Chapter One

Basics of Economics
1.1 Definition of economics
 The science of economics in its current form is about 200 years
old.
 Adam Smith – the father of economics – brought out his
famous book, ―An Inquiry into the Nature and Causes of
Wealth of Nations
 Wealth definition (Adam Smith)
 Economics is the study of wealth only.
 The aim of economics is only increasing the amount of wealth in a
nation.
 Wealth consider only material goods. It does not include non-
material goods.
 Welfare definition(Alfred Marshall)
 Economics is not a science of wealth but a science of man primarily.
 Economics deals with ordinary men who are influenced by all natural
instincts.
 Wealth in itself is meaningless unless it is utilized for obtaining
material things of life.
 Economics only studies ‘material requisites of well being’. That is, it
studies the causes of material gain or welfare. It ignores non-
material aspects of human life.
  Scarcity definition
 Economics is fundamentally a study of scarcity and of the problems
to which scarcity gives rise.
General definition
 Economics studies about efficient allocation of scarce resources to
attain the maximum fulfillment of unlimited human needs.
o The rationales of economics= the two fundamental facts
that provide the foundation for the field of economics:-
1) Human (society‘s) material wants are unlimited.
2) Economic resources are limited (scarce).
 Economics is the study of how human beings make choices to use
scarce resources as they seek to satisfy their unlimited wants.
Choice is at the heart of all decision-making.

The core of modern economics is formed by its two major

branches:- microeconomics and macroeconomics
A. Microeconomics
 Is concerned with the economic behavior of individual decision
making units such as households, firms, markets and industries.
 Deals with individual income, individual prices, individual
outputs, etc.
 Its central problem is price determination and allocation of
resources.
 Its main tools are the demand and supply of particular
commodities and factors.
 It helps to solve the central problem of what, how and for whom
to produce‘ in an economy so as to maximize profits
  Discusses how the equilibrium of a consumer, a producer or an
industry is attained.

B. Macroeconomics
 Deals with the effects and consequences of the aggregate behavior
of all decision making units in a certain economy.
 Deals with national income and output and general price level
 Its central problem is determination of level of income and
employment.
 Its main tools are aggregate demand and aggregate supply of an
economy as a whole.
 Helps to solve the central problem of full employment of resources
in the economy.
 Concerned with the determination of equilibrium levels of income
and employment at aggregate level.
Both microeconomics and macroeconomics are
complementary to each other
Positive and normative analysis
A. Positive economics
 concerned with analysis of facts
 tries to answer the questions what was; what is; or what will be?
 It does not judge a system as good or bad
 Any disagreement on positive statements can be checked by looking
in to facts.
B. Normative economics
 deals with the questions like, what ought to be?/ what the economy
should be?
 It evaluates the desirability of alternative outcomes based on one‘s
value judgments about what is good or what is bad.
 cannot be proved or rejected with reference to facts B/C it is a
matter of opinion
 Any disagreement on a normative statement can be solved by
voting.

Inductive and deductive reasoning in

economics
 The fundamental objective of economics is the establishment of
valid generalizations about certain aspects of human behavior.
 Those generalizations are known as theories= a simplified picture
of reality.
 There are two methods of logical reasoning: inductive and
deductive

a) Inductive reasoning- is a logical method of reaching at a

correct general statement or theory based on several independent and
specific correct statements.

 It is the process of deriving a principle or theory by moving from

particular to general economic analysis.
 Inductive method involves the following steps.
1. Selecting problem for analysis
2. Collection, classification, and analysis of data
3. Establishing cause and effect relationship between economic
phenomena.
 b) Deductive reasoning- is a logical way of arriving at a
particular or specific correct statement starting from a correct
general statement.
Major steps in the deductive approach include:
1. Problem identification
2. Specification of the assumptions
3. Formulating hypotheses
4. Testing the validity of the hypotheses

1.4 Scarcity, choice, opportunity cost and

production possibilities frontier
1. Scarcity
 Is fundamental economic problem that any human society
faces.
 refers to the fact that all economic resources that a society
needs to produce goods and services are finite
 Imbalance between our wants and the means to satisfy
those wants.
Resources are classified into two:-
Free resources: A resource is said to be free if the
amount available to a society is greater than the
amount people desire at zero price.
 Scarce (economic) resources: A resource is said to be
scarce or economic resource when the amount
available to a society is less than what people want to
have at zero price.
Examples of scarce resources:-
 All types of human resources- refers to the physical and
mental effort put into production.
 Most natural resources like land, minerals, clean water,
forests…
 All types of capital resources
Economic resources are classified into four:-

1. Land: refers to all natural resources that are used in

production, such as the land itself, minerals, water, air
and plants.
 The reward for the services of land is known as rent.
2. Labor: refers to the human effort, both physical and
mental, that is used in the production of goods and
services.
 The reward for labor is wage.
3. Capital: refers to the tools, machinery, equipment,
buildings, and infrastructure that are used in the
production process.
 The reward for the services of capital is called interest.
4. Entrepreneurship: refers to the ability and willingness to
take risks and innovate in order to create and manage a
business venture.
 The reward for entrepreneurship is called profit.
 Entrepreneurs organize and combine the other three
categories of resources (LLC) to produce goods and services.
Scarcity vs Shortage
 Scarcity does not mean shortage.
 Shortage is when people are unable to get the amount they
want at the prevailing or on going price.
 Shortage is a specific and short term problem but scarcity is
a universal and everlasting problem.

Scarcity → limited resource → limited output → we

might not satisfy all our wants →choice involves costs →
opportunity cost
3. Opportunity cost
 The amount or value of the next best alternative that must
be sacrificed.
 Is the potential benefit or value that could have been
gained from choosing one alternative from over another
when decision making.
 It is measured in goods & services but not in money costs
  It should be in line with the principle of substitution
The Production Possibilities Frontier or Curve
(PPF/ PPC)
 Is a curve that shows the various possible combinations of
goods and services that the society can produce given its
resources and technology.
 To draw the PPF we need the following assumptions.
A. The quantity as well as quality of economic resource
available for use during the year is fixed.
B. There are two broad classes of output to be produced
over the year.
C. The economy is operating at full employment
(efficiency).
D. Technology does not change during the year.
E. Some inputs are better adapted to the production
of one good than to the production of the other

The PPF describes three important concepts:

 i) The concepts of scarcity: - the society cannot have unlimited
amount of outputs even if it employs all of its resources and
utilizes them in the best possible way.

ii) The concept of choice: - any movement along the curve

indicates the change in choice.

iii) The concept of opportunity cost: - when the economy

produces on the PPF, production of more of one good requires
sacrificing some of another product which is reflected by the
downward sloping PPF.

Economic Growth and the PPF

 Economic growth or an increase in the total output level
occurs when one or both of the following conditions occur.
1. Increase in the quantity or/and quality of economic
resources.
2. Advances in technology
 Economic growth is represented by outward shift of the
PPF.
 Basic economic questions
 Economic problems faced by an economic system due to
scarcity of resources are known as basic economic
problems.
 These problems are common to all economic systems.
 They are also known as central problems of an economy.
What to Produce?
 is also known as the problem of allocation of resources.
 It implies that every economy must decide which goods
and in what quantities are to be produced.
 As economic resources are limited we must reduce the
production of one type of good if we want more of
another type.

How to Produce?
 This problem is also known as the problem of choice of
technique.
 Once an economy has reached a decision regarding the
types of goods to be produced, and has determined their
respective quantities, the economy must decide how to
produce them
 The various techniques of production can be classified into
two groups:

1. A labour-intensive technique involves the use of

more labour relative to capital, per unit of output.

2. A capital-intensive technique involves the use of

more capital relative to labour, per unit of output.
 The choice between different techniques depends on
the available supplies of different factors of production
and their relative prices.

For Whom to Produce?

 This problem is also known as the problem of
distribution of national product.
 It relates to how a material product is to be distributed
among the members of a society.
 An economy that wants to benefit the maximum
number of persons would first try to produce the
necessities of the whole population and then to
proceed to the production of luxury goods.

1.6 Economic systems

 An economic system is a set of organizational and
institutional arrangements established to answer the
basic economic questions.
 There are three types of economic system:

1.Capitalist economy /Capitalism

 Is the oldest formal economic system in the world.
 It became widespread in the middle of the 19th
century.
 In this economic system, all means of production are
privately owned, and production takes place at the
initiative of individual private entrepreneurs who
work mainly for private profit.
 Government intervention in the economy is minimal.
 This system is also called free market economy or
market system or laissez faire.
 Features of Capitalistic Economy
 The right to private property: economic or productive
factors such as land, factories, machinery, mines etc. are
under private ownership.
 Freedom of choice by consumers: Consumers can buy the
goods and services that suit their tastes and preferences.
Producers produce goods in accordance with the wishes of
the consumers. This is known as the principle of consumer
sovereignty.
 Profit motive: Entrepreneurs, in their productive activity,
are guided by the motive of profit-making.
 Competition: In a capitalist economy, competition exists
among producers, among buyers & among employers.
 Price mechanism: All basic economic problems are solved
through the price mechanism.
 Minor role of government: The government does not
interfere in day-to-day economic activities and confines
itself to defense and maintenance of law and order.
 Self-interest: Each individual is guided by self-interest and
motivated by the desire for economic gain.
 Inequalities of income: There is a wide economic gap
between the rich and the poor.
 Existence of negative externalities: A negative externality
is the harm, cost, or inconvenience suffered by a third
party because of actions by others.

Advantages of Capitalistic Economy

 Flexibility or adaptability: It successfully adapts itself to
changing environments.
 Decentralization of economic power: Market mechanisms
work as a decentralizing force against the concentration of
economic power.
 Increase in per-capita income and standard of living:
Rapid growth in levels of production and income leads to
higher per-capita income and standards of living.
 New types of consumer goods: Varieties of new consumer
goods are developed and produced at large scale.
 Growth of entrepreneurship: Profit motive creates and
supports new entrepreneurial skills and approaches.
 Full utilization of productive resources is possible due to
innovations and technological progress.
 High rate of capital formation: The right to private
property helps in capital formation.

Disadvantages of Capitalistic Economy

 Inequality of income: Capitalism promotes economic
inequalities and creates social imbalance.
 Unbalanced economic activity: the economy can develop
in an unbalanced way in terms of different geographic
regions and different sections of society.
 Exploitation of labour: In a capitalistic economy,
exploitation of labour (for example by paying low wages) is
common.
 Negative externalities: are problems in capitalistic
economy where profit maximization is the main objective
of firms.

Command economy
 Command economy is also known as socialistic economy.
 The economic institutions that are engaged in production
and distribution are owned and controlled by the state.
 In the recent past, socialism has lost its popularity and
most of the socialist countries are trying free market
economies.

Main Features of Command Economy

Collective ownership: All means of production are
owned by the society as a whole, and there is no right to
private property.

Central economic planning: Planning for resource

allocation is performed by the controlling authority
according to given socio-economic goals.

Strong government role: Government has complete

control over all economic activities.

Maximum social welfare: Command economy aims

at maximizing social welfare and does not allow the
exploitation of labor.

Relative equality of incomes: Private property does

not exist in a command economy, the profit motive is
absent, and there are no opportunities for accumulation
of wealth.

Advantages of Command Economy

Absence of wasteful competition: There is no place for
wasteful use of productive resources through unhealthy
competition.
Balanced economic growth: Allocation of resources
through centralized planning leads to balanced
economic development. Different regions and different
sectors of the economy can develop equally.
Elimination of private monopolies and inequalities:
Command economies avoid the major evils of capitalism
such as inequality of income and wealth, private
monopolies, and concentration of economic, political
and social power.

Disadvantages of Command
Economy
Absence of automatic price determination: Since all
economic activities are controlled by the government,
there is no automatic price mechanism.
Absence of incentives for hard work: There is no
financial incentive for hard work and efficiency. The
economy grows at a relatively slow rate.
Lack of economic freedom: Economic freedom for
consumers, producers, investors, and employers is
totally absent, and all economic powers are
concentrated in the hands of the government.
Red-tapism: it is widely prevalent in a command
economy because all decisions are made by government
officials.
 Mixed economy
 is an attempt to combine the advantages of both the
capitalistic economy and the command economy.
 It incorporates some of the features of both and allows
private and public sectors to co-exist.

Main Features of Mixed Economy

 Co-existence of public and private sectors: Public and
private sectors co-exist in this system. Their respective roles
and aims are well-defined.
 Public sector- Industries of national and strategic
importance, such as heavy and basic industry, defense
production, power generation
 Private sector- consumer-goods industry and small-
scale industry
 Economic welfare: Economic welfare is the most important
criterion of the success of a mixed economy. The public
sector tries to remove regional imbalances, provides large
employment opportunities and seeks economic welfare
through its price policy.
 Government control over the private sector leads to
economic welfare of society at large.
 Economic planning: The government uses instruments of
economic planning to achieve co-ordinated rapid economic
development, making use of both the private and the public
sector.
 Price mechanism: The price mechanism operates for goods
produced in the private sector, but not for essential
commodities and goods produced in the public sector. Those
prices are defined and regulated by the government.
 Economic equality: Private property is allowed, but rules
exist to prevent concentration of wealth. Limits are fixed for
owning land and property.
 Progressive taxation, concessions and subsides are
implemented to achieve economic equality.

Advantages of Mixed Economy

 Private property, profit motive and price mechanism: All are
also the advantages of mixed economy

Adequate freedom: Mixed economies allow adequate

freedom to different economic units such as consumers,
employees, producers, and investors.
Rapid and planned economic development:
 Planned economic growth takes place, resources are
properly and efficiently utilized, and fast economic
 development takes place because the private and public
sector complement each other.

Social welfare and fewer economic inequalities: The

government‘s restricted control over economic activities helps
in achieving social welfare and economic equality.
Disadvantages of Mixed Economy
Ineffectiveness and inefficiency: A mixed economy might not
actually have the usual advantages of either the public sector
or the private sector.
 The public sector might be inefficient due to lack of
incentive and responsibility, and the private sector might be
made ineffective by government regulation and control.

Economic fluctuations: If the private sector is not properly

controlled by the government, economic fluctuations and
unemployment can occur.

Corruption and black markets: if government policies,

rules and directives are not effectively implemented, the
economy can be vulnerable to increased corruption and black
market activities.

1.7 Decision making units and the circular

flow model
 There are three decision making units in a closed economy.
These are households, firms and the government.
i) Household: A household can be one person or more who
live under one roof and make joint financial decisions.
Households make two decisions.

 Selling of their resources

 Buying of goods and services.

ii) Firm: A firm is a production unit that uses economic

resources to produce goods and services.
Firms also make two decisions:
a) Buying of economic resources
b) Selling of their products.

iii) Government: A government is an organization that has

legal and political power to control or influence households,
firms and markets.
 Government also provides some types of goods and services
known as public goods and services for the society.
 The three economic agents interact in two markets:
1. Product market:
  it is a market where goods and services are transacted/
exchanged.

 a market where households and governments buy

goods and services from business firms.
2. Factor market (input market): i

 is a market where economic units transact/exchange

factors of production (inputs).

 In this market, owners of resources (households) sell

their resources to business firms and governments.
 The circular-flow diagram is a visual model of the economy
that shows how money (Birr), economic resources and goods
and services flows through markets among the decision
making units.
 For simplicity, let‘s first see a two sector model where we
have only households and business firms. In this case,
therefore, we see the flow of goods and services from
producers to households and a flow of resources from
households to business firms.
 In the following diagram, the clock – wise direction shows
the flow of economic resources and final goods and services..
–
 Chapter Two
Theory of Demand and
Supply
2.1 Theory of demand
 The purpose of the theory of demand is to determine
the various factors that affect demand.
 Demand is when the consumer is willing and able to
purchase the commodity, which he/she desires.
 His/her desire should be backed by his/her purchasing
power.
 Demand- means the desire of the consumer for a
commodity backed by purchasing power.
 More specifically, demand refers to various quantities
of a commodity or service that a consumer would
purchase at a given time in a market at various prices,
given other things unchanged (ceteris paribus).
 The quantity demanded of a particular commodity
depends on the price of that commodity.

 Law of demand: states that price of a

commodity and its quantity demanded are inversely
related. i.e., as price of a commodity increases
(decreases) quantity demanded for that commodity
decreases (increases), ceteris paribus.

2.1.1 Demand schedule (table), demand curve

and demand function
 A demand schedule states the relationship between
price and quantity demanded in a table form.
 Demand schedule can be constructed for any
commodity if the list of prices and quantities
purchased at those prices are known.
 An individual demand schedule is a list of the various
quantities of a commodity, which an individual
consumer purchases at various levels of prices in the
market.
 Demand curve is a graphical representation of the
relationship between different quantities of a
commodity demanded by an individual at different
prices per time period.

 Demand function is a mathematical relationship

between price and quantity demanded, all other things
remaining the same.
 A typical demand function is given by: Qd=f(P)
 Let the demand function be Q = a+ bP
 b is the slope of the demand curve.
 to find a, substitute price either at point A or B.
 Therefore, Q=15-2P is the demand function for orange
in the above numerical example.

 Market Demand: The market demand schedule,

curve or function is derived by horizontally adding the
quantity demanded for the product by all buyers at
each price.

Individual and Market demand curve

 Numerical Example: Suppose the individual demand

function of a product is given by: P=10 - Q /2 and there
 are about 100 identical buyers in the market. Then the
market demand function is given by:
P= 10 - Q /2 ↔ Q /2 =10-P ↔ Q= 20 - 2P and Qm =
(20 – 2P) 100 = 2000-200P

Determinants of demand
 The demand for a product is influenced by many
factors. Some of these factors are:

I. Price of the product

II. Taste or preference of consumers
III. Income of the consumers
 Goods are classified into two categories depending on
how a change in income affects their demand.
 These are normal goods and inferior goods.

 Normal Goods are goods whose demand increases

as income increase.

 Inferior goods are those whose demand is inversely

related with income.
 Inferior goods are poor quality goods with relatively
lower price and buyers of such goods are expected to
shift to better quality goods as their income increases.
 The classification of goods into normal and inferior is
subjective and it is usually dependent on the socio-
economic development of the nation.

IV. Price of related goods

 Two goods are said to be related if a change in the
price of one good affects the demand for another
good.
 There are two types of related goods. These are
substitute and complimentary goods.
 Substitute goods- are goods which satisfy the same
desire of the consumer.
 For example, tea and coffee or Pepsi and Coca-Cola
are substitute goods.
 If two goods are substitutes, then price of one and the
demand for the other are directly related.
 Complimentary goods- are those goods which are
jointly consumed.
 For example, car and fuel or tea and sugar
 If two goods are complements, then price of one and
the demand for the other are inversely related.

IV. Consumer expectation of income and

price
 Higher price expectation will increase demand while a
lower future price expectation will decrease the
demand for the good.

VI. Number of buyers in the market

 An increase in the number of buyers will increase
demand while a decrease in the number of buyers will
decrease demand.
 When we state the law of demand, we kept all the
factors to remain constant except the price of the
good.
 A change in any of the above listed factors except the
price of the good will change the demand, while a
 change in the price, other factors remain constant will
bring change in quantity demanded.
 A change in demand will shift the demand curve from
its original location.
 For this reason those factors listed above other than
price are called demand shifters.
 A change in own price is only a movement along the
same demand curve.
 Changes in demand: a change in any determinant of
demand—except for the good‘s price causes the
demand curve to shiftchange in demand
 If buyers choose to purchase more at any price, the
demand curve shifts rightward—an increase in
demand.
 If buyers choose to purchase less at any price, the
demand curve shifts leftward—a decrease in demand.
 Elasticity of demand
 The concept of elasticity is used to analyze the
quantitative relationship between price and quantity
purchased or sold.
 Elasticity is a measure of responsiveness of a
dependent variable (Demand) to changes in an
independent variable(Price).
 Elasticity of demand refers to the degree of
responsiveness of quantity demanded of a good to a
change in its price, or change in income, or change in
prices of related goods.
 Commonly, there are three kinds of demand
elasticity: price elasticity, income elasticity, and cross
elasticity.

i. Price Elasticity of Demand

 Is the degree of responsiveness of demand to change
in price.
 It indicates how consumers react to changes in price.
 The greater the reaction the greater will be
 the elasticity, and the lesser the reaction, the smaller
will be the elasticity.
 Price elasticity of demand is a measure of how much
the quantity demanded of a good responds to a
change in the price of that good.
 Price elasticity of demand can be computed as the
percentage change in quantity demanded divided by
the percentage change in price.
 Price elasticity demand can be measured in two ways.
These are point and arc elasticity.
A . Point Price Elasticity of Demand
 This is calculated to find elasticity at a given point.
 The price elasticity of demand can be determined by
the following formula.
 The main drawback of the point elasticity method is
that it is applicable only when we have information
about even the slight changes in the price and the
quantity demanded of the commodity. But in practice,
we do not acquire such information about minute
changes
 b. Arc price elasticity of demand
 .. We use the arc method of elasticity when there are
big gaps in price as well as the quantity demanded.
 In arc price elasticity of demand, the midpoints of the
old and the new values of both price and quantity
demanded are used.
 It measures a portion or a segment of the demand
curve between the two points. An arc is a portion of a
curve line, hence, a portion or segment of a demand
curve.
 The formula for measuring arc elasticity is…

Note that:
 Elasticity of demand is unit free because it is a ratio of
percentage change.
 Elasticity of demand is usually a negative number
because of the law of demand.
 If the price elasticity of demand is positive the product
is inferior.
 If demand is said to be elastic and the product is
luxury product
 If 0≤ |Ed|<1 demand is inelastic and the product is
necessity
 If |Ed|=1 demand is unitary elastic.
 If |Ed|= 0, demand is said to be perfectly inelastic.
 If Ed = ∞, demand is said to be perfectly elastic.
Determinants of price Elasticity of Demand
 The following factors make price elasticity of demand
elastic or inelastic other than changes in the price of
the product.
i. The availability of substitutes: the more substitutes
available for a product, the more elastic will be the price
elasticity of demand.

ii.Time : In the long- run, price elasticity of demand

tends to be elastic. Because:
 More substitute goods could be produced.
 People tend to adjust their consumption pattern.
iii) The proportion of income consumers spend for a
product:-the smaller the proportion of income spent for
a good, the less price elastic will be.
iv) The importance of the commodity in the consumers’
budget :
 Luxury goods = tend to be more elastic, example: gold.
 Necessity goods = tend to be less elastic example: Salt.

Income Elasticity of Demand

 It is a measure of responsiveness of demand to change
in income.

Cross price Elasticity of Demand

 Measures how much the demand for a product is
affected by a change in price of another good.

i) The cross – price elasticity of demand for substitute

goods is positive.
ii) The cross – price elasticity of demand for
complementary goods is negative.
iii) The cross – price elasticity of demand for unrelated
goods is zero.

TRY THIS

Theory of supply
 Supply indicates various quantities of a product that
sellers (producers) are willing and able to provide at
different prices in a given period of time, other things
remaining unchanged.
 The law of supply: states that, as price of a
product increase, quantity supplied of the product
increases, and as price decreases, quantity supplied
decreases.
 It tells us there is a positive relationship between price
and quantity supplied.
2.2.1 Supply schedule, supply curve and supply
function
 A supply schedule is a tabular statement that states
the different quantities of a commodity offered for
sale at different prices.

 A supply curve conveys the same information as a

supply schedule. But it shows the information
graphically rather than in a tabular form.
 The supply of a commodity can be expressed as
S = f(P), where S is quantity supplied and P is price of
the commodity.

 Market supply: It is derived by horizontally adding

the quantity supplied of the product by all sellers at
each price.

Determinants of supply
Apart from the change in price which causes a change in
quantity demanded, the supply of a particular product is
determined by:

i) price of inputs ( cost of inputs)

 An increase in the price of inputs such as labor, raw
materials, capital, etc causes a decrease in the supply
of the product (leftward shift of the supply curve).
 A decrease in input price causes an increase in supply.
 ii) technology
 Technological advancement enables a firm to produce
and supply more in the market. This shifts the supply
curve outward.
iii) prices of related goods
iv) sellers‘ expectation of price of the product
v) taxes & subsidies
vi) number of sellers in the market
vii) weather, etc.

Elasticity of supply
 It is the degree of responsiveness of the supply to
change in price.
 It may be defined as the percentage change in quantity
supplied divided by the percentage change in price.
 We can measure the price elasticity of supply using
point and arc elasticity methods.
 However, a simple and most commonly used method
is point method.
 The formula for measuring price elasticity of supply is:-

 The supply is elastic when a small change on price

leads to great change in supply.
 It is inelastic or less elastic when a great change in
price induces only a slight change in supply.
 If the supply is perfectly inelastic= represented by
vertical line.

Market equilibrium
 Market equilibrium occurs when market demand
equals market supply.
 example: Given market demand: Qd= 100-2P, and
market supply: P =( Qs /2) + 10
a) Calculate the market equilibrium price and quantity
b) Determine, whether there is surplus or shortage at
P= 25 and P= 35.
Effects of shift in demand and supply on equilibrium
 Factors such as changes in income, tastes, and prices
of related goods will lead to a change in demand.

 A decrease in demand reduces both the equilibrium

price and the quantity and vice versa.
 ii. When supply changes and demand
remains constant
III) Effects of combined changes in
demand and supply
 When both demand and supply increase, the quantity
of the product will increase definitely.
 When demand and supply decline, the quantity
decreases.

Chapter Three
Theory of Consumer Behavior
 Consumer theory is based on the premise that we can
infer what people like from the choices they make.
 Consumer behavior can be best understood in three
steps:-
 First, by examining consumer‘s preference
 Second, we must take into account that
consumers face budget constraints – they have
 limited incomes that restrict the quantities of
goods they can buy.
 Third, we will put consumer preference and
budget constraint together to determine
consumer choice.

3.1 Consumer preferences

 A consumer makes choices by comparing bundle of
goods.
 Given any two consumption bundles, the consumer
either decides that one of the consumption bundles is
strictly better than the other, or decides that she is
indifferent between the two bundles.
 In order to tell whether one bundle is preferred to
another, we see how the consumer behaves in choice
situations involving two bundles.
 If she always chooses X when Y is available, then it is
natural to say that this consumer prefers X to Y.
 We use the symbol ≻ to mean that one bundle is
strictly preferred to another, so that X ≻Y should be
 interpreted as saying that the consumer strictly prefers
X to Y.
 Indifference refers to a situation where the consumer
has no preference between different combinations of
goods.
 If the consumer is indifferent between two bundles of
goods, we use the symbol ∼ and write X~Y.
 Indifference means that the consumer would be just as
satisfied, according to her own preferences, consuming
the bundle X as she would be consuming bundle Y.
 If the consumer prefers or is indifferent between the
two bundles we say that she weakly prefers X to Y and
write X ⪰ Y.
 The relations of strict preference, weak preference,
and indifference are not independent concepts; the
relations are themselves related.
 For example, if X ⪰ Y and Y ⪰ X, we can conclude that
X ~Y.
 That is, if the consumer thinks that X is at least as good
as Y and that Y is at least as good as X, then she must
be indifferent between the two bundles of goods.
 Similarly, if X ⪰ Y but we know that it is not the case
that X~ Y, we can conclude that X≻Y.
 If the consumer thinks that X is at least as good as Y,
and she is not indifferent between the two bundles,
then she thinks that X is strictly better than Y.

3.2 The concept of utility

 Utility is the satisfaction or pleasure derived from the
consumption of a good or service.
 In other words, utility is the power of the product to
satisfy human wants.
 Given any two consumption bundles X and Y, the
consumer definitely wants the X-bundle than the Y-
bundle if and only if the utility of X is better than the
utility of Y.
 ‘Utility’ and ‘Usefulness’ are not synonymous.
 Usefulness is product-centric whereas utility is
consumer-centric.
 Utility is subjective:- The utility of a product will vary
from person to person. That means, the utility that two
individuals derive from consuming the same level of a
product may not be the same.
 For example, non-smokers do not derive any utility
from cigarettes.
 Utility can be different at different places and time.
 For example, the utility that we get from drinking
coffee early in the morning may be different from the
utility we get during lunch time.

3.3 Approaches of measuring utility

 There are two major approaches to measure or
compare consumer‘s utility: cardinal and ordinal
approaches.
 The cardinalist school postulated that utility can be
measured objectively.
 According to the ordinalist school, utility is not
measurable in cardinal numbers rather the consumer
can rank or order the utility he derives from different
goods and services.
3.3.1 The cardinal utility theory
 According to the cardinal utility theory, utility is
measurable by arbitrary unit of measurement called
utils in the form of 1, 2, 3 etc.
 For example, we may say that consumption of an
orange gives Bilen 10 utils and a banana gives her 8
utils, and so on.
 From this, we can assert that Bilen gets more
satisfaction from orange than from banana.
3.3.1.1 Assumptions of cardinal utility theory
The cardinal approach is based on the following major
assumptions.
1. Rationality of consumers.
 The main objective of the consumer is to maximize
his/her satisfaction given his/her limited budget or
income.
 Thus, in order to maximize his/her satisfaction, the
consumer has to be rational.
2. Utility is cardinally measurable
 According to the cardinal approach, the utility or
satisfaction of each commodity is measurable.
 Utility is measured in subjective units called utils.
3. Constant marginal utility of money
 A given unit of money deserves the same value at
any time or place it is to be spent.
 A person at the start of the month where he has
received monthly salary gives equal value to 1 birr
with what he may give it after three weeks or so.
4. Diminishing marginal utility (DMU)
 The utility derived from each successive units of a
commodity diminishes.
 In other words, the marginal utility of a commodity
diminishes as the consumer acquires larger
quantities of it.
5. The total utility of a basket of goods depends
on the quantities of the individual
commodities
  If there are n commodities in the bundle with
quantitiesX1, X 2,…,Xn, the total utility is given
by TU = f (X1 X2,… Xn ).

3.3.1.2 Total and marginal utility

 Total Utility (TU) is the total satisfaction a consumer
gets from consuming some specific quantities of a
commodity at a particular time.
 As the consumer consumes more of a good per time
period, his/her total utility increases.
 However, there is a saturation point for that
commodity beyond which the consumer will not be
capable of enjoying any greater satisfaction from it.
 Marginal Utility (MU) is the extra satisfaction a
consumer realizes from an additional unit of the
product.
 In other words, marginal utility is the change in total
utility that results from the consumption of one more
unit of a product.
 Graphically, it is the slope of total utility.
 Mathematically, marginal utility is:

As it can be observed from the above figure,

 When TU is increasing, MU is positive.
 When TU is maximized, MU is zero.
 When TU is decreasing, MU is negative.

Law of diminishing marginal utility (LDMU)

 The law of diminishing marginal utility states that as
the quantity consumed of a commodity increases per
unit of time, the utility derived from each successive
 unit decreases, consumption of all other commodities
remaining constant.
 In other words, the extra satisfaction that a consumer
derives declines as he/she consumes more and more
of the product in a given period of time.
 This gives sense in that the first banana a person
consumes gives him more marginal utility than the
second and the second banana also gives him higher
marginal utility than the third and so on.
 The law of diminishing marginal utility is based on the
following assumptions.
 The consumer is rational.
 The consumer consumes identical or homogenous
product. The commodity to be consumed should
have similar quality, color, design, etc.
 There is no time gap in consumption of the good
 The consumer taste/preferences remain
unchanged
 Chapter Four
The Theory of Production and
Cost
 4.1 Theory of production in the short run
4.1.1 Definition of production
 Raw materials yield less satisfaction to the consumer
by themselves.
 In order to get better utility from raw materials, they
must be transformed into outputs.
 However, transforming raw materials into outputs
requires inputs such as land, labor, capital and
entrepreneurial ability.
 Production is the process of transforming inputs into
outputs.
 It can also be defined as an act of creating value or
utility.
 The end products of the production process are
outputs which could be tangible (goods) or intangible
(services).

4.1.2Production function
 Production function is a technical relationship
between inputs and outputs.
 It shows the maximum output that can be produced
with fixed amount of inputs and the existing
technology.
 A production function may take the form of an
algebraic equation, table or graph.
 A general equation for production function can, for
instance, be described as:
Q= f(X1,X2 ,X3 ,...,Xn), where, Q is output and X1, X2,
X3,…, Xn are different types of inputs.
 Inputs are commonly classified as fixed inputs or
variable inputs.
 Fixed inputs are those inputs whose quantity cannot
readily be changed when market conditions indicate
that an immediate adjustment in output is required.
 In fact, no input is ever absolutely fixed but may be
fixed during an immediate requirement.
 For example, if the demand for Beer rises suddenly in
a week, the brewery factories cannot plant additional
machinery overnight and respond to the increased
demand.
 Buildings, land and machineries are examples of fixed
inputs because their quantity cannot be manipulated
easily in a short period of time.
 Variable inputs are those inputs whose quantity can
be altered almost instantaneously in response to
desired changes in output.
 That is, their quantities can easily be diminished when
the market demand for the product decreases and
vice versa.
 The best example of variable input is unskilled labor.

 Short run- refers to a period of time in which the

quantity of at least one input is fixed.
 In other words, short run is a time period which is not
sufficient to change the quantities of all inputs so that
at least one input remains fixed.
 Short run periods of different firms have different
durations.
 Some firms can change the quantity of all their inputs
within a month while it takes more than a year for
other types of firms.
 This sub-section is confined to production with one
variable input and one fixed input.
 Consider a firm that uses two inputs: capital (fixed
input) and labour (variable input).
 Given the assumptions of short run production, the
firm can increase output only by increasing the
amount of labour it uses.
 Hence, its production function can be given by:
Q = f (L)
where, Q is output and L is the quantity of labor.
 The production function shows different levels of
output that the firm can produce by efficiently utilizing
different units of labor and the fixed capital.
 In the above short run production function, the
quantity of capital is fixed. Thus, output can change
only when the amount of labour changes.

4.1.3 Total, average, and marginal

product
 In production, the contribution of a variable input can
be described in terms of total, average and marginal
product.

 Total product (TP): it is the total amount of

output that can be produced by efficiently utilizing
specific combinations of the variable input and fixed
input.
 Increasing the variable input (while some other inputs
are fixed) can increase the total product only up to a
certain point.
 Initially, as we combine more and more units of the
variable input with the fixed input, output continues
to increase, but eventually if we employ more and
more unit of the variable input beyond the carrying
capacity of the fixed input, output tends to decline.
 In general, the TP function in the short-run follows a
certain trend: it initially increases at an increasing
rate, then increases at a decreasing rate, reaches a
maximum point and eventually falls as the quantity of
the variable input rises.
 Marginal Product (MP): it is the change in output
attributed to the addition of one unit of the variable
input to the production process, other inputs being
constant.
 For instance, the change in total output resulting from
employing additional worker (holding other inputs
constant) is the marginal product of labour (MPL).
 In other words, MPL measures the slope of the total
product curve at a given point.

 In the short run, the marginal product of the variable

input first increases, reaches its maximum and then
decreases to the extent of being negative.
 That is, as we continue to combine more and more of
the variable input with the fixed input, the marginal
product of the variable input increases initially and
then declines.

 Average Product (AP): Average product of an

input is the level of output that each unit of input
produces, on the average.
 It tells us the man contribution of each variable input
to the total product.
 Mathematically, it is the ratio of total output to the
number of the variable input.
 The average product of labour (APL), for instance, is
given by:

 Average product of labour first increases, reaches its

maximum value and eventually declines.
 The AP curve can be measured by the slope of rays
originating from the origin to a point on the TP
curve.