Chapter One

1. The Subject Matter of Economics

1.1. Definition and Nature of Economics
Economics is one of the most exciting disciplines in social sciences. There are 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) in availability.
The need to balance unlimited wants with limited resources has raised the question of
efficient utilization of scarce resources by minimizing loss or wastage.
Definition: - Economics is therefore, defined as a social science which studies how to
allocate scarce resources in the production and distribution of goods and services so as to
attain the maximum fulfillment of society’s material wants.
1.2. Scope of Economics
Generally, economics can be analyzed at micro and macro level.
A) Micro-economics: - is concerned with the economic behavior of individual decision
making units such as households, firms, markets and industries.
Some of the issues that are studied in microeconomics are:-
i) The behavior of consumers in maximizing satisfaction.
ii) How business firms make decision as to what, how, and for whom to produce outputs
so as to maximize profits.
iii)How prices of products and inputs are determined in product and factor markets.
iv) The different types of markets and how each type of market affects the efficiency of
producers and the welfare of consumers, etc.
B) Macro-economics: - is a branch of economics which studies (analyses) the economy as a
whole and sub-aggregates.
Example: -Total output level (GDP/GNP) of an economy
- Total employment (Unemployment) level.
- General Price level, etc

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 1.3. The methods of economic Analysis
The fundamental objective of economics, like any science, is the establishment of valid
generalizations about certain aspects of human behavior. Those generalizations are known
as theories. A theory is a simplified picture of reality. Economic theory provides the basis for
economic analysis which uses logical reasoning. There are two methods of logical reasoning.
These are inductive method of reasoning and deductive method of reasoning.
i) The inductive method: - is a logical reasoning that proceeds from the particular (facts) to
the general (theory).
 Inductive method involves the following steps
a) Selecting problem for analysis.
b) Collection, classification, and analysis of data
c) Establishing cause and effect relationship between economic phenomenons.
ii) The Deductive method: - is a logical reasoning to explain specific events on the basis of
the already established theory. Thus, in deductive method, reasoning goes from the
general (theory) to the particular (facts).
 Major steps in the deductive approach include:
a) Problem identification
b) Specification of the assumptions.
c) Formulating hypotheses.
d) Testing the validity of the hypotheses.

Policies

Principles or
theories

Induction Deduction
Facts
Note that: Inductive & deductive methods of analysis are complementary rather than
competitive.

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1.3.1. Whether Economics is a positive science or normative science, or both?
Positive economics (Analysis):- deals with objective explanation of how the economy
works. Positive analysis tries to seek answer to the questions what was, what is, or what will be.
Example: - what is the inflation rate this year?
- A rise in interest rate leads to a fall in investment.
A disagreement on positive statements can be checked by looking to facts.
Normative economics (analysis):- deals with how the economic problem should be solved.
Normative analysis is a matter of opinion (subjective in nature) which can not be proved or
rejected with reference to facts. It attempts to produce answers to the question “what ought
to be” and is based on value judgment.
Example: - the inflation rate in Ethiopia should not exceed 3%.
- The poor should pay no taxes.
A disagreement on a normative statement can be solved by voting.

1.4. The Concepts of Scarcity, Choice and Opportunity Cost

1. Scarcity:-
The fundamental economic problem that any human society faces is the problem of scarcity.
Scarcity refers to the fact that all economic resources that a society needs to produce goods
and services are finite or limited in supply. But their being limited should be expressed in
relation to human wants. Thus the term scarcity reflects the imbalance between our wants
and the means to satisfy those wants.

Resources 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. E.g. sunshine, air etc
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. Example,
labour, land, capital, entrepreneur, etc
 Labor: - refers to the physical as well as mental efforts of human beings in the
production and distribution of goods and services. The reward for labour is called wage.
 Land: -refers to the natural resources or all the free gifts of nature usable in the
production of goods and services. The reward for the services of land is known as rent.

3
  Capital: - refers to all the manufactured inputs that can be used to produce other goods
and services. Example: equipment, machinery, transport and communication facilities,
etc. The reward for the services of capital is called interest.
 Entrepreneurship: -refers to a special type of human talent that helps to organize and
manage other factors of production to produce goods and services and takes risk of
making loses. The reward for entrepreneurship is called profit.
Entrepreneurs are peopling who:
a) Organize factors of production to produce goods and services.
b) Make basic business policy decisions.
c) Introduce new inventions and technologies into business practice.
d) Look for new business opportunities.
e) Take risks of making losses.
Note: - Scarcity does not mean shortage. We have already said that a good is said to be
scarce if the amount available is less than the amount people wish to have at zero price. But
we say that there is shortage of goods and services when people can not 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.
2. Choice:-
If resources are scarce, then output would be limited. If output is limited, then we can not
satisfy all of our wants. Thus, choice must be made. Due to the problem of scarcity,
individuals, firms and government are forced to choose as to what output to produce, in
what quantity, and what output not to produce. In short, scarcity implies choice.
Choice, in turn, implies cost. That means whenever choice is made, an alternative
opportunity is sacrificed. This cost is known as opportunity cost.
3. Opportunity Cost:-
In a world of scarcity, a decision to have more of one thing, at the same time, means a
decision to have less of another thing. The value of the next best alternative that must be
sacrificed is, therefore, the opportunity cost of the decision.
Definition: Opportunity cost is the amount or value of the next best alternative that must be
sacrificed (forgone) in order to obtain one more unit of a product.

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 1.4.1. The Production Possibilities Frontier or Curve (PPF/ PPC)
The production possibilities frontier (PPF) 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 and is achieving full production
(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 (specialization).
Table 1.1: Alternative production possibilities of a certain nation
Types of Unit Production alternatives
products A B C D E
Food In metric 500 420 320 180 0
tons
Computer In no, 0 500 1000 1500 2000

Food 500 A

420 B - All points on the

.R PPF are attainable
320 C and efficient
- Point Q is
180 Q D attainable but
inefficient
- Point R is
unattainable
E
0 500 1000 1500 2000 Computer
Fig. 1.1 Production Possibilities Frontier
 The PPF describes three important concepts:
i) The concepts of scarcity: - the society can not 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 on the curve indicates the change in choice.

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 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. It is
reflected by the downward sloping of the PPF. Related to the opportunity cost we have a
law known as the Law of Increasing Opportunity Cost. This law states that as we
produce more and more of a product, the opportunity cost per unit of the additional
output increases. This makes the shape of the PPF concave to the origin.
The reason why opportunity cost increases when we produce more of one good is that
economic resources are not completely adaptable to alternative uses (specialization effect).
Opportunity cost of a good = the amount of the next best alternative sacrificed
The amount of another good gained
Example:- Referring to table 1:1 above;
Suppose currently the economy is operating at point B, what is the opportunity cost of
producing one more unit of computer?
Solution: Moving from production alternative B to C we have:
320  420  100
OC    0.2 (Scarifying 0.2 metric tons of food per computer)
1000  500 500
1.4.2. Economic Growth and the PPF
Economic growth or an increase in the total output level occurs when one or both of the
following factors 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.

Food

New PPF
PPC0 PPC1

0 Computer

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 Effect of improvement in the quality and /or quantity of resources.

Food Food Food

Computer Computer Computer

Effect of technological Effect of technological Effect of technological
advancement on both sectors advancement in food production only advancement in computer
production only

1.5. Basic Economic Questions and the Alternative Economic Systems

1.5.1. Basic Economic Questions
In connection with the problem of scarcity, any human society should answer the following
three basic questions.
1. What to produce and in what quantities: - Given the problem of scarcity, any human
society should decide on what outputs to produce and what not to produce.
2. How to produce: - this is a question of technological choice. That is, does a country use
labour-intensive or capital-intensive technology?
3. For whom to produce: - This is a question of distribution.

1.5.2. Alternative Economic systems

The way a society tries to answer the above fundamental questions is summarized by a
concept known as economic system. An economic system is a set of organizational and
institutional arrangements established to answer the basic economic questions. Customarily,
we can identify three types of economic system.
A. Pure capitalism
B. Command economy
C. Mixed economy
A) Pure capitalism: - also known as market economy or laissez- faire.
In pure capitalism, the three basic economic questions are answered as follows.
 Firms address the “what to produce” question by producing those goods and services
that give them the maximum possible profit.

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  The “how to produce” question is answered by choosing the technique of production
which are least costly.
 The “for whom to produce” question is addressed depending on peoples decision as
to how they spend their income.
In pure capitalism, economic activities are coordinated and directed through market
mechanisms.
Advantages of pure capitalism - It promotes economic efficiency
Disadvantage: - It leads to market failure. Some sources of market failure include
externalities, public goods, Monopoly power, Asymmetric information, etc.
B) Command Economy: unlike pure capitalism, command economy is characterized by:
 Public ownership of property/resources.
 Economic activities are co-ordinate and directed by the government through a
central planning committee.
 In such a system, the three basic questions are addressed by the government.
Advantage: - Fair distribution of income
- Absence of private monopolistic power
Disadvantage: - economic inefficiency.
C) Mixed Economy:- the mixed economy system takes the strong elements of pure
capitalism and command economy. In such a system, both the government and the market
decide on the questions of what, how and for whom to produce.

1.6. Decision making units and the circular flow of economic activities
1.6.1. Decision making units
Generally, there are three decision making units in a closed economy. They 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
a) Selling of their resources, and
b) 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.

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iii)Government: - A government is a set of organizations that have 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 in a society.

1.6.2. The circular flow of economic activities

The above mentioned economic agents interact in two markets:
i) Resource – markets where resources are bought and sold.
ii) Product markets where final products are bought and sold.

Look at the following three – sector circular flow model.

Resource Money income

Markets
costs

Labor, land, Labor, land,

capital capital
Subsidies Income support
Households
Firms taxes Government taxes

Goods & services Goods and services

revenue Product
markets Consumption expenditure

Fig 1.3 Three sector circular flow of resources

In order to produce goods and services, firms require resources. To acquire the resources
they need, they go to the resource market and buy the required resources. Firms pay money
to the resource suppliers- households. What firms pay is considered as cost of production.
Households receive income in the form of wages, rent, interest and profit. Once firms buy
those resources, they combine them and produce goods and services and supply to the
market. Households, on the other hand, require those goods and services in order to satisfy

9
their material wants. Now, firms as suppliers of goods and services, and households as
demanders of those goods and services interact in the product market.

As mentioned earlier, the government produces and supplies some goods and services such
as public education, public health services, defense services, street light etc. To produce
those goods and services, it needs resources. It can get resources from the resource markets
where households supply them. Once it acquires the necessary inputs, then the government
would produce and supply those goods and services to firms and households. But to provide
those goods and services, the government needs finance. It will get the money from
households and firms in the form of taxes.

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 Chapter -Two
2. Demand, Supply and Measurement of Elasticity
2.1. Theory of Demand
Individuals or households may desire or wish to have goods and services that they think will
satisfy their needs. However, having desire does not necessarily mean that the individual or
the household may actually posses the item. In order to have the desired goods and services,
an individual or a household should have the ability or the means by which the goods
and/or services can be obtained.

Definition: Demand indicates the different quantities of a product that buyers are willing
and able to buy at various prices in a given period of time, other things remain unchanged.

The relationship between prices of a product and different quantities purchased can be
presented in the form of a table, graph, or equation/function.

2.1.1. Demand Schedule (table)

Table 2.1: An individual household demand for orange per week:
Combinations A B C D E F
Price per kg 6 5 4 3 2 1
Quantity 2 3 4 5 6 7
demand/week

2.1.2. Demand curve:

Price

6 A
5 B
4 C
3 D Demand curve
2 E
1 F
0 2 3 4 5 6 7 Quantity

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 2.1.3. Demand function: - is a mathematical relationship between price and quantity
demand.
Qd=f(p)
Example: Let the demand function be Q = a+ bp
Q
b= (e.g. moving from point A to B on the curve)
P
32
b=  1
56
Q =a-p, to find a, substitute either point A or B.
6= a-2
a=8
Therefore, Q=8-p is the demand function for orange.
The law of Demand:-States that, all other things remain unchanged, as price of product
increases, quantity demanded decreases and vice versa.
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.

P P P Price

3 + 3 + 3 = 3

Q Q Q
5 7 2 14
Consumer – 1 Consumer -2 Consumer – 3 Market Demand
Numerical Example: - suppose the individual demand function of a product is given by:
P=10-1/2Q and there are about 100 identical buyers in the market. Then the market
demand function is given by:
P= 10-1/2Q
½Q =10-P
Q= 20 -2P
Qm = (20 – 2P)100= 2000-200P

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 2.1.4. Determinants of Demand
The demand for a product is determined or influenced by:
i) Price of the product.
ii) Taste or preference of consumers
iii) Income of the consumer
iv) Price of related goods and services
v) Consumer’s expectation of income and price
vi) Number of buyers in the market

The first determinant, price of the product, is known as own-price determinant of demand.
The remaining determinants are known as demand shifters since the entire demand curve
shifts inward or outward if one or more determinants(except own price) changes.
Price

P0 a
Change in quantity demanded caused by change in own Price.
P1 b

Q0 Q1 Quantity

Price

Change in Demand caused by change in demand shifters.

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i) Effects of changes in Taste or preference

Price -A favourable change in consumer’s taste causes an increase in demand.

. The reverse happens when there is unfavorable change in taste.

D1
D0

0 Quantity
ii) Effect of change in Income
The effect of a change in the income of a consumer on his/her demand for a product
depends on the nature of the product. For some goods/services an increase in
consumer’s income causes an increase in the demand for the product and a decrease in
income causes a decrease in demand. Such goods/services are called normal goods/
services. On the other hand, there are some goods/services whose demand varies
inversely with income. Such goods/services are called inferior goods/services.

P P

D0 D1 D1 D0
Q Q
For a Normal good For and inferior good
(As income increases (As income increases
Demand increases) demand decreases)
iii) Effects of changes in prices of Related Goods
Any two goods are related if they are a substitute for or complement to each other.
 When two goods are substitutes, the price of one good and demand for the other
are directly related. Example: Coca-cola and Pepsi-cola are substitute goods.
 When two goods are complementary, the price of one good and the demand for the
other are inversely related. Example: Car and Petrol are complement goods.

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 2.2. Theory of supply
So far we have seen the demand side of the market. Now let us see the supply side.
Supply: - Indicates the various quantities of a product that sellers (producers) are willing
and able to provide at various prices in a given period of time, other things remain
unchanged.

2.2.1. Supply schedule , curve and function

Table 2.2.: An individual seller’s supply schedule for butter:
Price ( birr per kg) 30 25 20 15 10
Quantity supplied kg/week 100 90 80 70 60

Price Q=2P+40

Quantity
The Law of supply: states that, ceteris paribus, as price of a product increase, quantity
supplied of the product increases, and as price decreases, quantity supplied decreases.
Market supply:-is derived by horizontally adding the quantity supplied of the product by
all sellers at each price.

Table-2.3: Derivation of the market supply of good X.

Price per Quantity Quantity Quantity Market supply per week
unit supplied by supplied by supplied by
seller 1 seller 2 seller 3
5 11 15 8 34
4 10.5 13 7 30.5
3 8 11.5 5.5 25
2 6 8.5 4 18.5
1 4 6 2 12

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 2.2.2. Determinants of Supply
The supply of a particular product is determined by:
i) price of the product: Causes change in quantity supplied
ii) price of inputs ( cost of inputs)
iii) Technology
iv) prices of related goods
v) Sellers’ expectation of price of the product.
vi) Taxes & subsidies
vii) Number of sellers in the market
viii) Weather, etc.
i) Effect of change in input price on supply of a product
An increase in the price of inputs such as labour, raw materials, capital, etc causes a
decrease in the supply of the product which is represented by a leftward shift of the supply
curve. Likewise, a decrease in input price causes an increase in supply.
ii) Effect of change in Technology
Technological advancement enables a firm to produce and supply more in the market. This
shifts the supply curve outward.
iii) Effect of change in Weather condition
A change in weather condition will have an impact on the supply of a number of
products, especially agricultural products. For example, other things remain unchanged,
good weather condition boosts the supply of agricultural products. This shifts the supply
curve for a given agricultural product outward. Bad weather condition will have the opposite
impact.
2.2.3. Market Equilibrium
Having seen the demand and supply side of the market, now let’s bring demand and supply
together so as to see how the market price of a product is determined. Market equilibrium
occurs when market demand equals market supply.

Price Sm - At point ‘E’ market demand equals

S>D market supply (equilibrium point)
(surplus) - P is the market equilibrium (market
P E clearing ) price.
- Q is the market equilibrium(market
D>S clearing) quantity.
(Shortage)
Dm
Q Q
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Numerical example:
Given market demand: Qd= 100-2P, and
Market supply: P = 1/2Qs+ 10
a) Calculate the market equilibrium price and quantity?
b) Determine, whether surplus or shortage occurs if P= 25?
Solution:
At equilibrium, Qd=Qs
a) 100 – 2P = 2P – 20
4P=120

P  30, And Q  40

b) Qd(at P=25) = 100-2(25)=50

Qs(at P= 25 ) = 2(25) -20 =30

There fore, a shortage of: 50 -30 = 20 has been occurred.

2.2.4. Effects of changes in Demand and supply on Equilibrium price and Quantity
When we calculate the equilibrium price and quantity, we assumed that the other
determinants of demand and supply (except own price) of a product were kept constant. But
what would happen to the equilibrium price and quantity when one or more determinants of
supply and/or demand changes? Let us see the following conditions.

i) when demand changes and supply remain unchanged:

P S0 -Increase in demand results in increase in equilibrium in price and quantity.

The reverse happens when there is decrease in demand.
P1 e1
P0 e0
D1

D0
Q0 Q1 Q

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 ii) When Supply changes and Demand remain unchanged

Price -Increase in supply results in decrease for

P0 e0 equilibrium price and increase quantity. The
reverse happens when there is decrease in
P1 e1 supply.

S0 S1 D0
Q0 Q1
iii) When both Supply and Demand changes
a) When demand increases and supply decreases:

P1

P0
S3S1S2
S0 D0 D1
0 Q0
Increase in demand and decrease in supply definitely increases the equilibrium price but the effect on
equilibrium output is indeterminate. The result depends on the size of increase in demand and decrease
in supply. If the amount of increase in demand is greater than the amount of decrease in supply, then
the equilibrium output increases. If the amount of increase in demand is smaller than the amount of
decrease in supply, then the equilibrium output decreases. If the amount of increase in demand is equal
to the amount of decrease in supply, then the equilibrium output remains the same.

b) When demand decreases and supply increases:

P0

P1
S0 S3 S1
S3 D1 D0
0 Q0
Decrease in demand and increase in supply definitely decreases the equilibrium price but the effect on
equilibrium output is indeterminate. The result depends on the size of decrease in demand and increase
in supply. If the amount of increase in supply is greater than the amount of decrease in demand, then the
equilibrium output increases. If the amount of increase in supply is smaller than the amount of decrease

18
in demand, then the equilibrium output decreases. If the amount of increase in supply is equal to the
amount of decrease in demand, then the equilibrium output remains the same.

c) When both demand and supply decreases

P0

S1
S0 D1 D0
0 Q1 Q0
Decrease in demand and supply definitely decreases the equilibrium output but the effect on equilibrium
price is indeterminate. The result depends on the size of decrease in demand and supply. If the amount
of decrease in demand is greater than the amount of decrease in supply, then the equilibrium price
decreases. If the amount of decrease in demand is smaller than the amount of decrease in supply, then
the equilibrium price increases. If the amount of decrease in demand is equal to the amount of decrease
in supply, then the equilibrium price remains the same.

d) When both demand and supply decreases:

P0

S0
S1 D0 D1
0 Q1 Q0
Increase in demand and supply definitely increases the equilibrium output but the effect on equilibrium
price is indeterminate. The result depends on the size of increase in demand and supply. If the amount of
increase in demand is greater than the amount of increase in supply, then the equilibrium price increases.
If the amount of increase in demand is smaller than the amount of increase in supply, then the
equilibrium price decreases. If the amount of increase in demand is equal to the amount of increase in
supply, then the equilibrium price remains the same.

b)Suppose the market for avocado is initially at equilibrium. The following events
happened simultaneously.
i) A researcher from AAU announced his research result that using avocado as a
cosmetic will make girls extremely beautiful.

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 2.3. Elasticity of Demand and Supply
Elasticity: - is a measure of responsiveness of a dependent variable to changes in an
independent variable. In economics we use the concept of elasticity of demand or supply to
measure the responsiveness of consumers or sellers to changes in price or other
determinants of demand or supply.
2.3.1. Elasticity of demand
Elasticity of demand measures responsiveness of buyers to changes in price or other
determinants of demand. Here we shall discuss three types of elasticities of demand.

1) Price Elasticity of Demand: is a measure of buyers’ responsiveness to changes in price.

It is given by :
%Qd Q1  Q0
E dp  , where % Qd  X 100
%P Q0
P1  P0
And % P  X 100
P0
Q1  Q0
X 100
Q0 Q  Q0 P0
Thus, E d 
P
 1 .  Q P0
P1  P0 P1  P0 Q0 .
X 100 P Q0
P0
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.
i) If   1, demand is said to be elastic

ii) If 0    1, demand is inelastic

iii) If   1, demand is unitary elastic.

iv) If = 0, demand is said to be perfectly inelastic.

v) If =, demand is said to be perfectly elastic.

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 Example: Given market demand: Qd= 80-2P, and
Market supply: Qs=-20+8P,
Find price elasticity of demand at the equilibrium point?
Solution: At equilibrium, Qd=Qs
80-2P = -20+8P
10P = 100
P= 10 and Q= 60
Q P0 10 1
Therefore, E  .  2    0.33
P Q0 60 3

Interpretation: an elasticity of -0.33 means that for a 1% increase (decrease) in the price of a
product, quantity demand will decrease (increase) by 0.33%.
A Linear Demand curve and Price Elasticity of Demand

P  
  - Elasticity varies along the curve
 1
0   1

 =0
Q
Determinants of price Elasticity of Demand
The following factors make price elasticity of demand elastic, inelastic and unitary elastic
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 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 lower 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.

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 2) Income Elasticity of Demand
It is a measure for responsiveness of demand for a change in income.

% Qd Q I
 dI   .
% I I Q Point income elasticity of demand

i) If  dI  1 , the good is luxury good.

ii) If  dI  1 ( and positive), the good is necessity good,

iii) If  dI  0, (negative), the good is inferior good.

3) Cross price Elasticity of Demand

Measures how much the demand for a product is affected by a change in price of another
good.
%Qx
 xy  Q x 1  Qx2 Py0 cross price elasticity of demand.
% Py .
Py1  Py0 Qx0

i) The cross – price elasticity of demand for substitute goods is positive.

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

Example: Given the following data on changes in quantity demand of Y in response to

changes in the price of good X:

Unit price of X Quantity demanded of Y

10 1500
15 1000
Calculate the cross –price elasticity of demand between the two goods? What can you say
about the two goods?
Q y  1000  1500  10  15  500 25
 xy   .  .  1
Px  15  10  1500  1000 5 2500
Therefore, the two goods are complements.

22
 2.3.2. Price Elasticity of Supply

Like the law of demand, the law of supply states only the nature of relationship between the
change in the price of a commodity and the quantity supplied. The quantitative relationship
is measured by the price elasticity of supply.

Price elasticity of supply is the measure of responsiveness of the quantity supplied of a

product to the changes in its market price. The formula of supply elasticity is given as:
εp= % change in quantity supplied(Q)
% change in price (P)
εp = ∆Q/Q = ∆Q, x P
∆P/P ∆P Q

Note that: the formula for measuring the price elasticity of supply is the same as that of
measuring the price elasticity of demand. Price elasticity of supply is always positive and
varies between 0 and ∞.

23
 Chapter Three
3. The Theory of Consumer Behavior
3.1. The Meaning of utility
Before discussing the concept of utility, let us first point out some of the assumptions that
economists make about the average consumer.
1. An average consumer is rational. That means:
a) A consumer has a clear-cut preference i.e. the consumer is able to compare any
two bundles X and Y and decide which one he/she prefers.
b) A consumer has a persistent (transitive) preference. For example, given three
consumption bundles X, Y and Z, if X> Y, and Y>Z, then he/she prefers X to Z
(X>Z).
2. The consumer is not free in his/her choice. This means the consumer’s choice is
constrained by his/her income level and the prices of goods and services.

Definition: Utility is defined as the power of a product to satisfy human wants.

Here it is important to note that utility is subjective. This means, the utility that two
individuals derive from consuming the same level of a product may not be the same.

3.2. Theories of Utility

There are two approaches to measure or compare consumer’s utility derived from
consumption of goods and services.
3.2.1. The Cardinal Utility Theory
According to the cardinalist approach, utility is measurable using arbitrary unit of
measurement called ‘util’ in the form of 1util, 2utils, 3utils, etc. For example,
consumption of an orange may give a consumer 10utils, and a banana may give him/her
7utils. From this we can say that an orange gives the consumer more utility than that of
a banana. According to the cardinal utility approach, therefore, utility is measurable and
comparable.
a. Total and Marginal Utility
Total Utility (TU): is the total satisfaction or pleasure a consumer derives from
consuming a specific quantity of a commodity at a particular time.
Marginal Utility (MU): refers to the extra satisfaction or pleasure a consumer derives
from consuming one more unit of a commodity.

24
 Mathematically:
Marginal utility (MU)= ΔTU Where, ΔTU = change in total utility
ΔQ ΔQ = change in the amount of the product consumed
Example: Table 3.1: Total and Marginal utility
Banana consumed per hour Total utility in utils Marginal utility
0 0 -
1 11 11
2 19 8
3 25 6
4 29 4
5 31 2
6 31 0
7 28 -3

Graphically, the above data can be represented as follows.

Total utility

40- TU

30-

20-

10-
0 2 3 4 5 6 7 Quantity
Marginal utility

15-

10-

5 MU

0 1 2 3 4 5 6 7
-5
Fig.3.1. Total and marginal utility

25
 b. The law of diminishing marginal utility
This law states that other things remaining constant, consuming successive units of a
product gives a consumer less and less extra satisfaction (utility). This law is based on the
assumptions that:
 The consumer is rational
 The consumer consumes identical or homogenous product.
 There is no time gap in the consumption of the good.
 The consumer taste/preference remains unchanged.

c. Consumer Equilibrium:- cardinal utility approach

As mentioned earlier, a consumer is assumed to be a utility maximizer. A consumer reaches

equilibrium position when he maximizes his/her total utility given his income and prices of
commodities. Analyzing consumer’s equilibrium requires answering the question as to how a
consumer allocates his money income among the various goods and services he/she
consumes.

I.Consumer equilibrium:- One commodity case

We begin with a simple model of one commodity case (say X). The consumer can either buy X
or retain his money income M. Under these conditions the consumer is in equilibrium when
the marginal utility of X is equated to its market price (PX). Symbolically we have:

MUX=PX

If MUX >PX, the consumer can increase his welfare by purchasing more units of X. Similarly,
if MUX< PX, the consumer can increase his total satisfaction by cutting down the quantity of
X and keeping more of his income unspent. Therefore, he/she attains maximum utility
when:

MUX= PX

II. A case of more than one commodity:

If there are more commodities, the condition for the equilibrium of the consumer is the
equality of the ratio of the marginal utilities of the individual commodities to their prices i.e.

26
 MU X MU Y MU N
i) = …………… , and
PX PY PN

ii) PXX + PYY +-----------------+ PzZ =M, where M is money income uses to purchase
Z commodities.

Example: Given a utility function of the form:

U(x,y) = 4x2 + 3xy +6y2: maximize utility subject to the budget constraint:

x + y = 56

Solution: The equilibrium condition is given by:

MU X MU Y
=
PX PY

Thus, MUX = 8x + 3y, and Px = 1

MUY = 12y + 3x, and Py = 1

Applying the equilibrium condition, we have:

X = 36, and Y = 20. There fore, the consumer purchases 20 units of good Y and 36
units of good X.

3.2.2. The Ordinal Theory of Utility (The Indifference Curve Approach)

Unlike the cardinal utility theory, the ordinal utility theory says that utility is not measurable
rather, the consumer can rank or order the utility he/she derives from consuming different
goods and services.

For example, if a consumer is subjected to three consumption bundles X, Y and Z, he/she

can rank or order his/her preference as:

1st preference = Y 1st = X

2nd preference =Z or 2nd = Z

3rd preference =X 3rd = Y, or any other ordering.

27
The ordinal utility theory provides another method of studying the consumer behavior. Since
it uses indifference curves to study consumer’s behavior, this theory is also known as the
indifference curve approach.

1. Indifference Set, Curve and Map

The indifference curve approach is based on the following assumptions;

 The consumer is rational (utility maximizer )

 The consumer can simply order/rank his/her performances.

 There is diminishing marginal rate of substitution.

 The consumer’s preference is transitive.

A) Indifference set: is a combination of goods for which the consumer is indifferent.

E.g. Combination Qx Qy
A 10 2
B 6 4
C 3 6
D 2 8
Note:- Each combination gives the consumer equal level of total utility.

B) Indifference Curve: is a line (curve) that connects all possible combinations of goods and
services which gives the consumer equal total utility.

Commodity Y

commodity X

Fig. 3.2. An indifference curve

28
C. Indifference Map: is a set of indifference curve

Commodity Y

U3
U2

U1
Commodity X

Fig: 3.3 an indifference map.

2. Properties of an indifference curve :
 An indifference curve is downward slopping.
 It is convex to the origin (reflects diminishing marginal rate of substitution).
 Indifference curves never cross each other. If they do, the consumer is not consistent
in his/her choice.

3. Marginal Rate of Substitution (MRS)

The MRS is the rate by which the consumer is willing to give up (scarify) one good so as to
obtain more of another good holding total utility constant. Consider the following figure.

X
In the above figure, in moving from point ‘a’ to ‘b’ the consumer is willing to scarify some
units of good Y to get more of good X.
In short, for two goods X and Y, the marginal rate substitution of good X for Y (MRSXY) shows
the amount of good Y the consumer is willing to give up so as to get more units of good X,
holding total utility constant. Mathematically:

29
 MRSXY = ΔY = The amount of good Y sacrificed = The slope of the
ΔX The amount of good X gained

The marginal rate substitution between two goods (such as X and Y) measures the slope of
an indifference curve.

4. Budget constraint of the consumer

The consumer has a given/constant income, which set limits to his maximizing behavior.
Income acts as a constraint in the attempt for maximizing utility. The income constraint, in
the case of two commodities, may be written as:
M= PXQX+PYQY
Where M=money income, PX = price of good X and PY=Price of good Y

We may represent the income constraint graphically using the budget line; whose equation is
derived from the budget equation by solving for QY.
M
QY=  PX QX
PY
If QX=0, i.e. if the consumer spends all his income on Y, he/she can buy QY=M/PY units of Y.
Similarly:
M  PY QY
QX=
PX

If the consumer spends all his income on X, i.e. at QY =0, then QX= M
PX
This assumption shows that the commodities can substitute one another.

M/PY

 PX
Slope=
PY

0 M/PX

30
Mathematically, the slope of the budget line is the derivative
QY PX M / PY PX
  
Qx PY M / PX PY
5. Equilibrium of the consumer (The indifference curve Analysis)
A consumer gets the maximum possible total utility when he buys that combination of goods
or services at which the budget line is tangent to the highest attainable indifference curve.
That is MRS must be equal to the ratio of commodity prices. Considering the earlier two
commodity model, we have;
MRSX,Y= MUX/MUY = PX/PY
(Slope of IC)= (Slope of the budget line)

M/Py

U unattainable

E IC3
Attainable A IC2
IC1

0 M/PX

At point E, MRSX,Y =
PX , equilibrium is at the point of tangency of IC2 with the budget line.
PY

31
 Chapter Four
4. Theories of Production and Cost
4.1. Theories of production
4.1.1. Definition of concepts

We have discussed in chapter one that “how to produce” is one of the basic economic
problem common to every economic system. The theory of production is concerned to deal
with this question. This section begins with the definition of basic concepts.

 Production: - is a process by which resources are transformed in to final goods and

services.

 Inputs to production: - are factors of production that go into the production of goods
and services.

 Fixed inputs: - are inputs whose supply can not be varied over the time period under
consideration.

 Variable inputs: - are those the supply of which can be varied in the short run.

 Short –run period: - is a time period over which at least one input is fixed.

 Long – run period: - is a period of time in which all inputs are variable. Short – run
doesn’t refer to relatively short period of time like a year or less, and long- run doesn’t
refer to a period of time greater than a year. They rather refer to the nature of
economic adjustment in the firm to changing economic environment.

 Production function: - describes the technological relationship between inputs and

outputs.
Example: Q = f( L, K, Ld, R…..)
Where; Q= Output
L= Labor
K= Capital
Ld= land
R= other raw materials

32
 4.1.2. Production in the Short – Run
Consider that a farmer wants to produce wheat on one hectare of land. To produce wheat,
s/he needs land, labor, fertilizer, water and some equipment. Assume that all of the inputs
except labor are fixed at a certain quantity. Look at the following hypothetical data with
labor, the variable input, and land a fixed input.
Given Q = f (L, L a )
Table-4.1: Short run production
Land Number of Output Average Marginal Stage of
workers/Labour (Q) product (APL) product (MPL) production
1 hectare 0 0 - -
“ 1 2 2 2
“ 2 5 2.5 3 Stage – I
“ 3 9 3 4
“ 4 12 3 3
“ 5 14 2.8 2
“ 6 15 2.5 1 Stage – II
“ 7 15 2.14 0
“ 8 14 1.75 -1 Stage – III

Graphically:

TP, AP and Mp

Stage – I II Stage – III

TP, ( Q= f(L, L a ))

AP
0 MP Labour

Fig. 4.1 Total, average and marginal products

 Total output (total product):- describes the total amount of output produced during
some period of time.
 Average product (AP):- is the total product per unit of the variable input.

TPL Q
APL = 
L L

33
  Marginal product (MP):- is a change in total product resulting from one unit change
in the variable input.
TPL Q
MPL= 
L L
1. Stage of production:
The short run production function can generally be classified into three stages of production.
Stage – I:
 It goes from the origin up to the point where average product is maximum or AP=MP.
 In this stage total product increases at an increasing rate.
 Each additional unit of labor contributes more than the average (i.e. MP > AP).
 In this stage the fixed input is underutilized.
Stage – II:
 It goes from the point where the AP is maximum to the point where MP is zero or TP is
maximum.
 In this stage TP increases at a decreasing rate.
 In stage – II, AP > MP.
Stage – III:
 It covers the range over which the marginal product is negative.
 In this stage TP diminishes.
 In stage – III, the additional unit of labor contributes negatively to total product.
 Since there is over employment of the variable input, the fixed input is over utilized.
 In this stage, AP > MP.
Note: A rational producer should produce in stage – II where marginal product of the
variable input is positive but diminishing.
2. The law of diminishing Marginal Returns
The law states that as an increasing amount of a variable input is combined with fixed
inputs, eventually the contribution of each additional amount of the variable input to the
total product declines. This is due to the fact that the amount of the fixed input per unit of
the variable input declines. The law starts to operate after the marginal product curve
reaches its maximum.

34
 4.1.3. Production with Two Variable Inputs: Isoquants

1. Definition of an Isoquant:

Isoquant is a firm’s counter part of the consumer’s indifference curve. An isoquant refers to a
curve that shows all the combinations of inputs that yield the same level of output. In this
context, “iso” means equal and “quant” means quantity, thus an isoquant represents a
constant quantity of output. The concept of isoquant schedule can be easily explained with
the help of the table given below.

Table 4.2: Isoquant schedule showing different combination of labor and capital
Combination of Labor Units of Units of Output of MRTSLK
and capital labor (L) capital (K) Cloth (meters)
A 5 9 100 -
B 10 6 100 3:5
C 15 4 100 2:5
D 20 3 100 1:5

Combinations A, B, C and D show different possibilities of producing 100 meters of cloth by

applying various combinations of labor and capital.

2. Isoquant map

It is a set of isoquants that show the maximum attainable output from any given
combination of inputs.

Capital Capital

9 A

IQ3 = 300 6 B

IQ2= 200 4 C

IQ1= 100 3 D Q=100

0 Labor 0 5 10 15 20 Labor

A) An isoquant map B) An isoquant curve

Fig 4.2 the Isoquant curve and map

35
 3. Properties of Isoquants

 An Isoquant slopes down ward. As the use of one variable input increase, the quantity of
the other variable input should decreases so as to produce the same level of total
product.

 Isoquants are convex to the origin. Convexity of isoquants implies not only the negative
shape but also a diminishing rate of Marginal Rate of Technical Substitution.

 Isoquants cannot intersect or be tangent to each other. Intersection or tangency of two

isoquants implies that certain combination of L and K can produce two different
quantities which is not true.

 Upper isoquants represent higher level of output. An upper isoquant always means a
higher level of output because any point on it (with in the economic region) indicates a
larger input combination than a lower isoquant, with either higher level of capital or
labor or both.

4. Marginal Rate of Technical Substitution (MRTS)

Marginal Rate of Technical Substitution is the rate at which one input can be substituted for
another without changing the level of output. In other words, the MRTS of labor for capital
may be defined as the number of capital, which can be replaced by one unit of labor, keeping
the level of output constant. In mathematical terms;

MRTS L,K = - K = slope of isoquant

L

In the above table (table 4.2) all the four factor combinations A, B, C and D produce the
same level of output i.e. 100 meters of cloth. They are all iso-product combinations. As we
move from combination A to combination B, it is clear that 3 units of capital can be replaced
by 5 units of labor; hence MRTSLK is 3:5. Similarly, when we move from combination B to C,
2 units of capital is replaced by 5 units of labor, and so on.

Marginal Rate of Technical Substitution can be also expressed in terms of ratio of marginal
products i.e.

36
 MRTSLK = MPL
MPK
To prove this, according to the definition; output remains constant on the isoquant curve.
Moreover, the loss in physical output from a small reduction in capital will be equal to the
gain in physical output from a small increment in labor.
Thus;

The loss in output due to reduction in capital is given as (-) MPK (K)

The gain in output due to increase in labor is given as (+) MPL (L)

To maintain same level of output, the above two conditions should be equal

(-) MPKK = (+) MPLL, Rearranging these we find;

- K = MPL
L MPK

But MRTSL,K =- K
L

Hence, MRTSL,K = MPL

MPK

The Law of Diminishing MRTS – along an isoquant curve, MRTS continuously declines,
hence making the curve convex to the origin. The reason is that along the isoquant, as the
quantity of labor is increased and the quantity of capital is reduced, the marginal
productivity of labor diminishes and the marginal productivity of capital increases. Therefore,
less and less of capital is required to be substituted by an additional unit of labor to
maintain the same level of output and hence a diminishing marginal rate of technical
substitution.

37
5. Economic Region of Production

The whole isoquant map or production plane is not technically efficient nor is every point on
an isoquant.

Capital A

b c B

a g Q3

f Q2

e Q1

0 Labor

Fig 4.3 Economic region of production

On the above figure one can notice that above the line OA and below the line OB the slope of
the iso-quant is positive, which means that more units of labor and capital is needed to
produce a given fixed output. As a result the production technique in these two regions is
technically inefficient.

The lines OA and OB are called ridgelines, which bound a region in which marginal products
of the two factors are positive. The ridge line OA connects those points with MPK=0, and ridge
line OB connects those points of the isoquant where MPL=0.

The range of diminishing marginal products of a factor but non-negative implies that
production concentrates on the range of isoquant over which their slope is negative and
convex to the origin. This is the area in figure 4.3 between the ridge lines and is called
economic region or technically efficient region of production.

38
 4.2. Theory of costs
4.2.1. Definition of concepts
To produce goods and services, producers need inputs/factors of production. To acquire
most of these factors of production, producers have to incur costs. Let us define basic
concepts before detail analysis.
Cost: - is the monetary value of inputs used in the production process. It can be private cost
or social cost. Private cost is the cost of producing an item to the individual producer. Social
cost is the cost of producing an item to the society. The former is further classified into
accounting and economic costs. Accounting cost is the explicit cost of purchased input only
(out –of – pocket expenditure to purchase inputs). Economic cost includes implicit cost or the
estimated cost of non–purchased inputs in addition to explicit inputs.

Social cost = Private cost + External cost

4.2.2. Costs in the Short – Run

Short run costs are divided into two; fixed and variable costs.
a) Fixed costs (over head costs): - are costs that do not vary (changes) as the
firm changes its output level.
Example: – Salaries of administrative staff
- Depreciation costs
- Rents on leased properties
- Interests on borrowed funds, etc.
b) Variable costs (running costs):- are costs that change (vary) as the firm change
its output level.
e.g. – wage for workers
- cost of raw materials
- running costs such as fuel, etc.
 Total cost (TC):- is the sum of fixed costs and variable costs.
Thus, TC(Q) = TVC(Q) + TFC
Look at the following hypothetical data

39
Table 4.3: TC, TFC, TVC, AC, AFC, AVC and MC
Output (Q) TFC TVC TC AFC AVC AC MC
0 100 0 100 - - - -
1 100 90 190 100 90 190 90
2 100 170 270 50 85 135 80
3 100 240 340 33.3 80 113.3 70
4 100 300 400 25 75 100 60
5 100 370 470 20 74 94 70
6 100 450 550 16.7 75 91.7 80
7 100 540 640 14.3 77.1 91.4 90
8 100 650 750 12.5 81.25 93.75 110
9 100 780 880 11.1 86.7 97.8 130
10 100 930 1030 10 93 103 150
TFC
Average fixed cost (AFC) =
Q
TVC
Average variable cost (AVC) =
Q
TC TFC  TVC
Average cost (AC or ATC) =   AFC  AVC
Q Q
dTC d (TFC  TVC ) d (TFC ) d (TVC ) d (TV )
Marginal cost (MC) =    
dA dQ dQ dQ dQ
A numerical example
Given a cost function as:
C(Q)=Q3-12Q2+60Q+100, where Q is the level of output

TC Q 3  12Q 2  60Q  100 100

AC    Q 2  12Q  60 
Q Q Q

TVC Q 3  12Q 2  60Q

AVC    Q 2  12Q  60
Q Q
TFC 100
AFC  
Q Q
dTC
MC   3Q 2  24Q  60
dQ

40
Graphical representation of costs

TC TC
TVC Note that:- total
TFC variable cost and
TVC total cost have an
inverse – s shape
which reflects the
law of diminishing
returns ( the law of
100 TFC variable proportion).

Q
Fig 4.2 Total cost, Total variable cost, and Total fixed cost curves.

AC
AVC
AFC MC
MC AC

AVC

AFC

0 Q
Fig 4.3: AC, AVC, AFC and MC curves

Relationship between AC and AVC curves:

a) They are U- shaped.
b) The AC is above the AVC since AC = AVC +AFC
c) The gap between AC and AVC is getting smaller and smaller as
output level increases because of the effect of AFC.
Relationship between AC and MC curves:
a) Wherever MC <AC, AC declines
b) Wherever MC >AC, AC rises
c) Whenever MC = AC, AC reaches minimum.

41
4.3. The Link between Production and cost functions
i) Average product and Average Variable cost

APL
Mathematically :
TP Q
a) APL= L 
L L
APL TVC W .L
b) AVC = 
L Q Q
AVC AVC 1 W
 AVC  WX 
APL APl

Q
ii) Marginal Product and Marginal Cost

MPL

Mathematically

TPL Q
a) MPL= 
L L
L
 (TC ) (TVC ) (W .L)
MPL b) MC=  
Q Q Q
MC MC L
MC=W. , b/c wage is constant.
Q

1 W
MC = W . 
MPL MPL

42
Bringing case i) and case ii) together:

MPL
APL
Note: - you can observe from the
figure as well as from the
mathematical illustration that AP
APL
and AVC are inversely related.
The same is true for MP and MC
L
functions.
MPL
MC
AVC MC
AVC

The Least Cost Rule

To produce a product at the least cost, the firm should spend its money in such a way
that the last birr spent on each factor of production brings equal marginal products.
Mathematically it is stated as:
MPL = MPK
PL PK

Where, PL = price of labor

PK = price of capital

43
 CHAPTER FIVE

5. PRICE AND OUTPUT DETERMINATION UNDER PERFECT COMPETITION MARKET

STRUCTURE

5.1. The firm, its objective and market structure

The objective of a consumer is maximization of utility; likewise the firms produce goods and
service and sell the product to consumers. Consumer demand for goods and services
determines the revenue side of a business operation. Production theory has been used to
derive the cost conditions faced by firms. Brought together, revenue and cost determines the
behavior of a profit maximizing business firm.

The most important factor that determines firm’s choice of price and output is the market
structure. The term market structure refers to the organizational features of an industry that
influence the firm’s behavior in its choice of price and output. Economists have found it
useful to classify markets in to two broad general types.
a) perfect competition
b) Imperfect competition
i) monopoly
ii) monopolistic competition and
iii) oligopoly

This classification is mainly based on the numbers of firms in the industry, the nature of
products and the nature of entrance of new firms. In this unit, we investigate how price and
output are determined in perfectly competitive markets in the short as well as long run
periods.

Perfect competition is a market structure characterized by a complete absence of rivalry

among the individual firms, because there are so many firms in the industry so that no
personal recognition among individual firms in a market. Perfect competition is characterized
by the following assumptions.

44
1. Large number of sellers and buyers: under perfect competition the number of sellers
is assumed to be too large that the share of each seller in the total supply of a product
is very small. Therefore, no single seller can influence the market price by changing
the quantity supply. Similarly, the number of buyers is so large that the share of each
buyer in the total demand is very small and that no single buyer or a group of buyers
can influence the market price by changing their individual or group demand for a
product. Therefore, in such a market structure, sellers and buyers are not price
makers rather they are price takers i.e. the price is determined by the interaction of
the market supply and demand forces.

Price DD SS Price

Pe Demand Curve

0 Qe Quantity 0 Quantity

a) The market b) the firm

Fig 5.2: Market equilibrium and the firm’s demand curve

2. Homogeneous product: - homogeneity of the product implies that buyers do not

distinguish between products supplied by the various firms of an industry. Product of
each firm is regarded as a perfect substitute for the products of other firms. Therefore
no firm can gain any competitive advantage over the other firm.

3. Perfect mobility of factors of production: - factors of production are free to move

from one firm to another throughout the economy. This means that labor can move
from one job to another and from one region to another. Capital, raw materials, and
other factors are not monopolized.

4. Free entry and exit; there is no restriction or market barrier on entry of new firms to
the industry, and no restriction on exit of firms from the industry. A firm may enter
the industry or quit it on its accord.

45
 5. Perfect knowledge: - there is perfect knowledge about the market conditions. All the
buyers and sellers have full information regarding the prevailing and future prices and
availability of the commodity.

6. No government interference: - government does not interfere in any way with the
functioning of the market. There are no discriminator taxes or subsidies, no licensing,
no allocation of inputs by the procurement, or any kind of direct or indirect control.
That is, the government follows the free enterprise policy. Where there is intervention
by the government, it is intended to correct the market imperfection.
5.2.Short – Run Equilibrium
A. Equilibrium of a firm
A profit maximizing firm is in equilibrium at the level of MC equal to MR (the marginal
approach). And short – run equilibrium is based on the following assumptions

 Capital is fixed and labor is variable

 Price of inputs are given

 Price of the commodity is fixed, and

 The firm is faced with short run cost curves.

There are two approaches of profit maximization; total and marginal approach.

i) The total approach: according to this approach profit is maximized when the vertical
difference between total revenue (TR) and total cost(TC) is the largest. symbolically;

∏= TR-TC and TR=P x Q Where ∏ =profit TR=Total revenue, TC= Total cost, P= price of
output, Q=quantity of output. It can be shown graphically by assuming linear total revenue
function as follows;

TR, TC TC

TR

0 Xa Xe Xb

Fig 5.1: The total approach of profit maximization

46
In the above figure, the firm maximizes its profit at the output Xe, where the vertical distance
between TR and TC curves is the widest. At output levels less than Xa and greater than Xb
the firm incurs loss.

ii) The marginal approach: according to this approach, the firm maximizes profit or
minimizes loss by producing that level of output where the following two conditions are
fulfilled;

 The first order condition (F.O.C); MR = MC

Symbolically MR=MC, but MR=dTR/dQ and MC=dTC/dQ

Hence dTR/dQ = dTC/dQ

 The second order condition (S.O.C); MC should be increasing at a higher

rate than MR.

Symbolically; d2TC/d2Q > d2TR/d2Q

Price of a commodity is fixed by the market forces in a perfectly competitive market, the
firms; therefore have horizontal demand curve as shown above. As shown by the line P=MR,
it implies that the price equals marginal revenue, i.e. AR =MR. It can be seen in the figure
below that MC curve intersect the P=MR line at point E, from below, where MC=MR a
perpendicular drawn from point E to the output axis determines the equilibrium output at
OQe. It can be seen in the figure that output OQe meets both the first and the second order
condition of profit maximization. At output OQe, therefore profit is maximum. The output
OQe is thus the equilibrium output. At this output, the firm is in equilibrium and is making
maximum profit. Firm’s maximum pure profit is shown by the area PeEE’P.

Price (P) SMC

SAC
Pe E P= MR
Abnormal profit
P’ E’
0 Qe output (Q)

Fig 5.3: Super normal profit in the short run Equilibrium

47
In the short run, a firm may not always earn abnormal profit. This happens only if its short –
run average cost (AC) is below the price. If its AC is tangent to P = MR line, the firm makes
only normal profit/zero profit. If its short – run average cost (AC) is above the price, the firm
makes losses.
Price
SMC SAC
Pe E P= MR

0 Qe output
Fig 5.4: A firm earning normal profit in the short run
If AC is above the price (P=MR), the firm incurs losses. And it is shown below graphically.
Price MC AC

P’ E’
Pe loss E P=MR

0 Qe output
Fig 5.5: A firm incurring loss in the short run
The firm makes losses in the above graph. And the total loss is shown by the area
PeP’E’E=PeP’XOQe and per unit loss is PeP’ = EE’
Shut –down or close – down points
In case a firm is making loss it must cover its short run average variable cost (SAVC). A firm
unable to cover its minimum AVC will have to close down. The MC/MR intersects AVC at its
minimum level as shown in the figure below.
Price
MC AC
AVC
Pe E P= MR

0 Qe
Fig 5.6: the shut down point

Point E denotes the “shut –down point” or “break – even point” because at any price below
OPe, it pays firms to close down as it minimizes its loss.

48
 i. Equilibrium of an industry
Before we determine equilibrium of an industry, we need to derive the supply of the market.
The supply curve is derived on the basis of its equilibrium output. The equilibrium output
determined by the intersection of MR and MC curves, is the optimum supply by a profit
maximizing (or cost minimizing) firm. The derivation of supply curve of a firm is shown in
figure 5.7, (a) and (b).
As the figure shows, the firm’s SMC passes through point M, on its SAVC
(a) (b)
Cost MC SS
SAC

P2 R AVC
P1 M

0 Q1 Q2 0 Q1 Q2
Fig 5.7: derivation of supply curve

According to the figure, at price OP1, OQ1 is the minimum supply of the firm. In the short
run, the equilibrium level of output at this point is OQ1. When price increases to OP2, the
equilibrium point shifts from M to R and output increases to OQ2 and so on. By plotting this
information, we get a supply curve.

A shown in the previous discussions, the industry/market supply curve is a horizontal

summation of the supply curves of the individual firms. Industry supply curve can be
obtained by multiplying the individual supply at various prices by the number of firms, if
firms have identical supply curve. In short run, however, the individual supply curves may
not be identical, if so, the market supply curve can be obtained by summing horizontally the
individual supply curves.

An industry is in equilibrium in the short-run when market is cleared at a given price i.e.
when the total supply of the industry equals the total demand for its product, the prices at
which market is cleared is equilibrium price. When an industry reaches at its equilibrium,
there is no tendency to expand or to contract the output. The equilibrium of the industry is
shown at point E in the following figure.

49
 Price D S

Pe E

0 Qe
Fig 5.8: the market equilibrium

The industry demand curve and supply curve intersect at point E determining equilibrium
price 0Pe and output 0Qe. In short – run equilibrium of the industry, some individual firms
may make pure profit, some normal profits and some may make even losses depending on
their cost and revenue conditions, as we will discuss in the next sub-topic, this situation will
however not continue in the long-run.
5.3. Long-run equilibriums of the firm and industry
The short-run, by definition is a period in which:
 firms cannot change their size, their capital is fixed
 existing firms cannot leave the industry, and
 new firms cannot enter the industry.

In contrast, long run is a period in which these constraints disappear. It permits change in
technology and employment of both, labor and capital.

In this section we analyze the equilibrium of the firm and industry in long run. It may be
noted that the process through which firms and industry reach their respective equilibrium
position is a continuous process of adjustment and readjustment of price and output with
the changing conditions in the long-run.

A) Equilibrium of the firm in the long-run

To show the long run equilibrium, let us begin with a short-run situation suppose (i) short
run price is given at OP1, as shown in as SAC1 and SMC1, as shown in panel (A), given the
price OP1, the firms are in equilibrium at point E1. It may be noticed that the firms are
making abnormal profit. Abnormal profit brings about two major changes in the industry.

50
One – existing firms get incentive to increase the scale of their production. This phenomenon
is shown by SAC1 and SMC1. Two – attracted by the abnormal profit, new firms enter the
industry. For these reasons, the industry supply curve, SS1, shifts out ward to SS2 (panel A).
The shift in supply curve brings down the market price to OP2 which is the long-run
equilibrium price. Thus, equilibrium price is once again determined in the market.
Panel (A) Panel (B)

S1
SMC1 SAC1 LMC
P1 E1 S2 P1 E1 AR=MR LAC
SMC2 SAC2
P2 E2 P2 E2 AR=MR
D1
0 Q1 Q2 0 q1 q2
Fig 5.9: Long –run equilibrium of the firm
Given the new equilibrium market prices OP2, firms attain their equilibrium in the long run
where AR=MR=LMC=LAC=SMC=SAC. That is, firms in the industry reach their equilibrium
position in the long run where both short run and long run equilibrium condition coincide.

B. Equilibrium of the industry

An important condition for the industry to be in equilibrium is that it produces the level of
output at which the quantity demanded equals to the quantity supplied of a product. This is
achieved at which all firms are in equilibrium producing at the minimum point of their LAC
curve and making just normal profits. Under these condition there is no further entry or exit
of firms in the industry, given the technology and factor prices.

DD SS SAC SMC LMC LAC

Pe E

0 Qe 0 q1
Fig 5.10: Equilibrium of the industry

51
 CHAPTER SIX

6. PRICE AND OUTPUT DETERMINATION UNDER IMPERFECT COMPETITION

MARKET STRUCTURES

6.1. Monopoly Market Structure

In this chapter, all types of imperfect market structures are discussed. These are Monopoly,
Monopolistic competition and Oligopoly market structures. We start by discussing the
monopoly market structure.

Definition, monopoly is a market structure where there is only one firm that produces and
sells a particular commodity or service and there are no close substitutes available. Since the
monopoly is the only seller in the market, the industry is a single firm industry and it has no
direct competitors.

6.1.1. Sources of monopoly

The emergence and survival of monopoly is attributed to the factors which prevent the entry
of other firms in to the industry. The barriers to entry are therefore the sources of monopoly
power. The major sources of barriers to entry are:

i) Legal restriction: Some monopolies are created by law in public interest such monopoly
may be created in both public and private sectors. Most of the state monopolies in the
public utility sector, including postal service, telegraph, telephone services, radio and TV
services, generation and distribution of electricity, rail ways, airlines etc… are public
monopolies.

ii) Control over key raw materials: Some firms acquire monopoly power from their
traditional control over certain scarce and key raw materials that are essential for the
production of certain other goods. E.g. Bauxite, graphite, diamond, etc…..for example
Aluminum Company of America had monopolized the aluminum industry because it had
acquired control over almost all sources of bauxite supply; such monopolies are often
called raw material monopolies.

iii) Efficiency: a primary and technical reason for growth of monopolies is economies of
scale, the most efficient plant (probably large size firm, which can produce at minimum

52
 cost, could eliminate the produce at minimum cost, could eliminate the competitors by
curbing down its price for a short period and can acquire monopoly power. Monopolies
created through efficiency are known as natural monopolies.

iv) Patent rights: another source of monopoly is the patent right if a firm for a product or
for a production process. Patent rights are granted by the government to a firm to
produce commodity of specified quality and character or to use a specified rights to
produce the specified commodity or to use the specified technique of production, such
monopolies are called to patent monopolies.

6.1.2. Demand and Revenue curves under monopoly

In perfectly competitive market firms face a horizontal, straight line demand curve and
industry faced a downward sloping demand curve. Under monopoly, however, there is no
destination between the firm and the industry. The monopoly industry is a single firm
industry and the firm’s demand curve is the demand curve of industry. The monopoly firm
has the option to choose between price to be charged or output to be sold. Once it chooses
price, the demand for its output is fixed, similarly, if the firm decides to sell a certain
quantity of output, then its price is fixed.
Price

MR D = AR

0 Quantity
Fig 6.1: demand and revenue curves of a monopolist

AR curve for a firm is the same as its demand curve, since a monopoly firm faces a down
ward sloping demand curve, its AR also slopes down ward to the right. What is much more
important in the analysis of the equilibrium of a monopoly firm is the relationship between
AR and MR. There is a specific relationship between AR and MR, i.e. the slope of MR is twice
that of AR. That is, given the linear demand function, marginal revenue curve is twice as
steep as the average revenue curve. This reaction can be proved us follows. Let us assume
the monopoly firms faced with price function or overage revenue function as.

53
 P = a – bQ
TR = Q (a-bQ)
TR = aQ – bQ2
MR = dTR/dQ = d(aQ-bQ2)/dQ = a – 2bQ
MR = a-2bQ

Note that: the slope of price function equals b, where as the slope of MR function equals 2b.
It means that the slope of the MR function is twice that of the AR function.

6.1.3. Short-run Equilibrium under Monopoly

The monopoly firm, like a competitive firm, reaches its equilibrium when it maximizes total
profit. We can employ the two approaches we have discussed in chapter 5; the total and
marginal approaches.

1. Total approach (using the TR and TC curves)

According to this approach profit is maximum when the difference between TR and TC is
large. Graphically, it is found at the points where two parallel lines are tangent to the TR and
TC curves. Notice that the profit maximizing Level of output is lower than the revenue
maximizing output level. (Q  <Qr)

TR and TC TC

TR

Profit function

. 0 a Qπ b Qr Output
Fig. 6.2: Short run Equilibrium of a monopoly firm (total approach)

2. Marginal Approach (using the marginal revenue and cost curve)

According to this approach profit is maximum when two conditions are satisfied
simultaneously. These are:
 The first order condition (F.O.C): i.e. MC=MR, and,
 The second order condition (S.O.C): i.e. the slope of MC> the slope of MR

54
 Graphically,

Price

SMC
Pe C SAC
A B
E
MR P=AR

0 Qe Output
Fig. 6.3: Short run Equilibrium of a monopoly firm, marginal approach

In the above figure, the monopoly firm choose price and output combination for which MR=
MC. The MR and MC curves intersect one another at point E. Point E determines the profit
maximizing output for a firm at OQe. At this output, firm’s MR =MC and the output OQe can
be sold per unit at only one price i.e. 0Pe. Thus, the determination of output determines
simultaneously the price for the monopoly firm.

At output OQe and price 0Pe, the monopoly firm maximizes its per unit monopoly or
supernormal profit, which is the difference between AR and AC i.e. AR-AC is 0P- 0A= PeA or
and its total monopoly profit ABCPe (super price is greater than average cost).

A Monopoly is assumed to make profit in the short run using its monopoly power. However
depending on its revenue and cost conditions, it may not make profit or even incur a loss.
Exceptions:-
 There may be zero profit if the average cost is equal to the average revenue.

Price
SMC

Pe C SAC

0 Qe Output
Fig. 6.4: Short run Equilibrium of a monopoly firm with zero profit

55
  There may be loss in the short run if the average cost is greater than the average
revenue. In the following figure, the per unit cost (OA) exceeds the per unit price
(OPe). This results in a loss.
Price

A B SMC SAC

Pe C

0 Qe Output
Fig. 6.5: Short run Equilibrium of a monopoly firm incurring loss

6.1.4. Long run Equilibrium and Capacity Utilization under Monopoly

Previously, you have learned a competitive industry is in a long run equilibrium when all
firm reach in the same level of optimum efficiency (i.e. producing up to the minimum level of
LAC) or satisfy the following condition; SMC=SAC =LMC=LMR= LAC =P which implied zero
profit. Depending on the market size, cost and revenue conditions- profit maximizing output
for a monopoly may fall beyond, at or before the minimum of LAC according to the level of
capacity utilization. Hence, we may have three kinds of equilibrium positions for a monopoly
in the long-run accordingly. These are:

a) Long-run equilibrium with capacity underutilized:

Price
SAC LAC

Pe C SMC LMC

A B E

MR P=AR=D
0 Qe Output
Fig. 6.6: Long-run equilibrium with capacity underutilized
The monopoly firm is in a long run equilibrium (LMC=LMR) producing OQe, charging OPe
and earning abnormal profit equivalent to the area ABCPe. As shown above, even the existing
plant size (SAC) is not optimally utilized because production is not at its minimum point.
Optimum capacity utilization in the long run equilibrium is found at point E, minimum point
of LAC.

56
 b) Long run equilibrium with over utilized capacity

Price

LMC
Pe C
SAC LAC

A B
MR P=AR=D
0 Qe Output
Fig. 6.7: Long-run equilibrium with capacity over utilized

The monopoly firm is in a long run equilibrium (LMC= LMR) producing OQe, charging OPe
and earning abnormal profit equivalent to the area ABCPe. As shown above, even the existing
plant size (SAC) is over utilized because production is beyond the minimum point of LAC.
c) Long- run equilibrium with optimal utilization of capacity

Price
LMC
SMC LMC
Pe C LAC
SAC

A B

0 Qe Output
Fig. 6.8: Long-run equilibrium with capacity underutilized

The monopoly firm is in a long run equilibrium (LMC= LMR) producing OQe, charging OPe
and earning abnormal profit equivalent to the area ABCPe. Production is at the minimum
cost (minimum of LAC). Equilibrium is held when LMC = LMR = LAC= SMC = SAC. As shown
above, even the existing plant size (SAC) is optimally utilized because production is at the
minimum point of LAC. In all cases, we can see that a monopoly can even get abnormal
profit even in the long-run.
Numerical Example
Given Q = 100 – 0.2P and
TC = 50+20Q+Q 2 Find the profit maximizing price and output,
assuming
a) A firm in imperfect competition
b) A firm in perfect competition

57
Solution:
a) A firm in imperfect competition

To maximize profit:
dTR dTC
F.O.C MR = MC =
dQ dQ
Q = 100 – 0.2P
P = 500 – 5Q
TR =QP=Q(500 – 5Q)
TR =500Q– 5Q2
MR = 500-10Q and MC= 20+2Q
MR = MC
500-10Q= 20+2Q
480 = 12Q
Q = 40
P = 300
TR = 12000
TC = 2450
π = 9550

S.O.C Slope MR < Slope MC

The slope of MR should be less than the slope of MC
- 10 < 2

b) A firm in perfect competition?

58
 6.1.5. Monopoly Vs Perfect Competition
The forgoing table will help you to understand the similarities and differences between
perfectly competitive market structure and monopoly market structure.
Comparison tools Pure competition Monopoly
1. Goal of the firm Profit maximization Profit maximization
2. Assumption:
a) Products - Homogeneous - Homo/heterogeneous
b) Number of firms - Many - Single
c) Entry and exit - Free - Blocked
d) Cost curves - U-shaped - U-shaped
3. Behavioral rules of the firm
a) Demand curve - Perfectly elastic - downward sloping
b) Policy variable - Only output - P, Q, R & D, advertisements
c) Profit Maximization - MR= MC - MR= MC
d) Model type - Static - Static
4. Long run Equilibrium Price
LMC LAC Price LMC
Pm C LAC
Pc MR=AR
A B
MR AR
0 Qc 0 Qm
a) Equilibrium price Pc< PM PM > Pc
b) Equilibrium output Qc > Qm Qm >Qc
c) Profit at Equilibrium  c (  =0)<  m  m(  =ABCPm)>  c (  =0)
d) Capacity utilization at -Full capacity utilization -Under utilization of capacity
Equilibrium -optimal resource allocation -sub-optimal resource allocation
-There is no social welfare loss -There is social welfare loss known as
Dead weight loss
Price
A Price
-Assuming constant LAC, LMC A
the Consumer surplus is Pc E LAC Pm D LMC
calculated as follow:
Pc F E LAC
0 Qc
Consumer surplus = OAEQC 0 Qm Qc
- OPcEQC Consumer surplus = OADQm
= APcE - OPmDQm
=APmD

This is less than APcE by

PCPmDF+DEF but PCPm DF is part of
monopoly TR and DEF is the lost
welfare.

59
 6.2. Monopolistically Competitive Market Structure
6.2.1. Introduction
In the late 1920s, economists became increasingly dissatisfied with the use of pure
competition as an analytical model of business behavior. It was obvious that pure
competition could not explain several empirical facts. The assumption of homogeneous
product, in the theory of pure competition, did not fit with the real world. Moreover
advertising and other selling activities, practices widely used by business men, could not be
explained by pure competition. The idea that firms expand their output with falling costs,
without however growing infinitely large, as the pure competition model would predict in the
event of continuously decreasing costs, was particularly the main cause of the dissatisfaction
which caused a wide spread reaction against pure competition theories.

Piero Sraffa pointed out that the falling cost dilemma of the classical theory could be resolved
theoretically in various ways:
i) introducing a falling demand curve for the individual firm
ii) adopting general equilibrium approach in which shifts of costs induced by external
economics of scale ( to the firm and the industry) could be adequately incorporated
iii) Introducing a U – shaped selling cost curve into the model.
Of these solutions, he adopted the first, that is, he argued that a model in which
the individual demand curve is a negatively sloping, is more operational and
theoretically more plausible. Edward Chamberlain and Joan Robinson also
adopted the same approach in works they independently published in 1933.
Advertising did not appear in the analysis of pure competition. However, it plays a great role
in industry that can neither be described as pure competition nor pure monopoly. A
combination of consumers’ preference for variety and competition among producers has led
to similar but differentiated products in the market place. This situation has been described
as monopolistic competition.
Chamberlain defined monopolistic competition as a market structure in which a large
number of sellers sell differentiated products which are close but not perfect substitute for
one another. It has elements from both competitive and monopoly market structures it is
similar to competitive market structure in all aspects except its differentiated products.
These heterogeneous products create some power for the firms like firms in monopoly market
structure.

60
 6.2.2. Assumptions underlying the monopolistic competition:
1) There is large number of sellers and buyers.
2) The products of the sellers are differentiated, yet they are close substitute of one
another
3) There is free entry and exit.
4) Both in the short – run and long –run, the goal of the firms is profit maximization.
5) The price of factors and technology are given in the short run.
6) The long-run consists of a number of identical short run periods, which are assumed
to be independent of one another in the sense that decisions in one period do not
affect future period and are not affected by past actions. The optimum decision in any
one period is the optimum decision for any other period. Thus, by assumption
maximization of short run profits implies maximization of long-run profits.
7) Both demand and cost curves for all products are uniform. This requires that
consumers’ preferences be evenly distributed among the different sellers, and
differences between the products be such as not to give rise to differences in costs.
The last assumption leads to a model, which is very restrictive since it precludes the
inclusion in the ‘group’ of similar products which have different costs of production.

6.2.3. Product differentiation, demand and cost curves

Chamberlain defined product differentiation as the existence of any significant basis for
distinguishing the goods or services of one seller from others. Product differentiation is
intended to distinguish the product of one producer from that of the other producers in the
industry. The aim of product differentiation is to make the product unique in the mind of the
consumer. Differentiation may be in terms of brand name, trade mark, color, style etc.
These factors create preference for certain product in particular. This preference determines
the shape and position of the demand curve in addition to price. Another factor known as
selling cost also determines the shape of the demand curve. The three factors (preference,
price and selling cost) make the demand curve downward sloping.
Selling cost is a new concept of cost added by Chamberlain. It is a type of cost incurred to
alter the shape and slope of the demand curve for a product. It introduces the special feature
of certain product. Selling costs include costs incurred on, for example, advertisement,
salesmen salaries etc. These make the demand curve less elastic and shift upward. The
shape of the selling cost curve is u-shaped like other cost curves.

61
 6.2.4. The Concept of Industry and Product Group
An industry is defined as a group of firms producing homogenous products. But in this
market structure, there are firms producing different products. Each firm is an industry by it
self. This made the market demand curve inexistent to Chamberlain's model. To solve this
problem, he categorized the very close products under the same group. The group of
products under the same division is called product group. Products in the same group are
expected to be technological and economic substitutes. Technological substitutes are
products which can technically cover the same want. Example, all vehicles are technological
substitutes in the sense that they provide transport. Economic substitutes are products
which cover the same want and have similar prices. An operational definition of the “product
group” is that the demand of each single product be highly elastic and that it shifts
appreciably when the price of the other products in the group changes. In other words
products forming the group or industry should have high price and cross elasticity.
Therefore, for Chamberlain, an industry is defined as a group of firms producing products in
the same group or product group.

6.2.5. Equilibrium of a firm

A firm under monopolistic competition can influence its sales in two ways. It can change
price or the nature of its products and advertisement outlays. The first tool is used in the
short-run while others are possible only in the long –run. In the short-run, a firm in
monopolistic competition acts like a monopoly. It maximizes profit by equating marginal
revenue to marginal cost. Graphically, equilibrium in the short run is achieved when the
marginal cost curve intersects the marginal revenue from below. This point will give the
equilibrium price when extended to the demand curve and the equilibrium quantity when
extended to the x-axis. In the diagram below, the monopolistic firm earns a profit equivalent
to the area ABCPe at equilibrium price (Pe) and equilibrium quantity (Qe).

Price
Pe C SMC
SAC
A B

MR D=AR=P

0 Qe Output
Fig. 6.9: Short run Equilibrium of a firm in monopolistic competition

62
 6.3. Oligopoly Market Structure
Oligopoly market structure is a market structure in which few sellers sell differentiated or
homogeneous products. If they sell differentiated products, it is said to be differentiated
oligopoly. If they sell homogeneous products, it is said to be pure oligopoly. Again, Oligopoly
market structure can be collusive or non-collusive. In this section, you will learn two types of
non-collusive and two types of collusive oligopoly models.

6.3.1. Characteristic features of Oligopoly Market Structure

1) Intensive competition: since the number of firms is small, a single firm’s action has
significant effect on the market. Thus each firm watches the action of others attentively
and competition takes the highest form.
2) Interdependence: given the effect of an action made by a particular firm, others will react.
The first firm which initiates the move will consider the reactions to be made by others.
Hence, any decision making is interdependent.
3) Barriers to entry: like economies of scale, absolute cost advantage to old firms, price
cutting, control over important inputs, patent rights etc prohibit entry.

6.3.2. Oligopolistic Models

Oligopolistic models can be:
a) Non- collusive models Or b) Collusive models
1. Cournot’s model 1. Cartel, and
2. Stackelberg’s model 2. Price leadership
3. Sweezy's model
4. Bertrand’s model
5. Chamberlain's model

Non collusive models assume that there is no collusion or any form of agreement between the
sellers to act jointly towards price, market share, or competition. Collusive models, on the
other hand, assume some kind of agreement between the sellers under certain system.

63
 1) Non-Collusive Oligopoly Models
a) Cournot's model (Quantity competition)
Assumptions:
1. two firms (duopoly model )
2. MC=0
3. Demand curve with constant negative slope
4. No reaction for change in price or output.
5. Both firms don’t learn from their past experiences.
6. Simultaneous game.
Based on these assumptions Cournot concluded that each firm should finally supply 1/3rd of
the market at the same price and 1/3rd will remain unsupplied. Each firm competes by
producing half of the unsupplied potion of the market till equilibrium is achieved.
Price R

PA Z

PB

m
O Q1 Q2 Output
Fig. 6.10: Price and output determination under the cournot's model

Here are the procedures:

Period Firm A Firm b
I ½(1)=1/2 ½(1-1/2)=1/4
II ½(1-1/4)=3/8 ½(1-3/8)=5/16
III ½(1-5/16)=11/32 ½(1-11/32)=21/64
IV ½(1-21/64)=43/128 ½(1-43/128)=85/256
For firm A we have a series for different periods as
I=1/2
II=3/8=1/2-18
III=11/32=1/2-1/8-1/32
IV=43//128=1/2-1/8-1/32-1/128
The last series is a geometric function with
½ - (1/8+1/32+1/128) and its sum is given by a/(1-r)
½-1/8/1-1/4=1/3 units of the total output for firm A
rd

Similarly, the sum of the series for firm B is

I=1/4
II=5/16=1/4+1/16
III=21/64=1/4+1/16+1/32
IV=85/256=1/4+1/16+1/32+1/128
The last series sum is given by
a/(1-r) = 1/4/1-1/4=1/3rd units of the total output for firm B

64
Thus, each firm will be at equilibrium when producing 1/3rd of the market demand and the
equilibrium is stable at this point. The total market supply is (given by n/(n+1)=2/3units of
the total output.

Example 1) given the demand function for two firms as

Q =12-P
P=12-Q
Let us determine the output produced by each firm from their reaction curves.
Solution: Given P=12-Q=12-QA –QB
TRA=12QA –QA2- QAQB
MR=12-2QA-QB
MC=O
MR=MC = 12-2QA-QB=0…………………………………………………………….……… (i)
QA=(12-QB)/2 reaction curve for firm A
TRB = 12QB-QB2-QBQA
MR = 12-2QB –QA =0…………………………………………………….…………………. (ii)
QB = (12-QA)/2 reaction curve for firm B
Solving (i) and (ii) simultaneously:
( 12=2QA+QB)2
12=QA=2QB
24=4QA+2QB
- (12=QA =2QB)
12=3QA
QA=4Units QB =4Units P=4

b) The Bertrand model (Price Competition)

The Bertrand model differs from that of the Cournot in the sense that it considers price
rather than output as the strategic variable. Therefore, in this model
- the market is duopolistic
- a homogeneous commodity is produced.
- the firms compete through price setting
- simultaneous price setting
Let us examine the model given the following market demand and cost conditions.
P=30-Q; where, Q=Q1+Q2
MC1=MC2=3
The Cournot solution to this duopoly model is such that the firms should (each) produce
Q1=Q2=10units at equilibrium with a market clearing level of price equal to $10, each firm
will then earn a profit of $100.

What if these duopolies compete by simultaneously choosing price instead of quantity?

65
Because the good is homogenous, consumers will purchase only from the low price seller.
This implies that if different prices were charged, the low price seller would supply the entire
market and if the same prices were charged, consumers would be indifferent as to which
seller to buy from. What is the Nash equilibrium in this case?

Assume that the firms share the market equally. In this case, the Bertrand equilibrium is the
outcome of the incentive to undercut prices as lowering its selling price by a slight amount, a
firm will end up doubling its sales with all the customers flocking to it. The incentive to cut
and undercut prices is so strong that the firms will get themselves in cut throat pricing till
price is reduced down to the level that results with perfect competition. The Nash equilibrium
is then the competitive outcome i.e. firms set prices equal to marginal cost.
P1=P2=$3=MC
Industry output: Q=30-3=27
By assumption, Q1=Q2=13.5
With marginal cost pricing, both firms will earn zero economic profit. The competitive
outcome is Nash equilibrium because the firms cannot maximize profit by setting price
different from MC. If P>MC, the firm will lose all its customers. If P<MC, the firm will lose
money. The assumptions of price competition given product homogeneity and equal market
share are not satisfactorily justified.

2. Collusive Oligopoly Models

a) Cartel
A cartel is a formal organization of oligopoly firms in an industry aiming at centralizing
certain managerial decisions and functions of individual firms with a view to promoting
common benefits ranging from reducing competition and oligopolistic uncertainty to forming
barriers to the entry of new firms. The two important services that a Cartel renders to its
members are fixing prices and market sharing. There are two typical forms of cartels:

Cartel aiming at joint profit maximization

This type of cartel arrangement results from the desire to reduce uncertainty arising from
mutual interdependence among the firms. Therefore, the firms seek to maximize joint
(industry) profit. Consider two oligopolies producing a homogeneous product. If they form a
cartel aiming at joint profit maximization, then they will set a central agency with the

66
authority to decide on the industry level of output, a price to be charged, and the allocation
of production and profit among the firms. The central agency will collect information about
individual costs to derive the market supply curve by horizontally summing marginal costs of
participating firms. It is also assumed that the central agency will be able to calculate the
market demand and the corresponding marginal revenue curves. The agency then equates
industry marginal cost (which is the market supply curve) with marginal revenue and
determines the joint profit maximizing levels of price and output. In the following diagram
the cartel marginal cost curve is obtained by horizontally summing individual marginal cost
curves.
Given the market demand DD, the Cartel (monopoly) solution, which maximizes joint profit,
is determined by the intersection MC and MR at point E where
total output is Qe=Q1 + Q2
Price = Pe
In order to allocate production, the central agency requires each firm to take the joint profit
maximizing level of MR for use in its output setting rule:
MR* = MC1 for firm one and
MR* = MC2 for firm two
Therefore, firm-A should produce QA and firm-B should produce QB units of the total output
i.e. QA + QB = Q. The above arrangement helps to maximize the joint profit of the firms. The
firm with the lower cost will produce a larger amount of output but the distribution of profit
will be decided by the central agency alone.
Firm A Firm B
MCA MCB Price
P c P f Pe
a b d e MC

Ea Eb E

O QA O QB 0 Qe Quantity

Fig. 6.11: Price and output determination under Cartel aiming at joint profit maximization
The joint industry profit is the sum total of the areas abcP and defP. The second firm
produces QB units which is greater than QA simply because it has lower costs. The above
discussion doesn't imply that each firm will earn profit to the extent of the shaded region.
Rather, profit is shared among the firms through some arrangement under the agency.

67
Example: Assume that market demand is P = 100 – 0.5X and that the firms have costs given
by C1 = 5X1 and C2 = 0.5X22. The central agency maximizes profit
 =  1 +  2 by allocating output in such a way that MR = MC1 = MC2
P = 100 – 0.5X
TR = PX = (100 – 0.5X)X
TR = PX = 100X – ½ X2
MR = 100 – X
= 100 – X1 – X2
MC1 = 5 and MC2 = X2

At equilibrium: MR = MC1
100 – X1 – X2 = 5
95 – X1 – X2 = 0 …….I)
MR = MC2
100 – X1 – X2 = X2
100 – X1 – 2X2 = 0 ….II)
-2 (95 – X1 – X2 = 0)
(+) (100 – X1 – 2X2 = 0
-90 + X1 = 0
X1 = 90, X2 = 5
P = 100 – ½ (95)
= 52.5
b) Price Leadership
Price leadership is a form of collusion in which one firm (the leader) sets price and the others
(the followers) follow it. The follower firms are price takers even when the price set by the
leader does not help them to maximize their independent profits. They follow the leader
basically because they want to avoid uncertainties and price wars in exchange for some
losses of profits. Price Leadership may arise as a result of cost advantage, advantage related
to market share or experience of a firm.
The low cost price leader ship:
It is true that one among the group has (may have) a cost advantage over the others. In this
case, the low cost firm sets its profit maximizing level of output by equating its marginal
revenue with marginal cost and the rest of the firms will comply by behaving as price takers.
If both firms share the market equally as shown in the figure below, both firms will face the
same demand curve and their marginal revenue will also be the same. But firm-A is the low
cost firm and will have the discretion to lead the group. This it does by maximizing its own
profit in such a way that MCA = MR. Therefore, at equilibrium P will be charged by firm –A
and firm – B will adopt P as its selling price. But one can see that firm –B is not maximizing
profit at price P, as because its marginal revenue is less than marginal cost. In order to
maximize  , therefore, it has to reduce its supply to QBe and charge PB instead of P.

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 Price
MCB

PBe
Pe MCA

MR d

0 QBeQA=QB Output

Fig. 6.12: Price and output determination by a low cost firm with equal market share

Numerical Example: Given P=105 – 2.5X

C1 = 5X1
C2 = 15X2
Assume that the low cost firm is the leader, it sets price at MR= MC1 by assuming that the
other firm will follow the same price and output.
Assume that X1 = X2
P = 105 – 2.5 (X1 + X2)
P = 105 – 5X1 if X1 = X2
TR1=PX1= (105 – 5X1)X1
TR1=PX1= 105X1– 5X12
MR1 = 105 – 10X1 and MC1= 5
MR1 = MC1
105 – 10X1= 5
X1 = 10 and X2 = 10
P = 55 P = 55
TR1 = 550 TR1 = 550
TC = 50 TC = 150
 1 = 500  2 = 400
But the profit maximizing price and output for the second firm is:
P = 105 – 5X2
TR2=PX2=(105 – 5X2)X2
TR2 =105X2 -5X22
MR2 = 105 – 10X2 and MC= 15
MR2 = MC
105 – 10X2 = 15
X2 = 9
P = 60
TR = 540
TC = 135
 2 = 405 this means, the second firm lost $5.

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 CHAPTER SEVEN

7. FUNDAMENTAL CONCEPTS OF MACROECONOMICS

7.1. Introduction
Traditionally, economics is divided in to: micro-economics which studies about the behavior
of individual decision making units (households, firms, etc) at a disaggregated level, and
macroeconomics, which studies the overall or aggregate behavior of the economy. When you
think of the Ethiopian economy and the economies of the world at large, you may wonder
about a number of issues such as:
 What are the determinants of the economic growth of a country? Why is Ethiopia so
poor while some countries enjoy higher economic growth rate?
 Why does a country’s economic performance fluctuate through time?
 What is unemployment? How can we measure it?
 What is inflation? What are its causes? What is its impact on the economy?
 What is trade balance/deficient/balance of payment? How can we measure it?
 How do government policies affect the economic performance of a country? etc
All these and related questions are the concerns of macro economics. In connection to this,
therefore, the objectives of macroeconomics are full employment, price stability, economic
growth, and fair distribution of income among citizens of a country.
7.2. National Income Accounting
7.2.1. Definition
The most widely used measures of national output are:
Gross Domestic Product (GDP): is the total market value of currently produced final goods
and services that are produced with in a country’s borders during a given period of time,
usually one year.
Gross National Product (GNP): is the total market value of currently produced final goods
and services that are produced by domestically owned factors of production in a given period
of time, usually one year.
Thus, GNP = GDP +NFI, Where NFI = net factor income
NFI = (Factor income received by citizens from abroad) - (factor income paid to foreigners)
Note: If NFI >0, then GNP > GDP
If NFI < 0, then GNP < GDP
If NFI = 0, then GNP = GDP

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 7.2.2. Approaches in Measuring GDP/ GNP
A) Product Approach
This is the method of measuring GDP/ GNP by adding up the market value of output of
all firms in the country. In this approach, GDP is calculated by adding the market value
of goods and services currently produced by each sector of the economy. In this method
of measuring GDP, it is important to include only final goods and services in order to
avoid double counting. Double counting will arise when the output of some firms are used
as inputs of other firms. There are two possible ways of avoiding double counting.

Examples; i) Taking only the value of final goods and services.

No Sectors Value of Output ( in million birr)
1. Agriculture and allied activities 9309
- Agriculture 7000
- Forestry 1000
- Fishing 1309
2. Industry 147413
- Mining & quarrying 9842
- Large & medium scale manufacturing 91852
- Electricity & water 13,717
- Construction 32002
3. Service 357, 872
- Banking insurance and d real estate 121,704
- Public administration & defense 36,605
- Health 20,000
- Education 32,509
- Domestic & other services 147054
4. Net factor income from abroad 87,348
5. Capital consumption allowance 63,984

GDP = 9309+147413+357872 = 514594.

GNP = GDP + NFI = 514594 +87,348=601,942
NNP= GNP – Depreciation = 601942-63,984=537,958

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 ii) Taking the sum of the valued added by all firms at each stage of production
Sages of Values of output Cost of intermediate Value added
production (in birr) inputs
Framer 500 0 500
Oil Factory 2000 500 1500
Retailers 2500 2000 50
5000 (problem of double counting) 2500

B) Expenditure Approach:
Here GDP is measured by adding all expenditures on final goods and services produced in
the country.
GDP = C + Ig +G+X-M, where C = personal consumption expenditure
Ig= gross private investment expenditure
G= Government expenditure on goods and services
X= export income
M= Expenditure on imported goods & services.
Example-1: GDP at current market price measured using Expenditure Approach for a
hypothetical economy.
Types of Expenditure Amount (in million Birr)
1. Personal consumption expenditure 4500
Durable consumer goods 1500
Non-durable consumer goods 2000
Services 1000
2. Gross private domestic investment 600
Business fixed investment 250
Construction Expenditure 300
Increases in inventories 50
3. Government expenditure on goods and services 250
Federal government 100
State government 150
4. Net export -50
Exports 150
Imports 200
GDP at current market price 5300
Example-2: Given the following information for a hypothetical economy (in millions of Birr),
calculate GDP of this economy.
Let GDP = y, C= 100+0.1y, Ig= 0.5C, G= 2000, X= 600, M= 0.2X
Solution: Y= C + Ig + G + X –M
Y= 100 + 0.1y + 0.5 (100+0.1y)+2000+600-0.2(600)
0.85Y=2630
Y= 3094

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 C) Income Approach
GDP is calculated by adding all the incomes accruing to all factors of production used in
producing the national output. That is:
GDP = Compensation of employees (wages & salaries )
+ Rental income
+ Interest income
+Profits (proprietors’ profit plus Corporate profit
+Indirect business taxes
+Depreciation
-subsidies
-Transfer payments
Types of Income Value (in million Birr)
1) Compensation of Employees 45623.71
2) Rental Income 1249.32
3) Proprietor’s Income 10561.21
4) Corporate Profits 16960.33
Subtotal 27521.54
5) Net interest 5189.73
6) Depreciation 521.84
7) Indirect Business Taxes 476.51
8) Subsidy 11368.95
Gross Domestic Product 69195.70
9) Income from abroad 2036.20
10) Payments to abroad 11231.90
(9195.70)
Gross National Income 60000.00

7.2.3. Other National Income Accounts

1. Net Domestic product ( NDP) or NNP = GDP/GNP- Deprecation
2. National Income ( NI) = NNP – Indirect Business taxes + subsides
3. Personal income (PI)= NI – Undistributed corporate profit
- Corporate Income tax
- Social Security contribution
+ Transfer payments
+ Personal interest income
- Personal Disposable Income ( PDI) = PI – Personal income tax

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 7.2.4. Real GDP Vs Nominal GDP
Nominal GDP is the monetary value of currently produced goods and services measured at
current prices. Nominal GDP is not useful to compare a country’s economic performance
overtime. Because it is not clear whether this year GDP is greater or less than last period
GDP by the rise in real output level or the rise in prices of goods and services.

Real GDP is the value of currently produced goods and services measured at constant price
(base year price).
Real GDP = Nominal GDP X100
CPI
Where, CPI = consumer price index
Consumer Price Index: is the price of basket of goods and services relative to the price of
the same basket in some base year.
GDP Deflator:-measures the price of output relative to its price in the base year.
GDP Deflator = Nominal GDP
Real GDP
Example:
Item Amount (in million birr)
GDP 5000
Less Depreciation 200
NDP 4800
Less indirect business tax 100
Plus; NFI 200
NI 4900
Less: social security contribution 50
Corporate income tax 100
Retained corporate profit 200
Plus: public transfers 200
Net interest on government debt 50
PI 4800
Less : personal taxes 100
Personal disposable income 4700

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 7.2.5. Problems Associate with Measuring GDP/ GNP
The calculation of national income is not an easy task. The difficulties faced are as follows.
1. Definition of a nation: while calculating national income, nation does not mean only the
political or geographical boundaries of a country for calculating the value of final goods
and services produced in the country. It includes income earned by the nationals abroad.
2. Stages of economic activities: it is also difficult to determine the stages of economic activity
at which the national income is determined i.e. whether the income should be calculated
at the stage of production or distribution or consumption. It has, therefore, been agreed
that the stage of economic activity may be decided by the objective for which the national
income is being calculated. If the objective is to measure economic progress, then the
production stage can be considered. To measure the welfare of the people, then the
consumption stage should be taken into consideration.
3. Transfer payments: this also poses a great difficulty in the way of calculating the national
income. It has generally been agreed that the best way is to consider only the disposal
income of the individuals of groups.
4. Underground economy: no imputation is made for the value of goods and services sold in
the illegal market. The underground economy is the part of the economy that people hide
from the government either because they wish to evade taxation or because the activity is
illegal. The parallel exchange rate market is one example.
5. Inadequate data: in all most all the countries, difficulty has been faced in the calculation
of national income because of the non-availability of adequate data. Sometimes, the data
are not reliable. This is a general difficulty and may not be solved.
6. Non-monetized sector: this difficulty is special to developing countries where a substantial
portion of the total produce is not brought to the market for sale. It is either retained for
self-consumption or exchanged for other goods and services.
7. Valuation of depreciation: the value of depreciation is deducted from the gross national
product to get net national product. But the valuation of such depreciation is full of
difficulties. For example, changes in the price of capital goods from year to year, the age
composition of capital stock, depreciation in cost due to the use of the capital stock, etc.
8. Price level changes: since the national income is in terms of money whose value itself
keeps on changing, it is difficult to make a stable calculation which is assessed in terms of
prices of the base year. But then, the problems of constructing price index numbers will
arise.

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 7.3. Behavioral Foundations of Macroeconomics
7.3.1. Consumption

The first component of the national income accounting identity, Y=C+I+G+X-M is

consumption by households, which accounts the largest share of GDP, roughly 2/3 of it.
Household’s consumption decision affect the way the economy as a whole behave both in the
short run and in the long run.

In the short run analysis, consumption decision is crucial in its role in determining
aggregated demand. Fluctuations in consumption are the main elements of booms and
recessions i.e. it can be a shock to the economy. The marginal propensity to consume is the
determinant in fiscal policy multiplier. In the long run consumption decision is important in
its role in economic growth. The saving rate measures how much present of income is put
aside by present generation for its own future and for future generation.

A) Theories of Consumption
Some of the major consumption theories so far developed are Keynesian Consumption
Theory, Modegliani Life Cycle Hypothesis, Friedman Permanent Income hypothesis and
Fisher’s Intertemporal Model of Consumption. The first three are discussed in this course.
These theories try to identify different determinants of consumption, i.e. factors that affect
decision of individuals on the amount and path of consumption over time (under different
circumstances).
A. Keynesian Consumption Theory (Keynes’s conjecture)
The term ‘conjecture’ in this theory refers to an inference made based on incomplete
information. Keynes proposed that consumption is a function of income [C= f(Y)]. In simple

form, the consumption function can be stated as; C = C + cY. Where; c is the marginal
propensity to consume (the percentage change in consumption due to change in income), but
by the time Keynes didn’t interpreted it in this sense.
Keynes has made three major conjectures.
1. The value of ‘c’ or the marginal propensity to consume ranges between zero and one
i.e. 0  ‘c’  1. This is because our consumption (C) doesn’t increase by hundred
percent of an increase in income (Y). But as income increase we save some part. But
he didn’t make an attempt to prove this by the time.

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 2. Average propensity to consume (APC) = C/Y falls as income (Y) increases. Because
consumption (C) increases at a lower rate than income (Y) following from conjecture
number 1 above.
3. Income is the most important explanatory variable of consumption and interest rate is
irrelevant in explaining consumption. Some economists by the time say interest rate
determines consumption level. As interest rate in the banks increases people save
more money in banks to receive the higher interest income and thereby consume less.
But Keynes didn’t consider this effect.

B. Modigliani Life Cycle Hypothesis ( Ando - Modigliani Approach)

There was a conflict between earlier findings (for instance of Keynes theory and Kuznet’s
findings called consumption puzzle). For Keynes, the average propensity to consume (APC) is
a declining function of income; whereas for Kuznet the average propensity to consume (APC)
is stable or constant over time.

A typical individual has an income stream that is relatively low at the beginning and high at
the end of her/his life. The individual might be expected to maintain more or less constant or
perhaps slightly increasing level of consumption (See the figure below).

Consumption/Income

Saving Consumption

. Dissaving
Borrowing Income

0 Time

The model classified ages of individuals into three paths of age (young, middle and old age)
and so called life cycle hypothesis. An individual is a net borrower in earlier years of his/her
life and saves during the middle age to repay young age loans and to provide for old age
consumption. In the model, consumption is linear while income is non linear over time.

77
 C. Permanent Income Hypothesis (Friedman Approach)
According to permanent income hypothesis, income doesn’t have a predictive trend; rather
people experience random and temporary changes in their income from time to time. In
earlier theories consumption is taken as a function of current income.
C = f (Y)
But for Friedman consumption is not a function of current income, but a function of
permanent income. Income has two components: permanent income (YP) which is part of the
income expected to persist over time and transitory income (YT), part of the income which is
not expected to persist over time.
Y= YP+ YT and C = CP + CT
Consumption is a function of permanent income: C = f (YP). Assuming linear relationship,
the consumption function will take the form, C = YP where ‘’ is a constant.
YP and YT
YP
YT

0 Time
The extra transitory income (YT) above the trend of permanent income (YP) goes to savings or
purchase of durables for future consumption i.e. people usually save the transitory income
rather than consume. Thus, transitory income doesn’t explain consumption. According to
Friedman consumption puzzle arises because of error in variables (because of using wrong
variables).
7.3.2. Investment

Investment is the most unstable component of aggregate demand, and defined as the action
of putting something in to some venture in expectation of some returns; or alternatively it is
the formation of real capital, tangible or intangible, that will produce a stream of goods and
services in the future. The simple Keynesian function relates investment to real interest rate;
I=I (r). This function states that investment is inversely related to the real interest rate. That
is an increase in the real interest rate reduces investment and a decrease in the real interest
rate increases investment.

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 A) Types of Investment
There are different types of investments, which are included in the national income
accounting. Investment in the national income accounts includes:

i. Business fixed investment: the term “business” means that the investment goods are
bought by firms for future production. The term “fixed” means that this spending is for
capital that will remain fixed for a while, as opposed to inventory investment, which will
be used or sold shortly later. Business fixed investment includes machines, factories,
computers and cars used for the production of outputs. Business fixed investment is
important in two respects. First, investment spending is a significant component of
aggregate demand. The importance of investment to cyclical movements in income is ever
more than in proportion to its size as the share of GDP. The second important
macroeconomic role for business fixed investment follows from the fact that the net fixed
business investment measures the amount by which the stock of capital increased in
each period.

ii. Residential Investment: another type of investment which is made on the construction
of houses and included in the national income accounting and involving large
expenditure is the residential investment. This type of investment also varies with the
business cycle.

iii. Inventory Investment: this type of investment is made in the form of production. Money
is put into the production process while the produce is not brought to the market. The
produced goods are kept in the warehouses for future sale. It is not as such large enough
compared to the other forms investment. However, there is a strong relationship between
charges in inventory investment and change in output over the business cycle. Issues of
Inflation and Unemployment

7.4. Problems of Macroeconomics

7.4.1. Business Cycle
Business cycle refers to the recurrent ups and downs [fluctuations] in the level of
economic activity. Countries usually experience ups and downs in the level of total output
and employment through time. For some period of time, the total output level may
increase, after a while total outputs may decline. With this fluctuation in the overall
economic activity unemployment level also moves up and down.

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Level of economic activity

Time
We can identify four phases in a business cycle. They are: boom or peak, recession, trough or
depression, and recovery periods.

i. Boom or peak: is a phase in which the economy is producing the highest level of
output in a business cycle. It is a period of maximum output expansion. During
boom period, the economy is operating close to full capacity. Because of this, total
output and national incomes are very high business is good, and unemployment
level is too low. This is a period of prosperity.
ii. Recession or contraction: during a recession phase, the level of economic
performance generally declines. Total output declines, national income falls, and
business generally decline. As a result unemployment problem rises. When the
recession becomes particularly severe, we say that the economy reaches its trough
or depression phase in a business cycle.
iii. Trough or depression: this is the lowest point in a business cycle. In other words,
the economy reached a low point. Total output reaches to low while unemployment
rate is too high.
iv. Recovery: this is a period of time in which the economy starts to grow or recover.
Now more and more resources are employed in the production procss: output
increases, unemployment level diminishes and national income rises. When the
expansion of the economy reaches its maximum, the economy once again comes to
another boom or peak phase.
From one peak to the next peak or from one trough to the next trough is considered as one
business cycle. Recession and depression periods can cause sever hardship on
businesses and citizens of a country.

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 7.4.2. Unemployment
Another issue discussed in macroeconomics is the problem of unemployment.
Unemployment refers to group of people who are in a specified age, who are without a job but
are actively searching for a job. In the Ethiopia context, the specified age is between 14 and
60. But, what are the causes of unemployment? What are the types of unemployment? How
can we measure it? What is the economic cost of unemployment? These and other questions
are raised and addressed in macroeconomics.
To understand what unemployment is, one has to know what labour force means. To begin
with, we can classify the whole population of a country into two major groups: those in the
labour force and those outside the labour force.
Labor force includes group of people with in a specified age bracket, who are actually
employed and those who are without a job but are actively searching for a job. The age
bracket refers to the working age specified by the law of a country. According to the
Ethiopian labor law, for instance, people whose ages are greater than 14 are considered as
job seekers though formal employment requires a minimum of 18 years of age. Therefore, the
labour force does not include: Children <14 and retired people, Full time students, People in
mental and correctional institutions, and Very sick and disabled people etc

A) Types of unemployment
We can identify three types of unemployment
1. Frictional unemployment: - For some workers it takes time to search for a job and
they become unemployed between jobs for some time. This may be due to:
 Seasonality of work or Voluntarily switching of jobs
 Entrance/Re-entrance to the labour force
2. Structural unemployment:-refers to unemployment resulting from mismatch
between the skills or locations of job seekers and the requirements or locations of the
vacancies. Structural unemployment can be caused by:
 Permanent shift in pattern of demand for goods and services
 Technological change.
3. Cyclical unemployment:-this is also referred to as demand deficiency
unemployment. It results from declines in national output in periods of recession.
Note that Frictional and structural unemployment are more or less unavoidable, and hence
known as natural level of unemployment.

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B) Measuring Unemployment
Unemployment level in a country is, thus, measured by unemployment rate.
TU = FU + SU + CU, where TU = Total unemployment
FU= Fictional unemployment
SU= Structural unemployment
CU = Cyclical unemployment
Unemployment rate= number of unemployed x100
Labour force
Employment rate = number of employed x100
Labour force
7.4.3. Inflation
The third issue raised in macroeconomics is inflation. Inflation refers to a sustainable or
continuous increase in the average price level of goods and services. Deflation, on the other
hand, refers to the decrease in the average price level of goods and service. Is inflation
harmful? What are the causes of inflation? How can we measure it?

The inflation rate in the economy can be anticipated or unanticipated one. Anticipated
inflation is the rate of inflation expected to occur over a specified period of time where as
unanticipated inflation refers to that portion of the actual inflation that was not expected by
the society to happen.

Let us understand how the inflation originates or what causes it. Depending upon the
specific causes, three types of inflation have been distinguished. These are (1) Demand–pull
inflation (2) Cost-push inflation (3) Structural inflation.

A) Types of Inflation

1. Demand-pull Inflation
This represents a situation where the basic factor at work is the increase in aggregate
demand for output either from the government or the entrepreneurs or the households. The
result is that the pressure of demand is such that it cannot be met by the currently available
supply of output. Keynes explained that inflation arises when there occurs an inflationary
gap in the economy which comes to exist when aggregate demand exceeds aggregate supply
at full employment level of output.

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 2. Cost-Push Inflation
We can visualize situations where even if there is no increase in aggregate demand, prices
may still rise. This may happen if there is increase in costs independent of any increase in
aggregate demand. Three such autonomous increases in costs which generate cost-push
inflation have been suggested. They are:

 Wage-push inflation
 Profit-push inflation
 Increase in prices of raw materials, especially energy inputs; as rise in crude oil prices.

It may be noted that rise in prices of raw materials, especially of energy inputs (petroleum
products) which have a cost push effect are also called supply shocks.

3. Structuralist Theory of Inflation

Structural theory of inflation has been put forward as an explanation of inflation in the
developing countries especially of Latin America. The well-known economists, Myrdal and
Streeten who have proposed this theory have analyzed inflation in these developing countries
in terms of structural features of their economies. Kirkpatrick and Nixon have generalized
this structural theory of inflation as an explanation of inflation prevailing in all developing
countries.

Therefore, to explain the origin and propagation of inflation in the developing countries, the
forces which generate bottlenecks or imbalances of various types in the process of economic
development need to be analyzed. A study of these bottlenecks is therefore essential for
explaining inflation in the developing countries. These bottlenecks are of three types:

1. Agricultural Bottlenecks: The first and foremost bottlenecks faced by the developing
countries relate to agriculture and they prevent supply of food grains to increase adequately.
Of special mention of the structural factors are disparities in land ownership, defective land
tenure system which act as disincentives for raising agricultural production in response to
increasing demand for them arising from increase in people’s incomes, growth in population
and urbanization. Besides, use of backward agricultural technology also hampers
agricultural growth. Thus, in order to control inflation, these bottlenecks have to be removed
so that agricultural output grows rapidly to meet the increasing demand for it in the process
of economic development.

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2. Resources Gap or Government’s Budget Constraint: Another important bottleneck
mentioned by structuralists relate to the lack of resources for financing economic
development. In the developing countries planned efforts are being made by the government
to industrialize their economies. This requires large resources to finance public sector
investment in various industries. But socio-economic and political structure of these
countries is such that it is not possible for the government to raise enough resources
through taxation, borrowing from the public, surplus generation in the public sector
enterprises for investment in the projects of economic development. Revenue rising from
taxation has been relatively very small due to low tax base, large scale tax evasion, inefficient
and corrupt tax administration. Consequently, the government has been forced to resort to
excessive deficit financing (that is, creation of new currency) which has caused excessive
growth in money supply relative to increase in output year after year and has therefore
resulted in inflation in the developing countries. Besides, resources gap in the private sector
due to inadequate voluntary savings and underdevelopment of the capital market have led to
their larger borrowings from the banking system which has created excessive bank credit for
it. This has greatly contributed to the growth of money supply in the developing countries
and has caused rise in prices.

3. Foreign Exchange Bottleneck: The other important bottleneck which the developing
countries have to encounter is the shortage of foreign exchange for financing needed imports
for development. In the developing countries ambitious programme of industrialization is
being undertaken. Industrialisation requires heavy imports of capital goods, essential raw
materials and in some cases even food grains have been imported. Besides, imports of oil on
a large scale are being made. On account of all these imports, import expenditure of the
developing countries has been rapidly increasing. On the other hand, due to lack of export
surplus, restrictions imposed by the developing countries, relatively low competitiveness of
exports, the growth of exports of the developed countries has been sluggish. As a result of
sluggish exports and mounting imports, the developing countries have been facing balance of
payment difficulties and shortage of foreign exchange which at times has assumed crisis
proportions.

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 B) Measures to Control Inflation
1. Fiscal Policy: Reducing Budget Deficit

To reduce budget deficits and keep deficit financing within a safe limit, the government can
mobilize more resources through rising:

(a) Taxes, both direct and indirect,

(b) Market borrowings, and
(c) Raising small savings such as receipts from Provident Funds.
2. Monetary Policy: Squeezing Credit
Monetary policy refers to the adoption of suitable policy regarding interest rate and the
availability of credit. Monetary policy is another important measure for reducing aggregate
demand to control inflation. As an instrument of demand management, monetary policy can
work in two ways.

 First, it can affect the cost of credit and

 Second, it can influence the credit availability for private business firms.
3. Supply Management through Imports
To correct excess demand relative to aggregate supply, the latter can also be raised by
importing goods in short supply. To check the rise in food prices, the government has been
frequently importing them to enlarge their available supplies. At times of inflationary
expectations, there is a tendency on the part of businessmen to hoard goods for speculative
purposes. The attempt by the government to import goods in short supply would compel the
hoarders to release their hoarded stocks. Overall excess demand relative to supply will be
reduced if total imports of goods exceed the exports so that there is a net import surplus. At
times of inflationary pressures, efforts are to be made to enlarge import surplus as far as
possible. However, the country can achieve and enlarge this import surplus if it has either
enough foreign exchange reserves which can be used to spend on imports/if sufficient
foreign aid is available to import the goods in short supply.

4. Incomes Policy: Freezing Wages

Another anti-inflationary measure which has often been suggested is the avoidance of wage
increases which are unrelated to improvements in productivity. This requires exercising
control over wage-income. It is through wage-price spiral that inflation gets momentum. To
check this vicious circle of wages-chasing prices, an important measure will be to exercise
control over wages. If wages are raised equal to the increase in the productivity of labour,

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then it will have no inflationary effect. The proposal has been to freeze wages in the short run
and wages should be linked with changes in the level of productivity over a long period of
time. According to this, wage increases should be allowed to the extent of rise in labour
productivity only. This will check the net growth in aggregate demand relative to aggregate
supply of output.

5. Raising Aggregate Supply through Fuller Utilization of Productive Capacity

If productive capacity in the economy is not fully utilized; then excess demand can also be
reduced by adopting measures for utilizing fully the idle productive capacities in various
industries of the economy. This would augment the aggregate supply of output and reduce
the gap between aggregate demand and output and will therefore tend to check the
inflationary potential. With various measures, the aggregate demand can be reduced on the
one hand and the aggregate supply of output can be increased on the other. This would help
in bridging the gap between aggregate demand and aggregate supply which would enable us
to contain the inflationary pressures in the economy.

C) Inflation, unemployment and Phillips curve

Phillips curve is a curve which shows an inverse relationship between the rate of
unemployment and the rate of increase in money wages (wage inflation) i.e. the higher the
rate of unemployment, the lower the rate of inflation. The curve suggests that less
unemployment can always be attained by incurring more inflation and that the inflation rate
can always be reduced by incurring the costs of more unemployment. In other words the
curve suggests there is a trade-off between inflation and unemployment.
Letting Wt be wage rate of this period and Wt+1 the wage of next period, the rate of wage
inflation, gw, is given as:
gw = Wt+1 – Wt ……………………………………………………........................…… (1)
Wt
With natural rate of unemployment, U* we can write simple Phillips curve as
gw = - ε (U-U*) ……………………………………….......………………… (2)
Where ε is the measures the responsiveness of wage rate to deviation of unemployment from
the natural rate.
This equation states that wages are falling when the unemployment rate exceeds the natural
rate, that is, when U>U*, and rising when unemployment is below the natural rate.
Combining equations (1) and (2), we have

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 ε (U-U*) = Wt+1-Wt Rearranging
Wt
Wt+1- Wt = Wt(-ε (U-U*))
Wt+1= Wt + Wt(-ε (U-U*))
= Wt – Wt ε (U-U*)
Wt+1 = Wt [1- ε (U-U*)]

Inflation Rate

Phillips curve

0 Unemployment rate
Such relationship between inflation and unemployment raise the idea of policy trade off. The
Phillips curve rapidly becomes a cornerstone of macroeconomic policy analysis. It suggested
that policymakers could choose different combinations of unemployment and inflation rates.
That is we could have low unemployment as long as we put up with high inflation. The policy
measures to reduce unemployment always lead to higher inflation rate and policy measures
which reduce inflation rate always contribute to higher unemployment.

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