Principles of Microeconomics PDF

CHAPTER ONE 1. INTRODUCTION TO MICROECONOMICS WHAT ECONOMICS IS ALL ABOUT? Economics is about economizing; that is, about choice among alternative uses of scarce resources. Choices are made by millions of individuals, businesses, and government units. Economics examines how these choice...

CHAPTER ONE 1. INTRODUCTION TO MICROECONOMICS WHAT ECONOMICS IS ALL ABOUT? Economics is about economizing; that is, about choice among alternative uses of scarce resources. Choices are made by millions of individuals, businesses, and government units. Economics examines how these choices add up to an economic system, and how this system operates. Scarcity is central to economic theory. Economic analysis is fundamentally about the maximization of something (leisure time, wealth, health, happiness—all commonly reduced to the concept of utility) subject to constraints. These constraints—or scarcity—inevitably define a tradeoff. For example, one can have more money by working harder, but less time (there are only so many hours in a day, so time is scarce). One can have more apples only at the expense of, say, fewer grapes (you only have so much land on which to grow food—land is scarce). Adam Smith considered, for example, the trade-off between time, or convenience, and money. He discussed how a person could live near town, and pay more for rent of his home, or live farther away and pay less, ―paying the difference out of his convenience‖. Economics as a subject came into being with the publication of very popular book in 1776, ―An Enquiry into the Nature and Causes of Wealth of Nations‖, written by Prof. Adam Smith. At that time it was called Political economy, which remained operational at least up to the middle part of the 19th century. It is since then that the economists developed tools and principles using inductive and deductive reasoning. In fact, the ‗Wealth of Nations‘ is a landmark in the history of economic thought that separated economics from other social sciences. The word ‗Economics‘ was derived from the Greek words ‗Oikos‘ (a house) and ‗Nemein‘ (to manage), which meant managing a household, using the limited money or resources a household has. Let us explain a few important definitions frequently referred to in the economic theory. Wealth Definition The early economists like J.E. Cairnes, J.B.Say, and F.A.Walker have defined economics as a science of wealth. Adam Smith, who is also regarded as father of economics, stated that economics is a science concerned with the nature and causes of wealth of nations. That is, economics deal with the question as to how to acquire more and more wealth by a nation. J.S.Mill opined that it is the practical science dealing with the production and distribution of wealth. The American economist F.A.Walker says that economics is that body of knowledge, which relates to wealth. Thus, all these definitions relate to wealth. However, the above definitions have been criticized on various grounds. As a result, economists like Marshall, Robbins and Samuelson have put forward more comprehensive and scientific definitions. Emphasis has been gradually shifted from wealth to man. As Marshall puts, it is ―on the one side a study of wealth; and on the other, and more important side, a part of the study of man.‖ Welfare Definition Thus according to Marshall, economics not only analysis the aspect of how to acquire wealth but also how to utilize this wealth for obtaining material gains of human life. In fact, wealth has no meaning in itself unless it is used to purchase all those things which are required for our sustenance as well as for the comforts necessary for life. Marshall, thus, opined that wealth is a means to achieve certain ends. Scarcity Definition Lionel Robbins challenged the traditional view of the nature of economic science. His book, ―Nature and Significance of Economic Science‖, published in 1932 gave a new idea of thinking about what economics is. He called all the earlier definitions as classificatory and unscientific. According to him, ―Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses.‖ This definition focused its attention on a particular aspect of human behaviour, that is, behaviour associated with the utilization of scarce resources to achieve unlimited ends (wants). Robbins definition, thus, laid emphasis on the following points: (a) ‗Ends‘ are the wants, which every human being desires to satisfy. Want is an effective desire for a thing, which can be satisfied by making an effort for obtaining it. We have unlimited wants and as one want gets satisfied another arises. For instance, one may have the desire to buy a car or a flat. Once the car or the flat is purchased, the person wishes to buy a more spacious and designable car and the list of his wants does not stop here but goes on one after another. As human wants are unlimited, we have to make a choice between the most urgent want and less urgent wants. Thus the problem of choice arises. That is why economics is also called as a science of choice. If wants had been limited, they would have been satisfied and there would have been no economic problem. (b) ‗Means ‘or resources are limited. Means are required to be used for the satisfaction of various wants. For instance, money is an important means to satisfy many of our wants. As stated, means are scarce (short in supply in relation to demand) and as such these are to be used optimally. In other words, scarce or limited means/resources are to be economized. We should not make waste of the limited resources but utilize them very judiciously to get the maximum satisfaction. (c) Robbins also said that, the scarce means have alternative uses. It means that a commodity or resource can be put to different uses. Hence, the demand in the aggregate for that commodity or resource is almost insatiable. For instance, if we have a hundred rupee note, we can use it either to purchase a book or a fashionable clothe. We may use it in other unlimited ways as we like. Let us now turn our attention to the definitions put forward by modern economists. J.M.Keynes defined economics as the study of the management of scarce resources and of the determination of income and employment in the economy. Thus his study centered on the causes of economic fluctuations to see how economic stability could be established. According to F. Benham, economics is, ―a study of the factors affecting the size, distribution and stability of a country‘s national income.‖ Recently, economic growth and development has taken an important place in the study of economics. Prof. Samuelson has given a growth oriented definition of economics. According to him, economics is the study and use of scarce productive resources overtime and distribute these for present and future consumption. In short, economics is a social science concerned with the use of scarce resources in an optimum manner and in attainment of desired level of income, output, employment and economic growth. Note: 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. Free resources: A resource is said to be free if the amount available to a society is greater than the amount people desire at zero price. E.g. sunshine. Resources 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. -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 the risk of making loses. The reward for entrepreneurship is called profit. Entrepreneurs are individuals who: - Organize factors of production to produce goods and services. - Make basic business policy decisions. - Introduce new inventions and technologies into business practice. - Look for new business opportunities. - 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 t han 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. SUBJECT MATTER OF ECONOMICS Economics is divided into two major branches. These are: Microeconomics and Macroeconomics. Microeconomics is the study of the behavior and the relationship among the individual parts of the economy such as consumers, producers, buyers and sellers and how their interaction both determines and are determined by a system of market prices. Microeconomics examines the factors that affect individual economic choices, how changes in these factors affect such choices, and how markets coordinate the choices of various decision makers. On the other hand, Macroeconomics is the study of the entire economy in terms of the total amount of goods and services produced, total income earned, the level of employment of productive resources, and the general behavior of prices. Macroeconomics can be used to analyze how best to influence policy goals such as economic growth, price stability, full employment, interest rate and the attainment of a sustainable balance of payments. It is important to note that the boundary between Microeconomics and Macroeconomics has increasingly become narrow in recent years. The reason is that, just like Microeconomics, Macroeconomics also involves the analysis of aggregate markets for goods, services and factors of production. To understand how these aggregate markets operate, one must first understand the behavior of the firms, consumers, and investors who make up those aggregate markets. Thus, Macroeconomic analysis has become increasingly concerned with the Microeconomic foundations of aggregate economic phenomenon, and much of Macroeconomics is actually an extension of Microeconomic analysis. Note: Both microeconomics and macroeconomics are complementary to each other. That is, macroeconomics cannot be studied in isolation from microeconomics. Positive and Normative Economics Because of scientific nature of economic analysis, it is important to understand the difference between positive Economics and normative Economics. Positive Economics is the Economics of model building and deals with what will occur assuming the model is properly constructed. Positive Economics is concerned with the investigation of the ways in which different economic agents in society seek to achieve their goals. For example positive economists may analyze how a firm behaves in trying to make as much profit as it can or how a household behaves in trying to reach the highest attainable level of satisfaction from the consumption. Normative Economics on the other hand, is concerned with making suggestions about the ways in which the society‘s goals might be more efficiently realized. From the standpoint of policy recommendations, this approach involves economists in ethical question of what should or ought to be, so much so that they may take up strong moral positions. For example, the present high level of unemployment in Egypt ought to be reduced is a normative statement. In general, the chapters that follow will be concerned with positive Economics. Note : While discussing the scope of economics, we also think of whether economics is a positive or normative science. A positive science describes ‗what is‘ and normative science explains ‗what ought to be‘. Thus a positive science describes a situation as it is, whereas normative science analysis the situation and suggests/comments on wrongness or rightness of a thing/state. For example, ‗population in India is rising‘, is a positive statement and ‗Rising population is an obstacle in the way of development‘ is a normative statement. Choice and Opportunity Cost Choices are necessary because resources are scarce. Since we cannot produce every thing we would like to consume or spend, there must be some mechanism to determine what goods and services should be produced and what should be left out; whose wants should be satisfied and whose should remain unsatisfied. A decision to satisfy one set of wants necessarily means sacrificing some other sets. We usually call this sacrifice the opportunity cost. Opportunity cost is a term which means the cost of something in terms of an opportunity foregone (and the benefits that could be received from that opportunity), or the most valuable foregone alternative. In other words, the opportunity cost of a given commodity is the next best alternative cost or transfer costs. As we know that productive resources are scarce, therefore, the production of one commodity means not producing another commodity. The commodity that is sacrificed is the real cost of the commodity that is produced. This is the opportunity cost. Let us explain this with an example. Suppose a producer can produce a car or a computer with the money at his disposal. If the producer decides to produce car and not computer, then the real cost of the car is equal to the cost of computer, i.e., the alternative foregone. Let us take another example to explain the concept. For example, if a company decides to build hotels on vacant land that it owns, the opportunity cost is some other thing that might have been done with the land and construction funds instead. In building the hotels, the company has forgone the opportunity to build, say, a sporting center on that land, or a parking lot, or a housing complex, and so on. In simpler terms, the opportunity cost of spending a day for picnic with your friends could be the amount of money you could have earned if you had devoted that time to working overtime. Opportunity cost need not be assessed in monetary terms, but rather, is assessed in terms of anything that is of value to the person or persons doing the assessing. The consideration of opportunity costs is one of the key differences between the concepts of economic cost and accounting cost. Assessing opportunity costs is fundamental to assessing the true cost of any course of action. The simplest way to estimate the opportunity cost of any single economic decision is to consider, ―What is the next best alternative choice that could be made?‖ The opportunity cost of paying for college fee could be the ability to buy some clothes. The opportunity cost of a vacation in the Goa could be the payment for buying a motorbike. It is to be noted that opportunity cost is not the sum of the available alternatives, but rather of benefit of the best alternative of them. The concept of opportunity cost can be explained with a diagram that depicts opportunity cost between any two given items produced by a given economy. It is known in economics as the production possibility curve. In the imaginary economy discussed above which produces only cars and computers, the economy will be operating on the PPC if all resources (inputs) are fully utilized and used most appropriately (efficiently). The exact combination of cars and computers produced depends on the mechanisms used to decide the allocation of resources (i.e., some combination of markets, government, tradition, and community democracy). The concept of opportunity cost has become very popular in the recent years. The modern analysis of cost-benefit analysis is based on the theory of opportunity cost only. The cost-benefit analysis is a guiding tool for entrepreneurial decisions in the modern economy. Although opportunity cost can be hard to quantify, its effect is universal and very real on the individual level. The principle behind the economic concept of opportunity cost applies to all decisions, not just economic. 2. CENTRAL PROBLEMS OF AN ECONOMY Scarcity is the root cause of all economic problems. We know that resources are scarce or short in supply in relation to demand; but wants or ends are unlimited. As a consequence, we face the problem of choice among so many of our wants. This is because scarce means have alternative uses. Thus, we have to choose among the most urgent and less urgent wants. In fact, the basic problem of an economy is the problem of choice. More precisely, problem before us is to take right decisions in regard to the goals or ends to be attained and the way, the scarce means to be utilized for this purpose. Every economy faces some fundamental problems called as central problems of an economy. These are the following: (1) What goods and services are to be produced? The first major problem faced by an economy is what types of goods and services to be produced. As resources are limited, we must choose between different alternative collection of goods and services that may be produced. It may also imply whether to produce capital/producer goods or consumer goods. Moreover, we have to decide about the quantity of the goods to be produced in the economy. (2) How to produce these goods and services? The next problem we have to tackle is the problem of how to produce the desired goods in the economy. Thus the question of techniques to be used in the production comes in the mind. Whether we should use labour-intensive technique or capital – intensive technique. Labour-intensive method of production implies more use of labour per unit than capital whereas; capital- intensive technique indicates more use of capital per unit than labour. The choice depends on the availability of resources. A labour surplus economy can well use the labour–intensive technology. (3) For whom these goods and services are to be produced? Once we have decided what goods to be produced and what techniques to be used in the production of goods, we are encountered with another problem, i.e., the problem of distribution of goods in the economy. This is the problem of sharing of national income. (4) Are the resources efficiently used? We have also to see that scarce resources are efficiently utilized. This is the problem of economic efficiency or welfare maximization. (5) Are the resources fully employed? An economy must also try to achieve full employment of all its resources. (6) How to attain growth in the economy? An economy is to ensure that it is attaining sufficient growth rate so that it is able to grow larger and larger and develop at faster rate. It should be able not only to make a structural change from agrarian to industrial sector but also to increase per capita and national income of the country. An economy must not remain static. Its productive capacity must increase continuously. It is clear that the basic problem of an economy is the economizing of resources. The economizing problem arises in every type of economic society owing to the fact that resources are scarce in relation to multiple wants/ends. Production Possibility Frontier or Curve (PPF/ PPC): Just as individuals cannot have everything they want and must instead make choices, society as a whole cannot have everything it might want, either. This section will explain the constraints society faces, using a model called the production possibilities frontier (PPF). There are more similarities than differences between individual choice and social choice. Because society has limited resources (e.g., labor, land, capital, raw materials) at any point in time, there is a limit to the quantities of goods and services it can produce. Suppose a society desires two products, healthcare and education. The production possibilities frontier in the next Figure illustrates this situation. In the previous figure A Healthcare vs. Education Production Possibilities Frontier This production possibilities frontier shows a tradeoff between devoting social resources to healthcare and devoting them to education. At A all resources go to healthcare and at B, most go to healthcare. At D most resources go to education, and at F, all go to education. The figure shows healthcare on the vertical axis and education on the horizontal axis. If the society were to allocate all of its resources to healthcare, it could produce at point A. However, it would not have any resources to produce education. If it were to allocate all of its resources to education, it could produce at point F. Alternatively, the society could choose to produce any combination of healthcare and education on the production possibilities frontier. Society can choose any combination of the two goods on or inside the PPF. However, it does not have enough resources to produce outside the PPF. Most importantly, the production possibilities frontier clearly shows the tradeoff between healthcare and education. Suppose society has chosen to operate at point B, and it is considering producing more education. Because the PPF is downward sloping from left to right, the only way society can obtain more education is by giving up some healthcare. That is the tradeoff society faces. Suppose it considers moving from point B to point C. What would the opportunity cost be for the additional education? The opportunity cost would be the healthcare society has to forgo. The slope of the production possibilities frontier shows the opportunity cost. The PPF or PPC describes three important concepts: -The concept of scarcity: the society cannot have unlimited quantity of outputs even if it employs all its resources and utilizes them in the best possible way. -The concept of choice: any movement along the curve indicates the change in choice. -The concept of opportunity cost: when the economy produces on the PPF or PPC, production of more of one good requires sacrificing some of another product which is reflected by the downward sloping PPF or PPC. - All points on the PPF or PPC are attainable and efficient. - All points inside PPF or PPC is attainable but inefficient. - All point outside PPF or PPC is unattainable. Why Society Must Choose We learned that every society faces the problem of scarcity, where limited resources conflict with unlimited needs and wants. The production possibilities curve illustrates the choices involved in this dilemma. Every economy faces two situations in which it may be able to expand consumption of all goods. In the first case, a society may discover that it has been using its resources inefficiently, in which case by improving efficiency and producing on the production possibilities frontier, it can have more of all goods (or at least more of some and less of none). In the second case, as resources grow over a period of years (e.g., more labor and more capital), the economy grows. As it does, the production possibilities frontier for a society will tend to shift outward and society will be able to afford more of all goods. In addition, over time, improvements in technology can increase the level of production with given resources, and hence push out the PPF. Economic growth is represented by outward shift of the PPF or PPC. Figure shows Economic growths with a new PPF or PPC Shirts New PPF or PPC Old PPF or PPC However, improvements in productive efficiency take time to discover and implement, and economic growth happens only gradually. Thus, a society must choose between tradeoffs in the present. For government, this process often involves trying to identify where additional spending could do the most good and where reductions in spending would do the least harm. At the individual and firm level, the market economy coordinates a process in which firms seek to produce goods and services in the quantity, quality, and price that people want. However, for both the government and the market economy in the short term, increases in production of one good typically mean offsetting decreases somewhere else in the economy. *The Major Economic Problems Economic problems arise because human wants are unlimited whilst the resources available to satisfy such wants are limited. If an economy were to have unlimited wants and unlimited resources, there would be no need to study Economics! Moreover, there would be no economic problems because the economy would be able to satisfy all its wants from the available resources. Economic resources are not only limited but also have many competing ends. Consequently, every economy is faced with three core problems: what to produce, how to produce and for whom to produce. Let us look at each problem in turn. 1. What to Produce? What to produce refers to those goods and services and the quantity of each that the economy should produce. Since resources are scarce or limited, no economy can produce as much of every goods or services desired by all members of the society. More of goods or services usually mean less of others. Therefore, every society must choose exactly which goods and services to produce and how much of each to produce. 2. How to Produce? How to produce refers to the choice of the combination of factors and the particular technique to use in producing goods or services. Since goods or services can normally be produced with different factor combinations and different techniques, the problem arises as to which of these to use. Since resources are limited in any economy, when more of them are used to produce some goods and services, less are available to produce others. Therefore, society faces the problem of choosing the technique, which results in the least possible cost to produce each unit of the good or services it wants. 3. For Whom to Produce? For whom to produce refers to how much of the wants of each consumer are to be satisfied. Since resources and thus goods and services are scarce in every economy, no society can satisfy all of the wants of its people. In every society, the production and supply of goods and services is always smaller than the demand for them. For this reason, the economy should find a method to distribute the goods and services among the people as equitably as possible. It is important to note here that the above economic problems constitute the scope of Microeconomics. In other words, Microeconomics analysis is very much pre-occupied with the analysis of the three central economic problems. In the remainder of this course unit, our discussion and analysis shall revolve on the above economic problems. Method of analysis in economics: The fundamental objective of economics, like any science, is the establishment of valid generalizations about certain aspects of human behavior. Those generalizations are known as theories. A theory is a simplified picture of reality. Economic theory provides the basis for economic analysis which uses logical reasoning. There are two methods of logical reasoning: inductive and deductive. A. Inductive reasoning: Inductive reasoning is a logical method of reaching 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. The inductive method involves the following steps. ▪ Selecting problem for analysis. ▪ Collection, classification, and analysis of data. ▪ Establishing cause and effect relationship between economic phenomena. B. Deductive reasoning: 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: ▪ Problem identification. ▪ Specification of the assumptions. ▪ Formulating hypotheses. ▪ Testing the validity of the hypotheses.. Economic systems: The way a society tries to answer the above fundamental questions is summarized by a concept known as the economic system. An economic system is a set of organizational and institutional arrangements established to answer basic economic questions. Customarily, we can identify three types of economic system. These are capitalism, command, and mixed economy. 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. ▪ 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: Everyone 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 a 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. 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 labor: In a capitalistic economy, exploitation of labor (for example by paying low wages) is common. ▪ Negative externalities: are problems in a capitalistic economy where profit maximization is the main objective of firms. If economics makes sense for a firm to force others to pay the impacts of negative externalities such as pollution. 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 society, 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 labor. ▪ 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. ▪ 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. 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 the economic welfare of society at large. ▪ Economic planning: The government uses instruments of economic planning to achieve coordinated 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. ▪ Economic equality: Private property is allowed, but rules exist to prevent the concentration of wealth. Limits are fixed for owning land and property. Progressive taxation, concessions and subsidies 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.. 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 lives under one roof and make joint financial decisions. Households make two decisions. A) Selling of their resources. B) Buying of goods and services. 2. 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. 3. 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 society. The three economic agents interact in two markets: 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. 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 flow 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 (lower part of the diagram). On the other hand, the upper part shows where households sell factors of production to business firms through the factor market. The anti – clockwise 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. We also have a three-sector model in which the government is involved in economic activities. The only difference between the three-sector model from the two-sector model is that it involves government participation in the market. The government provides public services purchasing 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). The service provided by the government goes to 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 support to the firms and households. The main source of revenue for the government is the tax collected from households and firms.  Chapter summary Economics is a social science which studies efficient allocation of scarce resources to attain the maximum fulfillment of unlimited human needs. Economics has two main branches: 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. The 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 - Choose the correct answer: Which of the following is the best example of a microeconomic topic? a. The impact that the money supply has on inflation. b. The reasons for increases in the price of soft drinks. c. The effect that federal budget deficits have on the interest rate. d. The tradeoff between inflation and unemployment. Which of the following is a macroeconomics topic ? a. Wages of textile workers in the Northeast. b. The cost of producing 10,000 bookcases. c. The economy's annual growth rate. d. National demand for fish. e. Effects of farm subsidies on food prices. Scarcity: a. exists because resources are limited while human wants are unlimited. b. means we are unable to have as much as we would like to have. c. will likely be eliminated as technology continues to expand. d. is not an issue addressed in economics. Which of the following is not a resource ? a. Land. b. Labor. c. Money. d. Capital. True or false: Opportunity Cost - The cost of an opportunity forgone (and the loss of the benefits that could be received from that opportunity). Normative Statement - A statement about what actually is (was or will be), as opposed to what ought to be. An expression that can be verified by observation. Macroeconomics - The branch of economics that studies the economy of consumers or households or individual firms.  CHAPTER TWO 1. DEMAND AND LAW OF DEMAND In the first chapter we learnt that the basic economic problem faced by all societies is that of allocating scarce resources among competing uses in an attempt to satisfy the unlimited demands. We have also learnt how allocation of resources is done under different economic systems. In short, we saw that under free enterprise economy, the market forces of demand and supply are left to determine prices. Before looking in detail at the working of the price mechanism we first study separately the theory of demand and supply. In this chapter, we are going to concentrate on the theory of demand. 1- Demand Definition: In economics, demand has a special meaning, ―Demand is a relation that shows different quantities of a commodity that buyers will be willing and able to buy at different level of prices during a given period of time, while all other factors remain constant‖. The commodity, which may be a good or service, can be anything – burgers, shoes, haircuts, steel, or any other item that is purchased in a market. Notice that demand is a relation between price and the amount of a commodity that will be bought during a given time period. In other words, demand isn't simply a quantity; it is a "list" of quantities at different prices. NOTE: Economists use the term demand to refer to the amount of some good or service consumers are willing and able to purchase at each price. Demand is fundamentally based on needs and wants—if you have no need or want for something, you won't buy it. While a consumer may be able to differentiate between a need and a want, from an economist‘s perspective they are the same thing. Demand is also based on ability to pay. If you cannot pay for it, you have no effective demand. By this definition, a person who does not have a drivers license has no effective demand for a car. What a buyer pays for a unit of the specific good or service is called price. The total number of units that consumers would purchase at that price is called the quantity demanded. A rise in price of a good or service almost always decreases the quantity demanded of that good or service. Conversely, a fall in price will increase the quantity demanded. When the price of a gallon of gasoline increases, for example, people look for ways to reduce their consumption by combining several errands, commuting by carpool or mass transit, or taking weekend or vacation trips closer to home. Economists call this inverse relationship between price and quantity demanded the law of demand. The law of demand assumes that all other variables that affect demand (which we explain in the next module) are held constant. NOTE: "When other factors remain constant, there is an inverse (or negative) relationship between the quantity demanded of a good and its price". This is called the law of demand. In the definition, "Inversely" means that when the price of a good decrease, the quantity demanded increases. Also, when the price increases, the quantity demanded decreases. 2- Determinants of demand: Demand for a product depends upon a number of factors. The most important of these are—the price of the product, income of the consumer, tastes and fashion and the prices of related goods. We can put it in the functional form as: Dx = f (Px, I, Py, T, F…) Where : Dx = demand of good x; Px, = price of good x; I = income of the consumer; Py = prices of related goods; T = tastes and F = fashion. Thus, demand for a commodity depends upon the following factors: 1. Price of the product. 2. Income of the consumers. 3. Price of related goods. 4. Taste or preference of consumers. 5. Consumers expectation of income and price. 6. Number of buyers in the market, etc Now let us examine how each factor affects demand: 1. Price of the product: Price of a product is an important factor that determines demand for a product. When price of a product rises, consumers buy less and when prices fall, demand increases. Here, we assume other things (factors) to be remaining constant, i.e, ceteris paribus. Note: 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. The law of demand says that as the price of a good or service falls, the quantity demanded of that good or service increase. We can illustrate the law of demand by drawing a graph of the demand curve.  3- Demand Schedule and Demand Curve: The demand Schedule is a Table that shows the relationship between the price of a good and the quantity demanded. Demand Schedule Price Quantity demanded Point (L.E per unit) (Unit per day) A 0 6 B 1 5 C 2 4 D 3 3 E 4 2 F 5 1 G 6 0 A demand curve is the graph of a demand schedule. Each point along the curve represents a different price-quantity combination. Demand Curve The previous figure shows the demand curve slopes downward from left to right. This characteristic illustrates the law of demand. Note: Market demand is the sum of individual demands. If you were the only buyer of wheat in the market your demand schedule would be the demand schedule for the entire market. But there are many buyers. The total market demand schedule is obtained by adding up the quantities demanded by all buyers at each price. 2. 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 is positively related with income, while inferior goods are those whose demand is inversely (or negatively) related with income. In general, inferior goods are poor quality goods with relatively lower prices 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. 3. Price of related goods: Two goods are said to be related if a change in the price of one good affect 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 the 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 the price of one and the demand for the other are inversely related. 4. Taste or preference of consumers: When the taste of a consumer changes in favor of a good, her/his demand will increase, and the opposite is true. 5. Consumer expectation of income and price: Higher income or price expectation will increase demand, while a lower future income or price expectation will decrease the demand for the goods. 6. Number of buyers 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. 3- Two kinds of Changes Involving Demand: It's important to note that there may be two kinds of changes involving demand. One is "a change in the quantity demanded", which is reflected in a movement along the demand curve. The other kind is "a change in demand" which is reflected in a movement of the demand curve itself. (A) Change in the Quantity Demanded: The Change in the Quantity Demanded shows the relationship between price and Quantity demanded (with fixed other factors). This change refers to a movement from point to another on the same demand curve (a Movement along the Demand Curve). Change in quantity demanded Price (L.E per unit) A Price B C D E F G 1 2 3 4 5 6 Quantity The figure shows that: If price decreases, the Quantity demanded increases (Moving from A: B: C: D: E: F: G).  If price increases, the Quantity demanded decreases (Moving from G: F: E: D: C: B:A). (B) Change in Demand: The change in demand shows the relationship between other factors and demand (with fixed price). This change refers to Shift of the Demand curve (Shift to right "increase demand" or shift to lift "decrease demand"). Changes in Demand The previous figure shows that: When demand increases, the demand curve shifts rightward (D to D1). When demand decreases, the demand curve shifts leftward (D to D2). 4- Why does the Law of Demand Operate? Demand curve by and large slopes downward to the right. This is because of operation of the law of diminishing marginal utility. When the price of a commodity decreases, new demand is created. Also that existing buyers buy more. As the particular commodity has become cheaper, some people will purchase it in preference to other commodities. If the law of diminishing marginal utility is true, the demand curve must slope downwards. This is because only a downward sloping demand curve represents increase in demand due to fall in the prices of a commodity. Further, when price of a commodity falls, real income of the people increases. In other words, they are able to buy more goods and services now with the same amount of money they have. This is called income effect. Likewise, when the commodity is cheaper, it tends to be substituted for other commodities, which are dearer. This is called substitution effect. Both income effect and substitution effect together increase the capacity of the consumers to buy more of a commodity, when its price comes to low level. Another reason for downward sloping demand curve is that when a commodity becomes cheaper, it can be put to more uses or not so urgent uses. This also makes demand to be greater when price falls. 2- Elasticity of demand: Elasticity of demand, thus, measures the degree of responsiveness of demand to a change in price of the commodity. Prof. Alfred Marshall had introduced the concept of elasticity of demand in the economic theory. In his words, ―The elasticity (or responsiveness) of demand in a market is great or small according as the amount demanded increases much or little for a given fall in price and diminishes much or little for a given rise in price.‖ We may thus define elasticity of demand as the ratio of the percentage change in quantity demanded to the percentage change in price. NOTE: 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. Demand may be elastic or inelastic. When due to a small change in price, there is a great change in demand, it is said that demand is elastic. If a 5 percent cut in prices of car results in an increase in 30 percent in sales, demand is said to be highly elastic. In other words, demand has responded greatly. On the other hand, if a great change in price is followed by a small change in demand, it is inelastic demand. For example, the demand for salt is said to be inelastic because same quantity of it will be purchased even if price rises or declines. Whereas, demand for a car is elastic because a small rise/fall in price may greatly reduce/increase its demand. Price elasticity of demand is expressed as under: Ep = Percentage change in demand Percentage change in price There are five cases/kinds of price elasticity of demand. These are as follows: 1. Perfectly Inelastic Demand: Demand for a commodity will be said to be perfectly inelastic, if the quantity demanded does not change at all in response to a given change in price. If 10 percent change in price results in zero percent change in demand, it is exactly inelastic demand. The demand curve, in this case, is vertical straight line perpendicular to Y-axis as shown in the next Figure. 2. Inelastic or less than Unit Elastic Demand: Demand for commodity will be said to be inelastic (or less than unit elastic) if the percentage change in quantity demanded is less than the percentage change in price. If 10 percent change in price results in 6 percent change in demand, it is inelastic demand. This is shown in the next Figure. 3. Unitary Elastic Demand: Demand for a commodity will be said to be unit elastic if the percentage change in quantity demanded equals the percentage change in price. If 10 percent change in price results in 10 percent change in demand, it is unit elastic demand. The demand curve in such case is called rectangular hyperbola shown in the next Figure. 4. More than Unit Elastic ( elastic demand): Demand for a commodity will be said to be more than unit elastic if a change in price results in a significant change in demand for this commodity. If 10 percent change in price results in 14 percent change in demand, it is elastic demand. Figure below shows elastic demand. 5. Perfectly Elastic Demand: Demand for a commodity is said to be perfectly elastic, when a small change in its price results in an infinite change in its quantity demanded. If 10 percent change in price results in (α) percent change in demand, it is exactly elastic demand. In this case, demand curve is horizontal straight line parallel to X-axis as shown in the next Figure. The first and the last cases are rare in real life. Thus, we can summarize the types of elasticity in the table below: The table shows how a 10% change in price of a good influences quantity demanded. If there is no change or zero change in quantity demanded, elasticity is perfectly inelastic. Likewise, if the change is relatively less, demand is inelastic. In case of same change and more changes in demand, elasticity is unitary and elastic demand respectively. When there is very great change, demand is perfectly elastic. NOTE: -The elasticity of demand is always negative. This is because price and quantity are inversely related. But by convention, for the sake of simplicity, the minus sign is dropped in economics. - Substitute's goods have positive signal. - Complements goods have negative signal.  - Independent goods (Exy= zero) 5- Determinants of price elasticity of demand: Elasticity of demand differs from commodity to commodity. The various factors upon which elasticity depends are the following: 1. Substitute goods: A commodity will have elastic demand if there are good substitutes for it. This is because when price of a good rises, a consumer will not buy the good but purchase its substitute. 2. Nature of commodity: All necessities like salt, rice etc that have no substitutes/or less substitutes will have an inelastic demand. People have to purchase such commodities for their sustenance. Therefore, there will be some demand despite the changes in price. Demand for luxury goods, on the other hand, will be elastic. If prices of such commodities rise even a little, consumers refrain to buy. At the same time a little lowering of price of such commodities attract a large number of consumers. 3. Number of uses of commodity: The larger the number of uses to which a commodity can be put, the higher will be its elasticity. Therefore the demand of such goods will have elastic demand. For example, milk can be used for various purposes such as for making curd, cake, sweets etc. When its price goes down, demand increases but a little rise in its price makes demand fall greatly. 4. Possibility of postponement of consumption: If there is a possibility of postponement of consumption of a commodity then demand will be elastic otherwise inelastic. Demand for certain goods can be postponed for sometime such as computers, printers, scanners etc. People may wait till they become cheaper. Therefore, their demand is elastic. But the demand for food or electricity cannot be postponed. As such their demand is inelastic. 5. Percentage of income spent: The elasticity of demand is also influenced by the percentage of income spent on the purchase of a commodity. If the percentage is very less then the demand will be inelastic. For instance, we spend a very less amount of our total money income on things like agarbatties (incense sticks), matches, pens, pencils etc. If prices of such commodities rise also, our demand is not reduced. Thus, demand of such goods is inelastic. 6. Fashion: Commodities, which are in fashion, will have inelastic demand. Fashion minded people do not compromise with price. Even if price is high, some people will demand more just because goods are in fashion. 7. Change in taste: A habitual commodity or a commodity for which consumers have developed a taste will have inelastic demand. A chain smoker always requires a cigarette, whatever the price may be. Likewise, a habitual paan (betel nut) chewer cannot leave his habit, in spite of rise in price. In such cases, therefore, demand is elastic. 8. Price of the commodity: Very high priced or very low priced goods have low elasticity whereas moderately priced commodities are quite high-elastic. If a good is very expensive, demand will not increase much even if there is little fall in its price. And demand will not increase even at very low prices, because people have already purchased their requirement at low prices. 6-Income Elasticity of Demand It is the ratio of the percentage change in the amount spent on the commodity to a percentage change in the consumer‘s income, price remaining constant. That is, 7-Cross Elasticity of Demand The responsiveness of demand to a change in the prices of related commodities (substitutes and complementary) is called cross elasticity of demand. It is responsiveness of demand for commodity X to a change in price of commodity Y and is represented as follows:  Chapter summary Demand for a good refers to the quantity that will be purchased at a particular price during a particular period of time. Price of a good, income of the consumer, prices of related goods, consumer's tastes and preferences, consumer's 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 good increase when its price falls and decreases when the price rises. 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. Review questions - Choose the correct answer: Which of the following would NOT be a determinant of demand? a. the price of related goods b. income c. tastes d. the prices of the inputs used to produce the good Each of the following are determinants of demand except: a. tastes. b. technology. c. income. d. the price of related goods.  CHAPTER THREE 1-SUPPLY AND ITS DETERMINANTS MEANING OF SUPPLY Supply refers to the amount of good offered for sale in the market at a given price. Supply should be distinguished from stock. Stock is the amount of good which can be brought into the market for sale at a short notice. Thus supply is the quantity actually brought in the market but stock is a potential supply. Supply is a relation that shows different quantities of a good that sellers will be willing and able to make available for sale at different level of prices during a given time period, all other factors remain constant. SUPPLY SCHEDULE Supply schedule represents the relation between prices and the quantities of good supplied. It is a list of quantity supplied by producers at different prices. This is shown as under: It is seen that when price is Rs 1, quantity supplied is 10 units and as price increases, supply also increases. This shows that supply and price of the commodity are directly related. SUPPLY CURVE Supply curve is the graphical representation of the supply schedule. A supply curve is shown in the figure below. In the Fig., x-axis measures quantities of good supplied and y-axis measures price of the commodity. SS is the supply curve sloping upwards to the right, indicating that when price of the commodity increases supply also increase. It should be noted here that if price of the product falls too much, producers refuse to supply any good. Thus the price below which the seller will refuse to sell is called the reserve price. MARKET SUPPLY The total amount of goods supplied at various prices by all producers/sellers in a market is called market supply. A market supply schedule is shown as under. Let us assume that there are three sellers—A, B and C. Their individual supply schedule is shown in 2 nd, 3rd and 4th columns respectively. Market supply is the sum of A‘s, B‘s and C‘s supply of a commodity. We find that the market supply schedule also behaves in the same way as an individual‘s supply of a commodity. That is, at higher price, supply is greater and vice versa. LAW OF SUPPLY The law of supply states that, other things remaining same, as the price of a commodity rises, its supply also rises and as the price falls, supply contracts. Thus supply and price of a commodity have direct/positive relationship, i.e., higher the price, larger will be the supply and vice versa. According to Marshall, ―As the prices rise, other things remaining same, the supply rises and as the price falls the supply decreases‖. The law of supply can be explained through a supply schedule as shown under: It is seen in the table above that, as price of apples rise from 1 to Rs. 6, sellers increase supply of apples from 5 units to 30 units. Thus price and supply varies directly. Higher the price, more is the supply and vice versa, other factors remaining constant. These factors are money income of sellers and buyers, technology, costs of all factors of production, taxes and subsidies, prices of related goods etc. The law of supply states that, "When other factors remain constant, there is a positive relationship between the quantity supplied of a good and its price". This is called the law of supply. 2-DETERMINANTS OF SUPPLY Supply of a commodity depends upon a number of factors. The important determinants of supply can be grouped together in a supply function as follows:  SX = f (PX, PY, F, T, G) Supply function describes the functional relationship between supply of a commodity (say X) and other determinants of supply, i.e., price of the commodity (PX), prices of related commodities (PY), price of the factors of production (F), technology (T) and goals (G) or general objectives of the producer. Let us discuss the factors that determine supply of a product as under: 1. Price of the product: As already stated, price determines the supply of a product. When price is high, supply is more and vice versa. Producers are encouraged to produce more when price is high because of high profit margin. 2. Technology: The change in technology also affects supply of a product. It may reduce the cost of production and as a result supply will be more. Automatic and digital photocopier machines have increased the speed of photocopy per unit and hence large production. 3. Price of factors: Changes in prices of factors also cause a change in cost of production and thereby bring changes in the supply of the product. When costs of factors come down, it reduces the overall cost of production and as a result producers are induced to produce and supply more. 4. Prices of other products: Prices of substitutes and complements also affect the supply of a product. For example, if prices of tea rise, it will result in the reduction in the production and supply of coffee as the producers will withdraw resources from the production of coffee and devote these to the production of tea. 5. Future price expectation: If sellers expect the prices to rise in future, they would reduce supply of a product in the market and hoard the commodity to sell in the future. This is specially done for earning high profits. For example, when traders expect that price of kerosene oil will rise further, they create artificial scarcity and stock so as to sell and reap high profits in future. Note: A change in any of the above listed factors except the price of the good will change the supply, while a change in the price, other factors remain constant will bring change in quantity supplied. A change in supply will shift the supply curve from its original location. For this reason, those factors listed above other than price are called supply shifters. A change in own price is only a movement along the same supply curve. MOVEMENT ALONG AND SHIFTS IN SUPPLY CURVE A movement along the same curve simply indicates changes in quantities offered as a result of a change in the price. When supply changes not due to changes in the price of the product but due to other factors, such as change in technology, changes in the prices of related commodities, changes in price of inputs etc, it is said to be shifts in supply curve. (A) Chang in supply: The change in supply shows the relationship between other factors and supply (with fixed price). This change refers to Shift of the supply curve (Shift to right "increase supply" or shift to lift "decrease supply "). Supply is said to increase (supply curve shifts to the right) when, price remaining same, more is offered for sale and decrease (supply curve shifts to the left) when, at the same price, less is offered for sale in the market. This is illustrated in the Fig. above. SS is the supply curve before the change. S'S' shows a decrease in supply because at the same price OM' (OM' < OM) is offered for sale. S''S" shows an increase in supply because at the same price OH, more is supplied (OM" > OM). (B) Change in the quantity Supplied: The change in quantity supplied shows the relationship between price and quantity supplied for a good (with fixed other factors). This change refers to movement from one point to another on the same supply curve (movement along the supply curve). When there is a change in price (rise/fall), supply also changes (increases/decreases) and the phenomena is called extension and contraction in supply. In this case, equilibrium point moves along the same supply curve-either to left or right. In the next Fig., SS is the supply curve and the equilibrium point is E at OP price. When price falls to OP", supply gets reduced by N"N and supply increases to ON' when price rises to OP'. The equilibrium point E moves to E'' when price falls and moves to E', when price rises. Elasticity of Supply (Price elasticity of supply) Elasticity of supply is a measure of how much the quantity supplied of a good respond to a change in the price of that good, computed as the percentage change in quantity supplied divided by the percentage change in price. ES=∆QS\ ∆P When you calculate the price elasticity of supply the answer is always (positive). Degree of elasticity of supply: There are five degrees of elasticity of supply: I. Elastic supply: Percentage Change in quantity supplied is greater than of Percentage change in price, and ES> 1. 2. Inelastic supply: Percentage Change in quantity supplied is less than of Percentage change in price, and ES< 1. 3. Unit elastic supply: Percentage Change in quantity supplied equals Percentage change in price, and ES = 1. 4. Perfectly inelastic supply: Unresponsive quantity supplied of the change in price, and ES=0. 5. Perfectly elastic supply: Percentage Change in quantity supplied is very large of Percentage change in price, and ES= ∞ Determinants of elasticity of supply: The price elasticity of supply measures the response of a firm in terms of quantity supplied whenever there is a price change. But what affects the degree to which the firm can respond to the change in price? There are factors that influence the degree and pace at which firms can adjust their quantity in response to a price change. Determinants of price elasticity of supply refer to factors that either make the supply curve more elastic or inelastic. The main determinants of price elasticity of supply are the following. I. The length of the production period: This refers to how quick the production process is for producing a certain good. If the firm can quickly adjust its production process and produce output more quickly, it has a relatively more elastic supply curve. However, if the production process takes a lot of time and effort to change the quantity, the firm has then a relatively inelastic supply. 2. The availability of spare capacity: When the firm has spare capacity that it could use to produce output more quickly, the firm can easily adjust its quantity supplied to the price change. On the other hand, if a firm doesn‘t have much spare capacity, it is harder to adjust output to the price change. This way, the availability of spare capacity can influence the elasticity of the supply curve. 3. The ease of accumulating stocks: When firms can store and keep their unsold goods, they can adjust to the price change quicker. Imagine there‘s a sudden price drop; the capacity to store their unsold goods would make their supply more responsive to changes, as the firm could wait to sell its stock at a higher price later. However, if the firm doesn‘t have such capacity as it might face high costs or other reasons, it has a more inelastic supply curve. 4. Ease of switching production: If firms are flexible in their production process, this will help them have a more elastic supply, meaning they can adjust much quicker to price changes. 5. Market entry barriers: If there are many barriers to entering the market, it causes the supply curve to become more inelastic. On the other hand, if the market entry barriers are low, the supply curve is more elastic. 6. Time scale: Time scale is the period that the firms need to adjust their production inputs. The elasticity of supply tends to be more elastic in the long run rather than the short run. The reason for that is firms have more time to change their inputs, such as buying new capital or hiring and training new labor. In the short run, firms are faced with fixed inputs such as capital, which is hard to change in a short period of time. Firms then rely on variable inputs such as labor in the short run, which causes the supply curve to be more inelastic. All these contribute to the elasticity of the supply curve. 3-MARKET EQUILIBRIUM Market equilibrium occurs when the quantity of a commodity demanded in the market per unit of time is exactly equal to the quantity of the commodity supplied to the market over the same time period. Geometrically, equilibrium occurs at the intersection of the market demand curve and the market supply curve. The price and quantity at which equilibrium exists are known respectively as the equilibrium price and equilibrium quantity. The figure shows market equilibrium The forces of demand and supply determine prices in competitive markets. Market equilibrium occurs when market demand equals market supply. Also, determination of the demand and supply curves determines the equilibrium price and the equilibrium quantity in competitive markets. Thus:  At the equilibrium price, the quantity supplied precisely equals the quantity demanded (market equilibrium), and hence there is no tendency for the price to change. At any price below the equilibrium price, the quantity demanded exceeds the quantity supplied (shortage), and the price tends to rise. At any price above the equilibrium price, the quantity supplied exceeds the quantity demanded (surplus), and the price tends to fall. Table below illustrates how market equilibrium occurs through strong interactions between demand and supply. Price Total market Total market Shortage (L.E. per unit) demand supply Or (Unit per day) (Unit per day) surplus 0 600 0 600 Shortage 1 500 100 400 Shortage 2 400 200 200 Shortage 3 300 300 equilibrium 4 200 400 200 Surplus 5 100 500 400 Surplus 6 0 600 600 surplus From the previous table we notice that: 1-Market demand (=300 unit per day) equals market supply (=300) "equilibrium point". 2- The market equilibrium price (=3 L.E per unit). 3- The market equilibrium quantity (= 300 unit per day). 4-At the price below the equilibrium price (P), the quantity demanded exceeds the quantity supplied (shortage). 5-At the price above the equilibrium price (P), the quantity supplied exceeds the quantity demanded (surplus). Change in market 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. 1-When demand changes and supply remain 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. 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. 2-When supply changes and demand remain constant: Changes in supply are brought by changes in technical knowledge and factor prices. The following graph explains the effects of changes in supply. 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. 3-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.  Chapter summary Supply refers to the quantity of a good which producers are willing to produce and offer for sale at a particular price during a particular period of time. The price of a good, input price, techniques of production, policy of taxation and subsidy, expectations of future prices, the number of sellers, and prices of related products are the main determinants of supply. The law of supply states that other things remain the same, the quantity of any good 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 the quantity demanded of a good equal the quantity supplied of a good. Elasticity of supply is a measure of how much the quantity supplied of a good respond to a change in the price of that good, computed as the percentage change in quantity supplied divided by the percentage change in price. Elasticity of supply is determined by the length of the production period, The availability of spare capacity, The ease of accumulating stocks, Ease of switching production, Market entry barriers, and Time scale. There are five degrees of price elasticity of supply: elastic, inelastic, unit elastic, perfectly inelastic, and perfectly elastic. When calculating elasticity of supply, we must differentiate between point elasticity and arc elasticity.