Grade 11 Economics Textbook PDF

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ECONOMICS STUDENT TEXTBOOK GRADE 11 Writers: Guta Legesse Tessema (PhD) Dereje Fekadu Deressa (MSc) Editors: Chanyalew Degefa Merga (MA), Curriculum Editor Degela Ergano Done (PhD), Content Editor Taye Gebremariam Olamo (PhD), Language Editor Illustrator: Evaluators: Tadele Bayu Genet (MSc) Mekonnen Bersisa Gadisa (PhD) Book Designer: Tariku Mulushewa Dessea (MSc) Amsalu Dinote Kuye (MSc) Ararsa Hora Dabi (MSc) FEDERAL DEMOCRATIC REPUBLIC OF ETHIOPIA HAWASSA UNIVERSITY MINISTRY OF EDUCATION INTRODUCTION Economics, at its very heart, is the study of people. It seeks to explain what drives human behavior, decisions and reactions when faced with difficulties or successes. When you study economics you gain a toolkit of skills, approaches and ways of thinking that you can apply to a wide range of problems. Studying economics helps students gain the necessary skills so they can understand how economic markets around the world work. In the process, they build their analytical and problem-solving skills which will help them succeed now as students and in the future as working professionals. It enables people to understand people, businesses, markets and governments, and therefore better respond to the threats and opportunities that emerge when things change. Lessons and assignments will help young adults become financially literate by exploring personal finance strategies pertaining to saving, budgeting, investing, and more. This will give students the knowledge necessary to make practical economic decisions and become savvy consumers. This textbook is intended to support the learning of economic literacy so that students possess the tools to understand their economic world and how to interpret events that will, either directly or indirectly, affect them. Moreover, students will be supported to relate and translate economic literacy to explain economic reality on the ground. They will also be helped to acquire and develop their knowledge on what to expect in the future and how to manage their economic decisions. Finally, as per the Ethiopian General Education Curriculum Framework (GECF), Economics for Grade 11 is one of the compulsory general subjects in Social Sciences and Agriculture. Career and Technical Education that offer economics as a course are Business Sciences, Language and Social Sciences, Performing and Visual Arts and Agriculture. Economics for Grade 11 (consisting of 7 units) is covered in the total of 87 hours and 45 minutes per year, 3 periods each week with 45 minutes per period. In line with the above expectations, the student profile and the textbook contents are presented below. STUDENT PROFILE At the end of Grade 11 Economics study, students are expected to be in a better position in terms of the following: Knowledge  Knowledgeable in subject area (principles, theories, applications, etc.) Attitude  Cooperation  Motivation to become successful  Curiosity Digital Literacy  Data collection and organization  Report writing  Data analysis  Data analysis skills and tools Communication Skills  Group discussion  Presentation  Teamwork Business Management Skills  Start one’s own business  Support family business By the end of the last two grades of secondary education, namely, grades 11 economics students should be equipped to:  Continue their education in various disciplines of social and business sciences using their economics knowledge and skills.  Demonstrate knowledge of and appreciation about links between production, distribution and consumption.  Start and manage their own business.  Assist in managing family (small) businesses.  Articulate contemporary issues in economic growth, development.  Participate in collaborative engagements aimed at social and economic development.  Participate in various citizenship activities by recognizing and appreciating cultural aspects (including languages and religions) and livelihood of various places.  Discuss the key contemporary issues including unemployment, inflation, and poverty reduction using enquiry skills.  Articulate the link between poverty and environmental degradation.  Contribute to efforts aimed at bringing about a sustainable development in Ethiopia and beyond.  Conduct problem-solving economic research that demands data collection, organization, analysis, and evaluation. Note to Students: The units in this textbook contain references from other books and online or electronic resources. Due to space limitation, these are not included in your text book. Ask you teacher for those references. Grade 11 Economics Student Textbook Table of Contents UNIT 1 THEORY OF CONSUMER BEHAVIOR AND DEMAND INTRODUCTION1 1.1 Review of the Cardinal Utility Approach 2 1.2 The Ordinal Utility Theory and Preferences 4 1.2.1 Indifference Curve, Set and Map 7 1.2.2 Properties of Indifference Curves 10 1.2.3 The Marginal Rate of Substitution (MRS) 11 1.2.4 Marginal Utility and MRS 13 1.2.5 Special Types of Indifference Curves 14 1.3 The Budget Line or the Price line 16 1.3.1 Slope of the Budget Line 21 1.3.2 Factors Affecting the Budget Line 22 1.3.3 Effects of Changes in Income 22 1.3.4 Effects of Changes in Price of the Commodities 23 1.4 Optimum of the Consumer 25 1.4.1 Effects of Changes in Income and Prices on Consumer’s Equilibrium 27 1.4.2 Price Consumption Curve and Deriving the Demand Curve 28 Unit Summary 30 Review Questions 31 UNIT 2 MARKET STRUCTURE AND THE DECISION OF FIRMS INTRODUCTION34 2.1 Review of Market Structures 35 2.2 Perfect Competition Market 35 2.2.1 Demand, Revenue and Cost Curves 36 2.2.2 The Short-Run Equilibrium of Firm 40 2.2.3 Short Run Supply Curve of a Firm 45 2.2.4 Long run-equilibrium of Firm 46 2.3 Pure Monopoly Market 48 Table of Contents I Grade 11 Economics Student Textbook 2.3.1 Demand, Revenue and Cost under Monopoly 48 2.3.2 Short-run equilibrium under Monopoly 51 2.3.3 Price Discrimination under Monopoly 54 2.4 Monopolistic Competition Market 56 2.4.1 Product Differentiations and the Demand Curve 57 2.4.2 Costs under Monopolistic Competition 59 2.4.3 Short- run Equilibrium under Monopolistic Competition 60 2.4.4 The Concept of Industry and Product Group 61 2.5 Oligopoly Market 61 2.5.1 Collusive Oligopoly 62 2.5.2 Non-collusive Oligopoly 63 Unit Summary 64 Review Questions 65 UNIT 3 NATIONAL INCOME ACCOUNTING INTRODUCTION69 3.1 Nature of National Income Account and Its importance 70 3.2 The Concept of Gross Domestic Product (GDP) and Gross National Product(GNP)71 3.2.1 The Concept of Gross Domestic Product (GDP) 71 3.2.2 The concept of Gross National Product (GNP) 71 3.3 Approaches of Measuring National Income (GDP/GNP) 73 3.3.1 The Expenditure Approach 73 3.3.2 The Income Approach 76 3.3.3 Product or Value-added Approach 76 3.3.4 Circular Flow of Income and the GDP 77 3.4 Problems with GDP Measurement 79 3.5 The GDP Deflator and the Consumer Price Index 80 3.5.1 Nominal and Real GDP values 81 3.5.2 The GDP Deflator and other Measures of General Price 82 3.6 Other Measures of National Income Account 84 3.7 GDP and Income Distribution 87 Unit Summary 87 Review Questions 88 Table of Contents II Grade 11 Economics Student Textbook UNIT 4 CONSUMPTION, SAVING AND INVESTMENT INTRODUCTION90 4.1 Consumption 91 4.1.1 Average Propensity to Consume (APC) 94 4.1.2 Marginal Propensity to Consume (MPC) 94 4.1.3 Determinants of Consumption Expenditure 97 4.2 Saving 97 4.2.1 Average Propensity to Save (APS) 98 4.2.2 Marginal Propensity to Save 99 4.2.3 Determinants of Saving 99 4.3 The Relationship between Saving and Consumption 100 4.4 Investment 103 4.4.1 Investment Types 104 4.4.2 Determinants of Investment 107 4.4.3 Role of Investment in Economic Growth 109 Unit Summary 111 Review Questions 112 UNIT 5 TRADE AND FINANCE INTRODUCTION114 5.1 Overview of Domestic Trade 115 5.2 Basis of International Trade 118 5.3 Basic Theories of International Trade 119 5.3.1 The Mercantilists’ View on Trade 119 5.3.2 The Classical Trade Theories 121 5.4 Balance of Payment Components 129 5.4.1 The Current Account (CA) 130 5.4.2 The Capital Account (KA) 131 5.5 Trade Policies and Strategies 133 5.6 Exchange Rate Determinations 135 5.6.1 Nominal and Real Exchange Rate. 135 5.6.2 Fixed Exchange Rate Systems 137 Table of Contents III Grade 11 Economics Student Textbook 5.6.3 Floating Exchange Rate Systems 138 5.7 Regional Integration and Globalization Practices in the Ethiopian Context 138 5.7.1 Advantages and Disadvantages of Economic Integration 139 5.7.2 Globalization Practices in Ethiopian Context 141 Unit Summary 142 Review Questions 143 UNIT 6 ECONOMIC DEVELOPMENT INTRODUCTION145 6.1 Economic Growth and Economic Development 146 6.2 Measures of Productivity 147 6.3 Human Development Index (HDI) 149 6.3.1 Ethiopia’s HDI Value and Rank 152 6.3.2 Evaluation of HDI and its Relevance to Developing Countries 153 6.4 Capability Approach 154 6.5 Sustainable Development 156 6.6 Millennium Development Goals (2000-2015) 156 6.7 The Sustainable Development Goals (2015-2030) 158 Unit Summary 164 Review Questions 165 UNIT 7 MAIN SECTORS, SECTORIAL POLICIES AND STRATEGIES OF ETHIOPIA INTRODUCTION167 7.1 Overview of Agricultural Policies and Strategies 168 7.1.1 Uni-modal Agricultural Strategy 169 7.1.2 Bi-Modal Agricultural Strategy 170 7.1.3 Overview of Agricultural Policies and Strategies of Ethiopia 171 7.2 Specific Policies and Strategies of the Agricultural Sector 171 7.3 Problems of the Agricultural Sector 176 7.4 Specific Policies and Strategies of the Industrial Sector 178 7.4.1 The Imperial Regime (pre-1974) 179 Table of Contents IV Grade 11 Economics Student Textbook 7.4.2 The Derg Regime (1974-91) 180 7.4.3 The Post-1991 Regime 180 7.4.4 Problems of the Industrial Sector Post 1991 183 7.4.5 Possible Remedies for the problems of Industrial Sector 183 7.5 The Service Sector Policies and Strategies in Ethiopia 184 7.5.1 Education Sector Policies and Strategies 185 7.5.2 The Health Sector Policies and Strategies 187 7.5.3 The Transport Sector 189 7.5.4 The Tourism Sector 189 Unit Summary 190 Review Questions 191 Table of Contents V UNIT 1: THEORY OF CONSUMER BEHAVIOR AND DEMAND UNIT 1 THEORY OF CONSUMER BEHAVIOR AND DEMAND INTRODUCTION Consumers are one of the four economic agents in economic systems. The remaining agents are business firms, government and the entrepreneurs. These agents pursue their own goals. Consumers, for instance, aim to maximize satisfaction from what they consume given their limited resources. In this section, we study the satisfaction maximization behavior of a representative consumer with pre-defined assumptions to shape the behavior of the agent. We start the analysis by reviewing the cardinal utility theory followed by derivation of the demand curve. The next activity is a study of consumer behavior using ordinal utility theory. The key task in this unit is to study how a representative consumer makes the final consumption decision and chooses from the alternative combination of goods and services. This will enable you to identify the quantities of goods and services that the consumer would buy and indicate the corresponding best utility. In the later parts of the unit, you will learn about responsiveness of the optimal combinations of goods to changes in either the price or the income of the consumer. This constitutes a post optimization analysis. Learning Outcomes At the end of this unit, you will be able to:  differentiate between cardinal and ordinal utility approaches.  define the concept of indifference set, curve and map and the theory of ordinal utility  determine the optimum of the consumer using the ordinal utility approach INTRODUCTION 1 Grade 11 Economics Student Textbook Key Concepts  Utility  Consumer optimum  Indifference curve  Demand Curve  Budget line Start-up Activity 1. From your Grade 10 Economics, what do you remember about satisfaction or utility? 2. How do you measure the level of satisfaction you get from consumption? What are the indicators you often use? 1.1 Review of the Cardinal Utility Approach At the end of this section, you will be able to:  discuss cardinal utility theory.  apply the rules to find consumer optimum.  derive a demand curve.  appreciate the role of the approach. Start-up Activity 1. Is cardinal utility theory applicable in the real world? How about the ordinal utility approach? 2. What is the key difference between these two approaches? Utility refers to the level of satisfaction or happiness that consumers get from the consumption of goods and services. Cardinal utility theory is based on measurement of utility or satisfaction in absolute numbers. 1.1 Review of the Cardinal Utility Approach 2 UNIT 1: THEORY OF CONSUMER BEHAVIOR AND DEMAND Marginal utility (MU) is the additional satisfaction that a consumer gets because of changing consumption by one unit. It is an extra utility due to a change in consumption. The law of diminishing marginal utility says that as the amount of a good consumed increases, the marginal utility of the good decreases. Commodities are desired because of their ability to satisfy wants. Goods and services however, differ in their ability to satisfy wants. For example, an individual may choose coffee rather than tea. Another person may choose tea rather than coffee but both consumers will derive some level of satisfaction by consuming the good they have chosen. Given any two consumption bundles, the consumer can compare and decide that one of consumption bundles is better than another, or that they lead to the same satisfaction. The consumer is expected to state his/her preference. As we saw in Grade 10 Economics, cardinal utility assumes that utility is measurable in absolute or cardinal numbers. The unit of measurement is called “utils”. We use the concept of marginal utility, which is an extra utility or satisfaction from new consumption to show consumer optimum. The consumer faces limited money income, and this shows that scarcity of resources and hence, choice is mandatory. We want to find the best choice for the consumer, and this is defined by the point at which the marginal utility ratios for any two goods equals the price ratios and the consumer spends his/her entire income. Alternatively, we can state consumer optimum is the point where marginal utility per money spent is the same for all commodities and income equals expenditure. Suppose that the consumer consumes two commodities X and Y then at optimum point: MU X PX MU X MU Y = = or and income = expenditure MU Y PY PX PY Derivation of the Demand Curve Based on the definition for consumer optimum, we can derive the demand curve for a consumer. The derivation of the demand curve is based on the concept of diminishing marginal utility which is discussed in the previous grade. If the marginal utility is measured using monetary units, the demand curve for a commodity is the same as the positive segment of the marginal utility curve (see Figure 1.1). 1.1 Review of the Cardinal Utility Approach 3 Grade 11 Economics Student Textbook Activity 1.1 Assume that Fenet has decided to increase the consumption of tea from her current amount of 4 units to 5 units. If the total utility that Feneta gets from increasing her consumption increases from its previous value of 40 utils to 50 utils, what is the amount of marginal utility that she gets from the 5th cup of tea? 1.2 The Ordinal Utility Theory and Preferences After completing this section, you will be able to:  describe ordinal utility approach.  define the concept of indifference set, curve and indifference map.  calculate and interpret the marginal rate of substitution (MRS).  appreciate the contribution of utility theories in understanding consumers’ behavior.  analyze the different shapes of indifference curves for perfect substitutes and perfect complements. 1.2 The Ordinal Utility Theory and Preferences 4 UNIT 1: THEORY OF CONSUMER BEHAVIOR AND DEMAND Start-up Activity 1. What is marginal utility? How do we measure it? 2. Is utility maximization essential for you? How about for your neighbors? 3. Can people spend their income arbitrarily, i.e. without considering how best to use it? Preferences Preference is simply the ability of the consumer to state or express choices given alternatives. If a consumer faces two consumption bundles, say, X and Y, three things might happen. He/she may prefer X to Y, or Y to X or get same level of satisfaction from both X and Y. The first case is where the consumer prefers X to Y, and we can write it as X>Y. In the second case, the consumer prefers Y to X and hence, we can write the choice as Y>X. Finally, when a consumer gets the same level of satisfaction from any two combinations of goods, we say that the consumer is indifferent between the two goods or is unable to make choice of one good over another. This case is written as X~Y. When a consumer prefers a consumption bundle (x) to a bundle (y), it means that the x-bundle gives the consumer higher utility than the y-bundle. A bundle (x) is preferred to (y) if and only if the utility of (x) is larger than the utility of (y). The ordinal utility approach argues that utility cannot be measured in cardinal numbers as suggested by the cardinalist approach. The consumer is expected to rank different consumption bundles according to his/her preferences. The ordinal utility concept is based on the fact that it may not be possible for consumers to express the utility of various commodities that they consume in absolute terms, like, 1 util, 2 utils, or 3 utils, but it is always possible for the consumers to express the utility in relative terms. Consumers would also be able to rank commodities in the order of their preference as 1st, 2nd, 3rd and so on. This utility approach is based on some assumptions. We use indifference curves (ICs) to show satisfaction levels of consumers. ICs are locus of points showing alternative 1.2 The Ordinal Utility Theory and Preferences 5 Grade 11 Economics Student Textbook combination of two goods leading to the same utility of satisfaction. We will study properties of ICs in the next sections after we discuss the assumption used in this approach. Note  The ordinal utility theory assumes that the consumer can rank or order commodities according to his/her choice or preference. Assumptions of Ordinal Utility Theory This approach is based on simplifying assumptions most of which are indicated here under:  The consumers are rational: the goal of the consumers is maximization of their satisfaction or utility given their limited income and market prices.  Ordinal measurement of utility: utility is not absolutely (cardinally) measurable. This is because consumers are required only to order or rank their preference for various bundles of commodities.  Diminishing marginal rate of substitution (MRS): the marginal rate of substitution is the rate at which a consumer is willing to substitute one commodity (x) for another commodity (y) without affecting the total satisfaction of the consumer. Marginal rate of substitution is the slope of the indifference curve.  Complete ordering: all possible combinations of goods can be ordered into preferred, indifferent or inferior combinations when compared to a given combination of the goods. The total utility (U) of the consumer depends on the quantities of the commodities = consumed, i.e. U f ( x1 , x2 , x3 , …, Xn). Preferences are transitive or consistent: it is transitive in the senses that if the consumer prefers market basket X to market basket Y, and prefers Y to Z, and then he/she must also prefer X to Z.  Consistency of preference implies that if market basket X is preferred to market basket Y (X>Y) then, Y cannot be preferred to X at another time (Y not >X) for the same consumer.  Limited money income: the consumer is confronted with limited money income so that optimization is mandatory. This assumption is used to show the scarcity concept in economics.  Non – satiation assumption: consumers always prefer more of a good to less and 1.2 The Ordinal Utility Theory and Preferences 6 UNIT 1: THEORY OF CONSUMER BEHAVIOR AND DEMAND they are never satisfied or satiated. For example, if they are confronted with any two consumption bundles A and B, A is preferred to B if A contains at least more of one commodity. Activity 1.2 1. Give examples from your community that supports the assumption of rationality. 2. Do people buy and consume a good that reduces their satisfaction or utility? Some of the above listed assumptions are easy to understand and conceive while others need further elaboration. Rationality of agents is such a key assumption in consumer utility maximization process. We assume that consumers always aim for the best possible combination of the goods they buy that gives them the maximum possible satisfaction. We will look the other assumptions after we study indifference curves. 1.2.1 Indifference Curve, Set and Map After completing this section, you will be able to:  define an indifference curve.  differentiate between indifference curve and indifference map.  draw indifference curves. The ordinal utility approach is based on two very important tools or instruments. One is the indifference curve while the other is budget line. First, let us discuss indifference curves and we will move on to the budget line. An indifference curve (IC) is a concept used to represent an ordinal measure of the tastes and preferences of the consumer. Since it uses ICs to study the consumer’s behavior, the ordinal utility theory is also known as indifference curve analysis. There are three interrelated terminologies which are linked with concept of indifference: the indifference schedule (set), curve and map. Indifference set (schedule): this is a tabular presentation of the various combinations of 1.2 The Ordinal Utility Theory and Preferences 7 Grade 11 Economics Student Textbook goods from which the consumer derives the same level of utility. It is a combination of goods for which the consumer is indifferent, preferring none of the consumption bundles. Table 1.1 below is a typical indifference schedule that a consumer faces when comparing two goods. The numbers are hypothetical ones which are used to generate the standard shape of an IC. Under ordinal utility theory, we don’t measure utility in cardinal numbers as indicated in the table. We use the numbers to get familiar with the shape of an indifference curve in this approach. Once we have done that, we don’t rely on the cardinal numbers. The consumer faces four different possible ways (A to D) of combining his/her consumption of the two goods leading to the same level of satisfaction. All the four combinations of the two good X and Y give the consumer an equal level of total utility. Thus, the individual is indifferent between the combination presented as A, B, C or D. Looking at Table 1.1, combination B shows that the consumer faces 3 units of good (X), the orange, and 15 units of good (Y), the banana and this generates the same utility as any other combination that is indicated in the table, say combination D where the consumer has 7 units of orange, and 6 units of banana. In this movement, the consumer is buying more of one good (X) and less of another good (Y). Indifference curves: an indifference curve is a line that shows various combinations of two goods that provide the consumer with the same level of utility or satisfaction. It is the locus of points (combinations or bundles of goods), which yield the same utility (level of satisfaction) to the consumer, so that the consumer is indifferent between the combinations. An indifference curve is an iso-utility curve. If we draw a graph based on the data in Table 1.1 above on a two-dimensional X-Y plane, we get an indifference curve as shown. This is the conventional shape of an indifference curve. There are other shapes of an IC that apply to some special types of goods. 1.2 The Ordinal Utility Theory and Preferences 8 UNIT 1: THEORY OF CONSUMER BEHAVIOR AND DEMAND Note  An indifference curve is an iso-utility curve. It shows different ways of combining two goods X and Y that give the buyer the same level of satisfaction. When a consumer moves on the same indifference curve from point A to B, for instance, the consumer buys more unit of the X-good but must give-up in return some units of the Y-good to remain on the same level of satisfaction obtained at combination A. Any movement on an IC shows that consumer’s willingness to substitute one good for another without affecting overall satisfaction. Indifference map: this is a set or a collection of indifference curves with different levels of satisfactions. It is the entire set of indifference curves, which reflects the complete set of tastes and preferences of the consumer. In Figure 1.3, a higher indifference curve refers to a higher level of satisfaction and a lower indifference curve shows lesser satisfaction. IC2 reflects higher level of utility than that of IC1.Any consumer has lots of indifference curves, but not just one. 1.2 The Ordinal Utility Theory and Preferences 9 Grade 11 Economics Student Textbook If we compare consumption points R and S in Figure 1.3, we see that consumption basket S contains more of both goods A and B (A2, B2) compared to consumption basket given by R (A1, B1). Since more is preferred to less by assumption, the total satisfaction that is obtained from combination S must exceed the total satisfaction from combination R. Hence, the consumer must prefer S to R. Therefore, points on the upper indifference curves represent higher utility. Note  A consumer faces an infinite number of indifference curves representing different satisfaction levels. What determines the IC that can be achieved by a consumer at a given time is the income of the consumer and the prices of the goods. We will study this concept under the topic of budget line. 1.2.2 Properties of Indifference Curves Indifference curves have certain unique characteristics. 1. Indifference curves have a negative slope (downward sloping to the right): indifference curves are negatively sloped because the consumption level of one commodity can be increased only by reducing the consumption level of another commodity for a movement along an indifference curve. This means, that if the quantity of one commodity increases with the quantity of another remaining constant, the total utility of the consumer increases. On the other hand, if the quantity of one commodity decreases with the quantity of another remaining constant, the total utility of the 1.2 The Ordinal Utility Theory and Preferences 10 UNIT 1: THEORY OF CONSUMER BEHAVIOR AND DEMAND consumer reduces. Hence, in order to keep the utility of the consumer constant, as the quantity of one commodity is increased, the quantity of another must be decreased. 2. Indifference curves do not intersect each other: if they do intersect, the point of their intersection would mean two different levels of satisfaction from a single combination of goods, which is impossible. When ICs intersect, the transitivity rule is violated. Figure 1.4. shows that the problem with intersecting ICs. Combination E and C are on the IC1 and hence, the consumer is indifferent between them. Similarly, combinations E and D are on the same IC2, and hence, must lead to the same utility. The transitivity rule means that the consumer should be indifferent between combinations C and D which is not true. The consumer prefers D to C as it contains at least more of the X good relative to C. Hence, indifference curves cannot intersect with each other. 3. A higher indifference curve is always preferred to a lower one the further away from the origin an indifferent curve lies, the higher the level of utility it denotes. Baskets of goods on a higher indifference curve are preferred by the rational consumer, as they contain more of the two commodities than the lower ones. 4. Indifference curves are convex to the origin: this implies that the slope of an indifference curve decreases (in absolute terms) as we move along the curve from the left downwards to the right. This assumption implies that the commodities can substitute one another at any point on an indifference curve, but are not perfect substitutes. 1.2.3 The Marginal Rate of Substitution (MRS) Marginal rate of substitution of X for Y is defined as the number of units of commodity Y that must be given up in exchange for an extra unit of commodity of X so that the 1.2 The Ordinal Utility Theory and Preferences 11 Grade 11 Economics Student Textbook consumer maintains the same level of satisfaction. It is the rate at which one commodity can be substituted for another while keeping the level of satisfaction the same. When a consumer continues to substitute X for Y, the rate goes on decreasing as the two goods are assumed to be imperfect substitutes in a standard case. Number of units of Y given up MRS X ,Y = Number of units of X gained The MRSX,Y is a standard notation which shows how we want to increase consumption of the first commodity (X) by sacrificing the second commodity (Y). If we write MRSX,Y it means that we want to know how much of the X-good that the consumer is willing to give up getting one more unit of the Y-good. It is the negative of the slope of an indifference curve at any point for any two commodities such as X and Y, and is given by the slope of the tangent line at that point. Note that the slope of indifference curve is give as ∆y = MRS X ,Y. ∆x In other words, MRS refers to the amount of one commodity that an individual is willing to give up to get an additional unit of another good while maintaining the same level of satisfaction or remaining on the same indifference curve. Note that (MRSX,Y) measures the downward vertical distance (the amount of y that the individual is willing to give up) per unit of horizontal distance (i.e. per additional unit of x is required) to remain on the same indifference curve. That is, ∆Y MRS X ,Y = ∆X Because of the reduction in Y, MRS is negative. However, we multiply the value we get from the above expression by negative (-1) and express MRSX,Y as a positive value. We already know that there is a substitution between commodities (i.e. when the quantity of X increases, the quantity of good Y decreases) which gives the MRS a negative value. For interpretation purpose, we convert the negative MRS to positive MRS. In addition; note that MRS is defined only for a movement along the same indifference curve. The rationale behind the convexity of an indifference curve is that there is a fall in willingness to exchange the two goods as more and more of the goods are traded. A consumer’s subjective willingness to substitute X for Y (or Y for X) will depend on the 1.2 The Ordinal Utility Theory and Preferences 12 UNIT 1: THEORY OF CONSUMER BEHAVIOR AND DEMAND amounts of Y and X that he/she possesses. Referring to Table 1.1 above, we can calculate MRS at various points on the IC. For example, MRSX,Y (between points A and B) = ΔY/ ΔX = -8/2 = -4. The consumer is willing to forgo 8 units of banana to obtain 2 more unit of orange. For interpretation we say MRS= 4. MRSX,Y (between points B and C) = ΔY/ΔX = -6/2 = -3 and we use the absolute value and hence MRS = 3. If the consumer moves from point B to point C, he/she is willing to give up only 6 units of banana(Y) to obtain 2 unit of orange (X), so the MRS is 3 (∆Y/∆X = -6/2). Having still less of banana and more of orange at point C, the consumer is willing to give up only 3 unit of banana to obtain the same 2 units of orange. In this case, the MRS falls to 3/2. In general, as the amount of Y increases, the marginal utility of additional units of Y decreases. Similarly, as the quantity of X decreases, its marginal utility increases. Overall, the MRS decreases as we move downwards to the right. The diminishing slope of an indifference curve in absolute terms is the main reason why we have a convex IC in the standard case. 1.2.4 Marginal Utility and MRS The point in this section is to show the derivation of the MRS using MU concepts. A utility function U(X, Y) can be used to measure the marginal rate of substitution (MRS). Recall that the MRS measures the slope of the indifference curve at a given bundle of goods. It shows the rate at which a consumer is willing to substitute a small amount of good Y for good X without affecting total satisfaction. When calculating MRS we are moving on the same indifference curve, and hence there is no change in the total level of satisfaction. The consumer gives up one good and receives another good to maintain the same level of satisfaction. This interpretation gives us a simple way to calculate the MRS. Consider a change in the consumption of each good, (ΔY, ΔX), that keeps utility constant so that the consumer is moving along the same indifference curve. Then, we must have: MU1 * ΔX + MU2 * ΔY = ΔU = 0 This is true because the gain in utility due to consumption of more units of good X is canceled out by a loss (decrease) in utility due to a decrease in consumption of good Y. Overall, the change in total utility due to such substitutions should be zero as far as the consumer is on the same indifference curve. 1.2 The Ordinal Utility Theory and Preferences 13 Grade 11 Economics Student Textbook Solving for the slope of the indifference curve we have, ∆Y MU x MRS x, y = = − ∆X MU y Marginal rate of substitution (MRS) is defined as the negative of the marginal utilities ratios. Note that we have Y as numerator on the left and as a denominator on the right-hand side of the equality. Similarly, X is the denominator on the left-hand side but a numerator on the right-hand side. This is the standard expression and we need to note this. The algebraic sign of the MRS is negative, showing that if you want to get more of good X you must get less of good Y in order to keep the same level of utility. The negative sign shows that the possibility of trade-off or substitution between the two goods. However, economists often refer to the MRS by its absolute value, that is, as a positive number. We will follow this convention. Hence, we can write MRS as: MU X MRS X ,Y =. MU Y 1.2.5 Special Types of Indifference Curves So far, we have studied the shape of what is called a “standard indifference curve” which is downward sloping and convex to the origin. In this situation, we assume that the two commodities such as X and Y can substitute one another to a certain extent but are not perfect substitutes. There is imperfect substitutability between the two commodities. This is not the only possible shape for an indifference curve and next we will introduce two additional shapes of an indifference curve depending on the assumptions about the nature of the goods we study. These are indifference curves for perfect substitutes and perfect complements. Perfect Substitutes: these are goods which can be substituted for one another at a constant rate. The two goods are essentially the same. If two commodities are perfect substitutes, the indifference curve becomes a straight line with a negative slope. MRS for perfect substitutes is constant. All that matters to the consumer is the total number of the goods. A simple example is the case where the consumer faces a choice between a blue pen and a black pen. For many consumers, it does not matter whether you use a blue pen or a black pen. Hence, the consumer is willing to trade one black pen for one blue pen and will get the same level of satisfaction. Despite the number of exchanges, we assume that the rate of exchange remains the same (1:1 in this case). We say that the MRS between the two goods remains the same or it is constant. 1.2 The Ordinal Utility Theory and Preferences 14 UNIT 1: THEORY OF CONSUMER BEHAVIOR AND DEMAND Note  Indifference curves for perfectly substitutable goods are a downward sloping straight line. Note, however, that the rate of exchange is not always 1:1. It could be 2:1 or 2:3 or another number. What is important is that this rate remains the same no matter the number of exchanges we assume. In order to reflect this constant slope, the indifference curve is drawn as a straight line as shown in Figure 1.5 panel a. The utility function is given as U(X, Y) = aX + bY, where a and b are constants and X and Y are goods with perfect substitutability. Perfect Complements: these are goods which are to be consumed always jointly at a constant rate. A typical example is where a consumer wears a left shoe with a right shoe. The combination is 1:1 in this case. Utility is defined by such combinations and having more of only the right shoe, keeping the left shoe constant at one does not change total satisfaction. In terms of the shape of the indifference curve, we have a new shape due to the assumptions about the two goods. If two commodities are perfect complements the indifference curve takes the shape of a right angle as indicated in panel b of Figure 1.5 panel b. Suppose that an individual prefers to consume left shoes (on the horizontal axis) and right shoes on the vertical axis in pairs. Activity 1.3 1. Is it possible to substitute the two goods under perfect complements? 2. Can you wear two left-foot shoes or two right-foot shoes at a time and get the same level of satisfaction as wearing one left foot shoe and one right foot shoe? Why? Under perfect complements, the goods are to be consumed together at a pre-defined proportion and there is no way that one is substituted for another. Hence, under perfect complements, the MRS is zero (i.e. there is no substitution between the two goods). 1.2 The Ordinal Utility Theory and Preferences 15 Grade 11 Economics Student Textbook For perfect complements, the utility function is given as U(X, Y) = Min (aX, bY), where a and b are constants and X and Y are the perfect complement goods. Note  An indifference curve for perfectly complementary goods is L-shaped line. Note also that the properties of an indifference map remain the same under these two cases. The further away an indifference curve lies away from the origin, the higher is the utility that it denotes. Upper indifference curves are always preferred to the lower indifference curves. For L-shaped ICs, the vertex of the IC represents the right combination. 1.3 The Budget Line or the Price line After completing this section, you will be able to:  define a budget line.  draw a budget line.  differentiate between feasible and non-feasible areas on a budget line.  calculate the slope of a budget line.  analyze the effect on changes in prices and income on the position of budget line. 1.3 The Budget Line or the Price line 16 UNIT 1: THEORY OF CONSUMER BEHAVIOR AND DEMAND Start-up Activity 1. How much money do your parents or guardians spend each month? 2. Have you ever heard of them talking about budget and budgeting? 3. Why is budgeting important? Discuss in groups of four and report what you have discussed to the whole class. Note that, in economics we study demand of a consumer but not wish of a consumer. A consumer needs some amount of income to buy goods and services. Demand is wish backed by purchasing power. The budget line gives a summary of the buying ability of a consumer. In this section, we will study about the budget line and its properties. We start with a definition of the budget line. Next, we introduce a simple table providing a summary of possible combinations of two goods that a consumer would be able to buy with his/her available income and the prices of the two goods. We limit the analysis to two-goods case as it is not possible to study three or more goods on a two-dimensional X-Y plane. Assumptions of a budget line, slope of a budget line and finally changes in budget line will be discussed. In the previous section, we saw that indifference curves show the rate at which the consumer is willing to substitute one good for another, utility remaining the same. Indifference curves only tell us the consumer’s preference for any two goods; they cannot tell us which combination of the two goods will be chosen or bought. In this section, we will introduce a line which summarizes the buying abilities of a consumer. A utility maximizing consumer would like to reach the highest possible indifference curve on his/her indifference map. But the consumer’s decision is restricted by his/her income and price of the two commodities. Therefore, in addition to consumer preferences, we need to know the consumer’s income and price of the goods. In other words, individual choices are also affected by budget constraints that limit people’s ability to consume given the prices they must pay for various goods and services. 1.3 The Budget Line or the Price line 17 Grade 11 Economics Student Textbook This constraint is often illustrated by the budget line. A budget line is a line or a graph which indicates different combinations of two goods that a consumer can buy with a given income at a given prices. In other words, the budget line shows that the basket of goods that consumers can purchase, given their income and prevailing market prices. Together with an indifference curve, a budget line is an important function which is required to derive consumer optimum. Next, we will study the assumptions and properties of a budget line. Assumptions to Draw a Budget Line In order to draw the budget line facing the consumer, the following assumptions are important.  There are only two goods, X and Y, bought in quantities X and Y  Each consumer is confronted with market determined prices, Px and Py, of good X and good Y respectively  The consumer has a known and fixed money income (M). A change in any of these assumptions leads to a change in the position of the budget line and this will be studied later. The Budget Constraint or Budget Equation If the consumer spends all his/her income on two goods (X and Y), we can express the budget constraint as: M = PX X + PY Y , where, PX = price of good X, PY = price of good Y, X = quantity of good X, Y= quantity of good Y, and M = consumer’s money income. The budget constraint is sometimes called the “budget equation”. According to the above budget equation, the amount of money spent on X plus the amount spent on Y equals the consumer’s money income. For example, a household has 100 Birr per month to spend on bread (X) at Birr 4 each and Sugar (Y) at Birr 20 each. That is PX = 4, PY = 20, M = 100birr. Therefore, our budget line equation will be: 4X + 20Y = 100. 1.3 The Budget Line or the Price line 18 UNIT 1: THEORY OF CONSUMER BEHAVIOR AND DEMAND At alternative A, the consumer is using all his/her income to buy the Y-commodity (sugar). Mathematically, it is the y-intercept (0, 5). And at alternative F, the consumer is spending all his/her income on the purchase of good X. Mathematically; it is the X-intercept (25, 0). These are the two extreme values on the budget line. We may present the income constraint graphically by the budget line which is derived from the budget equation. To draw the budget line graph, we use these two points. The slope of the budget line can be easily estimated by using these two coordinates. Given a budget equation as M = PX X + PY Y. We can re-write this in terms of good Y (the good on the Y-axis) as follows. We need to go through two steps. First, take the PxX to the left of the equality and then, divide the whole equation by Py, the coefficient of Y. Hence, we have M − XPX =. YPY And rearranging we can derive the general equation of a budget line as: M PX M Y= − X , where is vertical intercept (Y − intercept) PY PY Py The horizontal intercept (i.e., the maximum amount of X the individual can consume, or purchase given his/her income) is given by: M PX − X= 0 PY PY Since quantity of y when we calculate X-intercept should be zero. This implies that, M PX = X. PY PY 1.3 The Budget Line or the Price line 19 Grade 11 Economics Student Textbook We can derive a formula to calculate the maximum amount of X that the consumer can buy as M X=. PX Hence, the values of the two intercepts can be easily computed by taking the ratio of income to the price of the good into consideration. Using the data in the Table 1.2, we can see that the X-intercept equals 25 (i.e. M/PX = 100/4) and the Y-intercept equals 5 (i.e. M/Py = 100/20). Note that a budget line is a locus of combinations or bundle of goods that can be purchased if all the income is spent. Given any budget line, there are two possible areas that are indicated by point A and point B. The area outside the budget line (such as point B on the graph) represents non-feasible (unattainable) areas for it is beyond the reach of the consumer. The total expenditure of combinations outside the budget line is beyond the income of the consumer unless income is increased. On the other hand, the area inside (such as point A) or on the budget line represents feasible or achievable expenditure. When a consumer is inside his/her budget line, it shows that his total expenditure is less than his/her total income. This shows that he/she has some money left to spend. In consumer theory, we assume that the consumer uses all incomes for consumption purpose and savings do not generate utility. Hence, we expect the consumer to be on the budget line where income is equal to expenditure. 1.3 The Budget Line or the Price line 20 UNIT 1: THEORY OF CONSUMER BEHAVIOR AND DEMAND 1.3.1 Slope of the Budget Line Note  The slope of a budget line is the negative of the price ratios of the two goods. The slope of a budget line is given by as the negative of the ratio of the prices of the two goods. It is defined as a ratio of the price of the good on the X-axis to the price of the good on the Y-axis. The definition is standard, and the slope can be measured as Py −. Px To see how the slope is calculated use the two intercepts. Slope is defined as the vertical distance over horizontal distance. Hence, ∆Y Y2 − Y1 = slope = ∆X X 2 − X 1 Using the values of the coordinates, the slope becomes; M M 0− Py Py M Px Px slope = = − = − * = −. M M Py M Py −0 Px Px Going back to the above table, we can calculate the slope and budget constraint. Note that given fixed prices, the budget line is a linear line with a constant slope. Using the coordinates such as movement from point B to point C, we can calculate slope of a budget line. Hence, for a movement from B to C, ∆Y Y −Y 3− 4 1 slope = = 2 1 = =− =−0.2. ∆X X 2 − X 1 10 − 5 5 Similarly for a movement from D to E ∆Y Y −Y 1− 2 1 slope = = 2 1 = =− =−0.2. ∆X X 2 − X 1 20 − 15 5 More easily, since slope can be calculated as a ratio of the two prices, with Px = 4 and Py = 20, the slope of the budget line is − Px −4 = −1 = = −0.2 Py 20 5 1.3 The Budget Line or the Price line 21 Grade 11 Economics Student Textbook 1.3.2 Factors Affecting the Budget Line Start-up Activity 1. What are the factors that affect the position of a budget line? 2. Mention at least two factors that might cause a change in a budget line. As we have seen above, the budget line depends on the price of the two goods and the income of the consumer. Any change in the price of the goods or the income of the consumer results in a shift in the budget line. Let us examine the impact of these changes one by one. The tips to understand the effect of these factors is to examine how the three important properties of a budget line change. These are changes in the slope, the X-intercept, and the Y-intercept of the budget line due to the suggested changes being considered. 1.3.3 Effects of Changes in Income If the income of the consumer changes (keeping the prices of the commodities unchanged) the budget line also shifts (changes). Increase in income causes an upward shift of the budget line that allows the consumer to buy more goods and services. In contrast to this, a decrease in income leads to a downward shift of the budget line that leads the consumer to buy less of the two goods. In order to show this, what we need to do is to calculate the new X and Y intercepts with the new income. Since the X-intercept is given as M/Px, a rise in income increases the maximum amount of good X that the consumer can buy. Similarly, the maximum amount of good Y that the consumer can buy is given by M/Py and an increase in income increases the quantity that can be bought of good Y. Connecting these two points will give us a new budget line. Figure 1.7.presents a parallel shift in budget line due to changes in consumer income. It is important to note that the slope of the budget line (the ratio of the two prices) does not change when income rises or falls. The budget line shifts from Bo to B1 when income decreases and to B2 when income rises. 1.3 The Budget Line or the Price line 22 UNIT 1: THEORY OF CONSUMER BEHAVIOR AND DEMAND 1.3.4 Effects of Changes in Price of the Commodities Changes in the prices of good X or good Y causes a rotation in the position of the budget lines. In Figure 1.8 below, a price rise of good X (panel a) results in the inward rotation from B0 to B1. A fall in the price of good Y in panel (b) is reflected by the outward rotation of the budget line from B0 to B1.We can notice that changes in the prices of the commodities change the position and the slope of the budget line. Let us now consider the effects of each price changes on the budget line. 1. What would happen if price of X falls, while the price of good Y and income remain constant? Since the Y-intercept (M/PY) is constant, the consumer can purchase the same amount of Y by spending the entire money income on Y regardless of the price of X. We can see from 1.3 The Budget Line or the Price line 23 Grade 11 Economics Student Textbook Figure 1.9 that a decrease in the price of X, money income and price of Y held constant, pivots the budget line outward, as from AB to AB’. The consumer can buy higher quantities of X due to the decrease in price of X. The X intercept shifts outward. The budget line rotates outward as indicated in the Figure 1.9. 2. What would happen if price of X rises, while the price of good Y and incme remain constant? Since the Y intercept M/PY is constant, the consumer can purchase the same amount of Y by spending the entire money income on Y regardless of the price of X. We can see from Figure 1.10 that an increase in the price of X, money income and price of Y held constant, pivots the budget line inward, from AB to AB’. 1.3 The Budget Line or the Price line 24 UNIT 1: THEORY OF CONSUMER BEHAVIOR AND DEMAND Activity 1.4 1. Show the effect of a rise in price of good Y if the price of good X and income remain constant. 2. What will be the effect of a proportionate (equal) increase in the prices of the two goods on the position of the budget line? 3. Assume that student Bereket has monthly pocket money of Birr 60 to spend on two goods (say tea and coffee) whose respective prices are Birr 3 and Birr 6. a. Draw the budget line. b. What happens to the original budget line if the income increases by 50%? c. What happens to the original budget line if the price of tea doubles? d. What happens to the original budget line if the price of coffee falls to Birr 3? 1.4 Optimum of the Consumer After completing this section, you will be able to:  state the necessary conditions for consumer optimum.  show graphically the optimum position.  discuss the effect of changes in income on consumer optimum.  analyze the changes in consumer optimum due to changes in prices of goods. Start-up Activity 1. What do we mean by an optimum of a consumer? 2. What factors affect an optimum of a consumer? Consumer seeks to maximize utility or satisfaction by spending their income on goods and services. They maximize utility by trying to attain the highest possible indifference curve, 1.4 Optimum of the Consumer 25 Grade 11 Economics Student Textbook given the budget line. The preferences of a consumer are indicated by the indifference curves and the budget line specifies the different combinations of X and Y which the consumer can purchase with the limited income. Therefore, the consumer tries to obtain the highest possible satisfaction within his/her limited budget or money income. This occurs where an indifference curve is at a tangent to the budget line so that the slope of the indifference curve (MRSX,Y) is equal to the slope of the budget line (PX/PY). Thus, the condition for utility maximization, consumer optimization, or consumer equilibrium occurs where the consumer spends all the income (i.e. the consumer is on the budget line) and the slope of the indifference curve equals to the slope of the budget line. Hence, at optimum position, PX MRSX,Y =. PY Note that, the consumer cannot purchase any bundle lying above and to the right of the budget line. This is true because, indifference curves above the region of the budget line are beyond the reach of the consumer and are irrelevant for equilibrium consideration. The question then arises as to which combinations of X and Y the rational consumer will purchase. Graphically, the consumer optimum or equilibrium is depicted in Figure 1.11. At point ‘A’ on the budget line, the consumer gets IC1 level of satisfaction. When he/ she moves down to point ‘B’ by reallocating his/her total income in favor of X he/she derives greater level of satisfaction that is indicated by IC2. Thus, point ‘B’ is preferred to point ‘A’. Moving further down to point ‘E’, the consumer obtains the greatest level of satisfaction (IC3) relative to other indifference curves. Combinations represented by points like ‘G’ are beyond the reach of the consumer or are unattainable with the existing income 1.4 Optimum of the Consumer 26 UNIT 1: THEORY OF CONSUMER BEHAVIOR AND DEMAND and price of the goods. Therefore, point ‘E’ (which represents combination X and Y) is the preferred position by the consumer since he/she attains the highest level of satisfaction within his/her reach and point ’E’ is known as the “point of consumer optimum”. This equilibrium occurs at the point of tangency between the highest possible indifference curve and the budget line. Put differently, equilibrium is established at the point where the slope of the budget line is equal to the slope of the indifference curve. 1.4.1 Effects of Changes in Income and Prices on Consumer’s Equilibrium Now we know how to arrive at the consumer optimum position. The next question is to study how this consumer optimum position changes when the income of the consumer changes or the price of the goods change. Note  Changes in income and prices of the two goods are the main factors that cause a change in the position of the budget line, and hence optimum position. Let us first consider the effect of a change in income on the equilibrium of the consumer all other things remaining constant. From our discussion on the budget line, we noted that an increase in the consumer’s income (all other things held constant) results in an upward parallel shift of the budget line. This allows the consumer to buy more of the two goods. On the contrary, when the consumer’s income falls, ceteris paribus, the budget line shifts downward, remaining parallel to the original one. Consider the case of an increase in income. Following the shifts in the budget line outward, the consumer will be able to meet one of the many ICs which were not previously achievable. This creates a new equilibrium position. A further increase in income shifts the budget line outward and hence another equilibrium position will be achieved and so on. We have several consumer optimum positions following the change in income as shown in Figure 1.12. The points R and S show that the new optimum points following the increase in income. If we connect all the points representing equilibrium market baskets corresponding to all possible levels of money income, the resulting curve is called the income consumption 1.4 Optimum of the Consumer 27 Grade 11 Economics Student Textbook curve (ICC). ICC is a locus of points representing various combinations of the two commodities that are purchased by the consumer at different levels of income, all other things remaining the same. The ICC joins the points of consumer optimum (equilibrium) as income changes (ceteris paribus). Or, it is the locus of consumer equilibrium points resulting when only the consumer’s income varies. Figure 1.12 shows that the ICC of a normal commodity case. Normal goods are goods for which consumption increases with income. Examples are meat and milk. There are other goods called “inferior good” of which consumption decreases as income of the consumer increases. Traveling by public bus is a typical example of an inferior good. Note that for some people travelling by bus could be a normal good if they were travelling on foot previously. In general, however, as income increases or as people get richer, they tend to reduce their consumption of inferior goods. Finally, a change in price of one or both of the goods changes the position of the budget line and hence, affects consumer optimum. This process leads to a new curve called the “price consumption curve” which is discussed below in detail. 1.4.2 Price Consumption Curve and Deriving the Demand Curve Here, we study the effect of change in price on the consumption of goods holding money income constant. In the discussion of budget line, we saw that an increase in the price of good X, for example, decreases the maximum amount of good X that the consumer can buy without affecting the vertical (Y) intercept of the line. In this case, the budget line rotates inward on the X-axis as presented in Figure 1.13. A decrease in the price of X will result in outward rotation of the budget line and this 1.4 Optimum of the Consumer 28 UNIT 1: THEORY OF CONSUMER BEHAVIOR AND DEMAND enables the consumer to buy more of good X. If we connect all the points representing equilibrium market baskets corresponding to each price of good X, we get the price- consumption curve. The price-consumption curve is the locus of the utility-maximizing combinations of products that result from variations in the price of one commodity when other product prices, the income and other factors are held constant. Note  Based on Figure 1.13: DD Budget line AB1 is drawn for the original price. DD When the price of good X decreases, we have a new budget line given by AB2. DD A further decrease in price of good X leads to a new budget line AB3. DD With the three possible budget lines, the consumer faces three equilibrium points which are indicated at E1, E2 and E3. DD Connecting such optimum points leads to the PCC. We can derive the demand curve of an individual for a commodity from the price consumption curve. Below is an illustration of deriving the demand curve when price of commodity X decreases from Px1 to Px2 to Px3. The successive decrease in price of good X will rotate the budget line outward. The consumer reaches new optimum points as indicated by the intersection between the new budget line and a new IC (such as point b or point c in Figure 1.14). 1.4 Optimum of the Consumer 29 Grade 11 Economics Student Textbook The lower panel of Figure 1.14 shows how we can derive the demand for an individual consumer from utility maximization pints. The demand curve is derived from the PCC which was constructed by changing the price of one of the two goods. Note that demand shows an inverse relationship between price of a good and quantity demanded at equilibrium. Unit Summary and Review Questions Unit Summary Utility refers to the want-satisfying power of a commodity. Total utility refers to the total satisfaction that is derived by the consumer from the consumption of a given quantity of a commodity. Marginal utility refers to the additional or extra utility which is derived from the consumption of an additional unit of a commodity. This approach is based on several assumptions which include: rationality of the consumer, ordinal measurement of utility, consistency and transitivity of preferences of consumer and diminishing marginal rate of substitution (MRS) between the two commodities. An indifference curve is a curve that shows various combinations of two commodities which give equal satisfaction to the consumer. An indifference map is a set of indifference curves, each one of which represents a given level of satisfaction. A standard indifference Unit Summary 30 UNIT 1: THEORY OF CONSUMER BEHAVIOR AND DEMAND curve slopes downward from left to right, is convex to the origin, two indifference curves do not intersect with each other, and a higher indifference curve represents higher satisfaction. Indifference of perfect substitutes is a linear line while it is L-shaped for perfect complement. Budget constraint represents all combinations of two commodities which can be purchased with a given budget at given prices of the two commodities. A budget line is a downward sloping line, whose slope equals the negative of the price-ratio of two commodities, a budget line changes its position when there is change in income or prices of the goods. Equilibrium of the consumer takes place at the point of tangency between the budget line and the indifference curve. At this point of tangency, the marginal rate of substitution (MRS) is the same as the price ratios of the two commodities. Mathematically, ∆Y MU x P MRS x, y == − = − x ∆X MU y Py Income consumption curve shows the optimal combination of two goods that the consumer can buy when his/her income changes. Price consumption curve shows the optimal combination of two goods that the consumer can buy when the price of one of the two goods changes. Demand curve is derived from the consumer optimum combinations under both the cardinal and ordinal approaches. Review Questions Part I: True or False Write ‘True’ for the correct statements and ‘False’ for the incorrect ones. 1. An indifference curve shows the constant utility line to the consumer. 2. The budget line shows the amount of utility that a consumer generates from his/her consumption. 3. The marginal rate of substitution is constant as we move down the indifference curve. 4. On an indifference map, higher indifference curves represent higher utility. 5. In consumer theory, the consumer has an infinite income to spend on goods and services. Review Questions 31 Grade 11 Economics Student Textbook Part II: Multiple Choices For the following questions choose the correct answer from the given alternatives. 1. Which one of the following is not a property of a standard indifference curve? A. Indifference curves are downward sloping. B. Indifference curves do not cross. C. Indifference curves are convex to the origin. D. Indifference curve have a constant slope. 2. Indifference curves that intersect would violate: A. the diminishing marginal utility assumption B. the transitivity property of indifference theory. C. the completeness of preference theory. D. none of the above 3. When a consumer wants to maximize his/her utility, he/she can do that by: A. maximizing the marginal utility obtained from only one good. B. saving more money and spending less on the goods. C. consuming outside his/her budget line. D. finding a point of tangency between his/her budget line and his/her indifference curve. 4. Given two commodities X and Y and level of income M, if price of good X increases (money income and price of Y remaining the same), which of the following is true? A. The budget line rotates to the right. B. The budget line rotates inward for the X commodity. C. The slope of the budget line remains the same. D. Both the X and Y intercept changes together. 5. Which one of the following curves shows the relationship between equilibrium quantities of two goods and the various levels of income? A. income consumption curve (ICC) B. price consumption curve (PCC) C. demand curve D. indifference curve (IC) Review Questions 32 UNIT 1: THEORY OF CONSUMER BEHAVIOR AND DEMAND Part III: Distinguish Terms Explain the difference between the pair of terms in 1-5 below. 1. Cardinal and ordinal utility theory. 2. Indifference curve and indifference schedule. 3. Linear indifference curves and L-shaped indifference curves. 4. Price consumption and income consumption curves. 5. Slope of budget line and slope of indifference curve. Part IV: Work Out For the following question, provide the required solution neatly and clearly. Assume that the total expenditure of a consumer on two goods X and Y is E = Birr 2900, and prices of goods X and Y are PX = Birr 50 and PY = Birr 40. The marginal utility from consumption of X and Y is given as MU x = X and MU y = 4Y. Required: a. Formulate his/her budget equation. b. Calculate the slope of the budget line. c. Work out the optimum quantities of the two goods that the consumer would buy. d. Draw a graph to show your answers. Review Questions 33 Grade 11 Economics Student Textbook UNIT 2 MARKET STRUCTURE AND THE DECISION OF FIRMS INTRODUCTION In general market is a mechanism by which the exchange of goods and services takes place as a result of buyers and sellers being in contact with one another, either directly or through mediating agents or institutions. Market structure refers to how different industries are classified and differentiated based on their degree and nature of competition for goods and services. The main criteria by which one can distinguish between different market structures are: the number and size of firms and consumers in the market, the type of goods and services being traded, and the degree to which information can flow freely. Market structure makes it easier to understand the characteristics of diverse markets. The four popular types of market structures include: perfect competition, oligopoly market, monopoly market, and monopolistic competition. This unit examines and reviews these markets. Learning Outcomes At the end of this unit, you will be able to:  analyze how firms maximize their profits in different markets.  state how perfectly competitive, pure monopoly, oligopoly and monopolistically competitive markets maximize their profit. Key Concepts  Price taker  homogenous products  price maker  differentiated products  short-run equilibrium  collusion and non-collusion INTRODUCTION 34 UNIT 2: MARKET STRUCTURE AND THE DECISION OF FIRMS 2.1 Review of Market Structures At the end of this section, you will be able to:  identify the basic characteristics of the market structures  discuss the similarities and differences among the market structures Start-up Activity From your Grade 10 Economics: 1. How do you define market? 2. What are the different market structures? 3. Discuss the characteristics of the market structures. The correct sequence of the market structure from most to least competitive is perfect competition, monopolistic competition, oligopoly, and pure monopoly. 2.2 Perfect Competition Market At the end of this section, you will be able to:  identify the demand, marginal revenue and cost of the firm  calculate firm’s equilibrium using total revenue and total cost approach  calculate firm’s equilibrium using marginal revenue and marginal cost approach  identify the level of price and output at which firms make profits and losses 2.1 Review of Market Structures 35 Grade 11 Economics Student Textbook Start-up Activity Based on your Grade 10 Economics: 1. What are the assumptions of perfectly competitive market? 2. Compare and contrast a perfectly a competitive market with a pure monopoly market? 3. How do perfectly competitive firms make price and output decisions? The characteristics of perfectly competitive market imply that every firm is insignificant as compared to the market size and since the product that it supplies is by no means different from the products supplied by other firms in the market, each individual firm cannot determine the prices for goods and services that are supplied to the market. In these markets, the prices for goods and services are determined by the interaction of all consumers and producers in the market, i.e. the interaction of demand and supply forces. Then, every firm will assume this price as a given and make its decision accordingly. 2.2.1 Demand, Revenue and Cost Curves In Figure 2.1, price is on the Y-axis and quantity is on the X-axis. Panel A represents the industry and Panel B represents the case of a firm. The market demand curve is DD and the market supply curve is SS. Furthermore, the point at which the market’s demand and supply curves intersect with each other is the equilibrium point. The price at this level is the equilibrium price and the quantity is the equilibrium quantity. All firms receive this price in a perfectly competitive market. As a result, in the perfectly competitive market firms are the price-takers and the industry is the price-maker. This implies that every individual firm in such markets faces a horizontal demand curve, indicating that the firm can sell whatever quantity (Q) of goods at the market-determined price. The average revenue curve is the demand curve of the firm. 2.2 Perfect Competition Market 36 UNIT 2: MARKET STRUCTURE AND THE DECISION OF FIRMS A firm earns revenue by selling the good that it produces in the market. A total revenue curve plots the quantity sold or output on the X-axis and the revenue earned on the Y-axis. Figure 2.2 shows that the total revenue curve of a firm. The curve is actually a straight line because the firm is a price taker in the market. The constant price is what makes the total revenue curve of a straight line. 2.2 Perfect Competition Market 37 Grade 11 Economics Student Textbook As it is shown in Figure 2.1 (A) the demand curve for perfectly competitive market is downward-sloping. As shown in Figure 2.3, the demand (DD) curve for an individual firm is horizontal and equals to the equilibrium price (P) of the market or average revenue (AR) and to the marginal revenue (MR) of the firm. (P = AR = DD = MR). TR - represents total revenue. Remember that: TR = P x Q TR PQ = = = P AR Q Q changein TR MR = change in Q Activity 2.1 From your Grade 10 Economics, what are the shapes of total fixed cost, total Variable cost, total cost, average variable cost and average cost curves? Why do they take those shapes? As shown in Figure 2.4, the ATC curve tends to have a U-shape. That is ATC tends to fall at first and then rise as the output level increases. The marginal cost curve falls briefly at first, and then rises. Marginal costs are derived from variable costs and are subject to the principle of variable proportions. 2.2 Perfect Competition Market 38 UNIT 2: MARKET STRUCTURE AND THE DECISION OF FIRMS As shown in Figure 2.4, the ATC curve tends to have a U-shape. That is ATC tends to fall at first and then rise as the output level increases. The marginal cost curve falls briefly at first, and then rises. Marginal costs are derived from variable costs and are subject to the principle of variable proportions. Note  From Figure 2.4 one can conclude that: DD When the average cost declines, the marginal cost is less than the average cost. DD When the average cost increases, the marginal cost is greater than the average cost. DD When the average cost stays the same (is at a minimum or maximum), the marginal cost equals the average cost. A perfectly competitive firm faces a perfectly elastic demand curve for its product: buyers are willing to buy any number of units of output from the firm at the market price. When the firm chooses what quantity to produce, then this quantity along with the prices prevailing in the market for output and inputs will determine the firm’s total revenue, total costs, and ultimately, level of profits. =Profit Total Revenue − Total Cost Or profit ( Price )( Quantity Produced ) − ( Average Cost ) (Quantity Produced ) 2.2.2 The Short-Run Equilibrium of Firm As you remember from your Grade 10 Economics the short run is a period of time in which the quantity of at least one input is fixed and the quantities of the other inputs can be varied. The long run is a period of time in which the quantities of all inputs can be varied. There is no fixed time that can be marked on the calendar to separate the short run from the long run. The short-run and long-run distinction varies from one industry to another. 2.2 Perfect Competition Market 39 Grade 11 Economics Student Textbook In order to explain the equilibrium of a competitive firm in the short run we can use two different approaches: 1. Total revenue (TR)- total cost (TC) approach and 2. Marginal revenue (MR)-marginal cost (MC) approach. Both approaches try to combine the revenue and cost functions of a competitive firm in order to determine the amount of goods and services that a firm has to produce at the given market price in order to maximize profit or minimize losses. 1. Total Revenue - Total Cost Approach A perfectly competitive firm can sell as large a quantity as it wishes, as long as it accepts the prevailing market price. Total revenue is going to increase as the firm sells more, depending on the price of the product and the number of units sold. Total revenue for a perfectly competitive firm is a straight line sloping up as shown in Figure 2.5. The slope is equal to the price of the good. Total cost also slopes up, but with some curvature as shown in Figure 2.5. In short run using total revenue – total cost approach the firm is at equilibrium when: ( Q ) R ( Q ) − C ( Q ) is maximum. The maximum profit will occur at the quantity where π= the gap of total revenue over total cost is largest. In Figure 2.5 the horizontal axis shows that the quantity produced; the vertical axis shows both total revenue and total costs. The firm is at equilibrium by producing ‘q’ level of output. a. Marginal Revenue – Marginal Costs Approach 2.2 Perfect Competition Market 40 UNIT 2: MARKET STRUCTURE AND THE DECISION OF FIRMS The marginal revenue curve shows that the additional revenue which is gained from selling one more unit. Notice also that marginal revenue in a perfectly competitive market does not change as the firm produces more output. Change in TC MC = Change in Q Marginal cost changes as the firm produces a greater quantity. For a perfectly competitive firm, the marginal revenue (MR) curve is a horizontal straight line because it is equal to the price of the good, which is determined by the market, shown in Figure 2.6. The marginal cost (MC) curve is initially downward-sloping showing that this is a region of increasing marginal returns at low levels of output, but is eventually upward-sloping at higher levels of output as diminishing marginal returns kick in. In short-run using marginal revenue – marginal cost approach the first condition for the equilibrium of the firm is when: 1. MR − MC = MC (e.g. points q1 and q4 in Figure 2.6). = 0 or MR ∆π ∆TR ∆TC ∆TR ∆TC = − = 0, where is marginal revenue and is marginal cost ∆x ∆Q ∆Q ∆Q ∆Q However, this condition is not sufficient since it may be fulfilled and yet the firm may not be in equilibrium. 2. The second condition for equilibrium requires that the MC be rising at the point of its intersection to the MR curve. This means that the MC must cut the MR curve from 2.2 Perfect Competition Market 41 Grade 11 Economics Student Textbook below, i.e. the slope of the MC must be steeper than the slope of the MR curve. In Figure 2.6 the slope of the MC is positive at q4 while the slope of the MR is zero at all levels of output. As a result, it is not q1, but q4 which is the equilibrium point as it satisfies the two conditions. Note that as the marginal revenue received by a perfectly competitive firm is equal to the price of the profit- maximizing rule for a perfectly competitive firm it can also be written as P = MC. The answer depends on the relationship between price and average total cost. 1. If the market price received by a perfectly competitive firm leads it to produce at a quantity where the price is greater than average cost, the firm will earn profits. 2. If the price received by the firm causes it to produce at a quantity where price equals average cost, which occurs at the minimum point of the AC curve, then the firm earns zero profits. 3. If the price received by the firm leads it to produce at a quantity where the price is less than average cost, the firm will incur losses. 2.2 Perfect Competition Market 42 UNIT 2: MARKET STRUCTURE AND THE DECISION OF FIRMS Figure 2.6 illustrates three situations: (a) where price intersects marginal cost at a level above the average cost curve, (b) where price intersects marginal cost at a level equal to the average cost curve, and (c) where price intersects marginal cost at a level below the average cost curve. The possibility that a firm may incur losses raises a question: why firms fail to avoid losses by shutting down and not producing at all? Does maximizing profit (producing where MR = MC) imply an actual economic profit? As shown in Figure 2.7, the answer is that shutting down can reduce variable costs to zero, but in the short run, the firm has already paid for fixed costs. As a result, if the firm produces a quantity of zero, it would still make losses because it would still need to pay for its fixed costs. So, when a firm is experiencing losses, it must face a question: should it continue producing (break even) or should it shut down? If price falls in the zone between the shutdown point and the zero profit point (breakeven point), then the firm is making losses but will continue to operate in the short run, since it is covering its variable costs. However, if price falls below the price at the shutdown point, then the firm will shut down immediately, since it is not even covering its variable costs. The intersection of the average variable cost curve and the marginal cost curve, which shows the price where the firm would lack enough revenue to cover its variable costs, is called the “shutdown point” “ (see Figure 2.8). 2.2 Perfect Competition Market 43 Grade 11 Economics Student Textbook Activity 2.2 A perfectly competitive firm has a cost function of C = Q2 + 20Q + 700 and the equilibrium price is Birr 100. Find: a. The profit maximizing level of output. b. The maximum level of profit. 2.2.3 Short Run Supply Curve of a Firm Start-up Activity From your Grade 10 Economics, how do you differentiate between short run and long run? Short run is a period in which supply can be changed by changing only the variable factors, fixed factors remaining the same. The supply curve indicates the relationship between price and quantity supplied. In other words, supply curve shows the quantities that a seller is willing to sell at different prices. That way, if the firm shuts down, it has to bear fixed costs. That is why in the short run, the firm will supply commodity till price is either greater or equal to average variable cost. Thus a firm will continue supplying the commodity till marginal cost is equal to price or average revenue. As a result short run supply curve of a perfectly competitive firm is that portion of marginal cost curve which is above average variable cost curve. From Figure 2.9, it is clear that there is no supply if price is below OP1. At price less than OP1, the firm will not be covering its average variable cost. At OP1 price, OQ1 is the supply. In this case, firms’ marginal revenue and marginal cost cut each other at M and OQ1 is equilibrium output. If price goes up to OP2, the firm will produce OQ2 output. This firm’s short run supply curve starts from A upwards through B (SS). 2.2 Perfect Competition Market 44 UNIT 2: MARKET STRUCTURE AND THE DECISION OF FIRMS Thus, under perfect competition, lateral summation of that part of short run marginal cost curves of the firms which lie above the average variable cost constitutes the supply curve of the industry. Short run supply curve of a competitive industry will always slope upwards since the short - run marginal cost curve of the industrial firms always slope upward. 2.2.4 Long run-equilibrium of Firm The long-run production period is a production period that allows any change to the production process. It is also a production period that allows the entrance and exit of firms into and out of the market. So, the most important variable that determines the long - run equilibrium of perfectly competitive markets is the adjustment to the number of firms in the market. In other words if the firms, which are already in the industry, are making pure economic profits, then new firms will start to enter the market since the return in the industry is larger than the return that can be generated somewhere else. On the other hand, if firms are making economic losses in a given industry in the short run, after making all the necessary adjustments if these losses cannot be eliminated in the long run, then firms will start to leave the market since the return in the industry under consideration is smaller than what can be earned elsewhere. Therefore, this adjustment to the number of firms in the market will continue until there is no more incentive for new firms to enter into the market as well as for the existing firms to leave from the market. i.e. at that point where firms are earning a return in a given industry which is exactly the same as the returns elsewhere, then the firm is said to be at a long-run equilibrium. 2.2 Perfect Competition Market 45 Grade 11 Economics Student Textbook In the long run, a firm achieves equilibrium when it adjusts its plant to produce output at the minimum point of its long-run average cost (LAC) curve. This curve is tangential to the market price defined demand curve. In the long run, a firm just earns normal profits. If a firm earns supernormal profits in the short run, then the industry will attract new firms into it. Eventually, this leads to a fall in prices of the goods and an increase in prices of the factors as the industry expands. These changes continue until the LAC curve is tangential to the demand curve. On the other hand, if firms make losses in the short run, then they leave the industry in the long run. This results in a rise in price and a drop in costs as the industry contracts. These changes continue until the remaining firms in the industry cover their total costs and make normal profits. In Figure 2.10, OP is the price and the firm which is making supernormal profits by working with the plant whose cost is SAC1. Therefore, the firm has an incentive to build new capacity and move along its LAC. Simultaneously, the excess profits attract new firms to the industry. This leads to an increase in the quantity supplied, shifting the supply curve to the right and a fall in the price, until it reaches the point OP1. At OP1, the firms and the industry are in long-run equilibrium. The Budget Constraint or Budget Equation Condition for Long - Run Equilibrium of a Firm For a firm to achieve long-run equilibrium, the marginal cost must be equal to the price and the long-run average cost. That is, LMC = LAC = P. The firm adjusts the size of its plant to produce a level of output at which the LAC is minimum. Therefore, in the long-run, we have: SMC = LMC = SAC = LAC = P = MR 2.2 Perfect Competition Market 46 UNIT 2: MARKET STRUCTURE AND THE DECISION OF FIRMS Hence, at the minimum point of the LAC, the plant works at its optimal capacity and the minima of the LAC and SAC coincide. Also, the LMC cuts the LAC at the minimum point and the SMC cuts the SAC at the minimum point. Therefore, at the minimum point of the LAC, the equality mentioned above is achieved. 2.3 Pure Monopoly Market At the end of this section, you will be able to:  identify the types of price discrimination under pure monopoly market  differentiate between demand curve, revenue and cost curve  analyze short - run equilibrium of firms Start-up Activity 1. Compare and contrast perfect competition and pure monopoly markets. 2. What are the sources of monopoly? Monopoly is at the opposite end of the spectrum of market models to perfect competition. A monopoly firm has no rivals; rather it is the only firm in its industry. There are no close substitutes for the good or service a monopoly produces. Not only does a monopoly firm have the market to itself, but it need not worry about other firms entering. In the case of monopoly, entry by potential rivals is prohibitively difficult. A monopoly does not take the market price as given; it determines its own price. It sele

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