Economics ch 1-3 ExamClass PDF

INTRODUCTION TO ECONOMICS powerPoint  Chapter One: Basics of Economics 1.1 Definition of Economics ❖ The word “Economics” is originated from the ancient Greek word “oeconomicus” equivalent phrase "household management" or "management of family affairs”. ❖ There is no univer...

INTRODUCTION TO ECONOMICS powerPoint  Chapter One: Basics of Economics 1.1 Definition of Economics ❖ The word “Economics” is originated from the ancient Greek word “oeconomicus” equivalent phrase "household management" or "management of family affairs”. ❖ There is no universally accepted definition of economics (its definition is controversial). ❖ Economic can be defined from different perspectives. 1) Wealth Definition: Adam Smith (1723-90) The formal definition of Economics can be traced back to the days of Adam Smith, a Scottish Economist, generally known as “ father of economics”. Wrote a book entitled “An Inquiry into the Nature and Causes of Wealth of Nations”, in the year 1776. Economics as a distinct subject started with his book. Economics is a science of wealth which studies the process of production, distribution, consumption and accumulation of wealth. ✓According to Smith: the great object of the political economy of every country is to increase the riches and power of that country. ✓ In a market economy, the way in which production and distribution of wealth will take place is through the Smithian ‘invisible hand’ mechanism or the ‘price system’ ✓ In general, economics is regarded by Smith as “the science of wealth”. However, the Smithian wealth definition did not served last long and got criticisms by other group of economist(mainly by Alfred Marshal). Critiques ✓ The definition is too narrow: Does not considered the major problems faced by a society, is condemned as ‘the bread-and-butter science’. ✓ Emphasize on the material aspect of human life, i.e., generation of wealth; ignored the non-material aspect of human life. Above all, as a science of wealth, it taught selfishness and love for money. Criticized as a “dismal science and bastard science” ✓ Ignored Scarcity and Choice aspects. Scarcity is the fundamental economic problem of any society, and thus, choice making is unavoidable. 2) Welfare Definition: Alfred Marshal (1842-1924) ❖ Alfred Marshall in his book ‘Principles of Economics” published in 1890 placed emphasis on human activities or human welfare rather than on wealth. In UNDP perspective, human welfare is primarily a matter of education, health and income, as reflected in the HDI, a composite of three social welfare variables (a long and healthy life, acquisition of knowledge and a decent standard of living)). ❖ Marshall defines economics as “a study of peoples’ activities/actions to achieve human welfare.” OR “a study of men as they live and move and think in the ordinary business of life (economic activities carried out by peoples in order to exist).” ❖ He argued that economics, on one side, is a study of wealth and, on the other side, is a study of man. ❖ Economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of well-being. ❖According to Marshall, wealth is not an end in itself as was thought by classical authors; it is a means to an end—the end of human welfare. From his definition: i. Economics is a social science since it studies the actions of human beings. ii. Economics studies the ‘ordinary business of life’ since it takes into account the money- earning and money-spending activities of man. iii. Economics studies only the ‘material’ part of human welfare which is measurable in terms of the measuring rod of money. It neglects other activities of human welfare not quantifiable in terms of money. iv. Welfare of mankind, rather than acquisition of wealth, is the primary objet of importance. Critiques ❖ The definition focus on the material welfare, ignores the non material welfare. Thus, the definition will be too narrow. ❖ Robbins argued that Marshall could not establish a link between economic activities of human beings and human welfare. There are various economic activities that are detrimental to human welfare. The production of war materials, wine, etc., are economic activities but do not promote welfare of any society. ❖Measuring welfare in terms of money is not valid, as welfare is abstract and subjective concept. ❖“Marshall’s welfare definition gives economics a normative character. However, Robbins argues Economics must be free from making value judgments, Economics is a positive science not a normative science.” ❖Ignores the fundamental concepts/problems of scarcity and choice. 3) Scarcity definition: Lionel Robbins(1898-1984) ❑ Robbins defined Economics in terms of allocation of scarce resources to satisfy human wants in his book entitled “An Essay on the Nature and Significance of Economics Science” in 1932. ❖According to Robbins, neither wealth nor human welfare should be considered as the subject-matter of economics. ❖His definition runs in terms of scarcity: “Economics is the science which studies human behaviour as a relationship between ends (outcomes, goals, destinations) and scarce means (resources) which have alternative uses.” ❖Economics is fundamentally the study of scarcity and the problems to which scarcity gives rise. Thus, the central focus of economics is on opportunity cost and optimization. ❖ By considering the basic economic problem, which is scarcity, Robbins brought Economics to nearer science and his definition is the most accepted definition of Economics. However, the scarcity definition of Robbins is also not free of criticism. ✓ Argue Economics to be as positive Economics. ✓ Gave less emphasis to wealth and welfare ❖Other contemporary Economists also defined Economics in their own way. 4) Growth Definition: Paul A. Samuelson(1915-2009) ❖ Paul Samuelson, an American economist defined Economics as “ a science of how men and society choose, with or with out money, to employ scarce productive resources which could have alternative uses, to produce various commodities over time, and distribute them for consumption, now and in the near future, among various people and groups in society.” Samuelson regards economics as a social science which emphasized the problem of scarce resources and the idea of alternative uses of resources. He emphasized on the consumption and distribution of various commodities for the present and future economic growth thereby highlighting the study of macroeconomics. ✓ Samuelson lays emphasis on the use of modern technique of cost-benefit analysis to evaluate the development programe for the use of limited resources. ❑ Samuelson’s definition of economics has superiority over that of Robbins because of the inclusion of time element thereby making the scope of economics dynamics. ❖Thus, the definition varies as the nature and scope of the subject grow over time. ❖Despite all these, however, the formal and commonly accepted definition is as follow. ❖“Economics is a social science which studies about efficient allocation of scarce resources so as to attain the maximum fulfillment of unlimited human needs. It is a science of choice making, it studies how people choose to use scarce or limited productive resources (land, labour, equipment, technical knowledge and the like) to produce various commodities.” ❖From the above definition. ✓Economics studies about scarce resources; ✓It studies about allocation of resources; ✓Allocation should be efficient: resources allocated according to their highest value use. ✓Human needs and wants are unlimited. ✓The aim (objective) of economics is to study how to satisfy the unlimited human needs up to the maximum possible degree by allocating the resources efficiently. 1.2 The Rationales of Economics There are two fundamental facts 1) Human (society‘s) material wants are unlimited. wants multiply— luxuries become necessities. 2) Economic resources are limited (scarce). ❖ Scarcity of resources is the fundamental economic problem to any society. In return, scarcity gives rise to the problem of choice. ❖Therefore, the basic economic problem is about scarcity and choice since there are only limited amount of resources available to produce the unlimited amount of goods and services we desire. ❖Thus, economics is the study of how human beings make choices to use scarce resources as they seek to satisfy their unlimited wants. Therefore, choice is at the heart of all decision-making. ❖As an individual, family, and nation, we confront difficult choices about how to use limited resources to meet our needs and wants. ❖Economists study how these choices are made in various settings; evaluate the outcomes in terms of criteria such as efficiency, equity, and stability; and search for alternative forms of economic organization that might produce higher living standards or a more desirable distribution of material well-being. 1.3 Scope and Method of Analysis in Economics 1.3.1 Scope of Economics ❖The field and scope of economics is expanding rapidly and has come to include a vast range of topics and issues. ❖In the recent past, many new branches of the subject have developed, including development economics, industrial economics, transport economics, welfare economics, environmental economics, and so on. ❖However, the core of modern economics is formed by its two major branches: microeconomics and macroeconomics. That means economics can be analyzed at micro and macro level. A. Microeconomics: is concerned with the economic behavior of individual decision making units such as households, firms, markets and industries. In other words, it deals with how households and firms make decisions and how they interact in specific markets. B. Macroeconomics: is a branch of economics that deals with the effects and consequences of the aggregate behaviour of all decision making units in a certain economy. In other words, it is an aggregative economics that examines the interrelations among various aggregates, their determination and the causes of fluctuations in them. ❖It looks at the economy as a whole and discusses about the economy- wide phenomena. ❖The distinctions between Microeconomics and Macroeconomics can be summarized as below: Microeconomics Macroeconomics ✓ Studies individual economic units ✓ Studies an economy as a whole of an economy and its aggregates. ✓ Deals with individual (income, ✓ Deals with national income and prices, outputs, etc.) economic output and general price level variables. Microeconomics Macroeconomics ✓ Its central problem is price determination ✓ Its central problem is determination of level and allocation of resources. of income and employment. ✓ Its main tools are the DD and SS of ✓ Its main tools are aggregate DD and particular commodities and factors. aggregate SS of an economy as a whole. ✓ It helps to solve the central problem of ✓ Helps to solve the central problem of full what, how and for whom to produce in an employment of resources in the economy. economy so as to maximize profits ✓ Discusses how the equilibrium of a ✓ Concerned and determination of consumer, a producer or an industry is equilibrium levels of income and attained employment at aggregate level Examples: Individual income, individual Examples: national income, national savings, savings, individual prices, an individual general price level, national output, aggregate firm‘s output, individual consumption, etc. consumption, etc. 1.3.2 Method of Analysis: Positive and Normative Economics A) Positive economics ❖it is concerned with analysis of facts and attempts to describe the world as it is. It tries to answer the questions what was; what is; or what will be? It does not judge a system as good or bad, better or worse. Examples: ✓The food inflation for March 2020 inflation rate in Ethiopia is 26.90 percent ✓Poverty and unemployment are the biggest problems in Ethiopia. ✓The life expectancy at birth in Ethiopia is rising. These statements are all concerned with real facts and information. Any disagreement on positive statements can be checked by looking in to facts. B) Normative Economics: ✓It deals with the questions like, what ought to be? Or what the economy should be? It evaluates the desirability of alternative outcomes based on one‘s value judgments about what is good or what is bad. In this situation, what is good for one may not be the case for the other. Normative analysis is a matter of opinion (subjective in nature) which cannot be proved or rejected with reference to facts. Examples: ✓Government should subsidize small scale enterprises, unemployment schemes/compensations. ✓Government should set a minimum wage rate ✓The poor should pay no taxes. ✓There is a need for intervention of government in the economy. ✓Females ought to be given a priority of job opportunity. Any disagreement on a normative statement can be solved by voting. 1.3.3 Inductive and deductive reasoning in economics ❖The fundamental objective of economics, like any science, is the establishment of valid generalizations about certain aspects of human behaviour. 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: inductive and deductive. A) Inductive reasoning: is a logical method of reaching at a correct general statement or theory based on several independent and specific correct statements. ✓In short, it is the process of deriving a principle or theory by moving from facts to theories and from particular to general economic analysis. ❖Inductive method involves the following steps. 1. Selecting problem for analysis 2. Collection, classification, and analysis of data 3. Establishing cause and effect relationship between economic phenomena B) Deductive Reasoning: is a logical way of arriving at a particular or specific correct statement starting from a correct general statement. In short, it deals with conclusions about economic phenomenon from certain fundamental assumptions or truths or axioms through a process of logical arguments. ❖The theory may agree or disagree with the real world and we should check the validity of the theory to facts by moving from general to particular. ❖ Major steps in the deductive approach include: 1) Problem identification 2) Specification of the assumptions 3) Formulating hypotheses 4) Testing the validity of the hypotheses 1.4 Scarcity, choice, opportunity cost and production possibilities frontier(PPF/PPC) A) 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 can be: 1) Free resources: if the amount available to a society is greater than the amount people desire at zero price. Example: sunshine 2) Scarce (Economic) resources: if the amount available to a society is less than what people want to have at zero price. Examples: ✓All types of human resources: manual, intellectual, skilled and specialized labor; ✓Most natural resources like land (especially, fertile land), minerals, clean water, forests and wild - animals; ✓All types of capital resources (like machines, intermediate goods, infrastructure ); and ✓All types of entrepreneurial resources ✓ Economic resources are usually classified into four categories. 1) Labour: 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. 2) 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. 4) 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. Note: Scarcity does not mean shortage. Scarcity occurs if the amount available is less than the amount people wish to have at zero price while shortage of goods and services is when people are unable to get the amount they want at the prevailing or on going price. ✓ Shortage is a specific and short term problem but scarcity is a universal and everlasting problem. 2) Choice: If resources are scarce, then output will be limited. If output is limited, then we cannot 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: 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. ✓ When opportunity cost of an activity increases people substitute other activities in its place Scarcity → choice → opportunity cost 4) The Production Possibilities Frontier or Curve (PPF/ PPC) ✓ PPF/PPC is a curve that shows the various possible combinations of goods and services that the society can produce given its resources and technology. ✓ Suppose a hypothetical economy produces food and computer given its limited resources and available technology (table 1.1). Types of Product Unit (Measurement) Production Alternatives A B C D E Food Metric tones 500 420 320 180 0 Computer Number 0 500 1000 1500 2000 ✓ The PPF describes three important concepts: i) The concepts of scarcity: - the society cannot have unlimited amount of outputs even if it employs all of its resources and utilizes them in the best possible way. ii) The concept of choice: - any movement along the curve indicates the change in choice. ✓ The concept of opportunity cost: - when the economy produces on the PPF, production of more of one good requires sacrificing some of another product which is reflected by the downward sloping PPF. ✓ 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 𝐚𝐦𝐨𝐧𝐮𝐭 𝐨𝐟 𝐧𝐞𝐱𝐭 𝐛𝐞𝐬𝐭 𝐚𝐥𝐭𝐞𝐫𝐧𝐚𝐭𝐢𝐯𝐞 𝐬𝐚𝐜𝐫𝐢𝐟𝐢𝐞𝐝 Opportunity Cost = 𝐓𝐡𝐞 𝐚𝐦𝐨𝐮𝐧𝐭 𝐨𝐟 𝐭𝐡𝐞 𝐠𝐨𝐨𝐝 𝐠𝐚𝐢𝐧𝐞𝐝 Example: Referring to table 1.1 or Figure 1.1 above, if the economy is initially 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: ∆𝒀 320−420 Opportunity Cost(OP) = = = 0.2, Implying, the economy ∆𝑿 1000−500 gives up 0.2 metric tons of food per computer. 5) Economic Growth and PPF/PPC ❖ Economic growth or an increase in the total output level occurs when one or both of the following conditions occur. ✓ Increase in the quantity or/and quality of economic resources ✓ Advances in technology ✓ An economy can grow because of an increase in productivity in one sector of the economy. For example, an improvement in technology applied to either food or computer would be illustrated by a shift of the PPF along the Y- axis or X-axis (Asymmetric Growth). 1.5 Basic Economic Questions ✓ Economic problems faced by an economic system due to scarcity of resources are known as basic economic problems. ✓ These problems are common to all economic systems. ✓ They are also known as central problems of an economy. ❖ Therefore, any human society should answer the following three basic questions. What to Produce? How to Produce? For Whom to Produce? A) What to Produce? ❖ This problem is also known as the problem of allocation of resources. It implies that every economy must decide which goods and in what quantities are to be produced. ❖ The economy must make choices such as consumption goods versus capital goods, civil goods versus military goods, and necessity goods versus luxury goods. ❖ As economic resources are limited we must reduce the production of one type of good if we want more of another type. ❖ Generally, the final choice of any economy is a combination of the various types of goods but the exact nature of the combination depends upon the specific circumstances and objectives of the economy. B) How to Produce? ❖ This problem is also known as the problem of choice of technique: Choosing between alternative methods or techniques of production. ❖ For example, cotton cloth can be produced with hand looms, power looms, or automatic looms. ❖ Similarly, wheat can be grown with primitive tools and manual labour, or with modern machinery and little labour. ❖ Broadly speaking, the various techniques of production can be classified into two groups: labor-intensive techniques and capital- intensive techniques. ❖ The choice between different techniques depends on the available supplies of different factors of production and their relative prices. C) For Whom to Produce ❖This problem is also known as the problem of distribution of national product. It relates to how a material product is to be distributed among the members of a society. ❖ The economy must decide, for example, whether to produce for the benefit of the few rich people or for the large number of poor people. ❖ An economy that wants to benefit the maximum number of persons would first try to produce the necessities of the whole population and then to proceed to the production of luxury goods. ✓ All these and other fundamental economic problems center around human needs and wants. Many human efforts in society are directed towards the production of goods and services to satisfy human needs and wants. ✓ These human efforts result in economic activities that occur within the framework of an economic system. 1.6 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. These are: Capitalism Economy Command Economy and Mixed Economy READING ASSIGNMENT! 1.7 Decision making units and the circular flow model ✓ There are three decision making units in a closed economy. These are households, firms and the government. i) Household: A household can be one person or more who live under one roof and make joint financial decisions. ✓ Households make two decisions. 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 iii) Government: A government is an organization that has legal and political power to control or influence households, firms and markets. ✓ provides some types of goods and services known as public goods and services for the society ✓ Purchase factors of production, goods and service from HH and Firms, respectively. ✓ Collects Tax from HH and Firms ❖ The three economic agents interact in two markets: A) Product market: it is a market where goods and services are transacted/ exchanged. That is, a market where households and governments buy goods and services from business firms. B) Factor market (input market): it is a market where economic units transact/exchange factors of production (inputs). In this market, owners of resources (households) sell their resources to business firms and governments. ❖The circular-flow diagram is a visual model of the economy that shows how money (Birr), economic resources and goods and services flows through markets among the decision making units. ❖ In the circular flow model, Firms, by selling goods and services to households, receive money in the form of revenue while HHs by supplying their resources to firms receive income/Revenue. ❖ The gov’t to provide public services purchase goods and services from business firms through the product market with a given amount of expenditure(G). While it also needs resources required for the provision of the services. This resource is purchased from the factor market by making payments to the resource owners (HHs). ❖ The main source of revenue to the government is the tax collected from households and firms. Fig 1.3 Two Sector Model Fig 1.4 Three Sector Model  Chapter Two: Theory of Demand and Supply 2.1 Theory of Demand ❖ The theory of demand is related to the economic activities of consumers-consumption. ❖ The purpose of the theory of demand is to determine the various factors that affect demand. What is demand in Economics? ❖ In economics the word “Demand” has a specific meaning, which is different from what we use it in our day to day activities. ❖ Demand refers to the amount of commodity which an individual buyer is willing and able to buy at a given price and during a given period of time. ❖Thus, demand is different from a mere desire. ❖Human wants are unlimited, and therefore, desires are many. But only a desire that is backed up by the capacity to pay the price for the commodity and the willingness to buy it, is termed as a demand. ❖We may say demand refers to an effective desire/wish. Demand = ability to pay + willingness to pay + availability of the good ❖ Law of demand: This is the principle of demand, which states that, price of a commodity and its quantity demanded are inversely related i.e., as price of a commodity increases (decreases) quantity demanded for that commodity decreases (increases), ceteris paribus. 2.1.1 Demand schedule (table), demand curve and demand function These are three ways of representing the relationship that exists between price and the amount of a commodity purchased. A) A demand schedule: is the relationship between price and quantity demanded in a table form. Table 2.1: Individual household demand for orange per week A B C D E Price (Per KG) 5 4 3 2 1 QD(Per Week) 5 7 9 11 13 B) Demand curve: is a graphical representation of the relationship between different quantities of a commodity demanded by an individual at different prices per time period. C) Demand function: is a mathematical relationship between price and quantity demanded, all other things remaining the same. ❖ A typical demand function is given by: 𝑸𝑫 = 𝒇(𝒑) ❖ Example: Let the demand function be 𝑸𝑫 = 𝒂 + 𝒃𝑷 ∆𝑸 Where 𝒃 = , which is the slope of the demand curve. ∆𝑷 For instance, if we move from point A to point B on figure 2.1 or Table 2.1, then, ∆𝑸 𝟕−𝟓 𝟐 𝒃= = = =-2 ∆𝑷 𝟒−𝟓 −𝟏 Thus, 𝑸𝑫 = 𝒂 − 𝟐𝑷 To find a, lets substitute for 𝑄𝐷 and P at pint A or B. 7= 𝒂 − 𝟐(𝟒); a = 𝟕 + 𝟖 = 𝟏𝟓 𝑸𝑫 = 𝟏𝟓 − 𝟐𝑷 ∶ The individual demand function 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. Example: Table 2.2: Individual and market demand for a commodity Prices Individual Demands Market Demand Consumer 1 Consumer 2 Consumer 3 8 0 0 2 0 5 3 5 4 9 3 5 7 6 14 0 7 9 8 20 ❖The following graph depicts market demand curve at price equal to three. Market Demand Function: Example: Suppose the individual demand function of a product is given by: 𝑷 = 𝟏𝟎 − 𝑸 /𝟐 and there are about 100 identical buyers in the market. Then the market demand function is given by: 𝑄 𝑃 = 10 − 2 𝑄 = 10 − 𝑃 2 𝑄 = 20 − 2𝑃 Market Demand Function = Number of buyers * Individual Demand function 𝑄𝑀 = 20 – 2𝑃 100 𝑄𝑀 = 2000 − 200𝑃 Thus, 𝑸𝒎 = 𝟐𝟎𝟎𝟎 − 𝟐𝟎𝟎𝒑: Market Demand Function 2.1.2 Determinants of demand ❖ The demand for a product is influenced by many factors. Some of these factors include: A) Price of the product itself: The price of a commodity is the most important factor which affects the demand for a commodity. ❖ Other things remaining the same, if price increases, quantity demanded decreases, and if price decreases, quantity demanded increases(Law of Demand). B) Income of the Consumer: Income of the consumer is also an important factor affecting the demand for a commodity. Generally, when income increases, demand also increases, and when income decreases, demand also decreases. This is true in the case of normal goods. However, in the case of inferior goods, with an increase in income their demand decreases and vice- versa. On the basis of nature, goods can be classified into two types: i) Normal Goods (Superior Goods): refer to those goods whose income effect is positive – i.e., all other factors remaining the same, as income increases, demand also increases and vice-versa. For example: Cheese, Butter, Chocolates, Biscuits, etc. ii) Inferior Goods: Inferior goods refer to those goods whose income effect is negative – i.e., all other factors remaining the same, as income increases, demand decreases and vice-versa. In general, inferior goods are poor quality goods with relatively lower price and buyers of such goods are expected to shift to better quality goods as their income increases. For example: Some Chinese shoes, coarse cloth, leftover food etc. C) Prices of Related Goods: Changes in the prices of related goods also affect the demand for a commodity. ❖ Related goods may be of two types: i) Substitute Goods: are those goods which can be used in place of each other to satisfy a given want. That is why they are also called competitive goods. ❖ For example, Coffee and tea, Pepsi and Coca-Cola, pens and pencils, butter and oil, etc. ii) Complementary Goods: are those goods which are used together/jointly to satisfy a given want. If two goods are complementary goods, a decline in the price of one would directly change the demand for the other commodity and vice-versa. ❖ For example, cars and petrol/fuel, pen and ink, tea and sugar are complements of each other. D) Tastes and Preferences: If a consumer is accustomed to certain commodities, he will demand that commodity and this leads to increase in the demand for that commodity. ❖ When the taste of a consumer changes in favor of a good, her/his demand will increase and the opposite is true. E) Consumer expectation of income and price ❖ Higher price expectation will increase demand while a lower future price expectation will decrease the demand for the good. F) Number of buyer in the market(Population) and family size ❖ Since market demand is the horizontal sum of individual demand, an increase in the number of buyers will increase demand while a decrease in the number of buyers will decrease demand. G) Climate/Weather: The demand for a commodity is also affected by climate. ❖ For example, demand for woolen clothes increases in cold seasons. On the other hand demand for coolers, cotton clothes etc., increases in hot seasons. Generally, demand mainly depends upon three factors, namely. Price of the commodity; Income of the consumer, and Price of related goods. ❖ On the basis of the above three factors, demand can be classified into three types: i) Price Demand, ii) Income Demand, and iii) Cross Demand. Change in Demand ❖ a change in any determinant of demand—except for the good‘s price causes the demand curve to shift. We call this a change in demand. ❖ When we state the law of demand, we kept all the factors to remain constant except the price of the good under consideration. ❖ A change in any of the above listed factors except the price of the good will change the demand, while a change in the price, other factors remain constant will bring change in quantity demanded. ❖ A change in demand will shift the demand curve from its original location. ❖ For this reason those factors listed above other than price are called demand shifters. ❖ A change in own price is only a movement along the same demand curve. ❖ Thus, a change in demand is observed by a shift in the demand curve, while a change in quantity demanded is expressed by a movement in the demand curve. 2.1.3 Elasticity of demand ❖ In economics, the concept of elasticity is very crucial and is used to analyze the quantitative relationship between price and quantity purchased or sold. ❖ Elasticity is a measure of responsiveness of a dependent variable to changes in an independent variable. ❖ Elasticity of demand refers to the degree of responsiveness of quantity demanded of a good to a change in its price, or change in income, or change in prices of related goods. ❖ Commonly, there are three kinds of demand elasticity: 1) price elasticity, 2) income elasticity, and 3) cross elasticity. i) Price Elasticity of Demand ❖ Price elasticity of demand: refers to the degree of responsiveness of demand to change in price. ❖ It is a measure of how much the quantity demanded of a good responds to a change in the price of that good, computed as the percentage change in quantity demanded divided by the percentage change in price. ❖ It indicates how consumers react to changes in price. ❖ The greater the reaction the greater will be the elasticity, and the lesser the reaction, the smaller will be the elasticity. ❖ Demand for commodities like clothes, fruit etc. changes when there is even a small change in their price, whereas demand for commodities which are basic necessities of life, like salt, food grains etc., may not change even if price changes, or it may change, but not in proportion to the change in price. ❖ Price elasticity demand can be measured in two ways. These are point and arc elasticity. A) Point Price Elasticity of Demand ❖ This is calculated to find elasticity at a given point, and given as: 𝑝 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑛𝑎𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 %∆𝑄𝐷 𝑒𝑑 = = 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 %∆𝑃 𝑄2 −𝑄1 𝒑 ∗100% 𝑄2 −𝑄1 𝑃1 ∆𝑸 𝑷𝟏 𝑄1 𝒆𝒅 = 𝑃2 −𝑃1 = * = * ∗100% 𝑃2 −𝑃1 𝑄1 ∆𝑷 𝑸𝟏 𝑃1 ❖ In this method, we take a straight-line demand curve joining the two axes, and measure the elasticity between two points Q2 and Q1 which are assumed to be intimately close to each other. ❖ Example: Suppose the price of the commodity falls from Birr 5 to Birr 4 and quantity demanded increases from 100 units to 150 units. Given this, Compute point price elasticity of demand.  𝑄2 −𝑄1 𝑃1 150−100 5 250 ❖ Solution: * = * = = -2.5 𝑃2 −𝑃1 𝑄1 4−5 100 100 ❖ This implies that, at price = Birr 5, if price decreases by 1%, quantity demand increases by 2.5%. NOTE: It should be remembered that the point elasticity of demand on a straight line is different at every point. B) Arc price elasticity of demand ❖ The main drawback of the point elasticity method is that it is applicable only when we have information about even the slight changes in the price and the quantity demanded of the commodity. ❖ But in practice, we do not acquire such information about minute changes. We may possess demand schedules in which there are big gaps in price as well as the quantity demanded. ❖ In such cases, there is an alternative method known as arc method of elasticity measurement. ❖ When elasticity of demand is measured over a finite range or ‘arc’ of a demand curve, it is called arc elasticity of demand. ❖ In arc price elasticity of demand, the midpoints of the old and the new values of both price and quantity demanded are used. ❖ It measures a portion or a segment of the demand curve between the two points. ❖ The formula for measuring arc elasticity is given below. 𝑪𝒉𝒏𝒂𝒈𝒆 𝒊𝒏 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝒅𝒆𝒎𝒂𝒏𝒅𝒆𝒅 𝑪𝒉𝒏𝒂𝒈𝒆 𝒊𝒏 𝒑𝒓𝒊𝒄𝒆 ↋ = 𝒂 𝒅 / 𝑺𝒖𝒎 𝒐𝒇 𝒕𝒉𝒆 𝒐𝒓𝒊𝒈𝒊𝒏𝒂𝒍 𝒂𝒏𝒅 𝒏𝒆𝒘 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝒅𝒆𝒎𝒂𝒏𝒅𝒆𝒅 𝑺𝒖𝒎 𝒐𝒇 𝒕𝒉𝒆 𝒐𝒓𝒊𝒈𝒊𝒏𝒂𝒍 𝒂𝒏𝒅 𝒏𝒆𝒘 𝒑𝒓𝒊𝒄𝒆𝒔 𝑄2 −𝑄1 𝑃2 −𝑃1 ∆𝑸 𝑷𝟐 +𝑷𝟏 ↋𝑎𝑑 = / = * 𝑄2 +𝑄1 𝑃2 +𝑃1 ∆𝑷 𝑸𝟐 +𝑸𝟏 Example: Assuming the previous hypothetical example, compute the arc elasticity of price demand. Solution: In terms of the above formula, 𝑎 ∆𝑸 𝑷𝟐 +𝑷𝟏 150−100 4+5 45 −9 ↋𝑑 = * = * = = = 1.8 ∆𝑷 𝑸𝟐 +𝑸𝟏 4−5 150+100 −25 5 ❖The arc elasticity formula is used if the change in price is relatively large. ❖It is a more accurate measure of elasticity than point elasticity method. ❖ From Price elasticity of Demand, we can have the following points ✓ Elasticity of demand is unit free because it is a ratio of percentage change. ✓ Elasticity of demand is usually a negative number because of the law of demand. If the price elasticity of demand is positive the product is inferior/giffen goods. ✓ If |↋| > 1, demand is said to be elastic and the product is luxury product. ✓ If , 0 < |↋| < 1, demand is inelastic and the product is necessity. ✓ If |↋| = 1, demand is unitary elastic. ✓ If |↋| = 0, demand is said to be perfectly inelastic. ✓ If |↋| = ∞, demand is said to be perfectly elastic. Determinants of Price Elasticity of Demand i) The availability of substitutes: the more substitutes available for a product, the more elastic will be the price elasticity of demand. ii) Time: In the long- run, price elasticity of demand tends to be elastic. Because: More substitute goods could be produced. People tend to adjust their consumption pattern. iii) The proportion of income consumers spend for a product:-the smaller the proportion of income spent for a good, the less price elastic will be. iv) The importance of the commodity in the consumers’ budget : ✓ Luxury goods: tend to be more elastic. Example: gold. ✓ Necessity goods: tend to be less elastic. Example: Salt. V) Number of use of the commodity: The higher the number of use of the commodity the higher will be the elasticity. Example: Electricity. vi) Habits of the consumers: Example: Cigarette Smokers ii. Income Elasticity of Demand ❖ It is a measure of responsiveness of quantity demanded to change in income. 𝑄2 −𝑄1 ∗100% 𝑄2 −𝑄1 𝑀1 ∆𝑸 𝑴𝟏 𝑄1 ↋𝑰𝒅 = 𝑀2 −𝑀1 = * = * ∗100% 𝑀2 −𝑀1 𝑄1 ∆𝑴 𝑸𝟏 𝑀1 ❖ Accordingly, ✓ If ↋𝐼𝑑 > 1, the good is luxury good. ✓ If 1 < ↋𝐼𝑑 < 1, ( and positive), the good is necessity good ✓ If ↋𝐼𝑑 < 0, (negative), the good is inferior good. Example: Suppose a consumer has money income of Birr 1000 and he purchases 4 kg of wheat. If his money income goes up to Birr 1200, he is now prepared to buy 5 kg of wheat. Compute the point income elasticity of demand. Solution: 𝑰 𝑄2 −𝑄1 𝑀1 5−4 1000 1000 ↋𝒅 = * = * = = 1.25, implies for a 1 percent increase 𝑀2 −𝑀1 𝑄1 1200−1000 4 400 in income there is a 1.25 percent increase in the demand of the commodity and the commodity is normal(luxury). iii) Cross Elasticity of Demand ❖ Measures how much the demand for a product is affected by a change in the price of another good(related good). ❖ The formula used to compute cross elasticity is: 𝑄𝑥2 −𝑄𝑥1 𝒙𝒚 ∗100% 𝑄𝑥2 −𝑄𝑥1 𝑃𝑦1 ∆𝑸𝑿 𝑷𝒚𝟏 𝑄𝑥1 ↋𝒅 = 𝑃𝑦2 −𝑃𝑦1 = * = * ∗100% 𝑃𝑦2 −𝑃𝑦1 𝑄𝑋1 ∆𝑷𝒚 𝑸𝑿𝟏 𝑃𝑦1  𝒙𝒚 According to the values of ↋𝒅 , 𝒙𝒚 i) If ↋𝒅 is positive, the goods are substitute goods. 𝒙𝒚 ii) If ↋𝒅 is negative, the goods are complementary goods. 𝒙𝒚 iii) iii) If ↋𝒅 is zero, the goods are unrelated goods. Example: Suppose that when the price of a good Y increases from 10 birr to 15 birr, then the quantity demanded of a good X has decreased from 1500 units to 1000 units. Compute the cross price elasticity of demand. Solution: 𝒙𝒚 𝑄𝑥2 −𝑄𝑥1 𝑃𝑦1 1000−1500 10 −𝟓𝟎𝟎 𝟏 ↋𝒅 = * = * = * = -0.667, implying for a 𝑃𝑦2 −𝑃𝑦1 𝑄𝑋1 15−10 1500 𝟓 𝟏𝟓𝟎 percent increase in the price of a good Y, there is 0.667 percent decrease in the quantity demanded of price good X. The two good are complementary. 2.2 THEORY OF SUPPLY ❖ Supply indicates various quantities of a product that sellers (producers) are willing and able to provide at different prices in a given period of time, other things remaining unchanged. ❖ The law of supply: states that, ceteris paribus, as price of a product increase, quantity supplied of the product increases, and as price decreases, quantity supplied decreases. 2.2.1 Supply schedule, supply curve and supply function ❖ A supply schedule is a tabular statement that states the different quantities of a commodity offered for sale at different prices. Table 2.3: an individual seller’s supply schedule for butter Price ( birr per KG) 30 25 20 15 10 QS(KG/Week) 100 90 80 70 60 ❖ A supply curve: conveys the same information as a supply schedule. But it shows the information graphically rather than in a tabular form. ❖ Supply Function: Mathematical representation. The supply function of a commodity can be briefly expressed in the following functional relationship: S = f(P), Where S is quantity supplied and P is price of the commodity. Market supply: It is derived by horizontally adding the quantity supplied of the product by all sellers at each price. 2.2.2 Determinants of supply ❖ Apart from the change in price which causes a change in quantity demanded, the supply of a particular product is determined by: i) Input Price: ❖ 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. Ii) State of Technology ❖ Technological advancement enables a firm to produce and supply more in the market. This shifts the supply curve outward. iii) Price of Related Goods: An increase in the price of other, related goods induces the firms to produce more of those other goods, leading to a reduction in the supply of the goods whose price has remained unchanged. iV) Objectives of the Firm: Beside/apart from to the primary profit maximization objective, firms could have such as objectives of maximum sales, maximum employment, more production, etc. In this case, the supply will be increasing. V) Weather condition ❖ A change in weather condition will have an impact on the supply of a number of products, especially agricultural products. Vi) Sellers‘ expectation of price of the product: vii) Number of sellers in the market vii) Taxes & Subsidies (Fiscal Policy) viii) Other factors: Market access (infrastructural development), political stability. etc. 2.2.3 Elasticity of supply ❖ It is the degree of responsiveness of the supply to change in price. It may be defined as the percentage change in quantity supplied divided by the percentage change in price. ❖ As the case with price elasticity of demand, we can measure the price elasticity of supply using point and arc elasticity methods. ❖ However, a simple and most commonly used method is point method. 𝑝 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑛𝑎𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑 %∆𝑸𝑺 ↋𝑠 = = 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 %∆𝑷 𝑄2 −𝑄1 𝒑 ∗100% 𝑄2 −𝑄1 𝑃1 ∆𝑸 𝑷𝟏 𝑄1 ↋𝑺 = 𝑃2 −𝑃1 = * = * ∗100% 𝑃2 −𝑃1 𝑄1 ∆𝑷 𝑸𝟏 𝑃1 𝒑 ❖ Given the value of 𝒆𝑺 , like elasticity of demand, price elasticity of supply can be elastic, inelastic, unitary elastic, perfectly elastic or perfectly inelastic. 2.3 Market equilibrium Market equilibrium occurs when market demand = market supply. Example: Given market demand: 𝑸𝒅 = 𝟏𝟎𝟎 − 𝟐𝑷, and market supply: 𝑷 = ( 𝑸𝒔 /𝟐) + 𝟏𝟎 a) Calculate the market equilibrium price and quantity b) b) Determine, whether there is surplus or shortage at P= 25 and P= 35 Solution: a) At equilibrium, Qdv= Qs 100 – 2P = 2P – 20 4P =120 𝑷∗ = 𝟑𝟎 and 𝑸∗ = 𝟒𝟎 b) Qd(at P = 25) = 100-2(25) = 50 and Qs(at P = 25 ) = 2(25) -20 =30 Therefore, there is a shortage of: 50 - 30 = 20 units Qd( at P=35) = 100-2(35) = 30 and Qs (at p = 35) = 2(35)-20 = 50 Therefore, there is a surplus of: 30 – 50 = -20 units. Effects of shift in demand and supply on equilibrium What will happen to the equilibrium price and quantity ? i) When demand changes and supply remains constant ❖ Thus, supply being given, a decrease in demand reduces both the equilibrium P and Q and vice versa. ii. When supply changes and demand remains constant ❖ Thus, give the demand, an increase in supply reduces the equilibrium P and increases the equilibrium Q, and vice versa. III) Effects of combined changes in demand and supply ❖ When both demand and supply increase, the quantity of the product will increase definitely. But it is not certain whether the price will rise or fall. ❖ Three Scenarios: 1) If an increase in demand is more than an increase in supply, then the price goes up. 2) if an increase in supply is more than an increase in demand, the price falls. 3) If the increase in demand and supply is same, then the price remains the same. ❖ Besides, when demand and supply decline, the quantity decreases. ❖ But the will depend upon the relative fall in demand and supply. change in price ❖ In this case too, there will be three Scenarios: 1) When the fall in demand is more than the fall in supply, the price will decrease. 2) When the fall in supply is more than the fall in demand, the price will rise. 3) If both demand and supply decline in the same ratio, there is no change in the equilibrium price, but the quantity decreases. Therefore, when both supply and demand change, the effect on the equilibrium price depends on the proportion of change(relative change) in demand and change in supply.  Quiz(10%) I) The market demand for a product is given as: 𝒑 = 𝟐𝟎 − 𝟏/𝟒𝑸𝒅 and the 𝟏 market supply for the product is given as: 𝒑 = 𝑸𝑺 + 𝟐. 𝟓 A) Compute the market clearing price and market clearing quantity. (4%) B) What happens to the equilibrium levels of price and quantity in (A), i) if both market demand and market supply decline in the same ratio or proportion. (2%) ii) If the decline in market supply is more than the decline in market demand. (2%) iii) If the decline in market demand is more than the decline in market supply. (2%) NB: Properly demonstrate your Answers for questions in (B) using Graphs. (Otherwise, will not be evaluated) Chapter Three: Theory of Consumer Behaviour ❖ Consumer theory is based on what people like, so it begins with something that we can‘t directly measure, but must infer. ❖ That is, consumer theory is based on the premise that we can infer what people like from the choices they make. ❖ Consumer behaviour can be best understood in three steps. 1) First, by examining consumer‘s preference, we need a practical way to describe how people prefer one good to another. 2) Second, we must take into account that consumers face budget constraints – they have limited incomes that restrict the quantities of goods they can buy. 3) Third, we will put consumer preference and budget constraint together to determine consumer choice. 3.1 Consumer preferences ❖ A consumer makes choices by comparing bundle of goods. ❖ Given any two consumption bundles, the consumer either decides that one of the consumption bundles is strictly better than the other, or decides that she is indifferent between the two bundles. ❖ In order to tell whether one bundle is preferred to another, we see how the consumer behaves in choice situations involving two bundles. ❖ If she always chooses X when Y is available, then it is natural to say that this consumer prefers X to Y. We use the symbol ≻ to mean that one bundle is strictly preferred to another, so that X ≻Y should be interpreted as saying that the consumer strictly prefers X to Y, in the sense that she definitely wants the X-bundle rather than the Y-bundle. ❖ If the consumer is indifferent between two bundles of goods, we use the symbol ∼ and write X~Y.  Indifference means that the consumer would be just as satisfied, according to her own preferences, consuming the bundle X as she would be consuming bundle Y. If the consumer prefers or is indifferent between the two bundles we say that she weakly prefers X to Y and write X ⪰ Y. The relations of strict preference, weak preference, and indifference are not independent concepts; the relations are themselves related. For example: ✓ if X ⪰ Y and Y ⪰ X, we can conclude that X ~Y. That is, if the consumer thinks that X is at least as good as Y and that Y is at least as good as X, then she must be indifferent between the two bundles of goods. ✓Similarly, if X ⪰ Y but we know that it is not the case that X~ Y, we can conclude that X≻Y. This just says that if the consumer thinks that X is at least as good as Y, and she is not indifferent between the two bundles, then she thinks that X is strictly better than Y.  3.2 The concept of utility ❖ Economists use the term utility to describe the satisfaction or pleasure derived from the consumption of a good or service. ❖ In other words, utility is the power of the product to satisfy human wants. ❖ Given any two consumption bundles X and Y, the consumer definitely wants the X-bundle than the Y-bundle if and only if the utility of X is better than the utility of Y. Do you think that utility and usefulness are synonymous? ✓ In defining utility, it is important to bear in mind the following points. 1) Utility and Usefulness are not synonymous. For example: Paintings by Picasso may be useless functionally but offer great utility to art lovers. ❖ Hence, usefulness is product centric whereas utility is consumer centric.  2) Utility is subjective. Vary from person to person. That means, the utility that two individuals derive from consuming the same level of a product may not be the same. For example: non-smokers do not derive any utility from cigarettes. 3) Utility can be different at different places and time. For example: the utility that we get from drinking coffee early in the morning may be different from the utility we get during lunch time. 3.3 Approaches of measuring utility ✓Two major approaches to measure utility: cardinal and ordinal approaches. ❖The cardinalist school postulated that utility can be measured objectively. ❖According to the ordinalist school, utility is not measurable in cardinal numbers rather the consumer can rank or order the utility he derives from different goods and services.  3.3.1 The cardinal utility theory ❖ According to the cardinal utility theory, utility is measurable by arbitrary unit of measurement called utils in the form of 1, 2, 3 etc. For example: we may say that consumption of an orange gives Bilen 10 utils and a banana gives her 8 utils, and so on. ❖ From this, we can assert that Bilen gets more satisfaction from orange than from banana. 3.3.1.1 Assumptions of cardinal utility theory ❖The cardinal approach is based on the following major assumptions. 1) Rationality of consumers. The main objective of the consumer is to maximize his/her satisfaction given his/her limited budget or income. Thus, in order to maximize his/her satisfaction, the consumer has to be rational. 2) Utility is cardinally measurable. 3) Constant marginal utility of money. A given unit of money deserves the same value at any time or place it is to be spent. 4) Diminishing marginal utility (DMU). The utility derived from each successive units of a commodity diminishes. In other words, the marginal utility of a commodity diminishes as the consumer acquires larger quantities of it. 5) The total utility of a basket of goods depends on the quantities of the individual commodities. ❖ If there are n commodities in the bundle with quantities 𝑿𝟏 , 𝑿𝟐 , 𝑿𝟑 ,...,𝑿𝒏 , the total utility is given by: TU = f (𝑿𝟏 , 𝑿𝟐 , 𝑿𝟑 ,...,𝑿𝒏 ) 3.3.1.2 Total and marginal utility A) Total Utility (TU) ❖ is the total satisfaction a consumer gets from consuming some specific quantities of a commodity at a particular time. ❖ As the consumer consumes more of a good per time period, his/her total utility increases. ❖ However, there is a saturation point for that commodity beyond which the consumer will not be capable of enjoying any greater satisfaction from it. B) Marginal Utility (MU) ❖ is the extra satisfaction a consumer realizes from an additional unit of the product. ❖ In other words, marginal utility is the change in total utility that results from the consumption of one more unit of a product. ❖ Graphically, it is the slope of total utility. ❖ Mathematically, marginal utility is: ∆𝑻𝑼 𝑴𝑼 = ∆𝑸 ❖ where, ∆𝑻𝑼 is the change in total utility, and ∆𝑸 is the change in the amount of product consumed. Example: Lets consider a hypothetical example given in Table 3.1 below. Table 3.1: Total and marginal utility Quantity Total Utility(TU) Marginal Utility(MU) 0 0 - 1 10 10 2 18 8 3 24 6 4 28 4 5 30 2 6 30 0 7 28 -2 ❖ Graphically, the above data can be depicted as follows. ❖ The total utility first increases, reaches the maximum (when the consumer consumes 6 units) and then declines as the quantity consumed increases. ❖ On the other hand, the marginal utility continuously declines (even becomes zero or negative) as quantity consumed increases. ❖ From the graph of TU and MU: ✓ When TU is increasing, MU is positive. ✓ When TU is maximized, MU is zero. ✓ When TU is decreasing, MU is negative. 3.3.1.3 Law of diminishing marginal utility (LDMU) Is the utility you get from consumption of the first orange the same as the second or the third orange? ❖ The law of diminishing marginal utility states that as the quantity consumed of a commodity increases per unit of time, the utility derived from each successive unit decreases, consumption of all other commodities remaining constant. ❖ In other words, the extra satisfaction that a consumer derives declines as he/she consumes more and more of the product in a given period of time. ❖ The LDMU is based on the following assumptions. ✓ The consumer is rational ✓ The consumer consumes identical or homogenous product. The commodity to be consumed should have similar quality, color, design, etc. ✓ There is no time gap/constant in consumption of the good ✓ The consumer taste/preferences remain unchanged 3.3.1.4 Equilibrium of a consumer ❖ The objective of a rational consumer is to maximize total utility. ❖ As long as the additional unit consumed brings a positive marginal utility, the consumer wants to consumer more of the product because total utility increases. ❖ However, the consumer has income/budget constraint. A) The case of one commodity ❖ The equilibrium condition of a consumer that consumes a single good X occurs when the marginal utility of X is equal to its market price. 𝑴𝑼𝒙 = 𝑷𝒙 Proof Given the utility function: 𝑼 = 𝒇(𝑿) ❖ If the consumer buys commodity X, then his expenditure will be 𝑷𝒙 𝑸𝒙. ❖ The consumer maximizes the difference between his utility and expenditure. 𝒎𝒂𝒙(𝑼(𝑸𝒙 ) − 𝑷𝒙 𝑸𝒙 ) ❖ The necessary condition for maximization is equating the derivative of a function to zero. 𝒅𝑼(𝑸𝒙 ) 𝒅𝑷𝒙 𝑸𝒙 ❖ Thus, − 𝒅𝑸𝒙 𝒅𝑸𝒙 𝒅𝑼(𝑸𝒙 ) ❖ Because , = 𝑴𝑼𝒙 𝒅𝑸𝒙 𝑴𝑼𝒙 = 𝑷𝒙 ❖ At any point above point C (like point A) where 𝑴𝑼𝒙 > 𝑷𝒙 , it pays the consumer to consume more. ❖ When 𝑴𝑼𝒙 < 𝑷𝒙 (like point B), the consumer should consume less of X. ❖ At point C where 𝑴𝑼𝒙 = 𝑷𝒙 the consumer is at equilibrium. B) The case of two or more commodities ❖ For the case of two or more goods, the consumer‘s equilibrium is achieved when the marginal utility per money spent is equal for each good purchased and his money income available for the purchase of the goods is exhausted. ❖ That is, 𝑴𝑼𝒙 𝑴𝑼𝒚 𝑴𝑼𝒏 1) 𝑷𝒙 = 𝑷𝒚 =⋯= 𝑷𝒏 2) 𝑷𝒙 𝑸𝒙 + 𝑷𝒚 𝑸𝒚 + ⋯ + 𝑷𝒏 𝑸𝒏 = M ❖ Where, M is the income of the consumer. Example: Suppose Saron has M=7 two goods: banana and bread. The unit price of banana = 1 Birr and the unit price of a loaf of bread = 4 Birr. ❖ The equilibrium state must satisfy the two conditions stated before. ❖ Accordingly, the equilibrium level of consumption for Saron will be: Banana = 3 units, and Bread = 1 loaf of bread. ❖ At this combination 𝑷𝒙 𝑸𝒙 + 𝑷𝒚 𝑸𝒚 = M That is (1*3) + (4*1) = 7 ❖ Given this, the total utility that Saron derives from this combination can be given by: TU = TU1 + TU2 TU = 14 + 12 TU = 26 ❖ Given her fixed income and the price level of the two goods, no combination of the two goods will give her higher TU than this level of utility. Limitation of the cardinal approach 1) The assumption of cardinal utility is doubtful because utility may not be quantified. Utility cannot be measured absolutely (objectively). 2) The assumption of constant MU of money is unrealistic because as income increases, the marginal utility of money changes. 3.3.2 The ordinal utility theory ❖ In the ordinal utility approach, it is not possible for consumers to express the utility of various commodities they consume in absolute terms, like 1 util, 2 utils, or 3 utils. ❖ However, it is possible to express the utility in relative terms. ❖ The consumers can rank commodities in the order of their preferences as 1st, 2nd, 3rd and so on. ❖ Therefore, the consumer need not know in specific units the utility of various commodities to make his choice. ❖ It suffices for him to be able to rank the various baskets of goods according to the satisfaction that each bundle gives him. 3.3.2.1 Assumptions of ordinal utility theory ❖ The ordinal approach is based on the following assumptions. 1) Consumers are rational: they maximize their satisfaction or utility given their income and market prices. 2) Utility is ordinal: utility is not absolutely (cardinally) measurable. Consumers are required only to order or rank their preference for various bundles of commodities. 3) Diminishing marginal rate of substitution: The marginal rate of substitution is the rate at which a consumer is willing to substitute one commodity for another commodity so that his total satisfaction remains the same. 4) The total utility of a consumer is measured by the amount (quantities) of all items he/she consumes from his/her consumption basket. 5) Consumer’s preferences are consistent. For example: if there are three goods in a given consumer‘s basket, say, X, Y, Z and if he prefers X to Y and Y to Z, then the consumer is expected to prefer X to Z. This property is known as axioms of transitivity. ❖ The ordinal utility approach is explained with the help of indifference curves. ❖ Therefore, the ordinal utility theory is also known as the indifference curve approach. 3.3.2.2 Indifference set, curve and map ❖ Indifference set/ schedule: is a combination of goods for which the consumer is indifferent. It shows the various combinations of goods from which the consumer derives the same level of satisfaction. Example: Consider a consumer who consumes two goods X and Y. Table 3.3: Indifference schedule Bundle(Combination A B C D Orange 1 2 4 7 Banana 10 6 3 1 ❖ In table 3.3 above, each combination of good X and Y gives the consumer equal level of total utility. ❖ Thus, the individual is indifferent whether he consumes combination A, B, C or D. ❖ Indifference curve: graphical expression of indifference set/schedule. It shows different combinations of two goods which yield the same utility (level of satisfaction) to the consumer. ❖ Indifference map: A set of indifference curves. 3.3.2.3 Properties of indifference curves 1) Indifference curves have negative slope (downward sloping to the right). because the consumption level of one commodity can be increased only by reducing the consumption level of the other commodity. 2) Indifference curves are convex to the origin. ✓ The convexity of indifference curves is the reflection of the diminishing marginal rate of substitution. implies that the commodities can substitute one another but are not perfect substitutes. 3) A higher indifference curve is always preferred to a lower one. 4) Indifference curves never cross each other (cannot intersect). ✓ The assumptions of consistency and transitivity will rule out the intersection of indifference curves. Figure 3.4 shows the violations of the assumptions of preferences due to the intersection of indifference curves. Note : The intersection of indifference curves the same bundles of commodities give different utility. 3.3.2.4 Marginal rate of substitution (MRS) ❖ Marginal rate of substitution is a rate at which consumers are willing to substitute one commodity for another in such a way that the consumer remains on the same indifference curve. ❖ It shows a consumer‘s willingness to substitute one good for another while he/she is indifferent between the bundles. ❖ MRS of X for Y ( 𝑴𝑹𝑺𝑿, 𝒀 ) is defined as the number of units of commodity Y that must be given up in exchange for an extra unit of commodity X so that the consumer maintains the same level of satisfaction. ❖ Since one of the goods is scarified to obtain more of the other good, the MRS is negative. ❖ Hence, usually we take the absolute value of the slope. 𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒖𝒏𝒊𝒕𝒔 𝒐𝒇 𝒀 𝒈𝒊𝒗𝒆𝒏 𝒖𝒑 ∆𝒀 𝑴𝑹𝑺𝑿𝒀 = = 𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒖𝒏𝒊𝒕𝒔 𝒐𝒇 𝑿 𝒈𝒂𝒊𝒏𝒆𝒅 ∆𝑿 Let’s consider the following indifference curve ❖ From the above graph, 𝑴𝑹𝑺𝑿,𝒀 associated with the movement from point A to B, point B to C and point C to D is 2.0, 1.6, and 0.8 respectively. ❖ That is, for the same increase in the consumption of good X, the amount of good Y the consumer is willing to scarify diminishes. ❖ This principle of marginal rate of substitution is reflected by the convex shape of the indifference curve and is called diminishing marginal rate of substitution. ❖ It is also possible to derive MRS using the concept of marginal utility. ❖ 𝑴𝑹𝑺𝑿,𝒀 , is related to 𝑴𝑼𝑿 and 𝑴𝑼𝒀 as follows: 𝑴𝑼𝒙 𝑴𝑹𝑺𝑿,𝒀 = 𝑴𝑼𝒚 Proof: Suppose the utility function for two commodities X and Y is defined as: 𝑼 = 𝒇(𝑿, 𝒀) ❖ Since utility is constant along an indifference curve, the total differential of the utility function will be zero. 𝝏𝑼 𝝏𝑼 𝒅𝑼 = 𝒅𝑿 + 𝒅𝒀 = 0 𝝏𝑿 𝝏𝒀 𝑴𝑼𝑿 𝒅𝑿 +𝑴𝑼𝒀 𝒅𝒀 = 0 𝑴𝑼𝑿 𝒅𝒀 =− = 𝑴𝑹𝑺𝑿,𝒀 𝑴𝑼𝒀 𝒅𝑿 Example: Suppose a consumer‘s utility function is given by U(X, Y) = 𝑿𝟒 𝒀𝟐 Find 𝑴𝑹𝑺𝑿,𝒀. 𝑴𝑼𝑿 𝝏𝑼 𝝏𝑼 Solution: 𝑴𝑹𝑺𝑿,𝒀 = ; 𝑴𝑼𝑿 = =4𝑿 𝒀 and = 𝟐𝑿𝟒 𝒀 𝟑 𝟐 𝑴𝑼𝒀 𝝏𝑿 𝝏𝒀 4𝑿𝟑𝒀𝟐 𝒀 𝑴𝑹𝑺𝑿,𝒀 = 𝟒 = 𝟐 𝟐𝑿 𝒀 𝑿 3.3.2.5 The budget line or the price line ❖ Indifference curves only tell us about consumer preferences for any two goods but they cannot show which combinations of the two goods will be bought. ❖ In reality, the consumer is constrained by his/her income and prices of the two commodities. ❖ This constraint is often presented with the help of the budget line. ❖ The budget line is a set of the commodity bundles that can be purchased if the entire income is spent. ❖ It is a graph which shows the various combinations of two goods that a consumer can purchase given his/her limited income and the prices of the two goods. ❖ In order to draw a budget line facing a consumer, we consider the following assumptions. ✓ There are only two goods bought in quantities, say, X and Y. ✓ Each consumer is confronted with market determined prices, 𝑷𝒙 and 𝑷𝒀. ✓ The consumer has a known and fixed money income (M). ❖ Assuming that the consumer spends all his/her income on the two goods (X and Y), we can express the budget constraint as: 𝑷𝒙 𝑸𝒙 + 𝑷𝒚 𝑸𝒚 = M ❖ By rearranging the above equation, we can derive the following general equation of a budget line: 𝑴 𝑷𝑿 𝑸𝒚 = − 𝑸𝒙 𝑷𝒚 𝑷𝒚 Graphically, Note: 𝑷𝑿 ✓ The slope of the budget line is given is by − 𝑷𝒚 ✓ Any combination of the two goods within the budget line (such as point A) or along the budget line is attainable. ✓ Any combination of the two goods outside the budget line (such as point B) is unattainable (unaffordable). Example: A consumer has $100 to spend on two goods X and Y with prices $3 and $5 respectively. Derive the budget line equation and sketch the graph. Solution: 𝑷𝒙 𝑸𝒙 + 𝑷𝒚 𝑸𝒚 = M 𝟑𝑸𝒙 + 𝟓𝑸𝒚 = 100 𝟓𝑸𝒚 = 100 - 𝟑𝑸𝒙 𝟏𝟎𝟎 𝟑 𝟑 𝑸𝒚 = − 𝑸𝒙 ; 𝑸𝒚 = 𝟐𝟎 − 𝑸𝒙 𝟓 𝟓 𝟓 Note: A budget is drawn for given prices and fixed consumer‘s income. Hence, the changes in prices or income will affect the budget line. ❖ Change in income: If the income of the consumer changes (keeping the prices of the commodities unchanged), the budget line also shifts (changes). ❖ Increase in income causes an upward/outward shift in the budget line that allows the consumer to buy more goods and services and, ❖ decreases in income causes in the budget line that leads the consumer to buy less quantity of ta downward/inward shift he two goods. ❖ It is important to note that the slope of the budget line (the ratio of the two prices) does not change when income rises or falls. Change in prices: ❖ An equal increase(proportion) in the prices of the two goods shifts the budget line inward. Since the two goods become expensive, the consumer can purchase the lesser amount of the two goods. ❖ An equal decrease(proportion) in the prices of the two goods, one the other hand, shifts the budget line out ward. Since the two goods become cheaper, the consumer can purchase the more amounts of the two goods. ❖ An increase or decrease in the price of one of the two goods, keeping the price of the other good and income constant, changes the slope of the budget line by affecting only the intercept of the commodity that records the change in the price. ❖ For instance, if the price of good X decreases while both the price of good Y and consumer‘s income remain unchanged, the horizontal intercept moves outward and makes the budget line flatter. The reverse is true if the price of good X increases. ❖ On the other hand, if the price of good Y decreases while both the price of good X and consumer‘s income remain unchanged, the vertical intercept moves upward and makes the budget line steeper. The reverse is true for an increase in the price of good Y. 3.3.2.6 Equilibrium of the consumer ❖ The preferences of a consumer (what he/she wishes to purchase) are indicated by the indifference curve. ❖ The budget line specifies different combinations of two goods (say X and Y) the consumer can purchase with the limited income. ❖ Therefore, a rational consumer tries to attain the highest possible indifference curve, given the budget line. ❖ This occurs at the point where the indifference curve is tangent to the budget line so that the slope of the indifference curve (𝑴𝑹𝑺𝑿,𝒀 𝑷𝑿 ) is equal to the slope of the budget line(− ). 𝑷𝒚 ❖ In figure 3.10, the equilibrium of the consumer is at point E, where the budget line is tangent to the highest attainable indifference curve (IC2). ❖ Mathematically, consumer optimum (equilibrium) is attained at the point where: Slope of indifference curve = Slope of the budget line 𝑷𝑿 𝑴𝑹𝑺𝑿,𝒀 = − 𝑷𝒚 𝑴𝑼𝑿 𝑷𝑿 =− 𝑴𝑼𝒀 𝑷𝒚 Example: A consumer consuming two commodities X and Y has the utility function 𝑼(𝑿, 𝒀) = 𝑿𝒀 + 𝟐𝑿. The prices of the two commodities are 4 birr and 2 birr respectively. The consumer has a total income of 60 birr to be spent on the two goods. a) Find the utility maximizing quantities of good X and Y. b) b) Find 𝑴𝑹𝑺𝑿,𝒀 at equilibrium. Solution: a) The budget constraint of the consumer is given by: 𝟒𝑸𝒙 + 𝟐𝑸𝒚 = 60 𝟔𝟎 𝟒 𝑸𝒚 = − 𝑸𝒙 ; 𝑸𝒚 = 𝟑𝟎 − 𝟐𝑸𝒙 ……….Budget Line 𝟐 𝟐 ✓ Thus, the slope of the budget line = 2 𝑴𝑼𝑿 𝒀+𝟐 ✓ Slope of the IC = 𝑴𝑹𝑺𝑿,𝒀 = = 𝑴𝑼𝒀 𝑿 ✓ At Equilibrium: Slope of the IC = slope of the budget line 𝒀+𝟐 = 2; Y+2 = 2X ; Y = 2X 𝑿 ✓ Substituting this in the budget equation results Y= 14 and X = 8 𝑴𝑼𝑿 𝒀+𝟐 𝟏𝟒+𝟐 𝟏𝟔 b) 𝑴𝑹𝑺𝑿,𝒀 = = = = =2 𝑴𝑼𝒀 𝑿 𝟖 𝟖 THANK YOU!!! We would like to thank all our ExamClass members for choosing our channel as their destination for FreshMan Exams and learning resources. Dear members, Your support and trust in us means a lot and motivates us to continue providing high-quality services. We appreciate your commitment to your education and look forward to helping you succeed.