Chapter Two

Fundamental Economic Concepts

2.1. Equilibrium Analysis: Supply and Demand Relationships
A market is defined as a group of buyers and sellers of a particular product or service.
Supply and demand are the most useful models for a competitive market, and shows how buyers
(customers) and sellers (businesses) interact in that market.
Quantity Demanded & Supplied
✓ Demand for a product is the amount that buyers are willing and able to purchase.
✓ Quantity demanded is the demand at a particular price, and is represented as the demand
curve.
✓ Supply of a product is the amount that producers are willing and able to bring to the
market for sale.
✓ Quantity supplied is the amount offered for sale at a particular price. The main
determinant of supply/demand is the price of the product.

Market Equilibrium

Equilibrium is defined as the intersection of supply and demand curves. The equilibrium price is
the price where the quantity demanded matches the quantity supplied. The equilibrium quantity
is the quantity where price has adjusted so that QD = QS. At the equilibrium price, the quantity
that buyers are willing to purchase exactly equals the quantity the producers are willing to sell.

Excess Supply/Demand
Excess Supply is where Quantity supplied > Quantity demanded (SS>DD), and results in
surpluses at the current price. A large surplus is known as a "glut".

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 N.B. When quantity supplied exceeds quantity demanded; price tends to fall until
equilibrium is restored.

In cases of excess supply:

• price is too high to be at equilibrium
• suppliers find that inventories increase
• suppliers react by lowering prices
Excess Demand
Excess Demand occurs when Quantity demanded > Quantity supplied, and results in shortages at
current prices.

In cases of excess demand:

• buyers cannot buy all they want at the going price

• sellers find that their inventories are decreasing
• sellers can raise prices without losing sales
• prices increase until market reaches equilibrium

Law of Supply and Demand

In free markets, surpluses and/or shortages tend to be temporary and obey the law of supply and
demand, since actions of buyers and sellers tend to match prices back toward their equilibrium
levels.

Exercises

1. Consider in perfectly competitive market the following demand and supply equations for
sugar:
Qd =1000-1000p where Q d is quantity demanded and Qs is quantity supplied
Qs=800+ 1000p

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Where P is the price of sugar per pound and Q is thousands of pounds of sugar.

a. What are the equilibrium price and quantity for sugar?

b. Suppose that the government wishes to subsidize sugar production by placing a floor on sugar
prices of $0.20 per pound. What would be the relationship between the quantity supplied and
quantity demand for sugar?

C. Identify market problem specifically at prices 0.2 per pound and what will be scientific
recommendation you suggest to solve the identified market problem?

2. Suppose that a perfectly competitive industry comprises 1,000 identical firms. Suppose,
further, that the market demand (QD) and supply (QS) functions are

QD=170,000,000 -10,000,000p QS= 70,000, 000 +15000, 000p

A. Calculate the equilibrium market price and quantity?

B. Given your answer to part a, how much output will be produced by each firm in the industry?

C. If market price is 2 birr specify Market problem and suggest scientific recommendation to
solve market problem.

D. If market price is 6 birr specify Market problem and suggest scientific recommendation to
solve market problem.

Marginal versus Incremental concepts:

The marginal concept is a key component of the economic decision-making process. It is

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

The incremental concept is the economist’s generalization of the marginal concept. Incremental
analysis involves examining the impact of alternative managerial decisions or courses of action

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on revenues, costs, and profit. It focuses on changes or differences between the available
alternatives .The incremental change is the change resulting from a given managerial decision.
For example, the incremental revenue of a new item in a firm’s product line is measured as the
difference between the firm’s total revenue before and after the new product is introduced

Time Value of Money

To achieve the objective of shareholder wealth maximization, a set of appropriate decision rules
must be specified. We just saw that the decision rule off setting marginal revenue (benefit) equal
to marginal cost (MR= MC) provides a framework for making many important resource-
allocation decisions. The MR =MC rule is best suited for situations when the costs and benefits
occur at approximately the same time. Many economic decisions require that costs be incurred
immediately but result in a stream of benefits over several future time periods.

Consider the following situation. You have just inherited $1 million. Your financial advisor has
suggested that you use these funds to purchase a piece of land near a proposed new highway
interchange. Your advisor, who is also a state road commissioner, is certain that the interchange
will be built and that in one year the value of this land will increase to $1.2 million. Hence, you
believe initially that this is a riskless investment. At the end of one year you plan to sell the land.
You are being asked to invest $1 million today in the anticipation of receiving $1.2 million a
year from today, or a profit of $200,000. You wonder whether this profit represents a sufficient
return on your investment.

You feel it is important to recognize that there is a one-year difference between the time you
make your outlay of $1 million and the time you receive $1.2 million from the sale of the land. A
return of$1.2 million received one year from today must be worth less than $1.2 million today
because you could invest your $1 million today to earn interest over the coming year. A dollar
received in the future is worth less than a dollar in hand today because a dollar today can be
invested to earn a return immediately. Therefore, to compare a dollar received in the future with
a dollar in hand today, it is necessary to multiply the future dollar by a discount factor that
reflects the alternative investment opportunities that are available.

Instead of investing your $1 million in the land venture, you are aware that you could also invest
in a one-year U.S. government bond that currently offers a return of 5 percent. The 5 percent
return represents the return (the opportunity cost) forgone by investing in the land project. The 5
percent rate also can be thought of as the compensation to an investor who agrees to postpone
receiving a cash return for one year.

In summary,

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 ➢ Present value recognizes that a dollar received in the future is worthless than a dollar in
hand today, because a dollar today could be invested to earn a return.
➢ Time value of money demonstrates that, all things being equal, it is better to have money
now rather than later.
➢ The time value of money is used to determine whether future benefits are sufficiently large
to justify current outlays.
➢ Mathematical tools of the time value of money are used in making capital allocation
decisions.

Present Value of a Future Payment

Present Value is the current value of a future amount of money, or a series of payments,
evaluated at a given interest rate.

Or or
Let’s find the present value of $18,000 if interest rates are currently 4%.
In the equation above, all we are doing is discounting the future value of an investment.
Present Value

From the above calculation we now

know our choice is between receiving
$18,000 or $15,386.48 today. Of course we should choose to postpone payment for four years.
The present value can be determined by solving for a mathematical solution to the formula.
Assuming

Future Value
➢ Future Value is the value at some future time of a present amount of money, or a
series of payments, evaluated at a given interest rate.
➢ Or Amount to which an investment will grow after earning interest.

Future Value – Single Amount

Or
Where
FV = Future value

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The present value can be determined by solving for a mathematical solution to the formula.
Assuming

Future Value
➢ Future Value is the value at some future time of a present amount of money, or a
series of payments, evaluated at a given interest rate.
➢ Or Amount to which an investment will grow after earning interest.
Future Value – Single Amount

Or
Where
FV = Future value PV = Present value
i = Interest rate n = Number of periods

=the interest factor

Assuming that the worth of $1,000 needs to be calculated after 4 years at a 10% interest per year,
calculate FV of money. Solution: PV = $1,000, i = 10%, n = 4, hence;

Future Value of $1(FVIF) using table value

Table 9.1

If $10,000 were invested for 10 years at 8%, the future value would be:

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