Introduction to Economics PDF

Introduction to Economics September 2019 Contents Chapter One............................................................................................................................................. 1 Basics of Economics...........................................................

Introduction to Economics September 2019 Contents Chapter One............................................................................................................................................. 1 Basics of Economics............................................................................................................................... 1 1.1 Definition of economics........................................................................................................ 1 1.2 The rationales of economics................................................................................................ 2 1.3 Scope and method of analysis in economics..................................................................... 2 1.3.1 Scope of economics............................................................................................................ 2 1.3.2 Positive and normative analysis...................................................................................... 4 1.3.3 Inductive and deductive reasoning in economics.......................................................... 4 1.4 Scarcity, choice, opportunity cost and production possibilities frontier............................. 5 1.5 Basic economic questions....................................................................................................... 10 1.6 Economic systems................................................................................................................... 11 1.6.1 Capitalist economy......................................................................................................... 11 1.6.2 Command economy........................................................................................................ 13 1.6.3 Mixed economy............................................................................................................... 14 1.7 Decision making units and the circular flow model...................................................... 15 Chapter summary................................................................................................................................ 19 Review questions................................................................................................................................ 19 Chapter Two.......................................................................................................................................... 21 Theory of Demand and Supply.......................................................................................................... 21 2.1 Theory of demand................................................................................................................ 21 2.1.1 Demand schedule (table), demand curve and demand function........................ 22 2.1.2 Determinants of demand............................................................................................ 24 2.1.3 Elasticity of demand.................................................................................................... 26 2.2 Theory of supply................................................................................................................... 31 2.2.1 Supply schedule, supply curve and supply function............................................. 31 2.2.2 Determinants of supply............................................................................................... 32 2.2.3 Elasticity of supply....................................................................................................... 33 2.3 Market equilibrium............................................................................................................. 34 Chapter summary.................................................................................................................................... 37 Review questions.................................................................................................................................... 38 Chapter Three....................................................................................................................................... 40 Theory of Consumer Behaviour........................................................................................................ 40 3.1 Consumer preferences........................................................................................................... 40 3.2 The concept of utility............................................................................................................. 41 3.3 Approaches of measuring utility........................................................................................... 42 3.3.1 The cardinal utility theory......................................................................................... 42 ii  3.3.2 The ordinal utility theory........................................................................................... 47 Chapter summary................................................................................................................................ 57 Review questions................................................................................................................................ 58 Chapter Four......................................................................................................................................... 60 The Theory of Production and Cost.................................................................................................. 60 4.1 Theory of production in the short run................................................................................. 60 4.1.1 Definition of production............................................................................................. 60 4.1.2 Production function..................................................................................................... 60 4.1.3 Total, average, and marginal product...................................................................... 62 4.1.4 The law of variable proportions............................................................................... 64 4.1.5 Stages of production.................................................................................................... 64 4.2 Theory of costs in the short run........................................................................................ 65 4.2.1 Definition and types of costs...................................................................................... 65 4.2.2 Total, average and marginal costs in the short run............................................... 66 4.2.3 The relationship between short run production and cost curves...................... 70 Chapter summary................................................................................................................................ 72 Review questions................................................................................................................................ 73 Chapter Five.......................................................................................................................................... 74 Market Structure.................................................................................................................................. 74 5.1. The concept of market in physical and digital space.......................................................... 74 5.2. Perfectly competitive market................................................................................................ 74 5.2.1 Assumptions of perfectly competitive market............................................................. 75 5.2.2 Short run equilibrium of the firm................................................................................. 76 5.2.3 Short run equilibrium of the industry.......................................................................... 82 5.3. Monopoly market................................................................................................................... 83 5.3.1. Definition and characteristics....................................................................................... 83 5.3.2. Sources of monopoly...................................................................................................... 83 5.4. Monopolistically competitive market................................................................................... 84 5.5. Oligopoly market................................................................................................................... 85 Chapter summary................................................................................................................................ 85 Review questions................................................................................................................................ 86 Chapter Six............................................................................................................................................. 87 Fundamental Concepts of Macroeconomics................................................................................... 87 6.1. Goals of macroeconomics...................................................................................................... 87 6.2. The National Income Accounting......................................................................................... 88 6.2.1. Approaches to measure national income (GDP/GNP)................................................ 88 6.2.2. Other income accounts.................................................................................................. 94 iii 6.3. Nominal versus Real GDP..................................................................................................... 95 6.4. The GDP Deflator and the Consumer Price Index(CPI).................................................... 95 6.5. The Business Cycle................................................................................................................. 97 6.6. Macroeconomic Problems..................................................................................................... 98 6.6.1. Unemployment............................................................................................................... 98 6.6.2. Inflation......................................................................................................................... 100 6.6.3. Trade deficit and budget deficit.................................................................................. 101 6.7. Macroeconomic policy instruments.................................................................................... 102 6.7.1. Monetary policy............................................................................................................ 102 6.7.2. Fiscal policy.................................................................................................................. 103 Chapter summary.............................................................................................................................. 105 Review questions.............................................................................................................................. 106 iv  Chapter One Basics of Economics Introduction Have you ever heard anything about Economics? Yes!!! It is obvious you heard about economics and even you talked a lot about economics in your day to day activities. And you may have questions such as: What are resources? What does efficient allocation mean? What are human needs? What does demand mean? What is economics? This course will answer those questions and introduce you to the nature of economics, demand and supply theories, theories of consumer, production, cost, market structure and fundamental concepts of macroeconomics at large. In this chapter you will be introduced to the subject matter of economics and the rationale that motivates us to study economics. Chapter objectives After successful completion of this chapter, you will be able to:  understand the concept and nature of economics;  analyze how resources are efficiently used in producing output;  identify the different methods of economic analysis ;  distinguish and appreciate the different economic systems;  understand the basic economic problems and how they can be solved; and  identify the different decision making units and how they interact with each other 1.1 Definition of economics Economics is one of the most exciting disciplines in social sciences. The word economy comes from the Greek phrase ―one who manages a household‖. The science of economics in its current form is about two hundred years old. Adam Smith – generally known as the father of economics – brought out his famous book, ―An Inquiry into the Nature and Causes of Wealth of Nations‖, in the year 1776. Though many other writers expressed important economic ideas before Adam Smith, economics as a distinct subject started with his book. There is no universally accepted definition of economics (its definition is controversial). This is because different economists defined economics from different perspectives: a. Wealth definition, b. Welfare definition, c. Scarcity definition, and d. Growth definition 1 Hence, its definition varies as the nature and scope of the subject grow over time. But, 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. As economics is a science of choice, it studies how people choose to use scarce or limited productive resources (land, labour, equipment, technical knowledge and the like) to produce various commodities. The following statements are derived from the above definition.  Economics studies about scarce resources;  It studies about allocation of resources;  Allocation should be efficient;  Human needs 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 that provide the foundation for the field of economics. 1) Human (society‘s) material wants are unlimited. 2) Economic resources are limited (scarce). 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 2  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. Microeconomics Macroeconomics  Studies individual economic units of an  Studies an economy as a whole and its economy. aggregates.  Deals with individual income, individual  Deals with national income and output prices, individual outputs, etc. and general price level  Its central problem is price determination  Its central problem is determination of and allocation of resources. level of income and employment.  Its main tools are the demand and supply of  Its main tools are aggregate demand and particular commodities and factors. aggregate supply of an economy as a  It helps to solve the central problem of whole. ‗what, how and for whom to produce‘ in an  Helps to solve the central problem of economy so as to maximize profits ‗full employment of resources in the  Discusses how the equilibrium of a economy.‘ consumer, a producer or an industry is  Concerned with the determination of attained. equilibrium levels of income and Examples: Individual income, individual employment at aggregate level. savings, individual prices, an individual firm‘s Examples: national income, national output, individual consumption, etc. savings, general price level, national output, aggregate consumption, etc. Note: Both microeconomics and macroeconomics are complementary to each other. That is, macroeconomics cannot be studied in isolation from microeconomics. 3  1.3.2 Positive and normative analysis Is economics a positive science or normative science, or both? What is your justification? Economics can be analyzed from two perspectives: positive economics and normative economics. 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. Example:  The current inflation rate in Ethiopia is 12 percent.  Poverty and unemployment are the biggest problems in Ethiopia.  The life expectancy at birth in Ethiopia is rising. All the above statements are known as positive statements. These statements are all concerned with real facts and information. Any disagreement on positive statements can be checked by looking in to facts. 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 since normative economics is loaded with judgments, 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. Example:  The poor should pay no taxes.  There is a need for intervention of government in the economy.  Females ought to be given job opportunities. 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. 4 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 1. Have you ever faced a problem of choice among different alternatives? If yes, what was your decision? 2. What is scarcity? Do you think that it is different from shortage? Why? It is often said that the central purpose of economic activity is the production of goods and services to satisfy consumer‘s needs and wants i.e. to meet people‘s need for consumption both as a means of survival and also to meet their ever-growing demand for an improved lifestyle or standard of living. 1. Scarcity The fundamental economic problem that any human society faces is the problem of scarcity. Scarcity refers to the fact that all economic resources that a society needs to produce goods and services are finite or limited in supply. But their being limited should be expressed in relation to human wants. Thus, the term scarcity reflects the imbalance between our wants and the means to satisfy those wants. 5  Free resources: A resource is said to be free if the amount available to a society is greater than the amount people desire at zero Resources price. E.g. sunshine Scarce (economic) resources: A resource is said to be scarce or economic resource when the amount available to a society is less than what people want to have at zero price. The following are examples of scarce resources.  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.  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.  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.  Capital: refers to all the manufactured inputs that can be used to produce other goods and services. Example: equipment, machinery, transport and communication facilities, etc. The reward for the services of capital is called interest.  Entrepreneurship: refers to a special type of human talent that helps to organize and manage other factors of production to produce goods and services and takes risk of making loses. The reward for entrepreneurship is called profit. Entrepreneurs are individuals who: o Organize factors of production to produce goods and services. o Make basic business policy decisions. o Introduce new inventions and technologies into business practice. o Look for new business opportunities. o Take risks of making losses. Note: Scarcity does not mean shortage. We have already said that a good is said to be scarce if the amount available is less than the amount people wish to have at zero price. But we say that there is shortage of goods and services when people 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. 6 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. Scarcity → limited resource → limited output → we might not satisfy all our wants →choice involves costs → opportunity cost 3. Opportunity cost In a world of scarcity, a decision to have more of one thing, at the same time, means a decision to have less of another thing. The value of the next best alternative that must be sacrificed is, therefore, the opportunity cost of the decision. Definition: Opportunity cost is the amount or value of the next best alternative that must be sacrificed (forgone) in order to obtain one more unit of a product. For example, suppose the country spends all of its limited resources on the production of cloth or computer. If a given amount of resources can produce either one meter of cloth or 20 units of computer, then the cost of one meter of cloth is the 20 units of computer that must be sacrificed in order to produce a meter of cloth. When we say opportunity cost, we mean that:  It is measured in goods & services but not in money costs  It should be in line with the principle of substitution. In conclusion, when opportunity cost of an activity increases people substitute other activities in its place. 4. The Production Possibilities Frontier or Curve (PPF/ PPC) The production possibilities frontier (PPF) is a curve that shows the various possible combinations of goods and services that the society can produce given its resources and technology. To draw the PPF we need the following assumptions. a. The quantity as well as quality of economic resource available for use during the year is fixed. b. There are two broad classes of output to be produced over the year. c. The economy is operating at full employment and is achieving full production (efficiency). 7  d. Technology does not change during the year. e. Some inputs are better adapted to the production of one good than to the production of the other (specialization). Suppose a hypothetical economy produces food and computer given its limited resources and available technology (table 1.1). Table 1.1: Alternative production possibilities of a certain nation Types of products Unit Production alternatives A B C D E Food metric tons 500 420 320 180 0 Computer number 0 500 1000 1500 2000 We can also display the above information with a graph. Food 500 A - All points on the PPF are 420 B attainable and efficient - Point Q is attainable but inefficient 320 C.R - Point R is unattainable 180 Q D E 0 500 1000 1500 2000 Computer Figure 1.1: Production Possibilities Frontier The PPF describes three important concepts: i) The concepts of scarcity: - the society cannot have unlimited amount of outputs even if it employs all of its resources and utilizes them in the best possible way. ii) The concept of choice: - any movement along the curve indicates the change in choice. iii)The concept of opportunity cost: - when the economy produces on the PPF, production of more of one good requires sacrificing some of another product which is reflected by the downward sloping PPF. 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. 8 The reason why opportunity cost increases when we produce more of one good is that economic resources are not completely adaptable to alternative uses (specialization effect). Example: Referring to table 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: 320  420  100 OC    0.2 (The economy gives up 0.2 metric tons of food per 1000  500 500 computer) 5. Economic Growth and the PPF Economic growth or an increase in the total output level occurs when one or both of the following conditions occur. 1. Increase in the quantity or/and quality of economic resources. 2. Advances in technology. Economic growth is represented by outward shift of the PPF. Food Old PPF New PPF Computer Figure 1.2: Economic growths with a new PPC 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. This is called asymmetric growth (figure 1.3). 9 Food Food Computer Computer Computer Figure 1.3: improvements in technology and quantity and/or quality of resources on national output 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? 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. How to Produce? This problem is also known as the problem of choice of technique. Once an economy has reached a decision regarding the types of goods to be produced, and has determined their respective quantities, the economy must decide how to produce them - 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. 10 Broadly speaking, the various techniques of production can be classified into two groups: labour-intensive techniques and capital-intensive techniques. A labour-intensive technique involves the use of more labour relative to capital, per unit of output. A capital-intensive technique involves the use of more capital relative to labour, per unit of output. The choice between different techniques depends on the available supplies of different factors of production and their relative prices. Making good choices is essential for making the best possible use of limited resources to produce maximum amounts of goods and services. 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, command and mixed economy. 1.6.1 Capitalist economy Capitalism is the oldest formal economic system in the world. It became widespread in the middle of the 19th century. In this economic system, all means of production are privately owned, and production takes place at the initiative of individual private entrepreneurs who work mainly for private profit. Government intervention in the economy is minimal. This system is also called free market economy or market system or laissez faire. Features of Capitalistic Economy  The right to private property: The right to private property is a fundamental feature of a capitalist economy. As part of that principle, economic or productive factors such as land, factories, machinery, mines etc. are under private ownership. 11  Freedom of choice by consumers: Consumers can buy the goods and services that suit their tastes and preferences. Producers produce goods in accordance with the wishes of the consumers. This is known as the principle of consumer sovereignty.  Profit motive: Entrepreneurs, in their productive activity, are guided by the motive of profit-making.  Competition: In a capitalist economy, competition exists among sellers or producers of similar goods to attract customers. Among buyers, there is competition to obtain goods. Among workers, the competition is to get jobs. Among employers, it is to get workers and investment funds.  Price mechanism: All basic economic problems are solved through the price mechanism.  Minor role of government: The government does not interfere in day-to-day economic activities and confines itself to defense and maintenance of law and order.  Self-interest: Each individual is guided by self-interest and motivated by the desire for economic gain.  Inequalities of income: There is a wide economic gap between the rich and the poor.  Existence of negative externalities: A negative externality is the harm, cost, or inconvenience suffered by a third party because of actions by others. In capitalistic economy, decision of firms may result in negative externalities against another firm or society in general. Advantages of Capitalistic Economy  Flexibility or adaptability: It successfully adapts itself to changing environments.  Decentralization of economic power: Market mechanisms work as a decentralizing force against the concentration of economic power.  Increase in per-capita income and standard of living: Rapid growth in levels of production and income leads to higher per-capita income and standards of living.  New types of consumer goods: Varieties of new consumer goods are developed and produced at large scale.  Growth of entrepreneurship: Profit motive creates and supports new entrepreneurial skills and approaches.  Optimum utilization of productive resources: Full utilization of productive resources is possible due to innovations and technological progress.  High rate of capital formation: The right to private property helps in capital formation. 12 Disadvantages of Capitalistic Economy  Inequality of income: Capitalism promotes economic inequalities and creates social imbalance.  Unbalanced economic activity: As there is no check on the economic system, the economy can develop in an unbalanced way in terms of different geographic regions and different sections of society.  Exploitation of labour: In a capitalistic economy, exploitation of labour (for example by paying low wages) is common.  Negative externalities: are problems in capitalistic economy where profit maximization is the main objective of firms. If economic makes sense for a firm to force others to pay the impacts of negative externalities such as pollution. 1.6.2 Command economy Command economy is also known as socialistic economy. Under this economic system, the economic institutions that are engaged in production and distribution are owned and controlled by the state. In the recent past, socialism has lost its popularity and most of the socialist countries are trying free market economies. Main Features of Command Economy  Collective ownership: All means of production are owned by the society as a whole, and there is no right to private property.  Central economic planning: Planning for resource allocation is performed by the controlling authority according to given socio-economic goals.  Strong government role: Government has complete control over all economic activities.  Maximum social welfare: Command economy aims at maximizing social welfare and does not allow the exploitation of labour.  Relative equality of incomes: Private property does not exist in a command economy, the profit motive is absent, and there are no opportunities for accumulation of wealth. All these factors lead to greater equality in income distribution, in comparison with capitalism. Advantages of Command Economy  Absence of wasteful competition: There is no place for wasteful use of productive resources through unhealthy competition.  Balanced economic growth: Allocation of resources through centralized planning leads to balanced economic development. Different regions and different sectors of the economy can develop equally. 13   Elimination of private monopolies and inequalities: Command economies avoid the major evils of capitalism such as inequality of income and wealth, private monopolies, and concentration of economic, political and social power. Disadvantages of Command Economy  Absence of automatic price determination: Since all economic activities are controlled by the government, there is no automatic price mechanism.  Absence of incentives for hard work and efficiency: The entire system depends on bureaucrats who are considered inefficient in running businesses. There is no financial incentive for hard work and efficiency. The economy grows at a relatively slow rate.  Lack of economic freedom: Economic freedom for consumers, producers, investors, and employers is totally absent, and all economic powers are concentrated in the hands of the government.  Red-tapism: it is widely prevalent in a command economy because all decisions are made by government officials. 1.6.3 Mixed economy A mixed economy is an attempt to combine the advantages of both the capitalistic economy and the command economy. It incorporates some of the features of both and allows private and public sectors to co-exist. Main Features of Mixed Economy  Co-existence of public and private sectors: Public and private sectors co-exist in this system. Their respective roles and aims are well-defined. Industries of national and strategic importance, such as heavy and basic industry, defense production, power generation, etc. are set up in the public sector, whereas consumer-goods industry and small-scale industry are developed through the private sector.  Economic welfare: Economic welfare is the most important criterion of the success of a mixed economy. The public sector tries to remove regional imbalances, provides large employment opportunities and seeks economic welfare through its price policy. Government control over the private sector leads to economic welfare of society at large.  Economic planning: The government uses instruments of economic planning to achieve co-ordinated rapid economic development, making use of both the private and the public sector.  Price mechanism: The price mechanism operates for goods produced in the private sector, but not for essential commodities and goods produced in the public sector. Those prices are defined and regulated by the government. 14   Economic equality: Private property is allowed, but rules exist to prevent concentration of wealth. Limits are fixed for owning land and property. Progressive taxation, concessions and subsides are implemented to achieve economic equality. Advantages of Mixed Economy  Private property, profit motive and price mechanism: All the advantages of a capitalistic economy, such as the right to private property, motivation through the profit motive, and control of economic activity through the price mechanism, are available in a mixed economy. At the same time, government control ensures that they do not lead to exploitation.  Adequate freedom: Mixed economies allow adequate freedom to different economic units such as consumers, employees, producers, and investors.  Rapid and planned economic development: Planned economic growth takes place, resources are properly and efficiently utilized, and fast economic development takes place because the private and public sector complement each other.  Social welfare and fewer economic inequalities: The government‘s restricted control over economic activities helps in achieving social welfare and economic equality. Disadvantages of Mixed Economy  Ineffectiveness and inefficiency: A mixed economy might not actually have the usual advantages of either the public sector or the private sector. The public sector might be inefficient due to lack of incentive and responsibility, and the private sector might be made ineffective by government regulation and control.  Economic fluctuations: If the private sector is not properly controlled by the government, economic fluctuations and unemployment can occur.  Corruption and black markets: if government policies, rules and directives are not effectively implemented, the economy can be vulnerable to increased corruption and black market activities. 1.7 Decision making units and the circular flow model There are three decision making units in a closed economy. These are households, firms and the government. i) Household: A household can be one person or more who live under one roof and make joint financial decisions. Households make two decisions. a) Selling of their resources, and b) Buying of goods and services. 15 ii) Firm: A firm is a production unit that uses economic resources to produce goods and services. Firms also make two decisions: a) Buying of economic resources b) Selling of their products. iii) Government: A government is an organization that has legal and political power to control or influence households, firms and markets. Government also provides some types of goods and services known as public goods and services for the society. The three economic agents interact in two markets: o 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. o 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. For simplicity, let‘s first see a two sector model where we have only households and business firms. In this case, therefore, we see the flow of goods and services from producers to households and a flow of resources from households to business firms. In the following diagram, the clock – wise direction shows the flow of economic resources and final goods and services. Business firms sell goods and services to households in product markets (upper part of the diagram). On the other hand, the lower part shows, where households sell factors of production to business firms through factor market. The anti – clock wise direction indicates the flow of birr (in the form of revenue, income and spending on consumption). Firms, by selling goods and services to households, receive money in the form of revenue which is consumption expenditure for households in the product market. On the other hand, households by supplying their resources to firms receive income. This represents expenditure by firms to purchase factors of production which is used as an input to produce goods and services. 16  A Two sector model MARKETS Revenue FOR Spending GOODS AND SERVICES Goods Firms sell Goods and and services Households buy services sold bought FIRMS HOUSEHOLDS Produce and sell Buy and consume goods and services goods and services Hire and use factors Own and sell factors of production of production Factors of MARKETS Labour, land, production FOR and capital FACTORS OF PRODUCTION Wages, rent, and Households sell Income interest Firms buy = Flow of inputs and outputs = Flow of Birr Figure 1.4: Circular flow of income with two sector model We have also a three sector model in which the government is involved in the economic activities. As shown in figure 1.5 below, the only difference of the three sector model from the two sector model is that it involves government participation in the market. The government to provide public services purchase goods and services from business firms through the product market with a given amount of expenditure. On the other hand, the government 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 (households). 17  A Three sector model MARKETS Revenue FOR Spending GOODS AND SERVICES Goods Firms sell Households buy Goods and and services Goods services sold and services bought Expenditure sold GOVERNMENT Subsidy Income support Provide social FIRMS services HOUSEHOLDS Produce and sell Taxes Provide supports Taxes Buy and consume goods and services Collect taxes goods and services Hire and use factors Buy goods and Own and sell factors Gov’t services Gov’t services of production services of production Hire and uses factors of production Factors of Payments Factors of production Labour, land, production and capital MARKETS FOR FACTORS OF PRODUCTION Income Wages, rent, Households sell and interest = Flow of inputs Firms buy and outputs = Flow of Birr Figure 1.5: Three sector circular flow of resources The service provided by the government goes to the households and business firms. The government might also support the economy by providing income support to the households and subsidies to the business firms. At this point you might ask the source of government finance to make the expenditures, payments and additional supports to the firms and households. The main source of revenue to the government is the tax collected from households and firms. 18 Chapter summary Economics is a social science which studies about efficient allocation of scarce resources so as to attain the maximum fulfillment of unlimited human needs. Economics has two main ranches: Microeconomics (deals with the economic behavior of individual economic units and individual economic variables) and Macroeconomics (deals with the functions of the economy as a whole). Resources can be categorized as free resources (that are free gifts of nature, are unlimited in supply) and economic resources (that are scarce such as land, labor, capital and entrepreneurship). Production Possibility Curve (PPC) is a curve that depicts all possible combinations of the maximum output that can be produced in an economy with given resources and technology. Economic system is a legal and institutional framework within which various economic activities take place. In economics there are three basic alternative economic systems such as Capitalistic economy, Command economy and Mixed economy. In a closed economy, the major decision-making units are households, firms, and the government. Review questions Part I: Discussion questions 1. Define economics from perspective of Wealth, Welfare, Scarcity, and Growth. Which definition more suits for economics? Why? 2. Why we study economics? Have you gained anything from this chapter? Would you discuss them please? 3. Define scarcity, choice and opportunity cost. Can you link them in your day to day lives? 4. What do you understand by positive economics and normative economics? 5. Explain why economics deals with allocation and efficient utilization of scarce resources only? 6. In recent years, especially around big cities, there is the problem of air pollution and the likelihood of poisoning is high. Given this scenario, do you think that air is free resource? Justify your answer. 7. Describe the four categories of economic resources. Which category of resources you and your family owned? 8. What is a production possibility curve? 9. Discuss the economic system in Ethiopia over the recent three regimes (EPRDF, Derg and imperial regime) 10. What are the central problems of an economy? Discuss them in detail. 19 Part II: Work out items 1. Assume that a certain simplified economy produces only two goods, X and Y, with given resources and technology. The following table gives the various possible combinations of the production of the two goods (all units are measured in millions of tons). Opportunity Cost of Production Possibility Good X Good Y Good X A 0 100 B 2 90 C 4 60 D 6 20 a) Calculate the opportunity cost of the production of good X at each point. What law does the trend in those values exhibit? b) What changes are required for this economy to shift the PPF outward? Suggested reading materials  A. Koutsoyiannis, Modern Microeconomics, 2nd edition, 1979  D.N.Dwivedi, 1997, Micro Economic Theory, 3rd edition., Vikas Publishing  R. S. Pindyck and D. L. Rubinfeld, Microeconomics, 2nd edition,1992  Varian, 2010, Intermediate Microeconomics: A Modern Approach, 8th edition  C.L.Cole, Micro Economics: A Contemporary Approach.  Ferguson & Gould‘s, 1989, Microeconomic Theory, 6th edition.  E. Mansfield, 1988, Microeconomics:Theory and Applications  Arnold, 2008, Microeconomics, 8th edition, International student edition 20  Chapter Two Theory of Demand and Supply Introduction Having learnt about the concept and meaning of economics as a subject and its nature, scope, different systems and various other fundamentals in the previous chapter, we now resort to a very important issue in economics. This is the issue of how free markets operate. In this chapter we will forward our exploration and understanding of the vast field of economics by focusing on two very powerful tools, namely, theory of demand and theory of supply. The purpose of this chapter is to explain what demand and supply are and show how they determine equilibrium price and quantity. We will also show how the concepts of demand and supply reveal consumers‘ and producers‘ sensitivity to price change. Chapter objectives After covering this chapter, you will be able to:  understand the concept of demand and the factors affecting it;  explain the supply side of a market and the determinants of supply;  understand how the market reaches equilibrium condition, and the possible factors that could cause a change in equilibrium and  explain the elasticity of demand and supply 2.1 Theory of demand 1. Are demand and want similar? Why? 2. Why can’t we purchase all that we need or we desire to have? 3. Can we say that, with a decrease in the price of a commodity, a consumer normally buys more of it? Why? 4. Explain why demand curves always slope downwards from left to right. Are there any exceptions to this? Demand is one of the forces determining prices. The theory of demand is related to the economic activities of consumers-consumption. Hence, the purpose of the theory of demand is to determine the various factors that affect demand. In our day-to-day life we use the word ‗demand‘ in a loose sense to mean a desire of a person to purchase a commodity or service. But in economics it has a specific meaning, which is different from what we use it in our day to day activities. 21 Demand implies more than a mere desire to purchase a commodity. It states that the consumer must be willing and able to purchase the commodity, which he/she desires. His/her desire should be backed by his/her purchasing power. A poor person is willing to buy a car; it has no significance, since he/she has no ability to pay for it. On the other hand, if his/her desire to buy the car is backed by the purchasing power then this constitutes demand. Demand, thus, means the desire of the consumer for a commodity backed by purchasing power. These two factors are essential. If a consumer is willing to buy but is not able to pay, his/her desire will not become demand. Similarly, if the consumer has the ability to pay but is not willing to pay, his/her desire will not be called demand. More specifically, demand refers to various quantities of a commodity or service that a consumer would purchase at a given time in a market at various prices, given other things unchanged (ceteris paribus). The quantity demanded of a particular commodity depends on the price of that commodity. Law of demand: 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 The relationship that exists between price and the amount of a commodity purchased can be represented by a table (schedule) or a curve or an equation. Demand schedule can be constructed for any commodity if the list of prices and quantities purchased at those prices are known. An individual demand schedule is a list of the various quantities of a commodity, which an individual consumer purchases at various levels of prices in the market. A demand schedule states the relationship between price and quantity demanded in a table form. Table 2.1 Individual household demand for orange per week Combinations A B C D E Price per kg 5 4 3 2 1 Quantity demand/week 5 7 9 11 13 22 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. Y Price 5 A 4 B 3 C 2 D 1 E 0 X Quantity demanded 55 7 9 11 13 Figure 2.1: Individual demand curve In the above diagram prices of oranges are given on ‗OY‘ axis and quantity demanded on ‗OX‘ axis. For example, when the price per kilogram is birr 1 the quantity demanded is 13 kilograms. From the above figure you may notice that as the price declines quantity demanded increases and vice-versa. 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) where Qd is quantity demanded and P is price of the commodity, in our case price of orange. Example: Let the demand function be Q = a+ bP Q b= (e.g. moving from point A to B on figure 2.1 above) P 75 b=  2 , where b is the slope of the demand curve 45 Q = a-2P, to find a, substitute price either at point A or B. 7= a-2(4), a = 15 Therefore, Q=15-2P is the demand function for orange in the above numerical example. Market Demand: The market demand schedule, curve or function is derived by horizontally adding the quantity demanded for the product by all buyers at each price. 23  Table 2.2: Individual and market demand for a commodity Price Individual demand Market Consumer-1 Consumer-2 Consumer-3 demand 8 0 0 0 0 5 3 5 1 9 3 5 7 2 14 0 7 9 4 20 The following graph depicts market demand curve at price equal to 3 Price Price Price Price 3 + 3 + 3 = 3 5 Q 7 Q 2 Q 14 Q Consumer-1 Consumer - 2 Consumer - 3 Market Demand Figure 2.2: Individual and Market demand curve Numerical Example: Suppose the individual demand function of a product is given by: P=10 - Q /2 and there are about 100 identical buyers in the market. Then the market demand function is given by: P= 10 - Q /2 ↔ Q /2 =10-P ↔ Q= 20 - 2P and Qm = (20 – 2P) 100 = 2000-200P 2.1.2 Determinants of demand The demand for a product is influenced by many factors. Some of these factors are: I. Price of the product II. Taste or preference of consumers III. Income of the consumers IV. Price of related goods V. Consumers expectation of income and price VI. Number of buyers in the market 24 When we state the law of demand, we kept all the factors to remain constant except the price of the good. A change in any of the above listed factors except the price of the good will change the demand, while a change in the price, other factors remain constant will bring change in quantity demanded. A change in demand will shift the demand curve from its original location. For this reason those factors listed above other than price are called demand shifters. A change in own price is only a movement along the same demand curve. Changes in demand: a change in any determinant of demand—except for the good‘s price- causes the demand curve to shift. We call this a change in demand. If buyers choose to purchase more at any price, the demand curve shifts rightward—an increase in demand. If buyers choose to purchase less at any price, the demand curve shifts leftward—a decrease in demand. When demand increases, demand Price curve shifts upward (D1) while a 1 decrease in demand shifts demand curve downwards (D2). 2 D1 D0 D2 Quantity Figure 2.3: Shift in demand curve Now let us examine how each factor affect demand. I. Taste or preference When the taste of a consumer changes in favour of a good, her/his demand will increase and the opposite is true. II. Income of the consumer Goods are classified into two categories depending on how a change in income affects their demand. These are normal goods and inferior goods. Normal Goods are goods whose demand increases as income increase, while inferior goods are those whose demand is inversely related with income. 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. However, the classification of goods into normal and inferior is subjective and it is usually dependent on the socio-economic development of the nation. 25 III. Price of related goods Two goods are said to be related if a change in the price of one good affects the demand for another good. There are two types of related goods. These are substitute and complimentary goods. Substitute goods are goods which satisfy the same desire of the consumer. For example, tea and coffee or Pepsi and Coca-Cola are substitute goods. If two goods are substitutes, then price of one and the demand for the other are directly related. Complimentary goods, on the other hand, are those goods which are jointly consumed. For example, car and fuel or tea and sugar are considered as compliments. If two goods are complements, then price of one and the demand for the other are inversely related. IV. Consumer expectation of income and price Higher price expectation will increase demand while a lower future price expectation will decrease the demand for the good. V. Number of buyer in the market 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. 2.1.3 Elasticity of demand 1. List some goods/commodities you think that increase in their prices will not significantly decrease their quantity demanded. 2. Can you list some products for which increase in their prices will significantly decrease/increase their quantity demanded? 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. Accordingly, we have the concepts of elasticity of demand and elasticity of supply. Elasticity of demand refers to the degree of responsiveness of quantity demanded of a good to a change in its price, or change in income, or change in prices of related goods. Commonly, there are three kinds of demand elasticity: price elasticity, income elasticity, and cross elasticity. 26  i. Price Elasticity of Demand Price elasticity of demand means degree of responsiveness of demand to change in price. It indicates how consumers react to changes in price. The greater the reaction the greater will be the elasticity, and the lesser the reaction, the smaller will be the elasticity. Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good, computed as the percentage change in quantity demanded divided by the percentage change in price. 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. The price elasticity of demand can be determined by the following formula. Percentage change in quantity demanded %Qd E dp   percentage change in price %P Q1  Q0 where %Qd  X 100 and Q0 P1  P0 %P  X 100 P0 Q1  Q0 X 100 Q0 Q  Q0 P0 Q P0 Thus, E d   1  P.. P1  P0 P1  P0 Q0 P Q0 X 100 P0 In this method, we take a straight-line demand curve joining the two axes, and measure the elasticity between two points Qo and Q1 which are assumed to be intimately close to each other. 27  Y In the diagram ‗RP‘ is the straight-line R Price demand curve, which connects both axes. In the beginning at the price ON the quantity N Qo demanded is OM. Then the price changes to ∆P N1 N1 Q1 ON1 and the new quantity demanded will be ∆Q OM1. The symbol ‗∆P‘ represents the change in price while the symbol ‗∆Q‘ shows the change in quantity demanded. O M M1 P Quantity 1.1.1.1.1.1.1.1 D Figure 2.4: Point elasticity of demand On a straight-line demand curve we can make use of this formula to find out the price elasticity at any particular point. We can find out numerical elasticities also on different points of the demand curve with the help of the above formula. 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. In arc price elasticity of demand, the midpoints of the old and the new values of both price and quantity demanded are used. It measures a portion or a segment of the demand curve between the two points. An arc is a portion of a curve line, hence, a portion or segment of a demand curve. The formula for measuring arc elasticity is given below. Change in quantity demanded Change in price Ed   Original quantity plus new Original price plus quantity demanded new price Symbolically, the formula may be expressed thus: Q1  Q0 P1  P0 Ed   Qo  Q1 Po  P1 28 Here, Qo = Original quantity demanded Q1 = New quantity demanded Po = Original price P1 = New price We can take a numerical example to illustrate arc elasticity. Suppose that the price of a commodity is Br. 5 and the quantity demanded at that price is 100 units of a commodity. Now assume that the price of the commodity falls to Br. 4 and the quantity demanded rises to 110 units. In terms of the above formula, the value of the arc elasticity will be 110  100 4  5 10 1 9 3 Ed =  =  =- = 100  110 4  5 210 9 21 7 Note that:  Elasticity of demand is unit free because it is a ratio of percentage change.  Elasticity of demand is usually a negative number because of the law of demand. If the price elasticity of demand is positive the product is inferior. i) If   1, demand is said to be elastic and the product is luxury product ii) If 0    1, demand is inelastic and the product is necessity iii) If   1, demand is unitary elastic. iv) If   0, demand is said to be perfectly inelastic. v) If   , demand is said to be perfectly elastic. Determinants of price Elasticity of Demand The following factors make price elasticity of demand elastic or inelastic other than changes in the price of the product. i) The availability of substitutes: the more substitutes available for a product, the more elastic will be the price elasticity of demand. ii) Time: In the long- run, price elasticity of demand tends to be elastic. Because:  More substitute goods could be produced.  People tend to adjust their consumption pattern. iii) The proportion of income consumers spend for a product:-the smaller the proportion of income spent for a good, the less price elastic will be. iv) The importance of the commodity in the consumers’ budget :  Luxury goods  tend to be more elastic, example: gold.  Necessity goods  tend to be less elastic example: Salt. 29  ii. Income Elasticity of Demand It is a measure of responsiveness of demand to change in income. %Qd Q I  dI  . %I I Q Point income elasticity of demand: i) If  dI  1 , the good is luxury good. ii) If  dI  1 ( and positive), the good is necessity good, iii) If  dI  0, (negative), the good is inferior good. iii. Cross price Elasticity of Demand Measures how much the demand for a product is affected by a change in price of another good. %Qx Q x 1  Q xo Py0  xy  =. %Py Py1  Py0 Q x0 i) The cross – price elasticity of demand for substitute goods is positive. ii) The cross – price elasticity of demand for complementary goods is negative. iii) The cross – price elasticity of demand for unrelated goods is zero. Example: Consider the following data which shows the changes in quantity demanded of good X in response to changes in the price of good Y. Unit price of Y Quantity demanded of X 10 1500 15 1000 Calculate the cross –price elasticity of demand between the two goods. What can you say about the two goods? Qx Py o  1000  1500  10  500 10  xy  *  . * .  0.67 Py Qxo  15  10  1500 5 1500 Therefore, the two goods are complements. 30  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. It tells us there is a positive relationship between price and quantity supplied. 2.2.1 Supply schedule, supply curve and supply function A supply schedule is a tabular statement that states the different quantities of a commodity offered for sale at different prices. Table 2.3: an individual seller’s supply schedule for butter Price ( birr per kg) 30 25 20 15 10 Quantity supplied kg/week 100 90 80 70 60 A supply curve conveys the same information as a supply schedule. But it shows the information graphically rather than in a tabular form. In this diagram the quantities of Supply curve oranges are measured along X axis and prices along Y axis. The supply Price curve slopes upward as we go from the left to the right. This means, as the price rises, more is offered for sale and vice-versa. Quantity Figure 2.5 supply curve The supply 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. 31 Table 2.4: Derivation of the market supply of good X Price per Quantity Quantity supplied Quantity Market supply unit supplied by by seller 2 supplied by per week seller 1 seller 3 5 11 15 8 34 4 10.5 13 7 30.5 3 8 11.5 5.5 25 2 6 8.5 4 18.5 1 4 6 2 12 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) price of inputs ( cost of inputs) ii) technology iii) prices of related goods iv) sellers‘ expectation of price of the product v) taxes & subsidies vi) number of sellers in the market vii) weather, etc. i) Effect of change in input price on supply of a product An increase in the price of inputs such as labour, raw materials, capital, etc causes a decrease in the supply of the product which is represented by a leftward shift of the supply curve. Likewise, a decrease in input price causes an increase in supply. ii) Effect of change in Technology Technological advancement enables a firm to produce and supply more in the market. This shifts the supply curve outward. iii) Effect of change in weather condition A change in weather condition will have an impact on the supply of a number of products, especially agricultural products. For example, other things remain unchanged, good weather 32 condition boosts the supply of agricultural products. This shifts the supply curve of a given agricultural product outward. Bad weather condition will have the opposite impact. Activity: Discuss how supply is affected by the changes in prices of related goods, taxes & subsidies, sellers’ expectations of future price of the product, and the number of sellers in the market? 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. The point price elasticity of supply can be calculated as the ratio of proportionate change in quantity supplied of a commodity to a given proportionate change in its price. Thus, the formula for measuring price elasticity of supply is: % ℎ 𝑒 𝑞 𝑙𝑒 Q P Q P 𝐸 = =   * % ℎ 𝑒 𝑒 Q P P Q Like elasticity of demand, price elasticity of supply can be elastic, inelastic, unitary elastic, perfectly elastic or perfectly inelastic. The supply is elastic when a small change on price leads to great change in supply. It is inelastic or less elastic when a great change in price induces only a slight change in supply. If the supply is perfectly inelastic, it will be represented by a vertical line shown as below. If supply is perfectly elastic it will be represented by a horizontal straight line as in second diagram. Price Price S Infinite elasticity or Perfectly perfectly elastic inelastic or P S zero elasticity Supply 0 Supply O Figure 2.6: Perfectly inelastic and perfectly elastic supply curves 33  2.3 Market equilibrium Having seen the demand and supply side of the market, now let‘s bring demand and supply together so as to see how the market price of a product is determined. Market equilibrium occurs when market demand equals market supply. - At point ‗E‘ market Price demand equals market D S supply (equilibrium point) H J - P is the market (P1) equilibrium (market (P) E clearing) price. G F - M is the market (P2) equilibrium (market clearing) quantity. S D Quantity M Figure 2.7: market equilibrium In the above graph, any price greater than P will lead to market surplus. As the price of the commodity increases, consumers demand less of the product. On the other hand, as the price of increases, producers supply more of the good. Therefore, if price increases to P1 the market will have a surplus of HJ. If the price decreases to P2 buyers demand to buy more and suppliers prefer to decrease their supply leading to shortage in the market which is equal to GF. Numerical example: Given market demand: Qd= 100-2P, and market supply: P =( Qs /2) + 10 a) Calculate the market equilibrium price and quantity b) Determine, whether there is surplus or shortage at P= 25 and P= 35. Solution: a) At equilibrium, Qd= 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, a surplus of 20 units 34 Effects of shift in demand and supply on equilibrium Given demand and supply the equilibrium price and quantity are stable. However, when these market forces change what will happen to the equilibrium price and quantity? Changes in demand and supply bring about changes in the equilibrium price level and the equilibrium quantity. i) when demand changes and supply remains constant Factors such as changes in income, tastes, and prices of related goods will lead to a change in demand. The figure below shows the effects of a change in demand and the resultant equilibrium price and quantity. DD is the demand curve and SS is the supply curve. Price S D1 D D2 E1 E1 P1 P E P2 D1 E2 D D2 S Quantity M2 M M1 Figure 2.8: The effect of change in demand on market equilibrium DD and SS curves intersect at point E and the quantity demanded and supplied is OM at OP equilibrium price. Given the supply, if the demand increases the demand curve will shift upward to the right. Due to a change in demand, the demand curve D1D1 intersects SS supply curve at point E1. The equilibrium price increases from OP to OP1 and the equilibrium quantity from OM to OM1. On the other hand, if demand falls, the demand curve shifts downwards to the left. Due to a change in demand, the curve D2D2 intersects the supply curve SS at point E2. The equilibrium price decreases from OP to OP2 and the equilibrium quantity decreases from OM to OM2. Supply being given, a decrease in demand reduces both the equilibrium price and the quantity and vice versa. 35 ii. When supply changes and demand remains constant Changes in supply are brought by changes in technical knowledge and factor prices. The following graph explains the effects of changes in supply. S2 Price D S S1 E2 P2 P E P1 E1 S2 S S1 D M2 M M1 Quantity Figure 2.9: The effect of change in supply on market equilibrium SS and DD intersect at point E, where supply and demand are equal at OM quantity at OP equilibrium price. Given the demand, if the supply increases, the supply curve shifts to the right (S1S1). The new supply curve, which intersects DD curve at E1, reduces the equilibrium price from OP to OP1 and increases the equilibrium quantity from OM to OM1. On the contrary, when the supply falls, the supply curve moves to the left (S2S2) and intersects the DD curve at point E2 raising the equilibrium price from OP to OP2 and reducing the equilibrium quantity from OM to OM2. 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. If an increase in demand is more than an increase in supply, then the price goes up. On the other hand, if an increase in supply is more than an increase in demand, the price falls but the quantity increases. If the increase in demand and supply is same, then the price remains the same. When demand and supply decline, the quantity decreases. But the change in price will depend upon the relative fall in demand and supply. When the fall in demand is more than the fall in supply, the price will decrease. On the other hand, when the fall in supply is more than the fall in demand, the price will rise. If both demand and supply decline in the same ratio, there is no change in the equilibrium price, but the quantity decreases. 36  Activity: Considering the initial market equilibrium of figure 2.9 above, show the new equilibrium 1. if there is an increase in supply and proportionate increase in demand 2. if the magnitude of an increment in demand is less than an increment in supply 3. if demand and supply change in the opposite directions Chapter summary Demand for a commodity refers to the amount that will be purchased at a particular price during a particular period of time. Price of the commodity, income of the consumer, prices of related goods, consumer‘s tastes and preferences, consumers‘ expectations and number of buyers are considered the main determinants of demand for a commodity. The law of demand states that, other things remaining constant, the quantity demanded of a commodity increases when its price falls and decreases when the price rises. Supply refers to the quantity of a commodity which producers are willing to produce and offer for sale at a particular price during a particular period of time. Price of a commodity, input prices, prices of related products, techniques of production, policy of taxation and subsidy, expectations of future prices, and the number of sellers are the main determinants of supply. Law of supply states that other things remaining the same, the quantity of any commodity that firms will produce and offer for sale rises with a rise in price and falls with a fall in price. Market equilibrium refers to a situation in which quantity demanded of a commodity equals the quantity supplied of a commodity. Goods can be categorized as normal good (a good for which the demand increases with increases in income), an inferior good (a good for which the demand tends to fall with an increase in the income of the consumer), substitute goods(are those goods which satisfy the same type of demand and can be used in place of one another), complementary goods( are those goods which are used jointly or together), and giffen goods(whose demand falls with a fall in their prices). Elasticity of demand refers to the degree of responsiveness of quantity demanded of a commodity to change in any of its determinants. There are three types of elasticity of demand: Price elasticity of demand, income elasticity of demand and cross price elasticity of demand. Price elasticity of demand is determined by availability of substitutes, nature of the commodity, proportion of income spent and time. 37  Review questions Part I: Distinguish between the following: 1. Normal goods and inferior goods 2. Complementary goods and substitute goods 3. Market demand and individual demand 4. Individual supply and market supply 5. Excess demand and excess supply Part II: Short answer and workout 1. Why does the quantity of salt demanded tend to be unresponsive to changes in its price? 2. Why is the quantity of education demanded in private universities much more responsive than salt is to changes in price? 3. To get the market demand curve for a product, why do we add individual demand curves horizontally rather than vertically? 4. The market for lemon has 10 potential consumers, each having an individual demand curve P = 101 - 10Qi, where P is price in dollars per cup and Qi is the number of cups demanded per week by the ith consumer. Find the market demand curve using algebra. Draw an individual demand curve and the market demand curve. What is the quantity demanded by each consumer and in the market as a whole when lemon is priced at P = $1/cup? 5. The demand for tickets to an Ethiopian Camparada film is given by D(p)= 200,000- 10,000p, where p is the price of tickets.If the price of tickets is 12 birr, calculate price elasticity of demand for tickets and draw the demand curve 6. Given market demand Qd = 50 - P, and market supply P = Qs + 5 A) Find the market equilibrium pric