Grade 10 Economics Textbook PDF

Ethiofetena.com Ethiopian No 1 Educational Website ECONOMICS STUDENT TEXTBOOK GRADE 10 ECONOMICS STUDENT TEXTBOOK GRADE 10 ECO...

Ethiofetena.com Ethiopian No 1 Educational Website ECONOMICS STUDENT TEXTBOOK GRADE 10 ECONOMICS STUDENT TEXTBOOK GRADE 10 ECONOMICS STUDENT TEXTBOOK GRADE 10 FEDERAL DEMOCRATIC REPUBLIC OF ETHIOPIA MINISTRY OF EDUCATION Ethiofetena.com Ethiopian No 1 Educational Website Take Good Care of This Textbook This textbook is the property of your school. Take good care not to damage or lose it. Here are 10 ideas to help take care of the book: 1. Cover the book with protective material, such as plastic, old newspapers or magazines. 2. Always keep the book in a clean dry place. 3. Be sure your hands are clean when you use the book. 4. Do not write on the cover or inside pages. 5. Use a piece of paper or cardboard as a bookmark. 6. Never tear or cut out any pictures or pages. 7. Repair any torn pages with paste or tape. 8. Pack the book carefully when you place it in your school bag. 9. Handle the book with care when passing it to another person. 10. When using a new book for the first time, lay it on its back. Open only a few pages at a time. Press lightly along the bound edge as you turn the pages. This will keep the cover in good condition. Ethiofetena.com Ethiopian No 1 Educational Website ECONOMICS STUDENT TEXTBOOK GRADE 10 Writers: Achalu Berecha Dhaba (MA, MSc) Leta Sera Bedada (PhD) Editors: Mesfin Ketema (M.Sc.) Enguday Ademe Mekonnen (Ph.D) Birhanu Engidaw Getahun (Ph.D) Illustrator: Endalkachew Mengesha Yasab (M.Sc.) Designer: Derejaw Lake Melie (M.Sc.) Evaluators: Mekonnen Bersisa Gadisa (PhD) Tariku Mulushewa Dessea (MSc) Ararssa Hora Dabi (MSc) FEDERAL DEMOCRATIC REPUBLIC OF ETHIOPIA HAWASSA UNIVERSITY MINISTRY OF EDUCATION Ethiofetena.com Ethiopian No 1 Educational Website Ethiofetena.com Ethiopian No 1 Educational Website Introduction to the Book This book is intended for grade 10 students in Ethiopia. Economics starts at grade 9, thus this book is subsequent to that. Students will learn subsequent content similar to that of the previous grade. Accordingly, there is a little depth and width in terms of theories and applications. The book has eight units. The first unit deals with the Theory of Consumer Behavior, under which students will learn from the definition of utility up to an illustration of the optimum of the consumer using the cardinal utility approach. The second unit deals with the Theories of Demand and Supply, in which students will learn from evaluating the effects of changes in demand and supply on equilibrium price and quantity to computing elasticities of demand and supply. The third unit covers the Theory of Production and Cost, in which students will learn everything from short- and long-run production to cost of production mapping. The fourth unit deals with the market structures, under which students will discuss various concepts, from basic features of different markets to understanding the sources of monopoly power. The fifth Unit deals with Theories of Banking and Finance, with in which students will learn various concepts from the Financial Intermediaries up to the role of indigenous financial institutions such as Iqub and Idir. The Sixth Unit deals with the theories and measurements of Economic Growth with in which students will learn various economic growth concepts, from explaining how to measure economic growth to discussing about productivity, measurements in economics. The seventh unit deals with discussing the overview of the Ethiopian Economy in which various economic situations in Ethiopia will be discussed, from the main sectors of the Ethiopian economy up to being able to write a brief report on Ethiopian economy. The eighth unit deals with Innovation and business startups in which students will learn various business concepts, from defining the term innovation up to conducting a strength, weakness, opportunity, and threat (SWOT) analysis of an existing enterprise. Each unit begins with an introduction that states the lessons and the outcomes. It also provides a list of the key words and concepts you will encounter in the unit. The objectives are listed at the beginning of each lesson. The start-up activities are to introduce you to the lesson. On many pages, you will find tables and figures that illustrate the topic you are studying. There are also examples thataim to elaborate on the concept you are studying. Each lesson has at least one set of questions linked to the objective of the lesson. At the end of each unit, there is a unit summary of what you have read. This will help you revise. Finally, unit review exercises enable you to test your knowledge and understanding of the unit content. I Ethiofetena.com Ethiopian No 1 Educational Website In learning the economic literature throughout all the units included in this book, there are two things expected from both the teacher and the students. First they should understand the basic theoretical background of each unit. A teacher should understand the theories before starting to teach the students. For this, s/he has to refer to the reference lists indicated at the end of the student text or teacher’s guide. The second thing is that students should try to associate the theories with the practical situation in their country. This can be accomplished via the different activities and also by examples that the teacher makes the students exercise. Finally, this book is just one resource that students will use to learn economics at this level. Additional reference materials, books, and documents are listed at the end of the book. II Ethiofetena.com Ethiopian No 1 Educational Website Table of Contents Content Page Unit 1: Theory of Consumer Behaviour 1 1.1 The Concept of Utility........................................ 2 1.2 The Cardinal Utility Theory..................................... 3 1.3 The Consumer Maximization Problem........................... 7 1.4 Introduction to the Ordinal Utility Theory....................... 12 Unit Summary.................................................. 14 Unit Review Exercises............................................ 15 Unit 2: Theories of Demand and Supply 17 2.1 Theory of Demand.......................................... 18 2.2 Theory of Supply............................................ 24 2.3 Market Equilibrium.......................................... 29 2.4 Elasticities of Demand and Supply............................. 36 Unit Summary.................................................. 44 Unit Review Exercises............................................ 46 Unit 3: Theories of Production and Cost 48 3.1 Theory of Production....................................... 49 3.2 Theory of Cost.............................................. 60 Unit Summary.................................................. 66 Unit Review Exercises............................................ 67 Unit 4: Market Structure 69 4.1 Perfectly Competitive Markets................................ 71 4.2 Pure Monopoly Market...................................... 75 4.3 Monopolistically Competitive Market.......................... 81 4.4 Oligopoly Market........................................... 84 Unit Summary.................................................. 86 Unit Review Exercises............................................ 87 Unit 5: Banking and Finance 89 5.1 Introduction to Financial Intermediaries........................ 90 5.2 Introduction to Financial Markets............................. 92 5.3 Introduction to Financial Institutions.......................... 94 5.4 Historical Development of Banks in Ethiopia.................... 97 5.5 Micro-finance Institutions................................... 103 5.6 Electronic Banking (e-banking)............................... 106 5.7 Indigenous Financial Institutions............................. 108 Unit Summary................................................. 111 Unit Review Exercises........................................... 112 III Ethiofetena.com Ethiopian No 1 Educational Website Unit 6: Economic Growth 113 6.1 Review of Macroeconomic Variables.......................... 114 6.2 Definition and Measurement of Economic Growth....................117 6.3 Sources of Economic Growth................................ 119 6.4 The Weaknesses of Using GDP /GDP Per Capita................ 123 6.5 The Business Cycle and Its Phases............................ 125 Unit Summary................................................. 127 Unit Review Exercises........................................... 128 Unit 7: The Ethiopian Economy 129 7.1 Compnents of Gross Domostic Product (GDP).................. 130 7.2 Real GDP Vs Nomail GDP.................................... 134 7.3 The Agricultural Secotor in the Ethiopian Economy............. 138 7.4 The Industrial Sector in the Ethiopian Economy................. 144 7.5 The Service Sector in the Ethiopian Economy................... 148 7.6 Agriculture versus Industrial Development..................... 151 Unit Summary................................................. 153 Unit Review Exercises........................................... 154 Unit 8:Business Startups and Innovation 155 8.1 Innovation................................................. 156 8.2 Business Startups........................................... 161 8.3 Types of Businesses Organizations............................ 163 8.4 Business Feasibiliry Analysis.................................. 168 Unit Summary................................................. 176 Unit Review Exercises........................................... 177 References 179 IV Ethiofetena.com Ethiopian No 1 Educational Website Unit Theory of Consumer Behaviour 1 Unit Introduction A consumer is a decision making unit (an individual or a household) who uses or consumes a commodity or service. The theory of consumer behavior is concerned with how a consumer decides on the basket of goods and services he/she consumes in order to maximize his/her satisfaction. In this unit, we will discuss how the consumer decides to spend his/ her income on different goods. The theory of consumer behavior, set out with the following important assumptions; y The consumer has a limited income. y The consumer is assumed to be rational. Given the consumer’s income and the market prices of the commodities, he/she spends the income on goods and services that give the highest possible satisfaction or utility. The consumer has relevant information to make a decision, is aware of his or her income, and is aware of the commodities available and their prices. Unit Objectives After completing this unit, students will be able to: 6 Explain cardinal utility 6 Discuss the law of diminishing marginal utility 6 Illustrate the consumer optimum under the cardinal approaches 6 Mention the assumptions of ordinal utility theory Main Contents 1.1. The concept of utility 1.2. The cardinal utility theory 1.3. The consumer maximization problem 1.4. Introduction to the ordinal utility theory Unit 1: Theory of Consumer Behaviour 1 Ethiofetena.com Ethiopian No 1 Educational Website 1.1 The Concept of Utility At the end of this section, students will be able to: 6 Define the term utility 6 Discuss relativity of utility Key Concepts Commodity, Satisfaction, Utility Startup Activity 1. Why do you buy goods and services? In our everyday lives, we buy different goods and services for consumption. Utility is the level of satisfaction or pleasure derived from the consumption of a good or service. Thus, utility is the power of a commodity to satisfy human wants. For example, bread has the power to satisfy hunger, while water quenches our thirst. In defining utility, it is important to bear in mind the following points: y Relativity of Utility: The utility of a commodity is subjective to a person’s needs. It is not absolute (objectively determined).The same commodity provides different utilities to different consumers. For example, non-smokers do not derive any utility from cigarettes. y The utility of a product can be different at different places and times. For example, the utility that we get from wearing jackets during the cold season is not the same as during the hot season. For the same consumer, utility varies from unit to unit, from time to time, and from place to place. For example, the utility we get from drinking tea early in the morning may be different from the utility we get during lunch time. y ‘Utility’ and ‘usefulness’ are not synonymous: usefulness is the concern of a product whereas utility is the concern of the consumer. Approaches to measuring Utility:Since utility is a qualitative concept, it is difficult to measure quantitatively, but economists try to quantify it in two different ways: cardinal utility and ordinal utility. Ă Activity 1.1 1. Define utility 2. Why is the level of utility obtained by consuming the same product by different individuals different? Unit 1: Theory of Consumer Behaviour 2 Ethiofetena.com Ethiopian No 1 Educational Website 1.2. The Cardinal Utility Theory At the end of this section, students will be able to: 6 Discuss the cardinal utility and its key assumptions 6 Compute total utility 6 Calculate marginal utility 6 State law of diminishing marginal utility 6 Derive consumer optimum Key Concepts utils, cardinal utility Startup Activity 1. How do you measure the satisfaction level (utility) that you get from goods and services? To get a higher level of satisfaction, the consumer must be able to compare the utility of the various baskets of goods that can be bought with the available income. According to Cardinal Utility theory, utility is measurable like weight, height, and temperature, and they suggested a unit of measurement of satisfaction called ‘utils’. The Cardinal School postulated that utility can be measured in monetary units (i.e., by the amount of money that the consumer is willing to pay for another unit of a commodity) or by subjective units called ‘utils’. Thus, the school assumes that the level of utility can be expressed in numbers. 1.2.1. Assumptions of Cardinal Utility Theory I. The consumer is Rational: 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. II. Cardinal Utility: Utility is a cardinal concept, which means the utility of each commodity is measurable, with the most convenient measure being money. III. Constant Marginal Utility of money: the utility that one derives from each successive unit of money income remains constant. IV. Diminishing Marginal Utility: The utility gained from the successive units of a commodity diminishes. In other words, the marginal utility of a commodity diminishes as the consumer consumes larger quantities of it. This is the law of diminishing marginal utility. Unit 1: Theory of Consumer Behaviour 3 Ethiofetena.com Ethiopian No 1 Educational Website V. 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 X 1 , X 2 ,...X n , the total utility is given by TU = f ( X1 , X 2; ……X n). 1.2.2. Measurement of Utility (Total and Marginal Utility) Total Utility (TU): refers to the total amount of satisfaction a consumer gets from consuming or possessing some specific quantities of a commodity (X) at a particular time. As the consumer consumes more of a good (X) per time period, his/her total utility increases. However, there is a saturation point for that commodity after which the consumer will not be capable of enjoying any greater satisfaction from it. Therefore, TUn refers to the total utility derived from consuming n units of a commodity X. Marginal Utility(MU): refers to the additional utility obtained from consuming an additional unit of a commodity. In other words, marginal utility is the change in total utility resulting from the consumption of one more unit of a product per unit of time. Mathematically, the formula for marginal utility is: TU MU  Where, TU is the change in total utility, and, Q Q is change in the amount of product consumed. Suppose Beka gets 10 utils of total utility by consuming 2 quantities of orange, and his total utility increases to 12 utils as he consumes 3 quantities of orange. Thus, consumption of the 3rd quantity of orange has caused total utility to increase by 2 utils (12 utils minus 10 utils). Therefore, themarginal utility of the 3rd orange is 2 utils. TU 12utils  10utils Thus, MU    2 utils Q 3 2 Activity 1.2 Find the missed value of total utility (TU) and marginal utility (MU) in the following table. Table 1.1 Numerical Values of marginal and total utility derived from consumption of hypothetical commodity (X). Quantity consumed (Qb) 0 1 2 3 4 5 6 7 8 9 10 Total Utility (TU) 0 8 15 20 24 24 22 19 5 Marginal Utility (MU) - 7 5 3 1 0 -3 -6 -8 Unit 1: Theory of Consumer Behaviour 4 Ethiofetena.com Ethiopian No 1 Educational Website Example: Given Table 1.2 Numerical Values of marginal and total utility derived from consumption of hypothetical commodity (banana). Quantity consumed (Qb) 0 1 2 3 4 5 6 7 8 9 10 Total Utility (TU) 0 12 22 29 34 36 37 37 36 34 30 Marginal Utility (MU) - 12 10 7 5 2 1 0 -1 -2 -4 Table 1.2 As a consumer consumes only one quantity of banana, both the marginal utility and total utility are equal, which is 12 utils. When a consumer consumes 2 quantities of banana, he/she gets 10 additional utils (marginal utility). The total utility from 2 quantities of banana is 22 utils (12 fromthe first quantity of banana and 10 from the second quantity of banana). Finally, at 7 unit of quantity, the saturation point of total utility, marginal utility becomes zero. After this maximum point of total utility, if he/she consumes more quantity of banana, his/her total utility decreases, which leads to dissatisfaction. Figure 1.1 is the graphical representation of table 1.2, and it shows the relationship between total utility and marginal utility. Figure 1.1: Relationship between total utility and marginalutility Figure 1.1 shows that total utility initially increases, and reaches ‘its pick (saturation) point’. This saturation point indicates that by consuming 7 quantities of banana, the Unit 1: Theory of Consumer Behaviour 5 Ethiofetena.com Ethiopian No 1 Educational Website consumer attains its highest satisfaction level of 37 utils. However, consumption beyond this point results in dissatisfaction, because consuming the 8th and more quantities of banana brings negative additional utility. On the other hand, the marginal utility continuously diminished and became zero when the total utility reached maximum, and then became negative as consumption increased beyond the saturation point of the total utility. Ă Activity 1.3 Table 1.3 total utility (TU) of hypothetical commodity Y. Quantity(Y) consumed 0 1 2 3 4 5 6 TUY 0 10 16 20 22 22 20 1. From the given table (1.3) a. Find marginal utility (MUY) b.Find quantity (QY) where total (TUY) reach maximum point and MUY will be zero. 2. What does it mean that marginal utility of a commodity is diminishing? 3. Explain the main assumptions of the cardinal utility theory. 1.2.3 The Law of Diminishing Marginal Utility (LDMU) Do you get the same utility from drinking the first glass of water and the second glass of water? The utility that a consumer gets by consuming a commodity for the first time is not the same as the consumption of the good for the second, third, fourth, etc. LDMU is central to the cardinalutility analysis of consumer behavior. This law states that as the quantity consume do facommodity increases over a unit of time,the utility derived by the consumer from the successive units goes on decreasing, provided the consumption of all other goods remains constant. The above(table 1.2) shows a numerical illustration of the law of diminishing marginal (LDMU). Here, TU increases with a nincrease inconsumption of banana, but at a decreasing rate.It means that MU decreases witha n increase in consumption. Unit 1: Theory of Consumer Behaviour 6 Ethiofetena.com Ethiopian No 1 Educational Website 1.3. The Consumer Maximization Problem At the end of this section, students will be able to: 6 Drive consumers’ budget equations 6 Compute the optimum for the consumer Key Concepts Consumer income/budget, Consumer equilibrium Startup Activity 1. Discuss in pairs how you spend your money. How should a consumer spend his/her income on different commodities? A consumer that maximizes utility reaches his/her equilibrium position when the allocation of his/her expenditure is such that the last birr spent on each commodity yields the same utility. A consumer budget (income) is the actual purchasing potential with which a consumer can purchase a set of goods or services, provided their prices. A consumer has limited income therefore the consumer’s budget shows the number of goods and services he/ she can afford. Assumptions: Economists have developed the concept of consumer equilibrium based on the following assumptions. y The consumer is rational. She/he aims at the maximisation of her/his utility or satisfaction, y Cardinal measurement of utility is possible, y If utility is measured in terms of money, the marginal utility of money remains constant, y The law of diminishing marginal utility operates, y The Consumer income is given and remains constant, y Commodity prices given and remain constant. I. Consumer Equilibrium:The Case of one commodity Let’s assume that the consumer consumes a single commodity, X. The consumer can either buy x or retain his money income Y. Under these conditions, the consumer is in equilibrium when the marginal utility of X is equated to its market price (px). Unit 1: Theory of Consumer Behaviour 7 Ethiofetena.com Ethiopian No 1 Educational Website Symbolically, MUx= Px y If MUx>Px, the consumer can increase his/her welfare by purchasing more units of X, and y If the MUx If bundle A>B, then B is not greater than A Similarly, it is assumed that consumers’ choices are characterized by transitivity: if bundle A is preferred to B and B is preferred to C, then bundle A is preferred to C. Symbolically, we may write the transitivity assumption as follows: ═> If bundle A >B and B>C, then A>C. Ă Activity 1.5 1. What is ordinal utility? 2. What are the assumptions of ordinal utility theory? Unit 1: Theory of Consumer Behaviour 13 Ethiofetena.com Ethiopian No 1 Educational Website Unit Summary The theory of consumer behavior is concerned with how consumers decide on the basket of goods and services they consume in order to maximize their satisfaction/ utility. Utility is the power of a commodity to satisfy human wants. There are two approaches for the measurement of utility: the Cardinal Utility and Ordinal utility approaches. The cardinal utility approach argues that utility is measurable and quantifiable with a unit of measurement of ‘utils’ while the ordinal utility approach argues that utility has only ordinal value and could only be ordered and ranked. The law of diminishing marginal utility states that as the amount consumed of a commodity increase, the utility derived by the consumer from the additional units (marginal utility) goes on decreasing. Under the cardinal utility approach, the consumer reaches equilibrium when the marginal utility of the commodity is equal to its price in the case of one commodity (MUx = Px), and when the ratio of the marginal utilities of the commodities to their prices is equal for all commodities. In the ordinal utility approach, utility cannot be measured absolutely, but different consumption bundles are ranked according to preferences. The concept is based on the fact that it may not be possible for consumers to express the utility of various commodities they consume in absolute terms, like, 1 util, 2 util, or 3 util, but it is always possible for consumers to express the utility in relative terms. It is practically possible for the consumers to rank commodities in the order of their preference, as 1st, 2nd, 3rd, and so on. Unit 1: Theory of Consumer Behaviour 14 Ethiofetena.com Ethiopian No 1 Educational Website Unit Review Exercises Part I: Write ‘True’ if the statement is correct or ‘False’ if the statement is incorrect. 1. Total utility is the sum of all marginal utilities. 2. Total utility increases as long as marginal utility is postive. 3. The law of diminishing marginal utility is an assumption of ordinal utility theory. 4. As ordinal utility, the level of satisfaction (utility) obtained from commodities is be measurable in monetary units. 5. Consistency and transitivity can be applied to a single commodity case. 6. An ordinal utility attaches figures to utility measurement, but a cardinal utility ranks market baskets. Part II: Multiple-choice items. Direction: Read the following questions and choose the correct answer from the given alternatives. 1. Which of the following is false about utility? A. The utility of a product can be different at different places and time. B. Utility means usefulness. C. Utility is pleasure derived from the consumption of a good or service. D. The same commodity gives different utilities to different consumers. 2. When we rank the utility gained from the consumption of different commodities as 1st , 2nd and 3rd, etc, we are measuring utility: A. Cardinally C. both Cardinally and Ordinally B. Ordinally D. Using Traditional theory 3. Which of the following assumptions is common in Cardinal and Ordinal approaches? A. Constant marginal utility B. Diminishing marginal utility C. Considering the consumer as rational D. Measuring the utility of each commodity in number. 4. Which one is true if total utility is increasing at a decreasing rate? A. Marginal utility is increasing. C. Marginal utility is decreasing. B. Marginal utilityiszero. D. MU will benegative. Unit 1: Theory of Consumer Behaviour 15 Ethiofetena.com Ethiopian No 1 Educational Website 5. Which of the following is true? A. The consumer is in equilibrium when the TUX =PX. B. If the MUX > PX, the consumer can increase his/her utility by purchasing less units of goods. C. If the MUX < PX, the consumer can increase his/her utility by purchasing more units of good. D. When the total utility curve reaches its maximum point, marginal utility becomes zero. Part III: Write detail answers to the following. 1. Mention at least one assumption that is common for both the cardinal and ordinal utility approaches. 2. What is meant by the marginal rate of substitution? Discuss with examples the principles of the diminishing marginal rate of substitution. 3. Assume a hypothetical consumer consumes good X and good Y. The price of good X is 1 and price of good Y is 3 and the consumer budget is birr 10 for the two goods. Where: QX is quantity of good X, QY is quantity of good Y and TUX and TUY is total utility from consuming good X and good Y respectively, MUx and MUyare marginal utilities for good X and good Y respectively. QX TUX QY TUY MUx MUy 0 0 0 0 1 10 1 24 2 19 2 45 3 27 3 63 4 34 4 78 5 40 5 87 6 44 6 90 7 41 7 91 8 41 8 91 9 40 9 90 Based on the given information (from the above table), answer the following questions. A. Calculate the marginal utility of the two goods B. Determine the quantities of the two goods that the consumer should buy in order to maximize his total utility. Unit 1: Theory of Consumer Behaviour 16 Ethiofetena.com Ethiopian No 1 Educational Website Unit Theories of Demand and Supply 2 Unit Introduction The tools of demand and supply can take us far in understanding not only specific economic issues but also how the entire economy works. As you recall, the circular flow model in your grade 9 course identified the participants in the product and resource markets. There, we asserted that prices were determined by the “interaction” between demand and supply in these markets. In this unit we examine that interaction in detail explaining how prices and output quantities are determined, determinates and elasticies of demand and supply. Market is a place, condition, or mechanism, which brings together both buyers (demanders) and sellers (suppliers) in order to exchange their goods and services. All situations which link potential buyers with potential sellers are markets. Thus, the market means the system in which sellers and buyers of a commodity interact to settle its price and the quantity to be bought and sold. Unit Objectives After completing this unit, students will be able to: 6 Explain the theory of demand. 6 Describe the theory of supply 6 Identify factors that affect demand and supply 6 Distinguish between individual and market demand 6 Distinguish between individual and market supply 6 Demonstrate market equilibrium both graphically and mathematically 6 Evaluate the effect of changes in demand and supply on equilibrium price and quantity. 6 Define elasticity 6 Calculate and interpret the different types of elasticity Main Contents 2.1. Theory of Demand 2.2. Theory of Supply 2.3. Market Equilibrium 2.4. Elasticities of Demand and supply Unit 2: Theories of Demand and Supply 17 Ethiofetena.com Ethiopian No 1 Educational Website 2.1. Theory of Demand At the end of this section, students will be able to: 6 Define the concept of demand 6 State factors affecting demand. 6 Explain demand schedule and demand curve 6 Interpret demand equations and the slope of a demand curve. 6 Distinguish between chages in demand and changes in quantity 6 Determine individual and market demand Key Concepts Demand, Demand schedule, Demand curve, Market demand Startup Activity 1. What do we mean by ‘demand’? 2. Do you think it is synonymous with ‘desire’ or ‘want’? Discuss the similarities and differences in pairs. In the previous unit, we studied and derived the consumer’s optimum given income, the price of the goods and preferences. The demand for a commodity is the quantity that consumers are able and willing to buy at various prices during a given period of time. Definition: Demand means the ability and willingness to buy a specific quantity of a commodity at the prevailing price in a given period of time. Therefore, demand for a commodity implies a desire to acquire it, along with the willingness and ability to pay for it. Thus, Demand = Willingness to buy + Ability to pay. 2.1.1 The Demand Schedule, Demand Function and the Demand Curve Demand could be expressed in the form of schedules, functions, or curves. Demand Schedule is a table showing different quantities of commodity that consumer is willing to buy at different level of prices, during a given period of time. Demand expresses the nature of functional relationship between the price of a commodity and its quantity demanded. Qd=f(P)=a-bP ;whereas ‘Qd‘ is quantity demanded, ‘P’ is price, ‘a’ is constant, ‘b’ coefficient of price, As quantity is function of price, or these variables are expressed in tabular form/ schedules, and can be transformed into curves. A demand curve is a curve that represents the relationship between the quantity of the good chosen by a consumer and the price of the good. The independent variable (price) is measured along the vertical axis, and dependent variable (quantity) is measured along Unit 2: Theories of Demand and Supply 18 Ethiofetena.com Ethiopian No 1 Educational Website the horizontal axis. The demand curve shows the quantity demanded by the consumer at each price. Let’s consider the relationship between the price of coffee and the quantity of coffee demanded using a hypostatical example. Table 2.1 shows how many kgs of coffee Amina buys each month at different prices per kg. If coffee is free (assume the price is zero), she buys 9 kg. At birr 5.00, she buys 8kg of coffee. As the price rises further, she buys fewer and fewer kgs of coffee. When the price reaches birr 45.00, Amina doesn’t buy any coffee at all. Table 2.1 Amina’s demand. The Demand Schedule shows the quantity demanded at each price. Price of coffe in birr (per 0 5 10 15 20 25 30 35 40 45 KG) Quantiy demanded (in KG) 9 8 7 6 5 4 3 2 1 0 Figure 2.1 Amina’s Demand Curve Table 2.1 is a demand schedule, a table that shows the relationship between the price of coffee per kg and the quantity of coffee demanded per kg. It shows how the quantity demanded of the good (coffee) changes as its price varies, ceteris paribus (all other things remain constant). The demand curve in figure 2.1 above, which graphs the demand schedule in table 2.1., shows how the quantity demanded of the good changes as its price varies. Because a lower price increases the quantity demanded, the demand curve slopes downward. The slope of a demand curve: the law of demand states (recall from your grade 9) Unit 2: Theories of Demand and Supply 19 Ethiofetena.com Ethiopian No 1 Educational Website quantity and price are inversely related: quantity demanded of a good (X) goes up when its price goes down. That is, the function has a negative slope, or the curve slopes downward. This important property is given the name of downward sloping demand. The law of demand can be stated as, all other things remaining constant, the quantity demanded of a commodity increases when its price decreases and decreases when its price increases. 2.1.2 Factors affecting demand Determinants of demand are factors that cause the consumer to increase or decrease their demand for a particular commodity. Demand is a multi-variety function in a sense that it is determined by many factors/variables. There are various factors affecting the demand for a commodity. Some of these are: y Price of the good: the price of a commodity is an important determinant of demand. Price and demand are inversely related. The higher the price, the lower the demand and vice versa. y Price of related goods: the price of related goods like substitutes and complementary goods also affect the demand.  Substitute goods are goods that can be used in place of each other to satisfy a given want. (For example, coffee and tea, pens and pencils, butter and oil, etc.).  Complementary goods are goods used together to satisfy a given want. (For example, tea and sugar, phone and sim-card, cars and petrol, gun and bullet etc.) In the case of substitutes, rise in the price of one commodity leads to an increase in the demand for its substitute. In the case of complementary goods, a fall in the price of one commodity leads to a rise in demand for both the goods. y Consumer income: is directly related to demand. A change in the consumer’s income significantly influences his demand for most commodities. If the consumers’ income increases, demand will be greater. y Taste and habits: these are very effective factors affecting demand for a commodity. When there is a change in the consumer’s taste, habits, or preferences, their demand will change. y Population: if the size of the population is greater, demand for goods will be greater. The market demand for a commodity substantially changes when there is a change in the total population. y Season: The demand for a commodity is also affected by the season. For example, demand for woolen clothes increases in the cold seasons. On the other Unit 2: Theories of Demand and Supply 20 Ethiofetena.com Ethiopian No 1 Educational Website hand, demand for cotton clothes increases in hot seasons. y Consumer’s future price expectation: If a consumer expects prices to rise in the future, he may buy more at the current price, and thus his/her demand rises. 2.1.3 Changes in quantity demanded and changes in demand Change in quantity demanded: Other things being equal, it designates the movement from one point to another point from one price quantity combination to another on a fixed demand schedule or demand curve. The cause of such a change is an increase or decrease in the price of the product being considered. Downward movement along the demand curve is called an extension of demand, while the upward movement is a contraction of demand. Figure 2.2: Extension of demand Figure 2.3: Contraction of Demand Change in Demand: A change in one or more of the determinants of demand (other than their own price) will change the demand data (the demand schedule). A change in the demand schedule, or more graphically, a shift in the location of the demand curve, is called a change in demand. An increase in demand causes the demand curve to shift upward to the right; whereas, a decrease in demand causes the demand curve to shift downward to the left. In other words, while an increase in demand is explained by an outward shift of the demand curve, a decrease in demand is explained by an inward shift of the demand curve. Unit 2: Theories of D emand and Supply 21 Ethiofetena.com Ethiopian No 1 Educational Website D1 D0 Figure 2.4: Shift in demand curve Figure 2.4 shows that when demand increases, demand curve shifts upward (D1) and a decrease in demand shifts the demand curve downwards (D2). The factors affecting demand, except for their own price, are called shifting factors. 2.1.4 Derivation of market demand Based on the number of consumer, demand is classified as individual demand and market demand. Individual Demand: Individual demand may be defined as the quantity of a commodity that a person is willing and able to buy at given prices over a specified period of time. Suppose Mr. Adamu purchases a kg of banana when the price is Birr 25, and he purchases 2 kg for a week when the price drops to Birr 20. And when the price further decreases to Birr 15 per kg, he buys 3 kg banana for a week, but when the price rises to Birr 30 per kg, he buys zero kg of banana. This can be shown in the table 2.2 below. Table 2.2: The hypothetical demand schedule for banana Price of banana in Birr/kg 10 15 20 25 30 Quantity demanded in kg 5 3 2 1 0 Market Demand: Market demand refers to the total quantity that all the users of a commodity are willing and able to buy at a given price over a specific period of time. The market demand for the commodity is simply the horizontal summation of the demand of all the consumers in the market. In other words, the quantity demanded in the market at each price is the sum of the individual demands of all consumers at that price. Assume that there are three consumers (say A, B, and C) in the market for a particular Unit 2: Theories of Demand and Supply 22 Ethiofetena.com Ethiopian No 1 Educational Website commodity X (say wheat). Their demand at each price is given as follows: Table 2.3: The individual and market demand schedule for wheat Price per quintal of wheat (Birr) 12 9 6 3 1 A 2 3 4 6 9 Quantity demanded per B 1 2 4 5 6 year (in quintals) C 0 1 2 4 5 Market (Total) 3 6 10 15 20 + + = Figure 2.5 summation of demand curves Thus, the market demand for a commodity shows the various quantities of the commodity demanded in the market per unit of time at an alternative price for the commodity holding everything else constant. However, if individual demand schedules were expressed as demand curves, the market demand curve would be derived by taking the horizontal summation of individual demand curves. Numerical Example: Suppose the individual demand function of a product is given by: QI = 50 - 5P and there are about 100 identical buyers in the market. Then the market demand function is given by: ⇒ Qm = (50 – 5P) 100 ⇒ Market Demand (Qm ) = 5000-500P Ă Activity 2.1 1. Define demand. 2. What factors affect demand? 3. Explain the demand schedule and demand curve concepts. 4. What is the difference between changes in quantity demanded and changes in demand? 5. What do you mean by individual demand and market demand? Unit 2: Theories of D emand and Supply 23 Ethiofetena.com Ethiopian No 1 Educational Website 2.2 Theory of Supply At the end of this section, students will be able to: 6 Define the concept of supply. 6 Explain supply function, supply curve, and supply schedule. 6 Interpret the slope of a supply curve. 6 Differentiate changes in quantity supply and changes in supply. 6 State factors that affect supply. 6 Derive market supply curve. Key Concepts Supply, supply schedule, supply curve Start-Up Activity 1. What comes to your mind when you hear the term “supply”? In a market, while buyers of a product constitute the demand side of the market, sellers of that product make up the supply side of the market. Supply may be defined as the various amounts of a product that a producer (firm) is willing and able to produce and make available for sale in the market over a specific time period, at given prices, ceteris paribus. Holding other factors constant, the quantity supplied of a good or service is the amount offered for sale at a given price. 2.2.1. Supply function, Supply schedule, and Supply curve A Supply function: is a statement that states the relationship between the quantity supplied (as a dependent variable) and its determinants (say price, as independent variable). Suppose that a single producer’s supply function for commodity X is given as: QX =F(PX)=a+bP, ceteris paribus. The supply schedule: is a tabular presentation of the (law of) supply. By substituting various “relevant” prices of X into the above supply equation, we get the producer’s supply schedule shown in table 2.4 below. Table 2.4 supply schedule Price per unit (in Birr/kg) 0 10 15 22 35 43 56 67 78 106 Quantity supplied (in kg) 0 1 2 3 4 5 6 7 8 9 Unit 2: Theories of Demand and Supply 24 Ethiofetena.com Ethiopian No 1 Educational Website Figure 2.6 supply curve The supply curve: is a graphical depiction of the supply schedule. Plotting each pair of values from the supply schedule in the table above on a graph and joining the resulting points we get the producer’s supply curve, figure 2.6 below. Table 2.4 illustrates that there is a positive relationship between the quantity supplied and its price. As we can see, the supplier requires a minimum price to start supplying its product, and then increases its quantities as the unit price for its product rises, and vice versa. Figure 2.6 is a graphic representation of the supply schedule where, conventionally, the price of the product is shown on the vertical axis and the quantity supplied on the horizontal axis. The curve is, more or less functional in accordance with the law of supply, which states that, in general, the higher the price of a good, the greater the quantity of the good suppliers are willing and able to make available in the market. The slope of a supply curve: the Law of supply expresses the direct relationship between the prices of a commodity and its quantity supplied. Price and supply are positively related. Hence, the slope of the supply curve is positive. 2.2.2 Changes in quantity supplied and changes in supply A change in quantity supplied: as we stated earlier, as the price of a goods increases, the quantity supplied increases. We call this kind of movement along the supply curve a “change in quantity supplied.” Thus, movement along the supply curve is caused by a change in the commodity’s own price. In such a situation, the supply curve remains the same. Other things being constant, the movement along the (same) supply curve is caused by a change in the price of the good. For example, movement from A to B, B to C, C to A, etc., refers to a change in quantity supplied. Unit 2: Theories of Demand and Supply 25 Ethiofetena.com Ethiopian No 1 Educational Website Change in supply: this kind of change refers to a shift in the position of the supply curve caused by a change in something other than the commodity’s own price. A shift in the supply curve may be caused by change in the prices of other goods, a change in the prices of factors of production, a change in production technique or a change in the goals of the producer. Figure 2.7 Movement on supply curve Figure 2.8 shift of supply curve 2.2.3 Factors affecting supply In constructing a supply curve, the economist’s assumption is that price is the most significant determinant of the quantity supplied of any product. But factors other than the good’s own price can change the relationship between price and quantity supplied. These other factors include: y The cost of factors of production: the cost depends on the price of factors. An increase in factor cost increases the cost of production, and reduces supply. y The state of technology: Using advanced technology increases the productivity of the organization and increases its supply. y External factors: external factors like this influence the supply. If there is a flood, this reduces the supply of various agricultural products. y Tax and subsidies: an increase in government subsidies results in more production and higher supplies. y Transport: better transport facilities will increase the supply. y The price of other goods: if the price of other goods is more than the price of commodity ‘X’, then the supply of commodity ‘X’ will be increased. Unit 2: Theories of Demand and Supply 26 Ethiofetena.com Ethiopian No 1 Educational Website 2.2.4 Derivation of the market supply curve The derivation of the market supply (schedule and curve) from the individual supply is similar to that of demand. That is, the market supply in a given market is the summation of the individual suppliers in that market. Suppose that there are only four suppliers of a specific type of shirt, and their demand schedule is given below. Table 2.5 Market Supply for shirt four sellers A, B, C, and D Unit price ( Birr) 1 2 3 4 5 6 A 0 0 1 2 4 7 Quantity B 0 1 2 3 4 6 supplied C 1 2 5 7 10 13 Total (Market) 1 3 8 12 18 26 As can be seen from the above supply schedule, the market supply schedule could simply be derived by taking the summation of the individual quantities supplied at all possible prices. Graphically, the market supply is the horizontal summation of the individual supply curves as shown below. Suppose we have only three suppliers in the market for a commodity, say soft drinks, and their supply curves are given as SA, SB, and SC. + + = Figure 2.9: Summation of the Supply curves Note that the market supply curve is flatter than the individual supply curves. We assume that the sellers are identical (perfect competitive market), hence they have the same supply curve. So, we can simply multiply the quantity supplied by a representative supplier by the number of sellers in that market in order to get the market quantity supplied at all possible prices. Example: Suppose there are 120 sellers of potatoes (in tons) in a market and the sellers have a more or less similar supply curve of the form (supply equation) Qs = 20p - 5. Driven by the market supply equation. What is the quantity supplied in the market when the price is Birr 4? Unit 2: Theories of Demand and Supply 27 Ethiofetena.com Ethiopian No 1 Educational Website Solution: i. Market supply is Qm = Qs x 120 = 120 (20p - 5) Qm = 2400p – 600 (market supply equation). ii. Total quantity (market) supplied at price Birr 4 is; Qm (p=4) = 2400 (4) – 600 =9600 - 600 = 9000 tons. Ă Activity 2.2 1. Define supply. 2. What is the market supply of 100 identical wheat suppliers if the supply function of a typical supplier is Qs = 3p - 2?. Unit 2: Theories of Demand and Supply 28 Ethiofetena.com Ethiopian No 1 Educational Website 2.3 Market Equilibrium At the end of this section, students will be able to: 6 Define market equilibrium. 6 Define surplus and shortage. 6 Explain how surpluses and shortages cause the price to move towards equilibrium. 6 Describe how change in demand and supply affect equilibrium. Key Concepts Market equilibrium, Excess demand, Excess supply Startup Activity 1. Have you ever heard of the term ‘Equilibrium’? What comes to your mind whenever you hear the term ‘Equilibrium’? In a general sense, the term ‘equilibrium’ means the “state of rest”. In the context of market analysis, equilibrium refers to the market condition that once achieved, tends to persist. This condition occurs when the quantity demanded of the commodity equals the quantity supplied of the commodity. This equality produces an equilibrium price (market- clearing price). 2.3.1. The derivation of equilibrium Having seen the theory of demand and supply, we can now bring them together to see how the buying decisions of households and the selling decisions of firms interact to determine the price of a product and the quantity actually bought and sold. Market equilibrium explains the balance between demand and supply for a commodity. That is, equilibrium occurs when the quantity demanded by the buyers equals the quantity supplied by the sellers in a particular market, so that the market clears. It is a condition that once it is achieved, tends to persist because economic agents have no incentive to change their behavior. The price level at which the market reaches equilibrium is called the ‘market clearing/ equilibrium price’, and the corresponding quantity is called the ‘equilibrium quantity”. The equilibrium price in a free market is determined by the market forces of demand and supply. Suppose that the market demand and supply schedules are given as shown in the table below: Unit 2: Theories of Demand and Supply 29 Ethiofetena.com Ethiopian No 1 Educational Website Table 2.6 Monthly demand and supply schedules for shirts Price per shirt Demand Supply Market Position 5(rise) 7 0 shortage (-) 10 (rise) 5 1 shortage (-) 15 (rise) 4 2 shortage (-) 20(stable) 3 3 equilibrium 25(fall) 2 4 surplus (+) 30(fall) 1 5 surplus (+) 35(fall) 0 6 surplus (+) The above table 2.6 shows how market equilibrium is reached. When the price of a shirt is, say, Birr 15, the quantity demanded is 4 units of shirts, but the quantity supplied is only 2 units of shirts. The result is a shortage of 2 units of shirts. Thus, unsatisfied buyers will bid the price up. Raising the price will reduce the shortage. If, however, the price of shirts rose to, say, Birr 25 per shirt, the quantity supplied is 4 units of shirts while the amount demanded is only 2 units of shirts. The result is a surplus of 2 units of shirts. This surplus will cause the price of shirts to fall as unsatisfied sellers bid the price down. As the price falls, the surplus will diminish. Thus, as the table shows, there is only one price of shirts (Birr 20) at which the market is in equilibrium, i.e. the quantity demanded and quantity supplied are equal at 3 units of shirts. At all other prices, the shirt market is in disequilibrium. We have already seen that a surplus causes prices to decline and a shortage causes prices to rise. With neither shortage nor surplus (at Br.20), there is no reason for the actual price of shirts to move away from this price. The economists call this the equilibrium price: ‘equilibrium’ means “in balance” or “at rest”. Graphically: this is the price at which the quantity demanded and the quantity supplied are equal. Figure 2.10 Market equilibrium Unit 2: Theories of Demand and Supply 30 Ethiofetena.com Ethiopian No 1 Educational Website The intersections of the downward sloping demand curve and the upward sloping supply curve indicate the equilibrium price and quantity (Birr 20 and 3 shirts). The shortage of shirts that would exist below the equilibrium price and the surplus that occurs above the equilibrium price. In a free market, disequilibrium itself creates the condition for equilibrium. 2.3.2. The concepts of excess demand and excess supply Excess demand occurs when the quantity demanded is greater than the quantity supplied, which leads to a shortage in the market. Excess supply occurs when the quantity supplied exceeds the quantity demanded, resulting in a market surplus. Figure 2.11 Excess demand and Excess Supply Therefore, graphically, the intersection of the supply and demand curves for a product indicates the market equilibrium (Q*, P*). Any price above this intersection will lead to a surplus because sellers will be willing to offer more of the commodity in the market while the buyers cut their demand. On the other hand, any price below the intersection point will discourage the suppliers and reduce the quantity supplied in the market while buyers are willing to buy more, indicating that there is a shortage. However, there is always a tendency for movement towards the equilibrium point. That is, when there is a surplus, there is a tendency for prices to move downward, and when there is a shortage there is a tendency for price to move upward. Example: If the market demand and supply functions of wheat are given as Qd = 80 – 3P and Qs = 9P -40, respectively. Then, what is the market clearing price in Birr/kg and the corresponding quantity in kg? Solution: Equate Qd = Qs to get the equilibrium price Q d = Qs 80 – 3p = 9p-40 substitute for Qd and Qs Unit 2: Theories of Demand and Supply 31 Ethiofetena.com Ethiopian No 1 Educational Website 120 = 12p rearrange p* = 10 birr/kg To get the equilibrium quantity (Q*), substitute this price into either of the functions. Qd = 80 – 3 (10) Q* = 50 kg. Therefore, the market clears when the price is Br.10/kg and both the quantity demand- ed and supplied are 50 kilograms. Graphically: Figure 2.12 Market equilibrium price and quantity For prices greater than 10, supply is greater than demand, which leads to excess supply (surplus), while prices less than 10 lead to excess demand (shortage). 2.3.3 Effects of change in demand and supply on equilibrium quantity and price We know that demand might change because of fluctuations in consumer tastes or incomes, changes in consumer expectations, or variations in the prices of related goods. Supply might change in response to changes in resource prices, technology, etc. Unit 2: Theories of Demand and Supply 32 Ethiofetena.com Ethiopian No 1 Educational Website Figure 2.13: The Effect of a change in Demand on the Equilibrium Changes in Demand: Suppose that supply is constant and increases in demand, leads to a rise in both the equilibrium price and quantity; and also if there is demand fall it leads to decrease in both the equilibrium price and quantity demanded. Look at figures 2. 13 (A) and (B) respectively. Change in Supply: Let’s suppose demand is constant but supply increases (decreases). This will affect the equilibrium by lowering (rising) the new market- clearing price and raising (lowering) the new equilibrium quantity. Look at the following figure 2.14: Figure 2.14: The Effect of a change in Supply on the Equilibrium Unit 2: Theories of Demand and Supply 33 Ethiofetena.com Ethiopian No 1 Educational Website Let’s see the summary of changes in demand, and changes in supply with the help of tables. Table 2.7 Factors Shifting Demand Curve (assume Supply remains constant) Factors Changing Effect on Direction of Effect on Effect on Demand Demand Shift in Equilibrium Equilibrium Demand Curve Price Quantity Increase in income Increase Rightward Increase Increase Decrease in income Decrease Leftward Decrease Decrease Increase in price of Increase Rightward Increase Increase Substitute Decrease in price of Decrease Rightward Decrease Decrease substitute Increase in price of Decrease Leftward Decrease Decrease complement Decrease in price of Increase Rightward Increase Increase complement Increase in taste and Increase Rightward Increase Increase preference for good Decrease in taste and Decrease Leftward Decrease Decrease preference for good Increase in number of Increase Rightward Increase Increase consumers Decrease in number of Decrease Leftward Decrease Decrease consumers Unit 2: Theories of Demand and Supply 34 Ethiofetena.com Ethiopian No 1 Educational Website Table 2.8 Factors that shift the Supply Curve (assume demand remains constant) Factors Changing Effect on Direction of Effect on Effect on Supply supply Shift in Equilibrium Equilibrium Supply Curve Price Quantity Increase in resource Decrease Leftward Increase Decrease price Decrease in resource Increase Rightward Decrease Increase price Improved technology Increase Rightward Decrease Increase Decline in technology Decrease Leftward Increase Decrease Expect a price Decrease Leftward Increase Decrease increase Expect a price Increase Rightward Decrease Increase decrease Increase in number of Increase Rightward Decrease Increase suppliers Decrease in number Decrease Leftward Increase Decrease of suppliers Ă Activity 2.3 1. Explain Excess demand and excess supply. 2. When supply remains unchanged, what is the effect of a change in demand on price? Unit 2: Theories of Demand and Supply 35 Ethiofetena.com Ethiopian No 1 Educational Website 2.4 Elasticities of Demand and Supply At the end of this section, students will be able to: 6 Define elasticity. 6 Explain the types of elasticity. 6 Describe elasticity of demand 6 Discuss elasticity of supply. 6 Analyse determinants of elasticity. Key Concepts Elasticity, Price elasticity, Income elasticity, Cross elasticity Elasticity is a measure of the sensitivity of one variable to another. It tells us the percentage change in one variable in response to a one percent change in another variable. 2.4.1The Elasticity of Demand Elasticity of demand is the measure of the responsiveness of demand for a commodity to changes in any of its determinants, such as the price of the commodity, price of related goods, and consumers’ income. Accordingly, there are three basic elasticities: I. Price elasticity of demand, II. Cross-price elasticity of demand & III. Income elasticity of demand I. Price elasticity of demand Price elasticity of demand is a measure of the degree of responsiveness (or sensitiveness) of consumers to changes in the price of the commodity itself. It may be defined as the ratio of the percentage change in quantity demanded to the percentage change in price. In other words, the price elasticity of demand ( ) is the percentage change in the quantity demanded divided by the percentage change in price. Economists measure the degree of elasticity or inelasticity by the elasticity coefficient ( ), which is given as follows: Unit 2: Theories of Demand and Supply 36 Ethiofetena.com Ethiopian No 1 Educational Website Price elasticity of demand is of two types: point elasticity and arc elasticity of demand. Point elasticity of demand: measures elasticity at a (given) point or for a very small change in price. Symbolically, we could write: Whereas, arc elasticity refers to price elasticity over a distance on the demand curve. In other words, arc elasticity measures the average responsiveness of consumer demand to changes in price over a range of extended prices. Symbolically, we could write: Arc elasticity of demand = = From the down sloping demand curve, we know that price and quantity demanded are inversely related. Thus, the price elasticity coefficient of demand, Ed, will always be a negative number. Therefore, we usually ignore the minus sign and simply present the absolute value of the elasticity coefficient to avoid any ambiguity that might otherwise arise. Interpreting Price Elasticity of Demand Values a) Price Elastic Demand: demand is said to be relatively elastic if a specific percentage change in price results in a larger percentage change in quantity demanded. Then, will be greater than 1. b) Price Inelastic Demand: If a given percentage change in price is accompanied by a relatively smaller change in the quantity of the good or service, then demand is said to be relatively price inelastic. For example, if a 10% increase in a product’s price is accompanied by only a 2% decrease in the quantity demanded, the price elasticity of demand will be = 0.02/0.1 = 0.2< 1 c) Unitary Elastic: When a percentage change in price and the accompanying percentage change in quantity demand are equal, the case separating elastic and inelastic demands is said to be unitary elastic. For example, if a 6% change in price results in a 6% change in quantity demanded, then = Unit 2: Theories of Demand and Supply 37 Ethiofetena.com Ethiopian No 1 Educational Website d) Perfectly Inelastic: this is a situation in which the quantity demanded of a certain product is invariable relative to the change in the price. The elasticity coefficient is equal to zero ( =0).This shows that a change in the price of a good or service does not bring about in any change in the quantity demanded i.e. e) Perfectly Elastic: denotes that a 1% change in price results in an infinite change in quantity demanded. In this regard, the consumer can buy all possible quantities at the given price and nothing else at other prices. Table 2.9 Summary of Price Elasticity of Demand Elasticity Description Implication / />1 Elastic % / /=1 Unitary elastic % 0 1, supply is elastic; < 1, then supply is inelastic; and = 1, then supply is unitary elastic. As the law of supply states, price and quantity supplied of a product are directly related. Hence, price elasticity of supply is positive. Example: Given table 2.12 Supply schedule. Price in Birr 60 80 100 120 Quantity supplied 14 16 18 20 Unit 2: Theories of Demand and Supply 42 Ethiofetena.com Ethiopian No 1 Educational Website Elasticity of supply when price is Birr 80 is: Recall, - Point elasticity of supply Determinants of the price elasticity of supply: There are factors which determine the price elasticity of supply. The main factors are: y Expectation of future prices: If producers expect a rise in the price of a commodity in the future, they will likely hoard the commodity to take advantage of the rise in future prices. The supply will, therefore, be less elastic. On the other hand, if they expect a fall in future prices, they will release the goods from their stocks. The supply will be more elastic. y Production period: The amount of time available to producers for responding to changes in product price is the main determinant of price elasticity of supply. Generally, supply is relatively elastic to price changes in the long-run and relatively inelastic in the short-run. The reason why supply is elastic for a longer period is that suppliers might produce good substitutes. In other words, time for adjustment is important because most production activities cannot be changed in scale overnight. y Factor substitution: If there are greater substitutes for factors of production, supply is more elastic. Whenever there is a slight change in the price of a factor input, it can be substituted for others, making supply quite elastic. With no substitutes, supply becomes inelastic. y Number of sellers: The market’s supply will be more elastic when there are large numbers of firms serving the market. With a smaller number of firms/ sellers, supply becomes inelastic. Ă Activity 2.6 1. Explain the meaning and types of elasticity 2. When is the market said to be in a state of equilibrium? 3. What will be the effect on the demand for tea if the price of coffee rises? 4. What factors determine price elasticity of demand? Unit 2: Theories of Demand and Supply 43 Ethiofetena.com Ethiopian No 1 Educational Website Unit Summary Demand for a commodity refers to the amount that will be purchased at a particular price during a particular period of time. The demand curve shows how the quantity of a good demanded depends on the price. According to the law of demand, as the price of a good falls, the quantity demanded also rises. Therefore, the demand curve slopes downward. In addition to price, other determinants of the quantity demanded included the income of the consumer, the prices of substitutes and complements, consumer tastes and preferences, consumer expectation, the number of consumers in the market, etc. If one of these other determinants changes, it leads to demand curve shifts. Individual demand for a commodity is the amount purchased by a single consumer at a given price during a particular period of time; while market demand is the horizontal summation of individual demand. In a market, while buyers of a product constitute the demand side of the market, sellers of that product make up the supply side of the market. Supply may be defined as a schedule, equation or a curve that shows the various amounts of a product that a producer (firm) is willing and able to produce and make available for sale in the market over a specific time period, at given prices, ceteris paribus. Holding other factors constant, the quantity supplied of a good or service is the amount offered for sale at a given price. The supply curve shows how the quantity of a good supplied depends on the price. According to the law of supply, as the price of a good rises, the quantity supplied also rises. Therefore, the supply curve slopes upward. In addition to price, other determinants of the quantity supplied include input prices, technology, and expectations. If one of these other determinants changes, it causes the supply curve to shift. The intersection of the supply and demand curves determines the market equilibrium. At the equilibrium price, the quantity demanded equals the quantity supplied. The behavior of buyers and sellers naturally drives markets toward equilibrium. When the market price is above the equilibrium price, there is a surplus of the good, which causes the market price to fall. When the market price is below the equilibrium price, there is a shortage, which causes the market price to rise. Elasticity of demand refers to the degree of responsiveness of the quantity demanded of a commodity to changes in any of its determinants. Price elasticity of demand is the ratio of a percentage change in a commodity’s quantity demanded to a given Unit 2: Theories of Demand and Supply 44 Ethiofetena.com Ethiopian No 1 Educational Website percentage change in its price. The numerical value of the price elasticity of demand ranges from zero to infinity. Price elasticity of supply measures the degree of responsiveness/ reaction of producers to price changes. The greater the reaction is the greater he elasticity; and the lesser the reaction, the smaller the elasticity. Like the elasticity of demand, the numerical value of the price elasticity of supply ranges from zero to infinity. Unit 2: Theories of Demand and Supply 45 Ethiofetena.com Ethiopian No 1 Educational Website Unit Review Exercises Part I: Write ‘True’ if the statement is correct or ‘False’ if the statement is incorrect. 1. Demand is different from want. 2. An increase in market demand and a decrease in market supply lead to raising the equilibrium price. 3. If the income elasticity of demand for a good is 3, then the demand is elastic. 4. The cross-price elasticity between coffee and tea is likely to be negative. Part II: Multiple-choice items. Direction: Read the following questions and choose the correct answer from the given alternatives. 1. Which one is the correct definition of demand, ceteris paribus? A. It is a willingness and ability to buy goods and services. B. It is an individual’s willingness to buy goods and services. C. It i s the amount of a product which a producer is willing to sell. D. All 2. __________ is a place, condition, or mechanism, that brings together both buyers and sellers in order to exchange their goods and services. A. Demand B. Supply C. Market D. Elasticity 3. Which of the following statements is true? A. Individual demand and market demand are both the same. B. The price and quantity demanded of a commodity are positively related. C. At equilibrium, the market demand and supply curves intersect. D. All of the above. 4. Which of the following is incorrect statement? A. The demand curve is downward sloping. B. The market demand curve is flatter than the individual demand curves. C. The law of demand states the inverse relationship between price of the commodity and quantity demanded. D. None of the above. 5. Which of these statements is false? A. The value of the price elasticity of demand is negative. B. The value of the cross elasticity of demand between coca-cola and Pepsi- cola is positive. C. The price elasticity of demand is inelastic for all commodities. D. None of the above Unit 2: Theories of Demand and Supply 46 Ethiofetena.com Ethiopian No 1 Educational Website 6. Which one of the following factors determines demand? A. Price of the product itself. B. Consumer’s income. C. Size of population. D. All of the above 7. Suppose the demand for good Z goes up when the price of good Y goes down. We can say that goods Z and Y are: A. Substitutes. B. Complements. C. Unrelated goods. D. Perfect substitutes. 8. Which of the is incorrect statement? A. When the price elasticity of a good is 1 then demand is unitary elastic. B. When income elasticity of demand is negative, the commodity is luxury good. C. When the cross elasticity of demand between two goods is 0 the two goods are unrelated. D. All of the above Part III: Write detail answers to the following. 1. What does the law of supply state? 2. What is the difference between the causes behind movement along the demand curve and the shift of the demand curve? 3. If the demand and supply functions of a good are given as Q = 250-3P and Q = 2P – 50, respectively; determine A. Equilibrium price. B. Equilibrium quantity. C. From the above information, would there be a shortage or surplus if the government decided the market price to be 75 units? Unit 2: Theories of Demand and Supply 47 Ethiofetena.com Ethiopian No 1 Educational Website Unit Theories of Production and Cost 3 Unit Introduction In the previous unit, we have discussed the theory of demand and supply. In this unit, we move to the theory of production and cost, which emphasizes the behavior of firms in the production of goods and services. Firms incur costs when they buy inputs to produce the goods and services that they plan to sell. In this unit, we examine the link between a firm’s production process and its total cost. Unit Objectives At the end of this unit, students will be able to: 6 State production and production functions in the short and long run. 6 Derive and draw the various average and marginal functions from the total functions. 6 Calculate the average and marginal cost and productivity values. 6 Draw and explain the relationship between different types of cost curves. 6 Show the relationship between production and cost curves. 6 Discuss the stages of production. 6 Analyze the concept of returns to scale in production. Main Contents 3.1 Theory of Production 3.2 Theory of Cost Unit 3: Theory of Production and Cost 48 Ethiofetena.com Ethiopian No 1 Educational Website 3.1. Theory of Production At the end of this section, students will be able to: 6 Define the function of production. 6 Describe short run and long run production functions. 6 Calculate the average and marginal products. 6 State the law of diminishing marginal productivity and its implications. 6 Explain the concept of returns to scale. 6 Clarify the stages of production. 6 Analyse technology change and the position of production curves. Key Concepts Production, production function, isoquant, returns to scale Startup Activity 1. How do you define ‘production’? What is needed to undertake production? Introduction Production is a scientific process that involves the transformation of raw materials (inputs) into desired products or services (outputs) by adding economic value. Production of goods and services involves transforming resources such as labor power, raw materials, services, and machines into finished products. Figure 3.1 Production 3.1.1 Production Function The production function is a function that shows the highest output that a firm can produce for every specified combination of inputs. In particular, the production function tells us the quantity of output the firm can produce given quantities of the inputs that it might employ. Assuming labor (L) and capital (K) as the only inputs, mathematically, the production function can be written as: Q = f (L,K).The production function allows inputs to be combined in varying proportions so that output can be produced in many ways (using either more capital or less labor or vice versa). Unit 3: Theory of Production and Cost 49 Ethiofetena.com Ethiopian No 1 Educational Website 3.1.2 Short Run Production Function As you may recall from your grade 9th economics class, the term short-run refers to the period of time over which at least one factor of production is fixed. In the real world, land and capital (such as plants and equipment) are usually treated as fixed factors. The long run is the period of time (planning horizon) which is sufficient when all quantities of inputs are variable. Here we are considering a simple production process with only two factors. We treat capital as the fixed factor, and labor as the variable factor. Production with one variable input: Production with one variable input (while the others are fixed) is obviously a short run phenomenon. So, let’s now consider a farmer producing wheat. To the farmer, the only variable input is assumed to be labor, and all other inputs, like land, capital, and technology, are fixed inputs. That is to say: 𝑄𝑄 = 𝐹𝐹(𝐿𝐿, 𝐿𝐿̅𝑎𝑎 , 𝐾𝐾, ̅ 𝑇𝑇̅ ) Where, Q=Quantity (output), L = Labor, La = Land, K = Capital, T = Technology, and the bar implies constant. So the short run production function tells us only the effect of a change in the farmer’s labor on the production of wheat, while keeping the size of land, capital, and technology constant. The following are the three basic concepts of the production function: Ö Total physical product (total product) (TP) Ö Average physical product (Average product) (AP) Ö Marginal physical product (marginal product) (MP) Total product (TP): refers to the total output produced by a given amount of a variable input, keeping the quantity of other (fixed) inputs constant. It is the overall amount of output produced by the factors of production employed over a given period. Average Product (AP): To calculate the average product (AP), the total product is divided by the number of units of that input. Suppose in the production of wheat, the AP of a farmer is obtained by dividing the total output by the number of workers employed. Total product 𝑇𝑇𝑇𝑇 This can be put in the form of: APL = = Number of workers 𝐿𝐿 Where APL denotes Average Product of Labor, TP denotes Total Product, and L denotes Labor. An average product measures the output per worker, which is an indication of the productivity of the input. Unit 3: Theory of Production and Cost 50 Ethiofetena.com Ethiopian No 1 Educational Website Marginal Product (MP): The marginal product (MP) is the extra or additional output obtained with one extra unit of the variable input while all other variables remain constant. In other words, the MP is the percentage change in total output resulting from a percentage change in variable input, all other things being equal. Change in total product ∆𝑇𝑇𝑇𝑇 Mathematically, MPL = = Change in number of workers ∆𝐿𝐿 As a result, the marginal product (MP) is equal to the slope of the total product (TP). Generally, we can say that the three, i.e. total product (TP), marginal product (MP), and average product (AP), are interrelated. 3.1.2.1. The Law of Diminishing Marginal Productivity In any production function with a fixed level of some of the inputs, it is impossible to expand the level of production indefinitely. Initially, as more of the variable inputs are employed together with the fixed ones, the output level increases dramatically to a certain extent, i.e. the marginal contribution of one more variable input (say, labor) increases sharply. But as the number of labor employed increases with a fixed capital, the production capacity goes to exhaustion and eventually the total output declines, i.e. the additional contribution of extra laborers employed becomes a loss or negative. Therefore, according to the law of diminishing returns, increasing the amount of the variable factor (labor) with the fixed factor (capital) will lead to an eventual decline in the marginal contribution of the additional labor to the total output. This is also accompanied by an eventual decline in total output. 3.1.2.2 Stages of production Assume capital is fixed. The production function shows different levels of output that the firm can obtain by efficiently utilizing different units of labor. In the short run production function above, the quantity of capital is fixed. Thus, output can change only when the amount of labor used for production changes. Hence, total production (TP) or total quantity (Q) is a function of labor (L). Now let us take a hypothetical example (table 3.1) that explains how a farmer can produce wheat on fixed land (one hectare of land) by changing only the amount of labor. Unit 3: Theory of Production and Cost 51 Ethiofetena.com Ethiopian No 1 Educational Website Table 3.1 short run productions and stages production Fixed input Variable Total Product Average Marginal Stages of (a hectare of input (TP) product Product production land) (labor) (In quintals) 1 hectare 0 0 --- --- » 1 5 5 5 » 2 11 6 5.5 » 3 19 8 6.33 Stage I » 4 30 11 7.5 » 5 40 10 8 » 6 48 8 8 » 7 54 6 7.71 » 8 57 3 7.12 » 9 59 2 6.56 Stage II » 10 60 1 6 » 11 60 0 5.4 » 12 58 -2 4.80 » 13 55 -3 4.23 Stage III » 14 51 -4 3.64 » 15 45 -6 3 Stages of Production: as table 3.1 shows, the total product goes through three different stages. y Stage I (increasing returns stage): this stage includes the range of variable inputs at which the MPL continues to rise, i.e., up to the point of MPL. y Stage II (the diminishing returns stage): this stage includes the value over which MPL is positive but decreasing. y Stage III (negative returns stage): defined as a range of negative MPL or decreasing TP. y In this stage of production, since MPL is negative, additional units of variable inputs (L) actually cause a decrease in TP. From table 3.1, we can sketch the graph to show the relationships between the variables, and also to explain the law of diminishing marginal returns. Unit 3: Theory of Production and Cost 52 Ethiofetena.com Ethiopian No 1 Educational Website Figure 3.2 Production curves and stages of production As you can see from the above graph, as we add more units of labor on the fixed inputs, our total product first increases. It, then reaches its maximum and starts to fall. The same is true for MPL and APL. TP and MPL are related in the following ways: y MPL increases when TP increases at an increasing rate. y It starts to fall but then remain positive when TP increases at a decreasing rate. y MPL reaches zero when TP is maximum and When TP is falling, MPL becomes negative. APL also increases first, reaches its maximum, and starts to fall, but it remains positive whenever TP is positive. The Relationship between MPL and APL: As you have seen from the above figure, the MPL curve reaches its maximum before the APL curve. Also, as long as the APL is rising, the MPL is above it; when the APL is falling, the MPL is below it. When the APL is at its maximum, the MPL is equal to the APL. Thus, y For the APL to rise the addition to TP (or MPL) must be greater than the previous APL, i.e. APL rises when MPL>APL. y For the APL to fall, the addition to TP (or MPL) must be less than the previous average, i.e. APL falls when MPL𝐴𝐴𝐴𝐴 = P 𝑄𝑄 𝑄𝑄 Note that average revenue (AR) and the price of the product (P) have the same meaning. Average revenue means the per unit revenue received by the seller from the sale of the commodity. On the other hand, price means the per unit payment made by the purchaser to purchase the commodity. Since the seller receives what the purchaser pays, the per unit revenue and per unit price are the same. That is why the AR curve and demand curve for a firm’s product are also the same. Therefore, from the firm’s viewpoint, the firm’s demand curve is also the average revenue curve. y Marginal Revenue: Marginal revenue is the change in total revenue resulting from one unit increase in sales. It is the additional amount of money or revenue the firm receives by selling one more unit of the product. It is calculated as the ratio of the change in total revenue to the change in the sale of the product, i.e. ∆𝑇𝑇𝑀𝑀 ∆(𝑃𝑃 ∗ 𝑄𝑄) 𝑀𝑀𝑀𝑀 = = ∆𝑄𝑄 ∆𝑄𝑄 Thus, in a perfectly competitive market, a firm’s average revenue, marginal revenue, and price of the product are equal, i.e. AR = MR = P = Dfirm. Marginal revenue can also be estimated as the change in total revenue with the sale of ‘n’ units of a product instead of (n – 1) units. Thus, MR = TRn– TR n – 1 Unit 4: Market Structures 73 Ethiofetena.com Ethiopian No 1 Educational Website Figure 4.3: Determination of equilibrium price under perfect competition In a perfect competition, a firm can sell any amount of output at a given market price. It means that a firm’s additional revenue (MR) from the sale of every additional unit of the commodity is just equal to the market price (P) or average rate of the commodity (AR). Hence, average revenue and marginal revenue become equal and constant in the given situation. Consequently, the AR and MR curves are the same and would be horizontal or parallel to the X-axis. Ă Activity 4.1 1. Define a perfectly competitive market. 2. Explain the characteristics of the perfect competitive market. 3. Explain the nature of demand and revenue curves in a perfectly competitive market. 4. A farmer usually sells 100 kg of coffee for Birr 200/kg. Calculate total revenue and average revenue. What will be marginal revenue if he/she decides to make an additional sale at 190? Unit 4: Market Structures 74 Ethiofetena.com Ethiopian No 1 Educational Website 4.2 Pure Monopoly Market At the end of this section, students will able to: 6 Define pure monopoly market 6 Review the characteristics of the pure monopoly market 6 Describe the reasons for the existence of pure monopoly 6 Analyze the nature of demand and revenue curves of pure monopoly market Key Concepts Monopoly, Demand and Revenue Startup Activity 1. What is a “pure monopoly market”? Discuss the topic in pairs. The second market structure in which we analyze the interaction between producers and consumers is that of a pure monopoly. The term “monopoly”