Market Structures

Based on the nature of the product, number of the sellers, and entry and exit of firms there are
four types of market structures.
1. Price and Output Determination under Perfect Competition
Perfect competition is a market structure characterized by a complete absence of rivalry
among the individual firms. Thus, perfect competition in economic theory has a meaning
diametrically opposite to the everyday use of this term. Most of the time, we see business
men using the word Competition as synonymous to rivalry. However, in theory, perfect
competition implies no rivalry among firms
A. Basic Characteristics of a Competitive Firm
Very large numbers of sellers and buyers: With many sellers no one market participant, or
small group of participants, can influence the market in a significant way. All buyers and
sellers have the option of trading with several others, often in a highly organized or structural
market. Farm commodity markets and foreign exchange markets are examples.
each firm has very small market share
Standardized product: Competing firms in a market offer a standardized good or service for
sale. Grain and livestock, for example, are traded in specific classes or grades, as are
diamonds and crude oil. Within a specific class or grade, buyers do not discriminate among
sellers. Often neither the buyer nor the seller physically examines the commodity exchanged
products in each group are perfect substitutes
Price Taker: In a purely competitive market, individual firms exert no significant control over
product price.
Its demand curve is infinitely elastic, indicating that the firm can sell any amount of output at
the prevailing market price. Since the share of the firm from the market supply is too small to
affect the market price, the only thing that the firm can do is to sell any quantity demand at
the ongoing market price. Thus, the demand curve that an individual firm faces is a horizontal
line.

Market P
P=AR=MR

Out put

Fig 1 the demand curve

indicates a single market price at which the firm can sell any amount of the commodity demanded.
The demand curve also indicates the average revenue and marginal revenue of the firm.

Freedom of entry and exit: New firms can enter and existing firms are free to leave the
industry. There are no restrictions such as licenses. Existing firms are free to exit without
getting approval from a government commission or other body. Farming usually meets this
condition
. Perfect mobility of factors of production Factors of production (including workers) are free
to move from one firm to another throughout the economy. Alternatively, there is also perfect
competition in the market of factors of production.
No government regulation by assumption, there is any government intervention in the
market. That is there is no tax, subsidy etc. A market structure in which all the above
assumptions are fulfilled is called pure competition. It is different from perfect competition
which requires the fulfillment of the following additional assumptions.

Perfect knowledge It is assumed that all sellers and buyers have a complete knowledge of
the conditions of the prevailing and future market. That is all buyers and sellers have
complete information about.
The price of the product

Quality of the product etc

Thus, a perfectly competitive market is a market which satisfies all the above conditions
(assumptions). In reality, perfectly competitive markets are scarce if not none. But since the

theory of perfectly competitive market helps as a bench mark to analyze the more realistic
markets, it is very important to study it.
B. Demand and revenue functions under perfect competition
An individual has no control over the market price (it is a price taker) so that the demand curve
he faces is given by a perfectly elastic (flat) horizontal line at the market price. In other words,
marginal revenue and average revenue for a competitive firm are identical to the firms demand
curve. For each unit of product being sold in the market, total revenue increases by the product
price.
Average revenue ( AR )

Total Re venue
Output

PQ
P
Q

is the same as
M arg inal revenue ( MR)

TR
Q

( P Q )
Q

Thus for the pure competitive market only

AR MR P

TR

_
TR=PQ

Fig 2 the total revenue of firm operating in a perfectly competitive market is linear (and increasing
function) of the quantity of sales.

Types of Revenue
Total revenue:
The total amount of money received by a firm(s) from the sale of a product.
The quantity sold (demanded) multiplied by the price at which it is sold
The total expenditures for the product produced by the firm(s)

Marginal revenue:

 The change in total revenue that results from the sale of one additional unit of a firms
product
The change in total revenue divided by the change in the quantity of the product sold

Average revenue:
Total revenue from the sale of a product divided by the quantity of the product sold
(demanded)
The price at which the product is sold when all units of the product are sold at the same
price
Graphically, the demand curve represents the MR and AR of the firm

P= AR = MR

Fig: 3 the AR curve, MR curve and the demand curve of an individual firm operating
under perfectly competitive market overlap.
D. Profit Maximization Approaches
Approaches to profit-maximization level of output are
The daily output for corn production
Total
Fixed
Q
0
1
2
3
4
5
6
7
8
9

Price
100
100
100
100
100
100
100
100
100
100

Rev
0
100
200
300
400
500
600
700
800
900

Cost
100
100
100
100
100
100
100
100
100
100

Variable

Total

Cost
0
39
68
107
156
235
334
483
682
981

Cost
100
139
168
207
256
335
434
583
782
1081

Total
MC

AC

AVC

P-AC

39
29
39
49
79
99
149
199
299

139
84
69
64
67
72.33
83.29
97.75
120.11

39
34
35.67
39
47
55.67
69
85.25
109

-39
16
31
36
33
27.67
16.71
2.25
-20.11

Profit
-100
-39
32
93
144
165
166
117
18
-181

10

100

1000

100

1380

1480

399

148

138

-48

-480

Short run equilibrium of the firm

A firm is said to be in equilibrium when it maximizes its profit (). Profit is defined as the
difference between total cost and total revenue of the firm:
= TR-TC
Under perfect competition, the firm is said to be in equilibrium when it produces that level of
output which maximizes its profit, given the market price. Thus, determination of equilibrium
of the firm operating in a perfectly competitive market means determination of the profit
maximizing output since the firm is a price taker. The level of output which maximizes the
profit of the firm can be obtained in two ways:
Total approach
Marginal approach

1.The total revenue-total-cost: - under this approach the profit-maximizing level of output is
obtained at a point where the difference between total revenue and total cost is the greatest. In
the above table, it is given by the sixth level of output, i.e. 166Birr.
In the diagram below both the total revenue (TR) and total cost (TC) curves are drawn. The
diagram indicates that the vertical distance between the TR and the TC is the largest at the Qe
level of output. At the same level of output the vertical distance between the horizontal axis
and the Profit function is the largest too.

TR TC
TC,TR

Q
Q0

Qe

Q1

Fig: 4 The profit maximizing output level is Q e because it is at this output level that the vertical
distance between the TR and TC curves (or profit) is maximum. For all output levels below Q 0
and above Q1 profit is negative because TC is above TR.

2.The marginal-revenue-marginal-cost approach: under perfect or pure competition case,

marginal revenue (MR), which is the additional amount of money someone receives for each
additional unit of product sold, is assumed to be identical to the price. Observe that the price is
not affected by the amount of product a firm or some group of firms sell. As a result the
following relation is concluded from this situation

MR AR P
This implies that the demand curve that the firm faces is given by the flat or perfectly elastic
curve (from the above table it is given at Birr 100).
How is then profit maximized?
Any producer keeps on producing a given product as long as the marginal return or price or the
average revenue obtained from the employment of the variable input is larger than the marginal
cost (MR>MC). Even if we know from the production theory that the rational firm produces at
Stage II, where the marginal product of a variable input is decreasing, we do not exactly know
the level of output the firm should produce.
The decision on how much to produce is determined by the maximum level of profit that could
potentially obtained from the production process. The amount of total profit is at its maximum
when the marginal profit is zero. Put differently, when the marginal cost (the slope of the cost
curve) equals to the marginal revenue (the slope of the total revenue curve), total profit will be at
its maximum.[NB. when a certain function reaches a maximum/minimum point, its marginal
value (slope) is zero at this extreme point]

Marginal Marginal Marginal

0
P rofit Revnue Cost
MR C PM
Thus, the condition for profit maximization under perfect competition is
MR= MC.necessary condition and
MC is increasing. sufficient condition
Graphically, the marginal approach can be shown as follows.

MC, MR
MC
MR

Q*

Qe

Fig 5.: the profit maximizing out put is Qe, where MC=MR and MC curve is increasing. At Q*,
MC=MR, but since MC is falling at this output level, it is not equilibrium out put. For all output
levels ranging from Q* to Qe the marginal cost of producing additional unit of output is less than
the MR obtained from selling this output. Hence the firm should produce additional output until
it reaches Qe.
Example: the corn production of firm A and firm B is given as follows

Firms
A
B
A*
B*

No of Price

Total

Total

input

of

Variable

fixed

Total

Corn

Price of Total

used
200
260
240
280

input
0.2
0.2
0.2
0.2

cost
40
52
48
56

cost
150
150
150
150

cost
190
202
198
206

output
116.3
124.3
122.2
125.6

output
2
2
2
2

revenue
232.6
248.6
244.4
251.2

If A wants to increase his output from its current level to, say 122.2 units, for the additional 5.9
units he needs to spend an additional cost of 8.00 Birr (Total cost of A - Total cost of A* = 198190) or 1.36 Birr /unit (8/5.9) of marginal cost. This value of 1.36 Birr is still less than the
marginal revenue of birr 2.00. Similarly, the increase in total revenue (244.4-232.6=11.8) is
higher than the increase in total cost (198-190=8.00). Thus at this level of production profit
increases by Birr 3.80 and the decision will be to produce the amount given by A*
What should be the decision about firm B? Why? Compare your answer with MC=3.08 and
MR=2.00.
The Break-even Point
At some specific output price the firm doesnt make any profit at the profit maximizing level of
output where MR=MC=AC. The corresponding level of output is then referred to as the breakeven point. For example if the price falls to Birr 63 in the above case then at that level of output
there will be zero economic profit or normal profit (the firm earns exactly its implicit cost). The
firm, despite making zero profit, prefers to operate rather than closing down since this way of
production covers its fixed costs fully.
The Shutdown Case
8

If the price falls further down to Birr 30 at this price MR is just equal to AVC, i.e., the firm is
losing money that amounts to the fixed costs. At this price the firm is indifferent between
operating and ending operations. If the price falls below this level, then the firm will incur a loss
and it is preferable shutting down to operating at a loss. But for the price above this closedown
price the firm minimizes its loss by operating rather than closing down. Thus, when MR=MC=
AVC, the level of output is referred to as the shutdown point.

2. PRICE AND OUT PUT DETERMNATION UNDER MONOPOLY

Definition of monopoly
Monopoly is quite opposite to perfectly competitive market. And it is defined as: a market
situation in which a single seller sells a product or provides a service for which there is no close
substitute. In monopoly there are no similar products whose prices or sales will influence the
monopolist price or sales. In another words, cross elasticity between monopolist product and
other commodities is zero or low. Since there is a single seller in monopoly market structure, the
firm is at the same time the industry.
The Basics of Monopoly
Monopoly markets share the following common characteristics.
1. Single seller: - a pure, or absolute, monopolist is a one-firm industry. A single firm is the
only producer of a specific product or the sole supplier of a service; the firm and the
industry are synonymous
2. No close substitutes: - the monopolists product is unique in that there are no good, or
close, substitutes. From the buyers viewpoint, there are no reasonable alternatives. The
buyer who does not buy the product frown the monopolist has no alternative but to do
without
3. Price maker: - the pure monopolist is a price maker; the firm exercises considerable
control over the price because it controls the total quantity supplied. Because it faces a
downward sloping demand curve, the monopolist can change the product price by
manipulating the quantity of the product supplied
4. Blocked entry: - a pure monopolist has no immediate competitors because there are
barriers to entry. Economic, technological, legal, or other obstacles exist to keep new
9

competitors from coming into the industry. Entry under conditions of pure monopoly is
totally blocked.

Causes for the emergence of monopoly

Economies of scale- the production cost is lower as very large numbers are
produced. Many public utilities- electric and gas companies, bus firms, local
water and sewerage companies are considered as natural monopolies that enjoy
such advantage

Legal ownership: patents and licenses

i. Patents aim to protect an inventor from rivals who would use the invention
without having shared in the cost of developing it. It is also used to
encourage creation and the production of new products.
ii. Licenses that generate monopolies are often put in place to promote
welfare or generate public revenue. Examples are EELPA, TELE, Postal,
Water Sewerage authority, National Lottery.

Ownership of essential resources:- a firm owning a resource essential to a

production process can prohibit the creation of rival firms

Strategic barriers:- it is a way of blocking entry by setting some mechanism

against potential entrants; for example, a monopolist might create an entry barrier
by cutting its price or greatly increasing advertising

2.1. The demand and revenue curves of the monopoly firm

Having the controlling power over the price of its product, a monopolist decides the market price
at which it needs to sell. If the monopolist wants to increase its sales it can do so by reducing the
price. This implies that it faces a downward sloping demand curve, which is also the market
demand curve. This means that the marginal revenue is less than the price for every level of
output, i.e., the marginal revenue curve lies to the left of the demand curve.
MR

TR
P
Q

The following figure illustrates this relationship

10

AR and RM curves for Monopoly

D=AR=P

MR

Quantity

T
M
DM is the demand curve and DT is the marginal revenue curve, which bisects the quantity
demanded OM. Thus the distance OT = TM
This can be shown mathematically as follows assuming linear demand function
1. The demand function
P = a - bx where a = constant, x=quantity demanded
2. The total revenue is
R = Px
= (a - bx)x = ( substituting P = a -bx)
= ax -bx2
3. The Average revenue
AR =

R Px

P a bx
x
x

Thus the demand curve is also the AR curve of the monopolist with slope = -b
4. The marginal revenue (the first derivative of R)
dR d (ax bx 2 )

dx
dx

=a-2bx
That is the MR is a straight line with the same intercept (a) as the demand curve, but
twice as steep ( i.e slope = -2b)
In short,
11

The monopolist maximizes profit or minimizes loss at the output where MR=MC and
charges the price which corresponds to this output on its demand curve.

The monopolist has no supply curve since any of several prices can be associated with a
specific quantity of output supplied

Assuming identical costs, a monopolist will be less efficient than a purely competitive
industry because the monopolist produces less output and charges a higher price.

The total revenue curve of the monopolist firm has an inverse U- shape. The total revenue of a
monopolist firm first increases with the quantity of sales (over the elastic range of the demand
curve), reaches its maximum (when the demand curve is unitary elastic), and finally decreases
when quantity of sales increases (over the inelastic range of the demand curve) the following
figure illustrates this fact.

P
Ep>1

Ep=1
P1

Ep<1
Q1

DD

TR

TR

12

Q
Q1
Fig: 6. the shape of total revenue curve and its relationship with the price elasticity of demand.
When Ep>1 TR and Q have positive relation, at a point where Ep=1, TR curve reaches its
maximum and when EP<1, TR and Q have negative relation.
Price Discrimination

Price discrimination refers to the charging of different prices for the same good. But not all
price differences are price discrimination. If the costs of offering a certain uniform
commodity (service) to different group of customers are different (say due to difference in
transport costs), price of the commodity may differ for each group owing to this cost
difference. But this cannot be considered as price discrimination. A firm is said to be price
discriminating if it is charging different prices for the same commodity without any
justification of cost differences. By practicing price discrimination, the monopolist can
increase its total revenue and profits.
The Necessary Conditions for Price Discrimination

For a firm to effectively practice price discrimination the following necessary conditions should
be fulfilled.
1-There should be effective separation of markets for different classes of consumers, so that
buyers of low price market cannot resale the commodity in high price market
A market is said to be effectively separated if one of the following points is met:
- Geographical variation with high transport cost so that the inter market price margin is unable
to cover the transport expense.
E.g. Domestic Vs international markets.
- Exclusive use of the commodity. For some services resale is inherently difficult. For example
you cannot resale Doctors services, Entertainment shows.
- Lack of distribution channels

13

2. The second necessary condition to successfully practice price discrimination is that the price
elasticity of demand should be different in each sub market.
For example, a movie theatre knows that college students and old people differ in their
willingness to pay for a ticket and can exercise discrimination by charging the college students a
higher price. This condition can be justified by using the markup formula. Suppose the firm has a
marginal cost of MC and the price elasticitys of demand for its product into different markets
are ed1 and ed2
Then the price in each market is
P1

MC
MC
, and .P 2
1
1
1
1
ed1
ed 2

If ed1= ed2, P1 will be automatically equal to P2.

Hence, ed1 = ed2 for the prices to differ.
3- Lastly, the market should be imperfectly competitive. In other words, the seller of the product
should have some monopoly power (it should not be price taker) to practice price discrimination.

3.Price And Output Determination Under Monopolistic Competition

Monopolistic competition characterizes many industries in the real world. Like the pure
monopolist, firms in these industries face downward- sloping demand curves. Like the pure
competition case, entry and exit are easy. It is a market structure with many buyers and sellers in
which product differentiation exists and there are elements of both monopoly and perfect
competition.
Characteristics of monopolistic competition
1)Relatively large number of sellers and buyers: - the number may range, say from 25 to 100,
but the hundreds or thousands needed for perfect competition. Because of the fairly large
number of firms such characteristics emerge:
i) Small market share: - each firm has a small percentage of the total market1, so each
has limited control over market price.
14

ii) No collusion: - the relatively large number of firms ensures that collusion to restrict
output and raise prices is all but impossible
iii) Independent actions: - with numerous firms, there is no feeling of mutual
interdependence. Each firm determines its policies without considering possible
reactions of rival firms
2)Product differentiation: - as a fundamental feature of monopolistic competition, purely
competitive firms turn out a homogeneous product, and monopolistically competitive
firms produce variations of a particular product. The non-price competition takes such
forms
i) Product quality: - the basic product is the same but features of the product differ
somewhat, for example, different terms on a credit card.
ii) Services: - some may provide carry out service while another grocery store lets you
carry your own purchases.
iii) Location: - some gas stations locate near interstate highways and sell at a higher price
than firms located in a city some distance from the highway. The location of some
firms may be convenient and they stay open the whole night.
iv) Advertising and packaging: - to differentiate their products many firms apply
perceived differences created through advertising or packaging. For example,
toothpaste in a pump container may be preferable to toothpaste in a tube for some
consumers
3)Easy entry: - entry in a monopolistically competitive industry is relatively easy. Economies
of scale and capital requirements are few
Product Differentiation and the Demand Curve
Product differentiation is any feature of a product of sellers that makes buyers to prefer one
product or sellers to that of another. It leads to different consumers preference. It is also the
basis for establishing a downward sloping demand curve. Chamberlin suggested that the demand
for a product is not only determined by the price but also by the style of the product, the
services associated with it and the selling activities of the firm. Thus, Chamberlin introduced
two additional policy variables in the theory of the firm: the product itself and selling costs.
Hence, the demand curve shifts if:
1. The style, services, or the selling strategy of the firm changes,
15

2. Competitors change their price, output, services or selling policies of a product;

3. Tastes, incomes, prices or selling policies of products from other industries change.
Product differentiation is intended to distinguish the product of one producer from that of the
other producer in the industry (in the group). It can be real differentiation or fancied (artificial)
differentiation. Real differentiation: exists when the inherent characteristics of the products have
slight differences (slight difference in quality, durability), in the specification of products (terms
of credit, transportation, guarantee, location of the firm), which determine the convenience with
which a product is accessible to the consumer. Example: chemical differences existing in
shampoos or conditioners.

On the other hand, fancied differentiation is established by

advertising or differences in packaging or differences in design (color or shape) or simply by

brand name.
In any case, the aim of product differentiation is to make the product unique in the mind of the
consumers.

And the effect of product differentiation leaves firms under monopolistic

competition with some degree of monopoly power. Because of this the firm is not a price
taker.
Monopolistic competition has less power than pure monopoly and more power than perfectly
competitive market structure over the price of its product. The power of the firm over price is
limited because of the existence of other competitors. Product differentiation creates brand
loyalty and gives rise to a negatively sloped demand curve.
Demand function
The monopolistically competitive firm faces a demand curve that is downward sloping, but much
more elastic that the demand curve facing a pure monopolist. The latter faces a fairly inelastic or
steeper demand curve, and hence marginal revenue curve. But a monopolistically competitive
firm, which sells a product that has many close substitutes, faces a more elastic or flatter demand
curve, of which slope is much closer to zero, and marginal revenue curve.
Short run and Long run
1)Short run

the firm can make excess profits or lose money, as the demand and marginal revenue
curve shift
16

The firm produces the level of output at which MR=MC and the price that corresponds
to this level of output is obtained using the demand curve.

The vertical distance between the ATC and the demand curve provides the excess profit
per unit sold

The excess profit attracts entry in the industry and the production of more close
substitutes, which leads to a downward shift in the demand curve that faces individual
firms

Finally, as the demand curve continues to shift down until the excess profit is
exhausted and the individual firm loses money

2)Long run

If a firm loses money as a result then it goes out of business and the demand curve that
faces for the firms that still remain in the industry will shift upward

Easy entry and exit of firms cause monopolistic competitors to earn only normal profit

The equilibrium output is such that price exceeds the minimum average total cost and
price exceeds marginal cost

4.Price and Output Determination Under Oligopoly

Oligopoly is a market organization in which there are few firms that produce identical or closely
substituted products (identical or differentiated). Oligopoly is said to exist when there are more than
one seller in the market, but their number is not so large so as to make the contribution of each firm
negligible. Firms thus, are

situated mutually interdependence. That is they behave as if any one

firms action directly affect other rivals and is affected by the action of others.
Oligopoly is a market dominated by a few large producers of a homogeneous or differentiated
product. Few is crucial here. Oligopolists have considerable control over prices but each must
consider the possible reaction of rivals to its own pricing, output, and advertising decisions.
Differentiated product

17

 a product that differs physically or in some other way from the similar products
produced by other firms,
a product such that buyers are not indifferent to the seller when the price charged by
all sellers is the same
Main Characteristics of Oligopoly
An oligopolistic industry is made up of relatively few firms producing either
homogeneous or differentiated products; these firms are mutually interdependent in
their pricing policies. An oligopoly with just two firms constitutes a duopoly.
Barriers to entry such as scale economies, control of patents or strategic resources, or
the ability to engage in retaliatory pricing characterize oligopolies. Oligopolies can
result from internal growth of firms, mergers, or both
the four-firm concentration ratio shows the percentage of an industrys sales accounted
for by its four largest firms (concentration ratio refers to the percentage of the total
sales of an industry made by the four or some other number largest sellers in the
industry)
firms enhance their profits through collusion (= a situation in which firms act together
and in agreement (collude) to fix prices, divide a market, or otherwise restrict
competition)
In general unpredictable action and reaction will make it difficult to analyze oligopoly market.
Firms may come in collusion with each other or may try to fight each other on the death. So
accordingly.
Oligopoly market is divided in to two. These are
Non-collusive Oligopoly and
Collusive Oligopoly
Non- Collusive Oligopoly
Oligopoly firms may cooperate (collude) or may not cooperate (no- collusion) in some activities
with respect to their businesses depending on their interest and agreement. If firms do not cooperate,
their decision-making process is analyzed using the non- collusive model. This implies that firms do
not enter in to collusive agreement. There are a number of non-collusive oligopoly models that give
us stable solution to the oligopoly problem that may arise. Example
1.

The Cournots model (1838)

2.

The Kinked demand (Sweezys) model (1839)

18

3.

The Stackelbergs model (1920)

4.

The Bertrands model (1883)

5.

The Chamberlains model (1883). For this course we

will discuss only some of them.
Collusive Oligopoly

One way of avoiding the uncertainty that may arise from interdependence of firms in oligopoly
market is to enter in to collusive agreement (that is to adopt more strategic cooperation). There
are two main types of collusive oligopoly. These are
1.

Cartels

2.

Price leadership.

CARTELS: A cartel is a cooperation of firms whose objective is to limit (reduce) the scope of
competitive environment that arises due to mutual interdependence of firms within the market
and act as a monopoly. There are two forms of cartel. These are
a) Cartel aiming at joint profit maximization
b) Cartel aiming at sharing the market

PRICE LEADERSHIP: The collusion among the oligopolies also entails that one firm will set the
market price and others followed (adopt) it. Followers usually prefer to avoid the uncertainty that
might occur because of their competitors reaction for their action even if this implies departure from
profit maximizing point.
Price leadership is more widespread than cartel. The two most common types of price leadership ar e

Price leadership by low cost firm

Price leadership by the dominant (large) firm

19

PART THREE: MACROECONOMICS

1. Major Problems of the Macro Economy
Any macro economy could have confront in either one or all of the following problems

How to increase production capacity of the economy?

o In most developing countries population size has grown much faster than
production. This situation gives rise the problem of poverty
o

As some countries grows faster some other may stagnate. This gives rise to the
problem of growth
Such problems entails the development of the Theory Of Growth

How to stabilize the economy?

o

many market economies have experienced fluctuations in their macroeconomic

performance
20

high inflation and/or

high unemployment
o leads to the wastage of resources
Such problems causes the emergence of Business Cycle
Theories

Other problems
o

Poor performance on the international trade causes a balance of trade deficit and
shortage of foreign currency to import even very important items like medicine
and oil.
As a result of this the Theory Of International Trade has got
its foundation

National Income Accounting

Basic Concepts

Gross Domestic Product(GDP)

GDP is the value of the total final goods and services produced within the boundaries of a
country for a given period of time and measured by the value-added principle. It is the single
most widely used measure of the output of an economy. It includes those goods and services
produced in the current time period only. GDP is evaluated at market prices (factor cost +
indirect taxes).

Gross National Product (GNP)

GNP is the value of output produced by land, labor, capital and entrepreneurial talent
supplied by citizens whether the resources are located at home or abroad.

GNP=GDP + foreign earnings of domestic residents and firms - earnings

in the domestic economy by foreign residents and firms

Net National Product (NNP)

NNP

is

the

market

value

of

annual

output

less

depreciation

(capital

consumption).Depreciation refers to estimates of the amount of capital worn out or used up

(consumed) in producing the gross domestic product.

National Income(NI)

21

It is all income earned by citizens of a particular nation for their current contributions to
production within the nation or abroad

Personal Income
It is all income received by households whether earned or not

Disposable Income
It is all income received by households less personal taxes

Limitations of GDP
Even if the most comprehensive measure of the economic performance of a nation, GDP has the
following limitations
1. Non-market productive Activities are Left Out
Because goods and services are evaluated at market prices in GDP, non market production is
left out. This includes such examples as homemakers' services and agrarian non market
production.
2. The Informal Economy is Left Out
Also left out of GDP are illegal forms of economic activity and legal activities that are not
reported to avoid paying taxes - the informal economy. Gambling and the drug trade are
examples of illegal activities. Repairmen may underreport or fail to report about the income
receipt from the service they provide to avoid tax payment.
3. GDP is not a Welfare Measure
GDP measures production of goods and services; it is not a measure of welfare or even of
material well-being. For one thing GDP do not reckon the welfare that can be realized from
leisure. If we all began to work 24-hour a day, GDP would increase, but we would not be
better off for leisure also contributes to maximize welfare.
GDP also fails to subtract for some welfare costs of production. If, for example, production of
chemical fertilizer cause environmental pollution, we only give weight to the amount of
fertilizer produced in GDP but may ignore the economic cost of pollution. Thus GDP is a
useful measure of the overall economic activity rather than welfare. In spite of these
shortcomings, GDP still serves to monitor the short run economic fluctuations and to analyze
the long run growth trends and take a corrective policy measures.

22

 Foreignsource Income arned

GNPGDP incomeof by foreigners
households insdethecountry

Capitalconsumption

N PGNP alowances
Depreciatons

National Indirect

23

Approaches to Measuring GDP

The total goods and services produced in a given period of time of a national economy can be
measured by three different methods
1. Production Method (Value-added Method)
This method consists of three stages

estimating the gross value of domestic output (GDP) in the various production units or
sectors

determining the costs of materials and services used and depreciation of capital goods

deducting these costs and depreciation from gross value to obtain net domestic output
the measurement takes place by the value- added principle

2. (Factor ) Income Method

According to this method the national economy performance is measured on the basis of the
income received by the factors of production that are used in the production of the final goods
and services. Even though the factors of production are usually categorized into labor, capital,
natural resource and entrepreneurship skills, under this consideration they are broadly grouped
into labor and capital. As a result the income of the economy is going to be divided between the
owners of factors of production.
o

Labor income, which is obtained by selling the labor service, includes wages and salaries
together with different kinds of benefits

Capital income includes

dividend

profits of both private (corporations, partnership and sole business organizations) and
public enterprises

interest payments on lent out funds

rent payments on land, buildings and other natural resources

3. Expenditure Method
This method measures spending made on the final goods and services on the basis of either

The uses of income for

o private consumption expenditure(C)
24

o private saving (S)

o tax payments (T)
o transfer payments(Rf)

The spending made for

o private consumer goods and services (C)
o private investment spending ( I )
o public goods and services(G)
o net investment abroad(NE)

Aggregate Expenditure can be given by

GDP C I G NE C S T R f

Nominal and Real GDP

Nominal GDP measures the value of the economy's total output evaluated at current
market prices, or in dollars. It changes when the overall price level changes as well as
when the actual volume of production changes

Real GDP measures the total output produced in any one period in terns of constant
price of some base year. It changes only when quantities change. For most purposes,
such as to compare the physical change in production/output or to analyze the
relationship between the actual quantity produced and the level of employment we
want a measure of output that varies only with the quantity of goods produced, real
GDP

Fluctuations in Economic Activities: Unemployment and Inflation

Unemployment
Fluctuations in economic activities lead to a fall in real GDP. As the real GDP falls, apart from
reducing the national production and national income, it leads to an excessive unemployment. It
is measured by unemployment rate
u

U the number of unemployed people

L
Total labor force

There are three kinds of unemployment

o

Frictional unemployment: - occurs when people have left jobs and are searching for a new
one
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Structural Unemployment: - occurs when there exist permanent shift in the pattern of
demand for goods and services or technology in a specific industry

Cyclical unemployment: - occur when the economy fails to operate at its potential level. In
this case the real GDP declines to its recession level

Frictonal Struc al Naturl

u nemployent unemployent unemployent

when the economy operates at zero cyclical unemployment, it is referred to as full

employment (in which case the actual unemployment rate is not zero)

if the economy operates at full employment rate the real GDP thus attained would be
potential real GDP

Costs of unemployment
-

reduce national output and tax revenues

increase mental and physical illness and other social problems but the problems can
be mitigated through unemployment insurance systems that maintain the well-being
to some extent

Inflation
It is the rate at which the general price level increases for goods and services and is measured by
the percentage change in consumer price index (CPI). CPI measures the retail prices of a fixed
market basket of several thousands of goods and services purchased by households.
26

CPI

pq
p q
t

where Pt and P0 are current price and base period prices respectively and q o is the quantity of
weighted basket of goods.
When inflation exists
-

the purchasing power of a nations currency declines, i.e., the currency buys fewer and
fewer goods as price increases

increases in nominal income will be absorbed by the increase in price

NominalIncomeRealIncomeCPI
OR
Growthrateof Growthrateof Growthrateof

NominalIncome Realincome CPI
real income declines if the rate of inflation is higher than the growth rate of
nominal income
Inflation can
-

result in varying benefits for debtors and creditors: if debtors borrowed money when
inflation was low and repay when there is inflation, debtors will be better off while
creditors are worse off. This is because now the purchasing power of money is low.
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harm saving as savers are creditors

Anticipation of inflation (expectation of price increase in the future) adversely affects the
performance of the economy. This means such anticipation can distort consumer choices by
causing buyers to purchase goods now that they might otherwise prefer to purchase in the future
and thereby distorting market prices.
Aggregate Demand and Aggregate Supply Equilibrium
Aggregate Demand
-

the relationship between the price level and the aggregate quantity of final products
demanded

the relationship is shown by aggregate demand curve which slopes downward

The aggregate demand curve for a given economy
Price level

Price level

Aggregate quantity demanded

Aggregate quantity demanded

when the aggregate demand curve shifts outward because of

an increase in demand

if

factors

other

than

price

level

changes,

the

aggregate

demand

changes

(increase/decrease)and the AD curve will shift (outward/downward)

-

such factors as real interest rate, the money stock, the foreign exchange rate, government
purchases, taxes, transfers and factors influencing demand for exports are factors responsible
for such a shift on the demand curve

The effects of the determinants of AD

real interest rate
real interest rate new investment price AD
quantity of money in circulation
28

money stock money holding in the hands of the public Spending AD

foreign exchange value
price of Birr in terms of other countries currency demand for export AND
demand for import AD
government purchases, taxes and transfer payment
government purchases AD
taxes disposable income AD
transfer payments AD
expectations
deterioration AD
improvement AD
foreign nations income and other economic conditions
income in foreign nations OR demand for export AD
Aggregate Supply
-

the relationship between the price level and the aggregate quantity of final products supplied

this relationship is given by the AS curve which slopes upward

the AS curve becomes flat during slack periods and steep when the economy is operating at
the potential real GDP

Price level

Aggregate supply
curve
Potential level of
real GDP
Excessive
unemployment

Over employment
level

Full employment
level
Aggregate quantity supplied

changes in such factors as input prices, in the quality and quantity of inputs and advance in
technology changes the AS curve outward (when AS increases) or inward (when AS
decreases)

The effects of the determinants of AS

price of input
nominal wage cost of production MC AS shift inward
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 availability /productivity of resources and advance in technology

size of labor OR other inputs quantity AS
improvement in the quality of inputs AND advance in technology AS
Economic Policy Instruments: Monetary, Fiscal and Income policies
Macroeconomic policy instruments: refer to macroeconomic quantities that can be directly
controlled by an economic policy maker. Instruments can be divided into two subsets:
- Monetary policy instruments- policy is conducted by the national (central) bank of a country.
- Fiscal policy instruments- Fiscal policy is conducted by the executive and legislative branches
of the Government and deals with managing a nations budget.
Monetary Policy
Monetary policy instruments consists in managing short-term rates (interest and discount rates),
and changing reserve requirements for commercial banks. Monetary policy can be either
expansive for the economy (short-term rates low relative to inflation rate) or restrictive for the
economy (short-term rates high relative to inflation rate). Historically, the major objective of
monetary policy had been to manage or curb domestic inflation. More recently, central bankers
have often focused on a second objective: managing economic growth as both inflation and
economic growth are highly interrelated.
In other words, monetary policy is the process by which the monetary authority of a country
controls the supply of money, often targeting a rate of interest for the purpose of promoting
economic growth and stability. The official goals usually include relatively stable prices and low
unemployment. Monetary theory provides insight into how to craft optimal monetary policy. It is
referred to as either being expansionary or contractionary, where an expansionary policy
increases the total supply of money in the economy more rapidly than usual, and contractionary
policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy
is traditionally used to try to combat unemployment in a recession by lowering interest rates in
the hope that easy credit will entice businesses into expanding. Contractionary policy is intended
to slow inflation in hopes of avoiding the resulting distortions and deterioration of asset values.
Monetary policy differs from fiscal policy, which refers to taxation, government spending, and
associated. There are different methods to exercise monetary policy.
i. Open Market Operations
There are two types of open market operations: Open market purchases government buys
securities to increase the monetary base. Open market sales = government sells securities to
decrease the monetary base. Thus, the government conducts open market operations by buying
and selling Ethiopian government securitiesespecially treasury bills.
ii. Discount Loans
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When the government or national bank can affect the volume of loans by setting the discount rate
it is discounting. A higher discount rate makes discount borrowing less attractive to banks and
will therefore reduce the volume of loans. A lower discount rate makes discount borrowing more
attractive to banks and will therefore increase the volume of loans.
iii. Changes in Reserve Requirements
By affecting the money multiplier, changes in the required reserve ratio can lead to changes in
the money supply. Changes in reserve requirements can cause problems for banks by making
liquidity management more difficult.
Fiscal Policy
Fiscal policy consists in managing the national Budget and its financing so as to influence
economic activity. It operated on managing government expenditure and taxation. There are two
types of fiscal policies. This entails the expansion or contraction of government expenditures
related to specific government programs. a. Expansionary fiscal policy it is used when the
government wants to raise total output and employment. It is usually taken during recession (low
total output) period. To achieve this objective the government increases its expenditure or/and
reduce taxes. This increase AD thereby total output and employment level increases. b.
Contractionary fiscal policy - it is used when the government want to control high inflation. To
achieve this objective the government decreases its expenditure or/ and raises taxes. This
decrease AD there by the general price level of goods and services decreases.
Income Policy
Income policy is another instrument by which government achieves its predefined goals and
objectives. It refers to a set of rules and regulation designed by a government to control wage and
price rise.

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