneously, and models that involve more
than one equation attempt to solve these equations simultaneously.
Economic models are built for purposes of analysis and prediction. By analysis we mean
determining how adequately we can explain the behavior of an economic agent such as a
consumer, a producer or the economic system as whole. Based on a set of assumptions, we use
deductive logic to develop laws of economics that describe the behavior of economic agents and
that have general application. Prediction implies the ability of a model to forecast the effects of
changes of some magnitude in the economy.

1.7.3 The Nature of Economic Laws

Economic laws are usually stated based on ceteris paribus. Ceteris paribus a Latin word
translated as “other things being equal,” used as a reminder that all variables other than the ones
being studied are assumed to be constant. Economic laws are also known as economic
generalizations and economic principles. Economic laws describe how man behaves as a
producer or as a consumer or how the economic system works and operates. Here are some main
features of economic laws:
a) Economic laws are a lot like statements of tendencies- lacks absolute predictive quality.
b) Economic laws are conditional- associated with a number of qualifications & assumptions.
c) Economic laws are scientific in nature- establish relationships between cause and effect.
d) Economic laws are not completely exact and definite- comparing to the physical sciences
sciences
e) Economic laws are not permanent and general. Consider the societal development

1.8 Resource Allocation

1.8.1 Definition and Types of Resources

A resource is anything, given by nature or produced by human efforts that can be used as an
input in production of output(s). Resources are means of producing goods and service that
society wants on. Consider the following example below. As the figure clearly illustrates,
housing production requires different types of inputs cement, labor, land, construction tools and
machinery etc. These inputs are called resources (factor inputs).

Inputs Output
Land, Labor Housing Apartments,
construction Production Villas, Business
tools, malls,
machinery, condominiums,
cement, etc
reinforcement
Most of the resources that are used to housing production might be used for production of other
outputs as well. For example, land can be used for planting a factory, for agricultural production

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etc. Because the same resources can be used for different purposes, resources are often said to
have alternative uses. Resources can be categorized into two.
1. Free Resource- is resources at which the quantity supplied exceeds the quantity demanded at
zero prices. To put it clearly, a resource is said to be free if the amount available to society is
greater than the amount people want at zero price. They have zero opportunity cost. For
instance, breathing air, wind, river water, and sunlight.
2. Economics Resource-is is resources that are limited in supply so that quantity demand exceeds
quantity supply. In other words, if the availability of a resource is less than the amount
people desire to have at zero prices, the resource is definitely an economic (scarce) resource.
As a result, they command a price and are not free. They have also positive opportunity cost.
Examples are Land, machinery, etc.
Economic resources are also called factors of production. Economic (Scarce) Resources are
classified in to the following:
A. Land/Natural resources: - Includes all the gifts of nature or natural resources that can be
used in the production of goods and services- catchall term that covers all of nature’s
endowment. Land does not include readymade resources (those resources that are
transformed, altered, or improved by man). For example, a barren (infertile) land that has get
improved or prepared to be used as a basement for the construction of a skyscraper is no
longer a free gift of nature and hence is not considered as land. The reward of land is rent.
B. Labor/human resources: - refers to all mental and physical capability or talents embodied
in people that human beings contribute to the production process. Skilled (expertise, trained,
experienced) labor and unskilled labor are the major components. The reward for labor is
wage.

C. Capital/man-made resources: - This refers to all manufactured inputs usable in the

production of other goods and services. It refers to the various durable manufactured types of
capital capable of producing other goods and services. Examples are equipment, machinery,
inventories, etc. ‘Improved’, ‘altered’, or ‘transformed’ Capital: - refers to those parts of gifts
of nature that are made better, or improved, or altered by people. Example, The barren land
prepared by an investor to be used as a foundation or basement for a skyscraper or steel
smelted from iron ore (ferric oxide, Fe2O3) in the blast furnace are considered as capital. The
reward for capital is interest.
D. Entrepreneurship: - is the special type of human expertise with the objective of making
profits that organizes and manages factors of production and takes the risk of making losses.
The person with such type of special talent is known as an entrepreneur and the reward for
this person is profit.
Characteristics of entrepreneurs or an Entrepreneur is different from labor in that:
 Initiative. It organizes factors of production to produce outputs.
 Decision maker.
maker. It makes non-routine business policy decisions

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 Risk-taker.
Risk-taker. The entrepreneur’s risks can be time, effort, business organization, the
invested funds and those associates or stockholders. Hence, all these look in both
pessimist and optimist senses.
 Innovator. It is engaged in innovation i.e. attempts to introduce new products, new
production techniques, new form of business organization.
 Quality of leadership-
leadership- must be a leader and able to influence people and win their
confidence.
 Knowledge of psychology etc.

1.8.2 Nature of Scarcity, Choice and Opportunity Cost

Since economic resources are generally limited in supply; the amount of goods and services that
any society can produce is also limited. Society can only satisfy some wants rather than all
wants. Thus, every society faces scarcity. The existence of scarcity does not imply that most
people are poor or that their basic needs are not being met. Scarcity exists simply because it is
human nature for people to want more than they can have.

Scarcity is the condition where by the resources, goods, and services available to individuals and
society are limited relative to the wants and desires for them. Thus , the term scarcity reflects the
imbalance between our wants and the means to satisfy these wants.
wants. The problem of scarcity lies
in the inability of people to produce the quantity and quality of all goods and services that all
people want. Society cannot have all the goods and services that it wants, but must choose which
commodities to produce and which to sacrifice. In short, society can only satisfy some wants
rather than all wants. Thus, every society faces scarcity.
The availability of a resource (good or service) in small quantities does not suffice for the
scarcity problem to exist, but it is necessary condition. As mentioned earlier, it should be noted
that scarcity does not mean shortage. A resource (good or service) is said to be scarce if the
amount available is less than the amount people want at zero price. But we say that there is
shortage of a resource (good or service) when people cannot get the amount they want at the
prevailing or on going price.
Thus, the sufficient condition for to scarcity problem to exist is that the amount that people want
shall outstrip the available amount of a resource (good or service) at zero prices. While shortage
is a specific and short-term phenomenon, scarcity is a universal and an everlasting one.
The most obvious implication of scarcity is the need to choose. Because, there are not enough
resources to do everything, people must decide what will be done with resources available and
what cannot be done. The society must make choices about what output to produce in what
quantities, and what output not to produce, how to produce and for whom to produce.
As you might well conceive, dealing with the above three economic problems involves choice.
By deciding which goods and services to produce, society will choose these at the expense of

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others. In other words, choice implies cost. I.e., choice involves sacrifice. This means that when
choice is made an alternative opportunity is sacrificed.

In our world of scarcity, a decision to have more of one good or service, at the same time means
a decision to have less of another good or service. The value of the next best alternative that must
be sacrificed is, therefore, the opportunity cost of the decision. On net, opportunity cost is
defined as the amount or value of the next best alternative that must be sacrificed or forgone in
order to obtain one more unit of a product.
Example: - Consider a student with only birr 1 at his disposal wants either to watch a movie or
drink a cup of milk. Assume the fee for the movie and the price of the cup of milk is each birr 1.
If the student at last resorts to watch the movie, then it means he would forgo the milk. Put more
clearly, when he decides to watch the movie, at the same time, he is deciding not to drink the
milk. Thus, the cost of watching of the movie is sacrificing one cup of milk. In short, the
opportunity cost of deciding to watch the movie (or simply watching the movie) is losing a cup
of milk (or simply a cup of milk).

Scarcity choice opportunity: This relation is known as economics

equation. The economics equation is clearly illustrated using the production possibilities curve.

1.8.3 Efficiency and The Production Possibility Frontier (PPF)

Once we understand the concept of Scarcity, Choice, and Opportunity cost, let’s now see what
we mean by efficiency and production possibility. We are exactly at the center of truth to
conclude that economics is a science of efficiency. To realize efficiency, an economy must
achieve both full employment and full production.

Full employment: - refers to the maximum use of all available resources (factors of production).
It means that no labor (worker) should be involuntarily out of work (unemployed). i.e., the
economy should provide employment for all who are willing and able to work. In addition, no
capital and land should sit idle, ceteris paribus.

Full production: - The employment of all available resources is a necessary but not sufficient
condition to achieve efficiency. Full production must also be realized. By full production, we
mean that all the employed resources shall be used so that they provide the maximum possible
satisfaction of our material wants.

In this case, two types of efficiency are considered:

 Productive efficiency- is the production of any particular mix of goods and services in the
least costly way.
 Allocative efficiency- is the production of that particular mix of goods and services that
the society wants most.

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Since resources are scarce, a full employment, full production economy cannot have an
unlimited output of goods and services. Therefore, people must choose which goods and services
to produce and which to forgo. The necessity and consequence of these choices can be best
understood through the production possibility model.

Production Possibility Curve (Frontier): - is a curve or graph that shows the various
combinations of goods and services that can be produced in a full employment, full production
economy in which case the available resources are fixed and technology is constant. The PPF
also depicts the maximum amount of one good that the society can produces given the output
level of the other good. Thus, it illustrated the scarcity, choice and opportunity cost

Assumptions of the PPF model:

1. Two products: -for simplicity, the economy is assumed to produce only two products:
bread, a consumer good and machine, a capital good to produce (bake) the bread.
2. Fixed resources: - The quantity and quality of economic resources available for use
during a certain period are fixed. This means both the quantity and quality of labor; Land,
Capital, and Entrepreneurship are fixed.
3. Fixed technology: - the state of technology-the methods used to produce goods and
services-does not change during specific (given) period of time. However, it would be
unlikely for technology to remain fixed in the long run.
4. Efficiency: - The economy is operating at full employment and achieving full production.
I.e., No resource must sit idle and the employment of these resources must provide us the
maximum possible output level.
5. Possibility of reallocation/shifting of resources: Nevertheless, both the quality and the
quantity of economics resources are fixed, they, within limits, can be shifted or
reallocated among different uses. Example, a plot of land can be used for factory site or
food production. Relatively unskilled laborer can work on a farm, at a fast-food
restaurant or in a gas station.
As a starting point to plot the PPF, let’s see the production possibilities table. This shows (refers
to) the schedule of different combination of two commodities that can be produced by fully
employing available resources with in the limits of fixed technology and resources.

Table 1 Production Possibilities schedule

Commodity type Production possibilities
A B C D E
Machine 100 90 70 40 0
Bread 0 10 20 30 40

Given the above hypothetical production possibilities schedule, the economy has five (5)
production possibilities. At alternative E, the economy would be devoting all its available

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resources to the production of Bread (consumer good); at alternative A, the economy insists in
devoting all of its available resources to produce Machine (Capital good). While these are un-
realistic extremes (alternatives A and E), an economy typically produces both consumer and
capital goods (on alternatives B, C, and D).
D).
Transforming the production possibilities schedule in to Production Possibilities Frontier
(Curve), we place capital goods (Machine) on the vertical axis and consumer goods (bread) on
the horizontal.

A
100 
90 B
G
70 C 
Machine

60
Units of

D
40  Figure: PPF model
F
30

E 
10 20 30 40
Bread (No of
Loaves)
Each point on the production possibilities curve represents some maximum out put of the two
products. The curve is a production frontier because it shows the limit of attainable outputs.

Given the PPF:

 Any combinations of the two commodities ON or WITHIN (to the left of) the curve are
attainable combinations. Example points B with a combination of 10 Bread, and 90 Machine
and point F with combination of 10 Bread and 40 Machine are all attainable Combinations.
 To produce ON the production possibilities frontier (points A, B, C, D, and E), a society
must achieve both full employment and full production,
production, i.e. a society is said to be efficient
when it cannot produce more of one good without producing less of another. This happens
when the society produces on the PPF. An efficient economy produces on the PPF because it
cannot produce more of one good without reducing production of another good. Example,
point B lies on the PPF (indicating a combination of 10 loaves of Bread and 90 machines); it
means that the society is producing efficiently. If the society wants to produce more bread,

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say 20 loaves Bread, the society is forced to reduce its production of machine from 90 to 70.
Thus, we say that the society is efficient at point B (and also at points A, C, D, and E)
E)
 Points inside the PPF (to the left of PPF) indicate that the combination is attainable but
inefficient. Points inside the PPF imply that the economy could have produced more of both
machine and bread (or at least one of them) if it achieved full employment and productive
efficiency. In other words, points that lie inside (With in) the PPF reveal that there are some
idle (unemployed) resources and /or the society is not producing at the least cost possible.
Example, Point F lies inside the curve, where the society produces 20 loaves of bread and 40
machines. In this case, the society is inefficient. Had there been full employment and full
production, the society could have produced more of at least one of the goods (say a shift
from point F to points C or D) or more of both goods (a shift from point F to point G).
 Points outside (to the right of PPF) the curve, such as point G, are unattainable within the
premise of existing technology and available resources. Point G is unattainable because
either the resources are not available or the state of technological progress prevents the
resources from being used efficiently. Point G can only be achieved by increases in resource
supply and quality, and technological advance, or in general economic growth.
On net, there are four important concepts embodied in the PPF or PPC illustrates four important
concepts:
A. Scarcity: The frontier depicts the maximum combinations of two goods that the society can
produce given the resources and technology. Unattainable points, like point G, outside the
PPF indicate the inevitability of scarcity. The point is that society cannot have unlimited
amount of output even if it employs all of its resources and utilizes them in the best possible
way.
B. Choice: - choice among outputs is reflected in the need for society to select among the
variety of attainable combinations of goods lying along the curve. Any movement on the
curve indicates the change in choice. Taking the above PPF as a reference, let’s consider
points B and D. If the society chooses to produce at point B, at the same time, it is choosing
to have more machine and fewer loaves of bread. Similarly, if it chooses to produce at point
D, the society is choosing to have more bread and fewer machines. Choice is indicated in the
graph by the movement along the curve either downward or upward (i.e. from point A to B to
C to D or to E or vice verse).
C. Opportunity cost: when the economy produces on the PPF, production of more of one good
requires sacrificing some of another good. The downward (Negative) slope of the PPF
implies the notion of opportunity cost. Opportunity cost of a given product is the amount of
some other product, which must be forgone or sacrificed to obtain some amount of that given
product. Example, in moving from point B to point C in the above PPF, 20 units of machine
must be given up (forgone) in order to obtain 10 additional loaves of bread. Thus, the
opportunity cost is given by:

Opportunity cost = Units given up of one good

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Units obtained of another good

In our case, Opportunity cost = =2
The Interpretation is: - In order to obtain 1 additional loaf of bread, 2 units of machine must be
sacrificed. I.e., the Opportunity cost of obtaining 1 additional loaf of bread is 2 units of
machine.
D. Increasing opportunity cost/concavity:
cost/concavity: – The concavity of the PPF reveals increasing
opportunity cost. The Law of Increasing Opportunity cost indicates the shape of the PPF is
concave or bowed outward. This reveals that the slope is increasing in either direction, which
means the amount of one good we have to give up in order to obtain the other good increases
along the curve.

The Law of Increasing Opportunity Cost states as more and more of a particular commodity is
produced, the opportunity cost of each additional output increases.

What is the economic rationale for the law of increasing opportunity cost?
 Economic resources are not completely adaptable to alternative uses OR
 Resources are not perfectly substitutable.
Restating, it is important to note the rationale behind the Law of Increasing Opportunity Cost.
Increasing opportunity cost and the outward bowed shape (concavity) of the PPF arises from the
fact that scarce resources are not equally productive in all activities, i.e. economic resources are
not completely adaptable to alternative uses or many resources are better at producing one good
than at producing others.

Taking the above PPF as a reference, let’s exemplify the concept of increasing opportunity cost.

Table 2 the Law of Increasing Opportunity Cost

Movement along Opportunity cost of producing Opportunity cost of producing one
the curve one loaf of bread unit of machine

From: A to B 1 We cannot determine the

B to C 2 opportunity cost of producing for
C to D 3 one more unit of machine when we
D to E 4 move downward.
From: E to D We cannot determine the ¼
D to C opportunity cost of producing ⅓
C to B for one more loaf of bread ½
B to A when we move upward. 1

1.8.4 Economic Growth and the PPF

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By economic growth, we mean an increase in the real output level of an economy over time.
Causes/ingredients of economic growth
1. Supply factor/ ability to grow
 quantity and quality of economic resources
 stock of real capital
 state of technology
2. Demand factor-in
factor-in order to realize its growing productive potential, a nation must provide
for the full employment of its expanding supplies of resources. This refers to the aggregate
demand.
3. Allocative factor- to achieve its productive potential, a nation must provide not only for the
full employment of its resources but also for full production from them. It refers to good
and effective policy.
Thus, increases in total output level occurs when there is an increase in the quantity and /or
quality of economic resources such as labor, natural resources, capital, etc. and advance
(progress) in technology, i.e. when methods or techniques of production are improved.

Original PPF
Capital

New PPF
goods

Economic
Growth
PPF2

Recession
PPF1

Consumer
goods
The increase in total real output (economic growth) is reflected by the outward (rightward) shift
of the PPF. When economic growth is realized, the production possibility frontier shifts outward
to the right (from PPF1 to PPF2).

1.9 Economic Problems and Economic Systems

1.9.1 Basic Economic Problems or Questions

The problems faced by the economies can be grouped under two categories:

a. Problems in achieving efficiency in production and distribution of goods and services, often
referred as the basic problems and are of three kinds;

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1. What to produce
2. How to produce
3. For whom to produce

b. Problems in achieving growth, full employment and stability- are macroeconomic problems
and specified as follows:
1. How to increase production capacity of the economy?
2. How stabilize the economy?
3. Other problem of macro nature (the problems of economic growth, inflation,
unemployment and foreign trade deficits).
Here, we are going to discuss only with the nature and sources of problems that arise in
achieving efficiency in production and distribution of goods and services.

1. What /When/Where/How Much to Produce?

This is the problem of choice between commodities. Answering this question amounts to
determining the type (kind) of goods and services and their respective quantities that society
chooses to produce with the limited resources available.

This concept includes questions like what should the society produce? Should it produce
consumer goods (food, Television, Car, etc) or capital goods (machinery, building, etc)? Should
the scarce resources be allocated to civilian or military equipments?

This problem arises mainly for two reasons: (i) scarcity of resources does not permit production
of goods and services that people would like to consume; (ii) all the goods and services are not
equally valued in terms of their utility by the consumers.
The question of ‘how much to produce’ is the problem of determining the quantity of each
commodity and services to be produced. This problem implies an efficient allocation of
resources to various goods and services. This problem is solved by the price mechanism or by
the force of supply and demand. In this case, consumer sovereignty is guaranteed.

This question is also solved by central planning authorities assigned by government.

2. How to produce?

This is a question related to the technology and organization of factors of production. This refers
to the technology of production i.e., to the way in which resources or inputs are organized to
produce goods and services. The choice of optimum technical process that makes the maximum
use of abundant resource is the nucleus of this concept. Should the society adopt labor-intensive
technique of production (techniques that use large labor) or capital-intensive (the technology that
makes maximum use of capital) techniques?

Consumer sovereignty is the idea that consumers ultimately dictate what will and will not
be produced by deciding what to and not to purchase.

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While the price mechanism determines the solution in market economy, this question is
answered by the decision of central authorities in the command economy.

3. For whom to produce?

This is the problem of distribution and consumption. It refers to the way through which the
output produced can be distributed among the members of society. This is concerned with the
distribution of national output among the various factors of production (Land, Labor, Capital,
and entrepreneurship).

In the market economy (free-enterprise economy), the price system determines the distribution
pattern of national output among the various society’s members or factors of production. As
modern governments are welfare-oriented, they often interfere to make the pattern of output
(income) distribution more efficient and equitable.

1.9.2 Economic Systems

An economic system is a set of organizational and institutional arrangements and coordinating

mechanisms established to answer the three basic economic questions. There are three economic
systems.
1. Pure capitalism/ Laissez-faire system
2. Command/ socialist/ planned system
3. Mixed/ realism/ hybrid system

1. Pure capitalism: - In such market system, each decision-making unit acts in its own self-
interest. The system allows private ownership of factors of production. In such an economic
system, the basic economic questions are solved by the price system (the forces of demand
and supply). Advocates of this system hold that there is no need for government to intervene
in the smooth operations of the economy rather government shall limit itself to the protection
of private property and to the provision of public goods such as defense, police protection,
and provision of appropriate environment for the operations of the market system. There is
not any country in the world that is purely capitalist. This system is also called free market
economy or laissez faire.

The specific characteristics of the system;

1. Market determination 6. Specialization
2. Freedom of enterprises and 7. Role of self-interest/ individualistic
consumer sovereignty system
3. Private ownership of resources 8. Profit motives
4. No/little government intervention 9. High inequality/ high marginality
5. Competition and independence 10. High hidden unemployment

Advantages of Capitalistic Economic System

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 Flexibility or adaptability  New types of consumer goods

 Decentralization of economic power  Growth of entrepreneurship
 Reward according to ability  Optimum utilization of productive
 Increase in per-capita income and resources
standard of living

Disadvantages of Capitalistic Economic System

 Inequality of income  Too much waste
 Unbalanced economic activity  Emphasis on materialism
 Exploitation of labor  Trade cycles of economic booms and
 Negative externalities depression

2. Command System/Socialism: - this system is also known as communism. The synonyms are
used to describe the general doctrine that people (the government) should own and
administer means of production. Unlike capitalism, command economy is characterized by:
 Public ownership of property (factors of production)
 Economic activities are coordinated and directed by the government through central
planning.
The fundamental economic questions are answered by the decisions of the central economic
planning board appointed by government. The former USSR (Soviet Union) and the then North
Korea and Cuba are the best examples of centrally planned economies. Our country during the
Dreg- regime had also more or less adopted command economy. Specific characteristics of the
system;
system
1. Central planning board 6. No-Specialization
determination 7. Role of social-interest/ collectivism
2. Authoritarian/restrictive policy i.e. system
no freedom of enterprises and 8. social motives
consumer sovereignty 9. High equity/ low marginality
3. Public ownership of resources between the rich and the poor
4. High government intervention 10. low hidden unemployment
5. No-competition and inter-
dependence

Advantages of Command Economic System

 Best utilization of resources  Elimination of private monopolistic
 Smooth working of the economy exercise and inequalities
 Fair distributions of income
 Balanced economic growth
 Absence of wasteful competition

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Disadvantages of Command Economic System
 Absence of automatic price determination
 Absence of incentives for hard work and efficiency (economic inefficiency)
 Red-tapism: all decisions are made by government officials
 Lack of economic freedom

3. Mixed Economy:
Economy - “The market needs the state as much as the state needs the market” is
the base of mixed economy. In mixed economy, the strong elements of both capitalism
and socialism are hybridized.

In this system, the government actively participates in the distribution of income, correcting
market failures, provision of public goods, stabilizing and directing the economy by
establishing an appropriate environment for the private sector.

In such a system, both the government and the market mechanism answer the fundamental
economic questions. While the allocation of resources is largely determined by the price
system (market mechanism), government plays an important role in determining aggregate
output, employment, distribution of income, controlling inflation, and others through various
policies. In mixed and capitalist system, consumer sovereignty is guaranteed.

Most modern economies of the world are mixed; such as Germany, U.S.A, UK, South Africa,
Ethiopia, Japan, China, and many others.
 Private property, profit motive and price mechanism
 Social welfare and fewer economic inequalities
 Rapid and planned economic development
 Adequate freedom
Disadvantages of Mixed Economic System
 Ineffectiveness of private sectors and inefficiency of public sectors
 Economic fluctuations: if the private sector is not properly controlled.
 Corruption and black market: if gov’t policies, rules and directives are not effectively
implemented
 Instability
Note: the success of mixed economic system depends totally on government efficiency and
effectiveness. E.g. Sweden, Denmark, and Switzerland.
CHAPTER TWO
THEORY OF DEMAND, SUPPLY AND MARKETS
The study of the demand and supply of goods and services, and the way they interact, is the
main subject matter of economics. They are the basic economic forces by which prices are set
under the free market mechanism. In other words, they are important tools to analyze how
prices are set in a free market condition. They are tools to analyze the behavior of households
and firms, the basic decision making units of an economy.
2.1 The Concept of Market

What is a Market? The word ‘market’ generally means a place or area where goods and
services are bought and sold. According to Samuelson and Nordhaus, a market is a
mechanism by which buyers and sellers interact to determine the price and quantity of goods
and services. A market is an institution or an established arrangement or place or mechanism,
which brings together buyers (demanders) and sellers (suppliers) of particular goods or
services. Demanders are households or the consuming units in an economy. Market is a place
where potential buyers and sellers meet. Put differently, market is an institutional
arrangement within which a voluntary exchange is taking place between buyers and sellers of
goods and services.
E.g. Retail store, Edaga-Seni in Mekelle, gas stations, etc.

Some important points in the market concept are:

 A market need not be situated in aparticular place/ locality. The geographical area of a
market depends how scatterd are the buyers & sellers. It may be as small as a fish
market in a corner of a city or as large as the entire world, e.g. the global markets for
arms, cars, electronic goods, aeroplanes, computers, oil...
 Buyers and sellers need not come in personal contact with eachother. The transaction
can be effected through postal services, telephone, fax, agents, or e-mail, etc. People do
buy many goods and services directly from the producers without having ever seen
them.
 The word ’market’ may refer to a commodity or service (e.g. fruit market, car market,
share market, money market, labor market, paper market, etc.)
 The economists distiguish between markets also on the basis of (a) nature of goods and
services, e.g. factor and commodity market or input and output market (b) number of
firms and degree of competition, e.g. competitive, monopolistic, oligopolistic market
etc

Thus, market model deals with the following theories.

1. Theory of demand – deals with behavior of only consumers of goods and services.
2. Theory of supply – deals with behavior of only suppliers of goods and services.
3. Theory of equilibrium – deals with interaction between the behavior of both sellers
and consumers of goods and services.
4. Theory of elasticity – deals with response/sensitive of sellers and consumers of goods
and services to policy, environmental, social, human, and variable( such as prices,
income etc) changes.
5. Market structure- deals with the different markets of the world.

2.2 The Concept of Demand

2.2.1 Definition
Demand in economics has different meaning as compared to our day-to-day use. Demand is
different from a simple want. The list of goods consumers want is quite different from the list
of goods they demand. The conditions for a demand to exist are: ability to pay for the good
desired, willingness to buy/pay the price of the good desired, and availability of the good /
resource itself. Simply, demand is a desire for a good, backed by ability and willingness to
pay. A desire without sufficient resources (money income) is merely a wish. A desire with
resources but w/t willingness to spend is only a potential demand. A desire accompanied by
ability and willingness to pay makes a real or effective demand.
Demand in economics is defined as a schedule, which shows the various amounts of a
product which consumers are willing and able to purchase at each specific price in a series of
possible prices during some specified period of time in a specified market. It shows the
quantities of a product which will be demanded at various prices, all other things being equal
(ceteris paribus assumption). The quantity demanded is the amount of a good or service
consumers are prepared to buy at a various given prices and during a given specified time
period, holding other factors constant. As we can see from the definition of demand, it is
possible to identify the following important elements:
1. Purchaser or demander for goods and services.
2. Seller or supplier of goods and services.
3. Products/ goods and services.
4. Prices
5. Time
6. Willingness and ability. Willingness alone is not effective in the market. Willingness
should be backed by ability. For instance, I may willing to buy a car but my ability
may not permit to do so.
Note: demand and quantity demanded are two different concepts.

2.2.2 Demand schedule

It is a tabular presentation of the demand for a commodity. It shows the quantities of product
that a household would be willing to buy at different prices. Demand Schedules are of two
types. (i) Individual demand schedule (ii) Market/aggregate demand schedule

1 Individual Demand Schedule:

Schedule: is a tabular statement which shows the quantity of a
commodity demanded by an individual household at various alternative prices per time
period.
Table 2.1: Hypothetical Demand Schedules for a Commodity X

Price per unit (in Birr/unit) Quantity demanded/week (quintals/week)

(1) (2) (3) (4)
100 5 30 110
80 4 40 120
60 3 50 150
40 2 70 200
20 1 90 250
10 110
Considering Column 1 and 3
The above table 2.1 shows that the buyers in this market demand 30 units of X per week at
the price of birr 100 per unit and so on.
The demand schedule tells us the possible price-quantity combination not the exact (actual)
price that exists in the market which is dependent on the demand and supply interaction. It is
simply a tabular statement of a buyer’s plans, or intentions, with respect to the purchase of a
product.

2 Market Demand Schedule: is a tabular statement which shows the different quantities of
a commodity demanded by different households or consumers in a market at various
alternative prices per time period. Please have you a look at the table 2.2 below which
shows how the hypothetical market demand schedules for a commodity is constructed

2.2.3 Demand Curve

It is a graphic representation of preferences for a particular good. In other words, it is the

graphic form of the demand schedule- the quantity on the horizontal axis and the price on the
vertical axis.

Price
(Birr/unit)

0
Quantity of X (units/week)

Fig.2.1. Model demand curve for commodity X

The demand curve shows an inverse relationship between product price and quantity
demanded. Each point on the demand curve represents a combination of price and quantity (a
specific price and corresponding quantity which the consumer will choose to purchase at that
price). This inverse relationship between price and quantity demanded is usually referred as
the law of demand. The demand curve slopes downwards from left to right.

2.2.4 The Law of Demand

The most important circumstance affecting the demand for a good is the price. People buy
more if the price of a good falls; they will buy less if the prices rise, holding other factors
constant. This fundamental law of demand can be stated as: Keeping all other factors being
 constant (ceteris paribus), the quantity demanded of a commodity increases when its price
falls or decreases and decreases when its price increases.

2.2.5 Individual Versus Aggregate (Market) Demand

The discussion so far was based on one consumer. However, in reality, there are many buyers
in a market competing for goods and services. Therefore, we have to consider also the market
(aggregate) demand too.

The market (aggregate) demand is driven by summing up the demand of all persons
participating in the market for that particular product. The market demand schedule can be
constructed by adding the quantities demanded by each consumer at the various possible
prices in a given market.

Illustration: Table 2.2: Hypothetical Market Demand Schedules for a Commodity X

Prices Consumer1’s Consumer2’s Consumer 3’s Aggregate (Market)
(Birr/Kg) demand demand demand demand (1+2+3)
5 0 0 0 0
4 10 0 10 20
3 15 20 35 70
2 20 30 50 100
1 30 40 70 140

2.2.6 Factors Influencing Demand

When we were talking about demand curve the assumption was that price is the most
important determinant of the amount of any product purchased. That is, price was the only
factor considered. It was assumed that other non-price (non-own-price) determinants of the
amount demanded are constant. When these non-price determinants of quantity demanded are
allowed to vary the location of the demand curve will be affected. Depending on the nature
of change these non-price determinants the new demand curve will shift either to the left or to
the right of the original demand curve. Generally, there are two determinants.
1. Own-price determinant/demand mover-the price of the product
2. Non-Own-price determinants of demand- these determinants of demand are also called
demand shifters. The major non-own-price determinants of demand are:

1. Price of Substitutes and Complementary Goods:

The demand for all goods is interrelated in the sense that they all compete for consumes’
limited income. The effect of the change in the price of other related goods is dependent on
the nature of the relationships between the goods in consideration. Two goods are substitutes
if they satisfy similar needs or desires. Two commodities are deemed to be substitutes for one
another, if change in price of one affects the demand for the other in the same direction i.e.
the demand for one rises as the price of the other rises or the demand for one falls as the price
of the other falls, assuming the other factors being constant. Example, commodities X and Y
are substitutes for one another if a rise in the price of X increases the demand for Y, and vice
versa. Example, tea and coffee, hamburger and hot-dog, wheat and rice, alcohol and drugs,
butter and cooking oil, etc. The relation between demand for a product and price of its
substitute is of positive nature.

For example, for many people butter is a substitute for cooking oil; thus if the price of butter
rises, consumers will purchase a smaller amount of butter, and this will cause the demand for
cooking oil to increase or the vice versa assuming the price of cooking oil and other factors
are constant.

Fig.2.2 Demand for Substitute and Complement Goods

Complementary goods are those goods that are jointly consumed or demanded. A commodity
is deemed to be a complement of another when it complements the use of the other. Example,
petrol is a complement to motor vehicles; butter and jam are complements to bread; milk and
sugar are complement to tea and coffee and so on. Conceptually, two goods are complements
for one another, if an increase in the price of one causes a decrease in the demand for another.
There is an inverse relationship between the demand for a good and the price of its
complement. The nature of relationship between the demand for a product and the price of its
substitute and complement is given in the following figure.

2. The Income of Consumers (Level of Income of Consumers) and Engle curves

It refers to the amount of money consumers has to spend in the market for a given period of
time. Since effective demand is the desire to buy a good backed by the ability to do so, it is
obvious that there must be a relationship between the demand for a firm’s product and the
consumer’s income (purchasing power).

The nature of the relationship between income and demand will depend upon the type of
product considered and the level of consumers’ income. Other things being equal, for most
commodities, an increase in income (purchasing power) will cause an increase in demand.
Conversely, the demand for such products will decline with a decrease in income. For the
purpose of income-demand analysis goods and services may be grouped in to four. The
relationship between income and the different kinds of goods is presented by the Engel
Curves-which states proportion of expenditure on essential goods decreases as income
increases.

a. Essential Consumer Goods (ECG): the goods and services which fall in this category are
essentially consumed by almost all persons of a society, e.g. food grains, clothes,
vegetable oils, sugar, matches, cooking fuel and housing, etc. the quantity demanded of
such goods increases with increase in consumer’s income only up to a certain limit, other
factors remaining the same. The relation of this category is shown by the curve ECG in
fig.2.3. As the curve shows, consumer’s demand increases until his income rises to OY2
and beyond this level of income, it does not.

b. Inferior Goods (IG): inferior and superior goods are generally known to both consumers
and sellers. Example, coarse textiles are inferior to refined ones, kerosene stove is inferior
to gas-stove; travelling by bus is inferior to travelling by taxi, and so on. As income
increases beyond some level, there are goods whose demand decreases. Such goods are
termed as inferior goods. The demand for inferior good is inversely related to income. At
low level of income people will tend to consume large amounts of these products but, as
their income rise, they will buy other quality goods, which are close substitutes. For
example, beans by meat, which is high protein food. However,
However the goods are not inferior
by nature; it is the commodity’s relationship with income which is inferior. It is shown by
the curve IG in fig. 2.3.

c. Normal goods: are those which are demanded in increasing quantities as consumer’s
income rises. Clothing is the most example of this category of goods. It is shown by the
curve NG in fig.2.3. Demand for such goods increase with increase in income of the
consumer, but at different rates at different levels of income. Demand for normal goods
initially increases rapidly with the increase in income and later, at a lower rate.

d. Prestige or luxury goods: are those which are consumed mostly by the rich section of the
society. Example, precious stones, studded jewellery, costly cosmetics, luxury cars, air
conditioners, costly decoration items (e.g. antiques), and etc. demand for such goods are
arises only beyond a certain level of consumer’s income. The relationship of this category
of goods is shown by the curve LG in fig.2.3.
 Fig.2.3. Income- demand curve

Demand for such goods may initially increase with increase in income (Y1) but it decreases
when income increases beyond this level. All inferior goods start out as normal goods and
only become inferior as income continues to rise.

3. Consumer’s taste and preferences:

Taste and preferences depend, generally, on the social customs, religious values or traditional
taboos attached to a commodity, habits of the people, the general life-style of the society and
also the age and sex of the consumers’. Change in these factors changes consumers’ taste and
preferences. These are usually subjective and changing. Positive taste and preference favor
the demand for a commodity. A change in favor of a good shifts the demand curve rightward.
A change in preferences away from the good shifts the demand curve leftward. This is only
within the limits of the market constraints, price and income constraint. Thus, taste and
preferences also influence demand for goods and services.

4. Change in number of buyers

The demand for a good or service in a particular area is related to the number of buyers in the
area. Since the market demand for a good or service is the sum of all individual demands, an
increase in the number of buyers in a market increases demand. Increase in the number of
buyers could be due to expansion of markets which could be caused by expansion of
transport system to rural areas and/or due to improvement in life expectancy, migration,
increase birth rate, and so on. However, fewer buyers mean lower demand for a product.
Number of buyers could be reduced due to trade restriction.

5. Seasonal factors
The demand for many products is influenced by the season. Example, demand for cloth
during holidays; demand for meat during fasting period.

6. Consumers’ expectations: of consumers about future income, price and product

availability affects demand. If consumers expect increase in price of a commodity in the
future they will buy more now though this is dependent on the cost of storage and the
availability of money to do the purchase now. Current demand depends heavily on long-
term expected income. Expectation of rise in future income may initiate consumers to
increase their current spending. It makes them more liberal in their spending behavior.

7. Demonstration effect: when new commodities or new models of existing ones appear in
the market, rich people buy them first. Some people buy new models of goods because
they have genuine need for them while others buy because they want to exhibit their
affluence. But, once new commodities come in vogue, many households buy them, not
because they have a genuine need for them but because others or neighborhood have
bought these goods. Purchases made on account of these factors are the result of
‘Demonstration effect’ or the ‘Bandwagon Effect’. These effects have a positive effect
on the demand, when a commodity becomes the thing of common use, some people,
mostly rich, decrease or give up the consumptions of such goods. This is known as ‘Snob
Effect’. It has a negative effect on the demand for the related goods.

8. Consumer-credit facility:
facility: availability of credit to the consumers from the sellers, banks,
relations, and friends or from any other source encourages the consumers to buy more
than what they would buy in the absence of credit facility.

9. Distribution of national income: if national income is evenly distributed, market

demand for normal goods will be the largest. If national income is unevenly distributed
i.e. if majority of population belongs to the lower income groups, market demand for
essential goods will be the largest whereas the same for other kinds of goods will be
relatively low.

10. Government influences: prohibitions or restrictions of some goods decrease the demand.
In real life these and other factors act simultaneously to determine the demand for a
commodity.

Summary note:
Increase in the demand for a commodity “A” can be caused by:
1. A rise in income if “A” is a normal good or a fall in income if “A” is an inferior good
2. An increase in the price of related good “B” if “B” is a substitute for “A” or a decrease in
price of related good “B” if “B” is a complement to “A”.
3. A favorable change in consumer tastes or preferences
4. An increase in the number of buyers in the market
5. Expectation of future increase in incomes, prices, and expectation of shortage of a
commodity in the future.
Conversely, a decrease in the demand for “A” can be associated with:
1. A rise in income if “A” is an inferior good or a fall in income if “A” is a normal good.
2. An increase in the price of related good “B” if “B” is complementary to “A” or a decrease
in the price of related good “B” if “B” is a substitute for “A”.
3. An unfavorable change in tastes or preferences
4. A decrease in the number of buyers in the market.
5. Expectation of future price and income decline and expectation of future supply increase.

2.2.7 Why does the demand curve slope down wards?

Demand curve normally slopes downwards, negative slope, to the right. There are several
reasons for this inverse relationship between the price of the commodity and its demand.
a. Law diminishing marginal utility:
utility: according to this law, if a consumer increases the
consumption of a commodity in a given time period, the utility from consumption of each
successive unit goes diminishing. Due to this reason, the consumer will purchase the
additional unit of commodity only when he can pay less for it. Thus, with a fall in price
more units of commodity will be demanded and with a rise in price, fewer units of
commodity will be demanded.
b. Income effect: when the price of a commodity falls, a consumer can buy more of the
commodity with the same amount, indicating an increase in real income. Also, a rise in
the price leads to a fall in real income of the consumer, and hence he buys less of the
commodity. This is called Income effect.
c. Substitution effect: when the price of a commodity falls, it becomes relatively cheaper
than its substitutes. So, people who are consuming the other good s would now start
consuming the commodity whose price has fallen, and as a result, its demand increases
which is called substitution effect of price change.
d. Change in the number of consumers:
consumers: a fall in the price of a commodity increases the
number of households who demand it in the market and vice versa.
e. Different uses of commodity:
commodity: at a lower price, a commodity will be in high demand for
being put to different uses. Conversely, at higher price, its use will be limited to a few
essential uses only and hence the total demand will go down. Example, electricity could
be used for various purposes like lighting lamps, heating rooms, and operating TV,
refrigerator, air conditioners etc. at low price. But if the price of electricity increases its
consumption will be restricted to only essential purposes and its demand will decrease
and vice versa.

2.2.8 Demand Function

It states the relationship between demand for a product (dependent variable) and its
determinants (the independent variables). Assume the quantity demanded of a commodity
(Dx) depends only on its price, other factors remaining constant. The demand function will
then read as demand for a commodity (Dx) depends on its price (Px). The same statement
may be written in its functional form as:: - Dx = f (Px). The demand function may be
expressed in the form of an equation as: Dx= a-bPx, where a &b are constants- a is intercept
and b is slope which quantifies the relationship between Dx and Px. The two most common
forms of demand-price relationship are linear and non-linear. So, the demand function takes
both forms.
Example: Dx =100-5Px (linear demand function) and Dx = aPx-b or Dx = (a/Px+c) b where
a,b,c > 0

2.2.9 Change in demand versus Change in quantity demanded

Change in demand (Shift in demand curve): Demand for different goods changes overtime.
Change in demand is the total change in the quantity data of the demand schedule having
price constant. It is indicated graphically by a shift in the demand curve either to the right or
left of the initial. A decrease in demand shifts the demand curve to the left of the initial and
an increase to the right of the initial. Change in demand is caused by change in one or more
of the non-price determinants of demand.
Change in quantity demanded (Movement along a Demand Curve): Other things being
equal, if the quantity demanded increases or decreases due to fall or rise of in the price of a
commodity alone it is known as movement along a demand curve or change in quantity
demanded. This is movement along the original (the same) demand curve. It is expansion
(downward movement) or contraction (upward movement) of quantity demanded. It is
brought about by a change in the price of the commodity under consideration and by nothing
else.

Y (c) Y Y
(a) (b)
Price

Price

Price
D2 D1 D3
O
O
Demand X X X
Demand Demand

Fig: 2.4 (a) extension of demand (b) contraction of demand (c) shifting in the
demand
Note that: both (a) and (b) shows Change in quantity demanded (Movement along a Demand
Curve). D2= decrease in demand D3 = increase in demand curve D1= original demand curve

2.3 The Concept of Supply

2.3.1 Definition
The term supply is often misused and confused with the term ‘stock’. Stock is the total
volume of a commodity produced during a period less the quantity already sold out. In
economics Supply of a commodity can be defined as the various quantities it that producers
are willing and able to offer for sale in a given time period at various corresponding prices. In
other words, from individual producer’s point of view, supply is a schedule, which shows the
various amounts of a product, which a producer is willing and able to produce and make
available for sale in the market at each specific price in a series of possible prices during
some specified time period. Thus, stock is potential supply, and supply may be less or, at the
most, equal to the stock of commodity.
Supply tells us the quantities of a product, which will be supplied at various prices, all other
factors being held constant. Like demand supply is a flow of goods and services.

2.3.2 The Supply Schedule:

It is a tabular presentation of the supply for a product. It shows a series of alternative price-
quantity supplied combinations. In other words, it lists the quantities supplied at each
different price, when other non-price factors are held constant. Supply schedules are two
types:

a. Individual supply schedule: a tabular statement which shows the different quantities of a
commodity offered for sale by an individual firm at different prices per time period.

Table: 2.3 Hypothetical supply schedules for commodity X

Price per quintal (in Birr) Quantity supplied/week (quintals/week)
(1) (2) (3) (4)
10 5 20 240
20 4 30 200
40 3 40 150
60 2 50 90
80 1 70 0
100 90
This shows with an increase in price the quantity supplied also increases. (See columns 1 and
3, and columns 2 and 4).

b. Market supply schedule: a tabular statement which shows sum of the quantities supplied
by all sellers.
Table: 2.3 Market supply schedules
Price (per Kg) Supply of firm (X) Supply of firm (Y) Market supply (X+Y)
5 15 12 27
8 20 18 38
12 28 25 53

2.3.3 The Supply Curve:

As with demand, we can plot the supply information as a graph. The supply curve is simply
the graphic representation of the supply schedule or the concept of supply. It is constructed
on a two-dimensional graph by assigning the price on the vertical (Y) axis and the quantity
supplied on the horizontal (X) axis. The supply curve has a positive slope showing the
positive or direct relationship between price and the quantity supplied, holding everything
else constant. It could be straight line or a curve. Supply curves also, like supply schedules,
are two types- individual supply curve and market supply curve.

An up-ward slopping curve reflects the fact that under certain conditions a higher price is an
incentive to producers to produce more of a good.
 (Br/ Quintal
S

Price

Quantity of wheat supplied

Quintal/Week
Fig: 2.2. Model Supply Curve for wheat

2.3.4 Law of Supply:

The law of supply shows the behavior of suppliers - those that at the receiving end in a
market. The law of supply can be stated as follows:
Other things being equal, the higher the price of a good, the greater is the quantity supplied,
i.e. price and quantity supplied is directly related. As price rises, the corresponding quantity
supplied rises; as price falls, the quantity supplied also falls. (See the hypothetical example
above). This means producers are willing to produce and offer for sale more of their products
at a high price than they are at a low price. Why? Possible reasons could be the profitability
argument, due to new suppliers coming in to the business, and due to diminishing marginal
returns occur in production process.
Suppliers are on the receiving end of the product’s price. To them, price is revenue per unit
and therefore, is an incentive or inducement to produce and sell a product. The higher the
price of the product, the greater will be the incentive to produce and offer it in the market.

2.3.5 Exceptions to the law of supply

There are some situations when the law of supply does not operate. They main exceptions
are:
 Future Expectations about Change in Prices: law of supply will not apply if there is
an expectation about change in prices of a commodity in the near future.
 Agricultural products: violates the law because their supply is governed by natural
factors such as flood, drought, rain fall etc.
 Perishable Commodities: the supply of perishable commodities like milk, fruits,
vegetables etc. is not affected by prices. Producers try to sell more perishable
commodities even when their prices decline.
 Good of Auction: Since supply of auction goods is limited, the law of supply does not
operate
 Artistic Goods: the law does not apply since the supply of these goods can be changed.

2.3.6 Why does the supply curve slope upwards?

A supply curve normally slopes upwards to the right. It is also known as the positive slope of
the supply curve, indicating a direct relationship between the price of the commodity and its
supply. The reasons are:
 Expectation of Profit: if prices are high, profit expectation increases with the result that
producers increase their output or production and the vice versa is true.
 Change in Stock: An increase in the price of a commodity induces the sellers to dispose
of at least a part of their stock and vice versa.
 Entry and Exist of Firms: If, due to rising prices there are high profits, new firms enter
into the market and add to the supply of the commodity and the vice versa is true.

2.3.7 Individual versus Aggregate (Market) Supply

So far the concept of supply was illustrated based on an individual producer of a product. An
individual supply curve represents the price-quantity combinations for a single seller (or
firm). However, in the real world markets there are many producers or suppliers of the same
product. Therefore, like in the case of demand, it is important to see at the aggregate or
market supply. The market supply is simply the horizontal sum of the individual supply
curves. The market supply curve represents the price-quantity combinations for all sellers of a
particular product.

S1
ILLUSTRATION:
ILLUSTRATION: S2 Sm (S1+S2) S

2.3.8 Factors Influencing Supply

Like demand, supply depends on many factors besides the price of the product. The major
ones are the following:

1. Change in price of inputs (factors of production)

Inputs are the things that are used in the production of goods and services. Change in the
price of inputs directly affects the cost of production.
Input costs = cost of production = units of inputs used X Respective prices
Therefore, there is close relationship between cost of production and supply.
An increase in the price of a factor will increase the cost of production of a firm. For a
particular commodity, when the costs of production are low, relative to market price, then it
will be profitable for producers to produce a great amount. When production costs are
varying high relative to price, producers will produce little (or may stop producing). This
lowers supply. A decrease in supply is shown by a shift of supply curve to the left of the
original; where as an increase in supply is shown by shift to the right.

2. Change in the level of technology

The state of technology affects the efficiency of production. Usually advancement or
improvement in technology allows producers to reduce their cost of production per unit of
output. This would therefore, have the effect of shifting the supply curve to the right.
However, the effect of technology on supply tends to be a long-term.

3. Change in the price of other goods within the producer’s production plan
Most producers produce or have the capability to produce more than one product. The
decision of how much of each product to produce (how to allocate the available resources
among the different goods within the production plan) depends on the profitability of the
other (s).
The effect of change in price of one good on the supply of the other(s) depends on the nature
of the relationships between the goods under consideration. The goods can be production
substitutes or complements.
Production Substitutes are those that might compete with the good for the scarce resources
on the farm or during production process. So if the price of an alternative product rose we
could expect its profitability to rise and so the farmer or producer might move some of his
resources out of their present use into the production of alternative. Therefore, two products
are substitutes in production when an increase in the price of one product causes a reduction
in the price of the supply of the other product. E.g. Wheat and Barley
Let a farmer allocates his 1ha of farmland for the production of these two products on 50-50
bases on the first instance. Any change in the price of one will have an effect on the supply of
the other, i.e., the quantity of wheat produced will depend on the price of barley and the
quantity of barley will depend on the price of wheat.
If the farmer is profit oriented, with an increase in the price of barley, the farmer will take out
some part of the wheat land for the production of barley. This leads to the decrease in the
supply of wheat assuming there are enough time for readjustment and no change in the price
of wheat. The reverse is also hold true. Generally, if the price of one production substitute
rises, this will decrease the supply of other substitute.
Production Complements are those goods that are produced together or jointly, or one is a
by-product of the other product. Their production process is inseparable. Generally, two
products are complements in production when an increase in the price of one product causes
an increase in the supply of the other product. If for instance the quantity of beef increased
due to increase in the price of beef in a market, then we would expect the supply of hides to
rise as well. Similarly barley and straw; milk and butter; mutton and skin are produced
together.

4. Change in the level of taxes and subsidies

Taxes are deductions from the profit of producers or they are additional costs to producers.
So their effect is similar to increase in cost of production. Subsidies, however, are opposite of
taxes. Subsidies are expense for the government or society but deductions from the cost of
production to the individual producer. The government, for instance, subsidies on fertilizer
products.

5. Number of Suppliers
The larger the number of suppliers the higher will be the volume of supply, other things being
constant.
6. Nature, especially weather and pests
Bad weather, pests and disease can greatly reduce supplies of agricultural products, while
good weather and absence of pests can greatly assist in increasing yields and hence supply.
a. Expectation of producers with regard to future price and other specific factors
b. Objective of the Firm:
Firm: Generally, the main objective of a firm is to maximize profit.
This needs maximum sales, maximum employment, more production, etc. then volume
of output or supply will increase, even when profit declines.

2.3.9 Change in Supply versus Change in Quantity Supplied

Change in Supply or Shift in the Supply Curve: Change in supply is a total change in the
location of the supply curve. The change or shift in supply could be an increase or a decrease.
It is caused by change in any of the non-price supply shifters or determinants. An increase is
shown using supply curve, by shift to the right of the initial. An increase in supply happens
when, due to changes in one or more of the non-price supply shifters, the amount supplied
increases at each market price.
Change in quantity supplied or Movement along a Supply Curve: This is movement from
one point to another point on a stable supply curve (the original supply curve). It is caused by
a change in the price of the specific product under consideration.

S2

S3 C
P3

P1 P1
A
P2

B
S1
O O
q2 q1 q3 Qs q2 q1 q3 Qs

a) Change in supply (shift of the supply b) Change in quantity supplied

Curve from S1 to S2 or S3) (movement from A to C or B)

2.4 Market Equilibrium Determination

The concept of equilibrium employed in almost every theory of economics in the fields of
price, income, growth.

2.4.1 Demand
emand and supply interaction in the market
Up to now we were considering the two market forces in isolation. However, the actual
market price, the actual quantity that demanders get in the market and the actual quantity that
producers offer are only determined when the two actors meet in a market. Therefore, we
shall now combine our analysis of demand and supply to show how a competitive market
price is determined.
The motives of consume and producers are different in that the consumer wishes to buy
cheaply while the supplier wishes to obtain the highest price possible. How are these
differences reconciled?

2.4.2 Determination of the equilibrium condition

In any market one of the following three conditions may exist:

Excess demand (shortage): a condition in which quantity demanded is greater than quantity
supplied. When excess demand occurs in an unregulated market, there is a tendency for price
to rise as demanders bid against each other for the limited supply. There are various
problems associated with shortage economy;
1. First come first served principle
2. Discrimination-some people will be satisfied while others will not.
3. Black market or under economy activities.
4. Queuing
There are different solutions for the problems associated with shortage economy;
 rationing or government intervention
 effective policy
Shortage = quantity demanded- quantity supplied

Excess supply (surplus): a condition in which quantity supplied is greater than quantity
demanded at the current price. When there is excess supply, price tends to fall as
competing suppliers attempt to sell their product by lowering the price. There are many
problems associated with surplus economy;
1 excess production problem/ lots of inventory/ products remain unsold
2 disposal product
3 discourage investors

Remedies
 dealers offers discounts to encourage buyers
 government provides subsidy to sellers.
Surplus= quantity supplied- quantity demanded

Equilibrium or balance- where the quantity demanded and quantity supplied are equal at the
current prices.

In the market price and quantity which is actually bought and sold are determined by the
interaction of the two decisions by the involved actors:
a. The buying decision of buyers (consumers)
b. The selling decision of producers

ILLUSTRATION: A hypothetical Market of Wheat

Price per quintal Quantity Demanded Quantity supplied Market Pressure on
 (In Birr) (Quintals/week) (Quintals/week) condition price
10 110 20 DD > SS Upward
20 90 30 DD > SS Upward
40 70 40 DD > SS Upward
60 50 50 DD = SS Neutral
80 40 70 DD < SS Downward
100 30 90 DD < SS Downward
Activity: Analyze the situation at each price level.

What happens when DD > SS, DD < SS and DD = SS?

The successive interaction of demand and supply in the market decides the level of price and
quantity that is acceptable by both buyers and sellers. This is the point of equilibrium in
the market.

At the equilibrium state, there is a balance between what is demanded and supplied. The two
opposing forces will be stabilized; neither surplus nor shortage occurs; the supply
decision of producers and the demand decision of buyer are mutually consistent. It is
the price-quantity combination in a market from which there is no tendency for buyers
or sellers to move away.
GRAPHIC ILLUSTRATION OF EQUILIBRIUM CONDITION

S
D
(Birr/qt)

Excess Supply
Price

E
PE Market Equilibrium

Excess Demand

D
S
Quantity of wheat
O
QE
Fig. 2.3: The equilibrium price and quantity as determined by market demand & supply
Market equilibrium is a price - quantity combination that results from the interaction of the
supply and demand curves such that at the indicated price, the quantity demanded
equals the quantity supplied.
Example: Let there be 5000 identical buyers of a commodity X in a market with an individual
demand function of Dx = 8-Px, and 1000 identical sellers of commodity X with an
individual supply function of Sx = 20Px, where Dx is quantity demanded, Sx is
quantity supplied and Px is price of the commodity X. For calculating the equilibrium
price and equilibrium quantity, we formulate the market demand and market supply
functions for the commodity X.
Solution: Market demand function= Number of buyers x individual demand function
 5000(8-PX) = 40,000-5,000Px
Market supply function= Number of sellers x individual supply function
1000(20Px) = 20,000Px
On equating the two market functions, we get:
40,000-5,000Px= 20,000Px or 25,000Px = 40,000 Px = 40,000/25,000
40,000/25,000Px= 1.6
Hence, equilibrium price of commodity X is Birr 1.6. On substituting the value of Px in either
of the two functions, say market demand function, we get:
Equilibrium quantity = 40,000- 5,000Px = 32,000 units.

Equilibrium Price
It is the price at which the wishes of buyers and sellers coincide. The price that exists when
the quantity demanded equals the quantity supplied in a given market for specific time
period. Graphically, this is represented by the level of price that exists at the point of
intersection of the demand curve and supply curve when they are superimposed on the same
graph (PE on the above graph).
At any price above the equilibrium price, suppliers want to sell more than consumers want to
buy and a surplus will result; at any price below the equilibrium price, consumers want to buy
more than producers are willing to offer for sale as is evidenced by the consequent shortage.
The equilibrium price level is also called the market-clearing price. Because at this price level
all what is supplied will be purchased by consumers and there will not be any surplus or
shortage.

Equilibrium Quantity
It is the quantity that corresponds the equilibrium price. In the above graph it is represented
by QE on the quantity axis. The quantity at which the amount of the good buyers are willing
to buy equals the amount sellers are willing to sell, and both equal the amount actually
bought and sold.
Disequilibrium Price: A prices other than equilibrium price. A price at which quantity
demanded does not equal quantity supplied. A state of either surplus or shortage is in a
market

Effects of change in Demand and Supply on the Equilibrium State

Equilibrium price and quantity are determined by supply and demand. Any time either
demand or supply or both change, equilibrium price and quantity change. There are different
cases where this occurs.
Case I. Change in Demand Supply being Constant
a. Increase in demand, supply being constant
b. Decrease in demand, supply being constant
Case II. Change in supply assuming that demand is constant
a. Increase in supply, demand being constant
b. Decrease in supply, demand being constant
Case III. When both demand and supply change (combined effect)
a. Supply and demand change in opposite direction (in equal or unequal magnitude of
change)
 a. When demand increases but supply decreases
b. When demand decreases but supply increases
b. Supply and demand change in the same direction (in equal or unequal magnitude of
change)
a. Both demand and supply increase
b. Both demand and supply decrease

Limitation of the Market as a Resource Allocator

Is the market system the best means of responding to the fundamental questions? There is no
definite answer to the question.
There are cases in favor of the market system:
1. Allocative efficiency: the basic economic argument for the market system is that it
promotes an efficient allocation of resources.
- Resources are used to produce the most wanted goods from
the individuals point of view - forces producers to employ efficient technologies
2. Freedom- emphasis on personal freedom
However, there are also cases against the market system. These arguments stress on the
limitation of the market system:
1. Demise of competition: competition, the control mechanism of the system, tends to
decline overtime.
2. Inherent income inequalities, inability to register collective wants, and the presence of
external benefits and costs prevent the market system from producing that collection of
goods most wanted by society.
3. The competitive market system does not guarantee full employment or price level
stability.
These arguments emphasis that the pattern of consumption and production, which an
unhindered price mechanism, could result- in, is not optimum. Therefore, a preferable
pattern, preferable from society’s point of view, can be obtained by adjusting the solution
provided through the market to the fundamental problem of satisfying the wants of
consumers from the resources, which are available.
Example: Public Goods (Collective Goods)- these are goods and services wanted by the
society as a whole but which individuals through the market cannot finance. Highways,
national defense, education, etc. are commonly cited examples. The market system is
incapable of registering such social, or collective, wants.

2.5 The Concept of Elasticity

Definition:
Definition:
Elasticity is a general concept that can be used to quantify the response in one variable when
another variable changes. It denotes the responsiveness of one variable to changes in another.
It is a measure of the responsiveness of a market to a stimuli (change in a variable).

Elasticity of Demand: Types and Determinants

So far the analysis has been concerned only with the direction of change in demand induced
by changes in either of its determinants (price, income, price of other related goods, etc.).
However, it is also important to determine how much the amount demanded will change in
response to a change in one of its determinants.
Elasticity is expressed numerically using an elasticity coefficient, an index independent of the
measurement units of the respective variables. This can be expressed for any explanatory
variable which can cause demand to change. There are various types of elasticities but here
we confined ourselves to two types only.
1. Elasticity of demand
2. Elasticity of supply
Most commonly, three types of elasticities of demand are computed:
1. Own-price elasticity of demand
2. Cross-price elasticity of demand
3. Income-elasticity of demand
In each case, the measure will be defined as the ratio of the proportionate change in the
quantity demanded for a particular good to the proportionate change in a specified
determinant of demand (price or income or price of related goods or services).
Own-price elasticity of demand: measures how sensitive or responsive consumers are to a
change in the price of the commodity under consideration other factors held constant. It is the
percent of change in the quantity of a good demanded that is induced by a one percent change
in price. It is the relative responsiveness of quantity demanded to changes in commodity
price; in other words, price elasticity is the proportional change in quantity demanded divided
by the proportional change in price.
Mathematically, the formula to calculate own-price elasticity of demand (Edp), or simply
called elasticity of demand, is given as follows:

Edp = Percentage change in quantity demanded

Percentage change in price
Edp = ΔQ / Qi = %ΔQ
ΔP /Pi % ΔP

Where, Q = Change in quantity demanded

P = Change in price
Qi = Initial quantity
Pi = Initial price

This formula is called point-elasticity formula. It only applies to calculate elasticity when the
changes in price and quantity are infinitesimal (very small) change. The percentage changes
are calculated by dividing the change in price by the original price and the consequent change
in quantity demanded by the original quantity demanded.

ILLUSTRATIVE EXAMPLE: The use of percentage avoids the problem that can be caused
by different units of measurement.
The own-price elasticity will be non-positive (showing the fact that price and quantity are
inversely related) but the convention among economists is to ignore the sign and to simply
consider the absolute value of the elasticity coefficient. Its numerical value varies from zero
to infinity.

However, the point elasticity formula has problems in applying it for large changes (even for
changes from zero to any positive figure). Therefore, the mid-point (arc elasticity) formula is
used.
Mid- point formula
Edp = Change in quantity ÷ Change in price
Average of quantities Average of prices

Edp = ΔQ ÷ ΔP
(Qi + Qf)/2 (Pi + Pf)/2

Where, ΔQ = Change in quantity demanded

ΔP = Change in price
Qi = Initial quantity Qf = Quantity final
Pi = Initial price Pf = Price final
In this formula the averages of the prices and quantities under consideration are taken as
reference points in determining the percentages in price and quantity.

Numerical Calculations of Elasticity Coefficient

Price (P) Quantities
6 0
4 10
2 20
0 30
There are three categories of price elasticity of demand based on the size of the elasticity
coefficient:
1. Elastic 2. Inelastic 3. Unitary elastic
Elastic: (Edp > 1). Quantity changes by a larger percentage than price, i.e. it occurs when
some percent change in price results in a large percentage change in quantity. A change in
price induces a more than proportionate change in quantity demanded. Consumers are quite
responsive to a price change. The larger the elasticity, the larger the percentage change in
quantity for a given percentage changes in price. In this case total revenue rises when price is
reduced, falls when price is raised (increased).

Inelastic demand: (Edp < 1). When a decline in prices brings a smaller percentage increase
in quantity, i.e. quantity changes by a smaller percentage than price. Consumers are less
responsive to a price change. Generally, a change in price causes a less than proportionate
change in quantity consumed; from this it follows that total revenue will fall when price is
reduced, and will rise when price is raised.
Unitary elastic: (Edp = 1). This is the intermediate case. In this situation quantity changes by
the same percentage as price, i.e. both changes in the same proportion.

There are also two extreme cases:

a). Perfectly inelastic: quantity demanded does not change as price changes. Quantity
demanded is completely unresponsive to changes in price. Own-price elasticity of demand
(Edp) is zero. The demand curve in this case is a vertical line.
b). perfectly elastic: consumers will purchase all they can at a particular price but none of the
product at a higher price (Edp = ∞). Here a slight change in price corresponds to an infinitely
large change in quantity. Quantity demanded is extremely responsive to even very small
changes in price (from buying to buying nothing). The demand curve in this case is a
horizontal line.
Cross-Price Elasticity of Demand
It measures the relative responsiveness of quantity demanded of a given commodity to
changes in the price of a related commodity. In other words, it is the proportional change in
the quantity demanded of good X divided by the proportional change in the price of good Y.

Edx = Proportionate change in the quantity demanded of good X

Proportionate change in the price of good Y

Where, good X and good Y are related goods.

Edx = ΔQx ÷ ΔPy

(Qx1 + Qx2)/2 (Py1 + Py2)/2

Where, ΔQ x = Change in quantity demanded of good X

ΔPy = Change in price good Y
Qx1= Initial quantity of good X Qx2 = Final quantity of good X
Py1 = Initial price of good Y Py2 = Final price of good Y

The sign and the magnitude of cross-price elasticity coefficient have meanings. The sign of
cross-elasticity is negative if goods X and Y are complements ( Edx < 0) and positive (Edx
>0) if X and Y are substitutes. The larger the magnitude of the Edx, the higher is the degree
of substitution or complementarity’s between the two goods.

Income- elasticity of demand

It relates changes in the quantity demanded to changes in income. It measures the degree of
responsiveness of the quantity demanded of a product to changes in income. In other words,
it measures the responsiveness of consumers to income changes as the demand curve shifts
from one position to another. It is the proportional change in quantity demanded divided by
the proportional change in income.
Edy = Percentage change in quantity (%ΔQ)
Percentage in income (%ΔY)
 Edy = ΔQ ÷ ΔY
(Q1 + Q2)/2 (Y1 + Y2)/ 2
Where, ΔQ = Change in quantity demanded
ΔP = Change in price
Qi = Initial quantity Qf = Quantity final
Yi = Initial income Yf = Income final
This is from quantity approach.
If demand increases when income increases, the income elasticity is a positive number and
such goods are superior or normal goods. ( Edy > 0)
If demand decreases with an increase income, the income elasticity is negative and such
goods are inferior goods. (Edy < 0).
Income elasticity of demand can be also calculated from expenditure measures.

Edy = % change in expenditure on good ‘X’

% Change in consumer income

In the same way as we did for the price elasticity of demand, income elasticity of demand can
be categorized in to three:

 Income elastic: the percentage change in quantity demanded of a good is greater than the
percentage change in income. Edy >1.
 Income inelastic: the percentage change in quantity demanded of a good is less than the
percentage change in income. Edy < 1.
 Income unit elastic: the percentage change in quantity demanded of a good is equal to the
percentage change in income. Edy = 1.

Determinants of Elasticity of Demand

Why does one commodity has an inelastic demand while another has very elastic? Several
factors influence the sensitivity of the quantity demanded to price:

1. Substitutability (the number of substitutes available):

The availability of closer and large number of substitutes determines the elasticity of demand
for a commodity. The demand for a commodity is more elastic if there are close substitutes
for it. That is, the larger the number and the better the substitutes that exists for a good or
service, the more elastic that particular good or service. This is because a small rise in price
will have a relatively large effect on consumption, as consumers switch to other commodities,
which are fairly similar but have not changed in price. On the other hand, commodities that
have few or poor substitutes tend to have inelastic demand.
In sum, the more substitutes for a good, the higher the price elasticity of demand; the fewer
substitutes for a good, the lower the price elasticity of demand.

2. The number of uses that the good can be put

The higher the number of uses a good has, the higher will be its elasticity of demand. In other
words, a commodity with several uses will be relatively more elastic because of the range of
markets in which the price change will exert an effect.
Example: Electricity- cooking, lighting, running factories, etc.
Coffee - as stimulant.
Commodities with few numbers of uses require a substantial change in price to affect total
demand.

3. The proportion of income spent on a particular product (percentage of one’s budget

spent on the good)
The larger the product’s share of the consumer’s budget, the more sensitive the consumer will
be to changes in its price. The products that take up small proportion of the budget tend to be
less elastic than product that ranks high in the budget. If a person spends high proportion of
his income on a product he or she is more sensitive to changes in its price. In general, buyers
are more responsive to price the larger the percentage of their budget that goes for the
purchase of the good.

Example: Good X A poor A rich

P1 1.25 1.25
P2 5.00 5.00
The poor is sensitive to change in the price of good X than the rich and will buy less or not at
all. Therefore, the demand for a particular commodity is likely to be less elastic among high-
income groups than is among low-income groups.

4. The extent to which the product is considered as luxury or necessity:

The demand for necessities tends to be inelastic. It is very difficult to get along without some
commodities like basic food; water, closing and shelter, so that if the price go up, the quantity
demanded will hardly change.

5. The definition of a product (the degree of commodity aggregation)

The price elasticity will depend to a large extent on how widely or narrowly a commodity is
defined.
Example:
The demand for beef is expected to be more elastic than the demand for all meat, which in
tern may be more prices elastic than the demand for all food. In general, the more broadly we
define a product, the lower its price elasticity. This is because there are fewer substitutes for
broadly defined products.

6. Time
In general, the demand for a product tends to be more elastic the longer the duration that the
price changes is expected to stay. As time passes, buyers have greater opportunities to be
responsive to a price change. Price elasticity of demand is larger in long run than short-run.

7. Habits:
The more the consumption of a good has a strong tradition and is very habitual, the less likely
are people to change consumption when price rises. That is, well-established habits can make
consumers’ buying patterns insensitive to increase in price.
Elasticity of Supply
As in the case of demand, the elasticity concept is also applicable to measure the behavioral
changes of the supplier in response to the changes in the determinants.

I. Price Elasticity of Supply

Price elasticity of supply (ESP) is the measure of responsiveness of producers in terms of
output to changes in the price of their products. In other words, it measures the
responsiveness of the quantity supplied of a good to its market price. More precisely, the
price elasticity of supply measures the percentage change in quantity supplied in response to
a one percent change in the good’s price.

Esp = Percentage change in quantity supplied of commodity Y

Percentage change in price of Y

Esp = ΔQ ÷ ΔP
(Qi + Qf)/2 (Pi + Pf)/2

Where, ΔQ = Change in quantity supplied

ΔP = Change in price
Qi = Initial quantity supplied Qf = Quantity supplied final
Pi = Initial price Pf = Price final

The Esp is a positive figure indicating the direct relationship between price and quantity
supplied. Esp is useful because it tells us the changes in quantify supplied resulting from a
given percent change in price.

E.g. If Esp is 3, a 5% increase in price will result in a 15% increase in quantity supplied.

As with the case of price elasticity of demand, depending on the magnitude of the coefficient,
price elasticity of supply can be categorized into three groups (types):

(I) Elastic-Esp >1, If the percentage rise in quantity supplied is greater than the percentage
rise in price that brought it about. That is, when a change in price causes a more than
proportionate change in quantity supplied. This means producers are relatively responsive to
price changes.

(II) Unitary elastic- Esp equal to one. This is that the percentage increase (change) of
quantity supplied is exactly equal to the percentage increase (change) in price.

(III) Inelastic- Esp < 1. If the percentage rise in quantity supplied is less than the percentage
rise in price that brought it about. That is, quantity changes by a smaller proportion than
price. This means producers are relatively insensitive to price changes.
There are also two extreme cases of elasticity of supply:

1. Perfectly elastic (Infinitely elastic)-Where

elastic)-Where changes in supply occur without any large
change in price being necessary. Where a small change in price changes quantity supplied
by an infinitely large amount. The supply curve for this case is a horizontal one.

2. Perfectly inelastic:
inelastic: The Esp is equal to zero (Where supply is fixed). Where a change in
price brings no change in quantity supplied. The supply curve for this case is vertical one.
E.g. Out of season demand, entrance ticket for some game.

II. Cross-elasticity of supply

Cross elasticity of supply (Esx) is defined as the percentage change in the supply of one good
in response to a one percent change in the price of alternative product (a product with in the
production possibility of the producer).

Esx = % change in quantity supplied of a good “X”

% Change in price of good “Y”
Where ‘X’ and ‘Y’ being production alternatives.
The value of the Esx can be negative or positive. If Esx is negative the two products under
consideration are production substitutes. If Esx is positive the two products under
consideration are complements in production (Complements in production means the two
goods are produced together.)

Determinants of Elasticity of supply

Why do different commodities have different elasticity of supply? What are the reasons
behind this? The major factors that influence the elasticity of supply are the following:
1 Time: - Time period under consideration and the length of the production cycle. The
longer the time period and/or the shorter the production cycle, then the easier it is to alter
the amount of that good produced, and so the more elastic is the supply likely to be. The
shorter the time for adjustment and/or the longer the production cycle, then the less elastic
is the supply likely to be. If the price change is expected to be temporary, there is little
incentive for a producer to change the level of output substantially because change in
output usually involves additional expense. In general the periods of supply are classified in
to three:
i. Momentary (Esp = 0). In this period supply is fixed.
ii. Short-run. In this period supply can be varied with the limit of the present fixed
costs.
iii. Long run. Costs may be varied and firms may enter or leave the market.

Elasticity of supply increases with time.

1. The availability of inputs

-Inputs
Inputs available implies high production level which in turn implies elastic supply
-Inputs unavailable implies low production level which in turn less elastic supply.
The availability is affected by the specific nature of the inputs required for the production of
the commodity in question. If the production of a product utilizes inputs that are commonly
used to produce other products, it will tend to have a more elastic supply than if it uses
specialized inputs suited only for its production.
1. Factor mobility: The ease with which factors of production can be moved from one use
to another will affect elasticity of supply. The higher the degree of mobility the higher
will be the elasticity.
2. The extent to which production can be expanded or reduced in an industry. This is
dependent on the cost-structure of production process.
3. Natural restriction on the production process:
process: E.g. seasonality of the production
4. Risk- taking.
taking. The more willing the producers are to take risks the greater will be the
elasticity of supply.

It’s Relevance to Agriculture

The
he relevance of the concept of elasticity in agriculture can be illustrated as following.

1. Price elasticity of demand in agriculture

E.g.
.g. Food: - It is mostly made from agricultural products. It is necessity means having
inelastic demand. Demand for food is mostly insensitive to price. Therefore, the implication
of increased level of production on the revenue of the industry from selling its products and
hence on the income of farmers can be analyzed based on the concept of elasticity.

2. Income elasticity of demand (Edy)

Expenditure Birr/ Month

Edy of food is low compared with that of the product of most other industries. With an
increase in the income of society, the proportion of this income spent for the purchase of
necessities declines. This is developed in to a law called Engle’s Law. The law states that
the proportion of personal expenditure devoted to necessities declines as income rises.

Total
Expenditure

Food and
clothing

Total
Expenditure

Y (income) Birr/
Month