Microeconomics I Chapter 1 5 HANDOUT 2023 PDF

Arsi University, College of Agriculture and Environmental Sciences, Department of Agricultural Economics
CHAPTER ONE
INTRODUCTION TO ECONOMICS
Definition and Scope of Economics

1. Economics is a social study of production, distribution and consumption of wealth or output. This
definition emphasizes three major economic activities. First the output must be produced (production);
second, the product must be distributed to potential consumers (distribution); and finally, consumers
must choose from the available goods for consumption (consumption).
2. Economics is the study of choice. Economic agents (producers and consumers of goods and services)
make choice because of scarcity, constraints or limitations of resources. There are two types of
constraints or limitations. These are economic constraints or limitations and non-economic constraints.
Economic constraints include:
a). Costs of production: includes cost of raw materials, cost of labour, cost of capital, etc. For instance,
rental cost of land and cost of fertilizers are some of the major components of costs of agricultural
production.
b). Opportunity costs: refers to benefits that one loses in the alternative uses of a given resource (labour
hours, money, land, etc.). For example, if you establish production machinery (factory) on a plot of
land that you would have used for production of agricultural output, the value of agricultural output
you have lost is your opportunity cost of establishing the machinery.
c). Income: is economic constraint or limiting factor for consumers to choose among available
consumption bundles. The consumption choices of two individuals with different monthly income are
virtually different. For instance, those who use taxi and those who own car; the difference is due to the
fact that less income has put constraint on the first person to choose cheap mode of transportation.
Non-economic constraints or limitations include climate conditions (such as prevalence of drought),
political factors (such as civil war or conflict between countries), cultural factors, religious factors,
customs and legal factors. For instance:
 The trade of some commodities such as drugs are legally prohibited even if it has some
economic values for the participants;
 Individuals have no incentives to invest or produce in war prone areas.
3. Economics is the study of decision making. The science of economics is used to make decision with
the help of economic principles. People may decide on:
 What to Produce? Which product (X, Y or Z) is profitable for producers in terms of revenue
or profit? This determines the output mix.
 How to produce? This is about which production method or technique to use and about what
inputs to use. E.g. Should we generate electricity from oil, coal, nuclear power, solar power?
 For whom to produce? Who is going to get the output produced? This helps to identify the
potential consumers.
 Where to produce? The location of our production unit or distribution centre depends on the
location of our potential customers. E.g If students are the potential customers, it’s better to
locate the distribution centre around schools.
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Microeconomics- I _ Note_ 2nd Year_2023, Agricultural Economics
 When to produce? This helps to determine the season of high demand for the product. E.g the
demand for exercise book is high during the Ethiopian New Year since schools open by then.
4. Economics is the study of wise and efficient use of limited resources. It is the science which tries to
reconcile unlimited human wants and limited/scarce economic resources to meet these wants. It is a
science which tries to find out the method of optimal or proper use of scarce economic resources. It
tries to identify the way that helps economic agents (human beings) produce maximum output or
benefit from limited resources.
Classification/Branches of economics
Economists have classified economics in to different branches. They follow different classification
based on different perspectives.
i. From the point of view of elements of analysis, economics has two major branches: Macroeconomics
and Microeconomics.
Microeconomics: - deals with micro/individual issues. In other words, microeconomics is concerned

with behaviours of individual economic units such as producers, consumers, business firms and other
economic decision making units. It is the study of transactions between people and businesses and how
the flow of money operates between these basic entities. Microeconomics also focuses on the supply
and demand relationship between buyer and seller and how this ultimately determines equilibrium
prices of goods and services.
Macroeconomics: - is concerned with the aggregate performance of the entire economic system. The
scale of macroeconomic discussions are typically on a country level and utilizes facts from that
country's economic performance (gross domestic product, inflation, government interest rates,
unemployment, international trade and the overall impact of imports and exports on a country's
economic growth).
ii. From the view point of interest whether to deal with economic explanations/understandings/ or with
what should be done to change or improve the existing economic conditions (whether to deal with
value judgement or not), we can divide economics as positive economics and normative economics.
Positive economics: - is concerned with the explanations of economic conditions. It answers the
question ‘what is?’ i.e., Positive economics tries to understand the existing economic situation. E.g.
what is the price of agricultural produces in market A? What is the inflation rate this year?
Normative economics: - deals with value judgement on economic situation. It answers the question
‘what should be?’ as in what should be done to increase employment and to reduce price?
iii. One way of dividing the world economy is on the basis of the economic policies a country follows.
From this perspective, we can divide world economy in to three: Command economy, mixed economy
and market economy.
iv. We can also classify economics into different areas of economic specializations. Some of these are:
Agricultural, Natural Resources, Environmental, Health, Education, Welfare, Labour, Industrial,
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Behavioural, Public, Monetary, Institutional, Development, Mathematical and Quantitative, Urban,

Rural, Regional, International, Law and Economics, etc.
Concepts in Economics
Factors of Production
This is an economic term used to describe the inputs that are used in the production of goods or services
in the attempt to make an economic profit.
The act of making goods and services is called production and the act of using them is called
consumption.
Goods are tangible (e.g shoes, bread), and services are intangible (e.g. education, entertainment).
In economics, factors of production are the inputs to the production process. Finished goods are the
output. Input determines the quantity of output i.e. output depends upon input. Input is the starting
point and output is the end point of production process and such input-output relationship is called a
production function.
Factors of production (or productive inputs or resources) are any commodities or services used to
produce goods and services. 'Factors of production' may also refer specifically to the primary factors,
facilitate production but neither become part of the product (as with raw materials) nor become
significantly transformed by the production process (as with fuel used to power machinery). The four
categories of factors of production are land, capital, labour and entrepreneurship.
Land- refers to all natural resource used to produce goods and services. This includes not just land,
but anything that comes from the land. Some common land or natural resources are water, oil, minerals
(such as copper), and forests. Land resources are the raw materials in the production process. These
resources can be renewable, such as forests, or non-renewable such as oil or natural gas. The income
that resource owners earn in return for land resources is called rent.
Capital- is the all man-made aids to production. These are physical assets used in production or these
are the final goods produced to be used as inputs in further production. It includes machines,
equipment, buildings humans use to produce goods and services. Some common examples of capital
include hammers, forklifts, conveyer belts, computers, and etc. Capital differs based on the worker and
the type of work being done. For example, a doctor may use a stethoscope and an examination room
to provide medical services. Your teacher may use textbooks, desks, and a whiteboard to produce
education services. The income earned by owners of capital resources is interest.
Labour- is the skills, abilities, knowledge (called human capital) and the effort exerted by people in
production of goods and services. Labour is all of the work that labourers and workers perform at all
levels of an organization, except for the entrepreneur. It includes skilled and unskilled labour. Both the
quantity and the quality of human resources are included in the labour factor. If you have ever been
paid for a job, you have contributed labour resources to the production of goods or services. The income
earned by labour resources is called wage.
Entrepreneurship- An entrepreneur combines the other factors of production by buying these factors
to produce a saleable product. This is the economic agent/a person who creates the enterprise.
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Entrepreneur is the person who sees the opportunity of new or better products and brings together the
resources needed for producing them. The entrepreneur is an organizer and a risk taker. Without the
entrepreneur combining land, labour, and capital in new ways, many of the innovations we see around
us would not exist. Think of the entrepreneurship of Henry Ford or Bill Gates. Without these people
and their ideas, no companies would ever exist. Entrepreneurial talent is paid profit.
Scarcity and Opportunity Cost
A society’s resources consist of natural endowments such as land, forests, and minerals; human
resources, both mental and physical; and manufactured aids to production such as tools, machinery,
and buildings. Such resources are called factors of production in economics, because they are used to
produce output that people desire. These outputs could be goods or services. Goods are tangible (e.g.,
shoes, bread), and services are intangible (e.g., education, entertainment).
People use these goods and services to satisfy their wants. The act of making goods and services is
called production and the act of using them is called consumption.
The quantity of factors of production and the goods and services they help produce is not infinite. The
existing resources are inadequate to satisfy the unlimited desires of people. Since resources are
insufficient to satisfy all desired uses, then there is scarcity, which is the core problem. Scarcity is the
imbalance between our desires and available resources. Then economic scarcity forces us to make
economic choices. Wants are insatiable, because no matter how much people have, they always want
more of them. Since not all wants can be satisfied, individuals have to pick and choose among the
possibilities open to them. Every society is faced with the same problems of scarcity and choice.
Scarcity forces individuals to economize on their use of resources. Every decision to produce or to
consume something means that we must forego producing or consuming something else. The cost of
engaging in certain activity, say, going to cinema, includes cost of the ticket and the value of what is
given up in order to participate in that activity. The time spent watching movie could have been spent
in other activities, such as work. You are therefore giving up the opportunity of working in order to
watch movie. The value of this foregone opportunity is called opportunity cost.
Definition: Opportunity cost is the value of the next best opportunity given up in order to enjoy a
particular good or service.
Suppose the person in the above example could have earned an hourly wage of Birr 20 had he decided
to work rather than go to the cinema. For the individual, the opportunity cost of enjoying a 1 hour and
45 minutes movie is Birr 35.
Decision making units and Economic Systems. The

Circular Flow
What is the difference between factor market and product market? In a market economy, there are
two distinct markets in which firms interact with households. Households are purchasers of goods and
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services that firms produce, and there is a flow of money to firms in payment for these goods and
services. The market in which these exchanges take place is referred to as the product market.
Firms buy factors of production from households in order to produce the goods and services they sell
to the households. The market in which these transactions take place is called the factor market.
Assuming that all factors of production are owned by households and all goods are produced by firms,
the circular flow model is given in Figure 1.1.
Product market
Factor market
Figure 1.1: The Circular Flow
The lower segment of the circular flow shows the flow factors of production such as labour and capital
from households to firms. In return, households receive factor payments, which then they use for the
purchase of goods and services from firms as shown in the upper segment of the diagram. This flow
of money represents the income of firms.
Economic Systems
Economists divide economic systems into four major groupsthe traditional economy, the planned
(command) economy, the market economy, and the mixed economy.
1) The Traditional Economy: The traditional economy answers the fundamental economic questions
by appeal to tradition. What is produced is what the young have been taught by their parents to hunt,
to gather, or to plant. The techniques of production of how to produce are also passed on, often without
change, from generation to generation. The amount of production is, of course, highly dependent on
good fortune. The last question, concerning distribution, is also traditionally determined. In fact,
traditional societies may have rules on how output is to be divided.
2) The Planned Economy: It answers the fundamental economic questions through planning or
through central command and control.
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The decisions regarding what, how, and how much to produce are spelled out and documented.
Detailed plans and orders are sent to producers, and these instructions carry the weight of the law. A
large part of the question of ‘who gets what’ is determined in the same way, because planners determine
wage rates and the amount of production of consumer goods. Economists use the term planned
economy to refer to one in which the government plays a larger role in answering the production and
consumption questions of the society.
3) The Market Economy: The organizing principles, here, are the forces of demand and supply. The
determination of what to produce is made by consumers, and the force of demand causes prices to go
up for certain products when consumers desire more of them.
In a sense, consumers vote with their money. The result of this voting process determines what will be
produced. Suppliers combine resources, determining how things are to be produced. Assuming
suppliers are self-interested and seek to maximize their profits, they tend to combine inputs to produce
any good or service at the lowest possible cost. This determination depends on the prices of resources.
Suppliers will use more of relatively abundant resources because they are relatively cheap. This, in
turn, helps conserve the scarcer (more expensive) resources. The goods are then distributed to
consumers who have the purchasing power to buy them. Those who have more purchasing power
receive more goods and services.
4) The Mixed Economic System: In the real world we find that economies are the blend of traditional,
planned and market economic systems. In practice every economy is a mixed economy in the sense
that it combines significant elements of all three systems.
When we speak of a particular economy as being a centrally planned economy, we mean only that the
degree of the mix is weighted heavily toward the command principle. When we speak of an economy
as being a market economy, we mean only that the degree of the mix is weighted heavily toward
decentralized decision making in response to market signals. It is important to realize that such
distinctions are always matters of degree, and that almost every conceivable mix can be found across
the world’s economies.
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CHAPTER TWO
THEORY OF DEMAND AND SUPPLY
Theory of Demand
Demand- refers to the desire and ability of buyers/consumers to purchase/consume a given amount of
goods or services, over a range of prices, over a given period of time. Demand refers to the whole set
of price-quantity combinations, i.e., demand defines the whole set of relationship between price and
quantity.
Quantity Demanded- the specific amount of a commodity that people are willing and able to buy at
a particular price, i.e., the quantity of a good or service that consumers demand at price Birr 1, the
quantity they demand at price Birr 2, etc.
Demand Schedule- a tabular listing that shows the quantity demanded at various prices, ceteris
paribus The phrase ceteris paribus means other things remain the same.
Table 2.1: Demand schedule of Mr.Bayu for bread

Price Quantity
0 250
5 200
10 150
15 100
20 50
25 0
Demand curve- a graphical representation of demand schedule showing the relationship between the
quantities demanded and its own price, ceteris paribus. It is the relationship showing the various
amounts of a commodity that buyers would be willing and able to purchase at possible alternative
prices during a given time period, all other things remaining constant. Plotting the price-quantity
relationships from the demand schedule on a two-axis plane derives the demand curve for a good or
service given in figure 2.1 below.
Price
25
20 Demand curve
15
10 Figure 2.1: The Demand Curve
0 50 100 150 200 250 Quantity
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Y axis = the sacrifices that must be made to obtain a commodity - price
X axis = the quantity demanded per unit of time
Individual’s demand for a product is the quantity of the good that consumer would buy at various
prices.
Table 2.2: Individual Demand Schedules
Demand schedule of A Price 0 1 2 3 4 5
Quantity 50 40 30 20 10 0
Demand schedule of B Price 0 1 2 3 4 5
Quantity 30 20 25 20 15 10
Market Demand- is a function of individual’s demand curve and can be obtained by horizontal
summation of individual demand curves. It tells us the total amount of goods and services purchased
in an economy.
Market demand is the sum of individual demands. It is the total quantity of a good or service consumers
are willing to purchase at different prices in a given period. Suppose there are three consumers in the
market. The market demand is the sum of the three quantities purchased by these consumers at each
possible price.
In a more general case, in which the market consists of n consumers with individual demand functions
for goods X is defined as:
Xi = f (PX)
Where Xi represents the quantity demanded of good X by individual i.
The market demand for good X (Xm) is given as:
n
Xm   Xi
i1
The market demand curve (see Figure 2.2), therefore, could be considered to show the relationship
between market demand (Xm) and price PX , other things remaining constant.
Table 2.3: Market Demand Schedule
Price 0 1 2 3 4 5
Quantity 80 60 55 40 25 10
The market demand curves are similarly obtained from simple horizontal summation of individual
demand curves as given below:
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Price
6
5 Market demand curve
4
3
2
1
0 10 25 40 55 60 80 Quantity
Figure 2.2: Market Demand Curve
Determinants of demand:
Demand for goods and services is affected by several factors. These include:
i. The price of the good and service (own price)-negative
ii. The tastes and preferences of the group demanding the good. -ve or +veEg. Animal fat leads
to a higher risk of heart attacks. This results in low demand for red meat.
iii. The income and wealth of the group. +ve or -ve
Normal goods: An increase in disposable income leads to the increase in demand for these goods.
Inferior goods: An increase in disposable income leads to a decrease in demand for these goods. Can
you give any example of such good?
iv. The Price of related goods and services (i.e. substitute goods. +ve and complements (negative)
v. The size of the group (population).
vi. Expectations about the future (eg. Of higher price)
vii. Others (Changes in the population, weather, length of adjustment period, availability of
substitutes, proportion of the consumer’s budget that a particular good represents, etc.). The
less of a consumers budget a commodity represents, the more inelastic the demand be. For e.g.
Salt….Even if price doubles, the consumption will not be affected very much).
Demand is, therefore, a multivariate function:
Qd = f(P, Po T, S, I, E,Z)
Where: P is output price
Po is the price of other goods and services.
T is the taste of consumers toward the good.
S is the size of the population in the market.
I is the income of consumers.
E is the expectation of consumers about future market conditions.
Z is other factors.
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All things that affect demand work through one of these factors. When studying demand all factors
that affect demand, except one, are kept constant (ceteris paribus) and we determine what happens to
demand when the factor under consideration changes.
Law of Demand- is a principle stating that as the price of a commodity increases, the fewer consumers
will purchase per unit of time, ceteris paribus. As price increases, the quantity demanded decreases
per unit of time, ceteris paribus. Why?
 Substitution Effect- When a price of a good starts to increase relative to the price of other
goods, then people start to buy less of that good and more of its substitutes.
 Income Effect- When price increases relative to income, people begin to buy less of the good
whose price has increased.
Demand function- shows the functional relationship between the quantity demanded of a good and its
price, ceteris paribus.
It is defined as: Q = f (P)
The demand function gives quantity demanded as a negative function of price. The most widely used
functional form is a linear demand curve, which is given as:
Q = a-bp Where, a is the intercept and -b is the slope (-ve).
Movement along the demand curve and shift in the demand curve
Changes in the determinants of demand cause changes in demand. These changes in demand which
result from changes in its determinants can be classified into movement along the demand curve and
shift of the demand curve.
Movement along demand curve- refers to that change in the quantity demanded of a good because
of changes in the prices of that good while other factors affecting demand (such as price of other goods,
income etc.) remaining the same (unchanged). In this case it is the Q d that changes. This represents
what is called change in quantity demanded.
P D
P1 a
P2 b
D
0 Q1 Q2 Q
Figure 2.3: Movement along the Demand Curve
Example 2.1
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Suppose a demand function for a theater ticket is given as Q  100  2P . If now price changes from
Birr 2 to Birr 2.50, its effect will be a decline in quantity demanded from 96 tickets to 95 tickets. On a
demand curve this can be shown by a movement from coordinate (2, 96) to coordinate (2.50, 95).
Shift in the demand curve- The demand curve is drawn on the assumption that other things remain
the same. If, however, the factors assumed constant change, their effect would be shifting the demand
curve. Shift in demand curve results from changes in one or more of the factors that affect demand
except the price of the commodity. Increase in demand is shown by the outward shift of the demand
curve whereas inward shift of the demand curve represents decrease in demand. Eg. When income of
consumers change (positive), when price of other substitutes change (positive). Here, the demand
changes.
Look at the following figure for illustration.
P
P1
D D1
D2
0 Q2 Q Q1 Q
Figure 2.4: Shift of the Demand Curve
When the tastes of the people change in favor of bread, it would be reflected by an increase in demand
for bread. At every price, consumers demand a larger amount than before. This, as shown in Figure
2.4, shifts the demand curve from D to D1. The opposite would have occurred if tastes change against
bread, in which case there would be decrease in demand, represented by a shift from D to D2.
The price of related goods and services also has effect on demand depending on the nature of the other
goods. There are two classes of such goods:
 Substitute goods- such goods are substitute to one another. As a result, an increase in the price of
such related goods leads to increase in demand for the other good. Consider Pepsi Cola and Coca
Cola. If the price of Coca Cola increases consumers will shift from the consumption of Coca Cola
to Pepsi Cola. This implies increase in the price of Coca Cola results in the increase of the demand
for Pepsi Cola.
 Complementary goods- these are goods that are jointly consumed. As a result, a rise in the price
of one such good results in decline in demand of the other good. Consider the case of sugar and
coffee. Coffee is consumed together with sugar. Thus, increase in the price of sugar causes decline
in demand for coffee. The converse is true for decrease in the price of sugar.
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Theory of supply
Supply: - refers to the quantity of goods offered for sale at a particular time or a particular place at
alternative prices. Supply defines the whole set of price-quantity relationship. It shows the quantities
that producers are willing and able to supply at alternative prices, ceteris paribus.
Supply schedule: is a tabular listing that shows quantity supplied at various prices, ceteris paribus.
Look at the table below.
Table 2.4: Supply Schedule
Price 5 10 15 20 25
Quantity 10 20 30 40 50
Supply curve: is a graphical representation of a supply schedule showing the quantity supplied at
various prices, ceteris paribus (see Figure below).
P Supply curve
25
20
15
10
5
0 10 20 30 40 50 Q
Figure 2.5: Supply Curve
Determinants of Supply
The supply of goods or services is affected by several factors. The factors that influence supply include:
1. The price of the good (P).
2. The level of technology (T).
3. The price of factors of production (Pf).
4. The number of suppliers/firms (S).
5. Expectations (E).
6. Others (Weather, Price of other commodities that use the same or similar set (bundle) of inputs:
Eg. Land to use for Corn or Wheat..If E(profit) from corn is greater than E(profit) from Wheat,
we expect the supply of corn to increase, Producer Expectations of price change).
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Everything that affects supply works through one of these determinants. Supply function is, then,
defined as
Qs = f (P, T, Pf, S, E, Z)
The Law of Supply
The supply curve shows the relationship between the quantity supplied of a good and its price.
Therefore, in order to see what happens when the price of the good under considerations changes,
everything but the price of the good must be held constant. Given these conditions, the law of supply
states that the quantity supplied of a good or service is usually a positive function of price, ceteris
paribus.
Individual Firm’s Supply
An individual firm’s supply shows the different quantities that the firm would supply at various prices.
So as to derive an individual firm’s supply schedule, just ask the firm the quantities it would supply at
alternative prices, and if it is able to state, then the different price-quantity supplied combinations
define the individual firm’s supply.
Market (Industry) Supply
The market supply curve is obtained by horizontal summation of the individual (firm) supply curves.
This curve represents the sum of the quantities supplied by each firm at different prices. If there are
just two firms in the market, for example, the market supply schedule can be derived from the simple
horizontal summation of the quantity supplied by the two firms at each price.
Table 2.5: Individual Supply Schedules
Supply schedule of Price 0 1 2 3 4
firm 1 Quantity 0 10 20 30 40
Supply schedule of Price 0 1 2 3 4
firm 2 Quantity 0 15 30 45 60
Table 2.6: Market Supply Schedule

Price 0 1 2 3 4
Quantity 0 25 50 75 100
Suppose in the above example, firm 1 has a larger market share and firm 2 has a relatively lower market
share. Accordingly, firm 1 has larger supply curve while firm 2 has a lower supply curve. In this case,
the industry (market) supply curve is given in Figure 2.6 below.
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P S2 S1
(S1+S2)=market supply
P2
P1
0 Y
Figure 2.6: Market Supply Curve
The market supply is the horizontal summation of individual supply curves. For price level less than
P2 firm 2 supplies no output at all. As a result the market supply curve coincides with firm 1’s supply
curve. For price level less than P1 since firm 1’s level of output is zero, market supply will also be zero.
Such market supply curve is a graphical depiction of how much will be offered for sale in the market
at various prices.
In a more general case with n number of firms in the industry (market), the market supply function
S(p) is given as:
n
S( p)   Si ( p) , where Si is the supply function of individual firms.

i 1
Supply Function- shows the functional relationship between price and quantity supplied, ceteris
paribus. And it is generally defined as:
Q = f (P)
The most widely used functional form is the linear supply curve, which is given as:
Q  c  dP
The slope of the supply function is d.
Movement along the Supply Curve

Movement along any supply curve occurs because of changes of the price of the good or service under
study while holding other factors constant. These changes in quantity supplied result as a positive
function of changes in price. Because producers are willing to sell more units if the price rises to cover
the additional costs of production, we observe movement along the same curve.
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Graphically, the effect of change in the price of the product concerned is shown by movement from
one point on the supply curve to another point on the same curve. In the figure below fall in price from
P1 to P2 leads to decrease in quantity supplied from Q2 to Q1.
Price
Supply
P1 b
P2 a
0 Q1 Q2 Quantity
Figure 2.7: Movement along the supply curve
Example: Suppose the supply function of a grocery is given as Q  20  5P . The effect of rise in
price from Birr 6 to Birr 7 would be rise of quantity supplied from Birr 10 to Birr 15. On a supply
curve, this would be shown by movement from coordinate (6, 10) to coordinate (7, 15).
Shifts in the Supply Curve- occur as any one of the ceteris paribus factors (factors kept constant earlier)
is altered. These constitute what is called change in supply (not change in quantity supplied). Change
in quantity supplied results from change in the price of the good with other things remaining the same.
Suppose technology changes, and this change has a positive effect. For instance, assume we are looking
at the supply of beef and that agricultural researchers develop a very inexpensive pill that causes a
young steer to double in weight rapidly. This technological advance means that more beef will be
supplied at each price. There will be increase in supply. Such an increase in supply is represented by a
rightward shift of the supply curve. In the figure below such effects are shown by shift of the supply
curve from S to S1 (see Figure 2.8).
P
S2 S
S1
P2
P1
0 Q2 Q1 Q
Figure 2.8: Shift of the supply curve
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Market Equilibrium
In a free market system output price as well as the level of output in a market are determined by the
forces of demand and supply. The condition of equality of demand and supply is called equilibrium.
Demand is a negative function of price while supply is a positive function of price. Coexistence of
buyers and sellers in a given market implies that if there is to be any exchange, there must be a price
at which the quantity that sellers are willing and able to sell must be equal to the quantity that buyers
are willing and able to buy.
Market equilibrium is a price-quantity combination that results from the interaction of the supply curve
and the demand curve such that at the indicated price, the quantity demanded equals the quantity
supplied.
The equilibrium has the property that once the market settles on that point it stays there unless either
supply or demand shifts. Additionally, a market that is not at the equilibrium position moves toward
that point. These two points can be made clear by considering the graphic representation of equilibrium
discussed below.
Graphic Approach to Equilibrium
To see how equilibrium comes about, consider the following hypothetical demand and supply of coffee
in a given market given by Table 2.7 and its corresponding figure (Figure 2.9).
Table 2.7: Supply of and Demand for Coffee

Price per Kg Kg supplied Kg demanded Difference
per month per month
Br 1.00 2 thousand 10 thousand 8 thousand excess quantity demanded
Br 2.00 4 thousand 8 thousand 4 thousand excess quantity demanded
Br 3.00 6 thousand 6 thousand Equilibrium (no excess )
Br 4.00 8 thousand 4 thousand 4 thousand excess quantity supplied
Br 5.00 10 thousand 2 thousand 8 thousand excess quantity supplied
Price/kg
5.00 4 thousand excess supply S
4.00
3.00
2.00
1.00 4 thousand excess demand D
0 1 2 3 4 5 6 7 8 9 10 Thousand Kg
Figure 2.9: Market Equilibrium
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At a price of Birr 2.00, suppliers want to supply 4 thousand kg of coffee and demanders want to
purchase 8 thousand kg. The quantity demanded exceeds quantity supplied by 4 thousand kg. This
means that some consumers do not get the desired amount at price Birr 2.00. Some of these consumers
will offer more and bid the price up. As the price rises, the quantity supplied, being a positive function
of price will rise and the quantity demanded, being a negative function of price, will fall. This will
continue until the price reaches Birr 3.00. At Birr 3.00, the amount consumers wish to purchase is
exactly equal to the amount suppliers wish to sell. This is the equilibrium price (market clearing price).
The output which corresponds to the equilibrium price is called the equilibrium quantity.
It is important to note that the point representing equilibrium price and equilibrium quantity is not the
same thing as the point where the amount sold equals the amount bought. Quantities bought and
quantities sold are always equal. But at equilibrium the quantity that suppliers wish to sell is exactly
equal to the quantity demanders wish to purchase, i.e., the equilibrium represents coincidence of wishes
on the part of consumers and producers.
 Excess demand causes an upward pressure on price. Thus price converges to the equilibrium
price.
 Excess supply causes a downward pressure on price. Thus, price follows a path towards the
equilibrium.
Once equilibrium is reached at the point of equality of the demand curve with the supply curve, it
remains there as long as demand and supply remain unchanged.
Numerical Approach to Equilibrium
At the equilibrium position, the demand function is exactly equal to the supply function. If demand is
given as Qd  a  bP and supply is given as Qs  c  dP , the equilibrium condition is
Supply = Demand
a  bP  c  dP
Example: Suppose the demand and supply functions in a particular market are given as:
Qd  100 2P
Qs  10  4P
At equilibrium Qd = Qs
100 2P 10 4P
Rearranging 6P  90
The equilibrium Price is, therefore, P = 15.
The equilibrium quantity is obtained by substitution.
17
Qd  100 2(15)  70  Qs
Market equilibrium condition is determined by the interaction of demand and supply forces. This
means, any change on one of the two or on both will affect the equilibrium condition. Now, let us
discuss how the equilibrium condition is affected by changes in demand or in supply or in both.
Effects of Change in Demand
When the ceteris paribus conditions (price of other goods, consumers’ income, taste, population size,
expectation etc.) change, there will be a shift in the demand curve. Such changes (shifts) in demand
result in a shift of the equilibrium position.
Assume first, there is increase in demand, for any one reason, represented by an upward (rightward)
shift in the demand curve. Such rise in demand, with supply constant, creates shortage at the initial
equilibrium price, and the unsatisfied buyers bid up the price. This causes a larger quantity to be
produced, with the result that at the new equilibrium more is bought and sold at a higher price. This
change, with supply remaining the same, shifts the equilibrium position from e0 to e1. The equilibrium
price rises from P0 to P1and equilibrium quantity rises from Q0 to Q1. That means, consumers are now
demanding larger quantities of the good at every price than before (See the figure below).
P
S0
P1 e1
P0 e0
P2 e2 D1
D0
D2
0 Q2 Q 0 Q1 Q
Figure 2.10: Effects of change in demand
On the other hand, fall in demand, ceteris paribus, creates surplus, and the unsuccessful sellers bid the
price downwards to clear the surplus. As a result, less of the commodity is produced and offered for
sale. At the new equilibrium, both price and quantity bought and sold are lower than they were
originally.
Such fall in demand is represented by a leftward (downward) shift of the demand curve, and causes
the equilibrium position to shift from e0 to e2. Accordingly, equilibrium price falls from P0 to P2 and
equilibrium quantity falls from Q0 to Q2.
With regard to change in demand the equilibrium price and quantity change in the same direction. The
magnitude of the change in price and quantity demanded depends on:
 The size (magnitude) of demand change
18
 The slope (elasticity) of supply

For any given supply curve, the higher the size of change in demand the higher the change in
equilibrium price and quantity (See Figure below). The size of change in demand is high in panel (b)
than in panel (a). Therefore, the changes in equilibrium price and quantity are high in the former than
in the later.
P S P S
P1 e1
P1 e1
P0 e0 P0 e0
D1 D1
D0 D0
0 Q0 Q1 Q 0 Q0 Q1 Q
(a) (b)
Figure 2.11: Shifts in demand in Different Magnitudes
For any given change in demand, the change in equilibrium price is higher and the change in
equilibrium quantity is lower the steeper the supply curve (the higher the slope of the supply curve).
The converse would be true if supply curve is flatter.
P S P
P1 e1 S
P0 e0 P1 e1
P0 e0
D1
D0 D0 D1
0 Q0 Q1 Q 0 Q0 Q1 Q
(a) (b)
Figure 2.12: Effects of Difference in the Slope of Supply
In the figure above, the supply curve in (a) is much steeper than the supply curve in (b). Accordingly,
the resulting changes in equilibrium price and quantity for any given shift of the demand curve are
different.
Assume the changes in demand in the two cases are equal. As demand shifts from D0 to D1, the changes
in equilibrium price and quantity are given by (P1-P0) and (Q1-Q0) respectively. Yet (P1-P0) is higher
in (a) than in (b), and (Q1-Q0) is higher in (b) than in (a).
As the demand curve shifts, the change in equilibrium price is higher and the change in equilibrium
quantity is lower for the steeper supply curve than for the flatter one.
19
This implies, therefore, that for any given change in demand, change in price will be higher and change
in quantity lower the steeper the supply curve.
Effects of Change in Supply
Shift in the supply curve resulting from changes in the ceteris paribus conditions, causes shift of the
equilibrium position (point). An increase in supply for one or the other reason would shift the supply
curve rightward from s0 to s1. With demand remaining the same, this shift causes shift of the
equilibrium point from e0 to e1. Accordingly, there will be shifts in equilibrium price and quantity.
P D S2 S0
S1
P2 e2
P0 e0
P1 e1
0 Q2 Q0 Q1 Q
Figure 2.13: Effects of Shift in Supply
The effect of such shift in supply would be decline in equilibrium price because the increase in supply
exerts downward pressure on price, and increase in equilibrium quantity because now that the total
supply at each price is higher compared to the initial condition, producers wish to sell off their products
at lower prices. Accordingly, the equilibrium price and quantity change from P0 to P1 and from Q0 to
Q1 respectively.
If, on the other hand, supply decreases as given by the leftward shift of the supply curve from S0 to S2,
there will be consequent shift of the equilibrium point from e0 to e2. The effect of such change in supply
is increase in equilibrium price and fall in equilibrium quantity because, with demand remaining the
same, producers are willing to sell lower quantities at each price. The equilibrium price and quantity
change from P0 to P2 and from Q0 to Q2 respectively.
20
The magnitude (size) of the changes in equilibrium price and equilibrium quantity due to change in
supply depend on:
 The size (magnitude) of supply change
 The slope (elasticity) of demand
First, let us consider changes in supply of different magnitude for any given demand curve. Large
change in supply causes large changes in equilibrium price and quantity than a small change in supply
(See the Figure below).
(a) (b)
P S0 P S0
S1 S1
P0 e0 P0 e0
P1 e1
P1 e1
0 Q0 Q1 Q 0 Q0 Q1 Q
Figure 2.14: Shifts in Supply in Different Magnitude

In Figure above, the change in supply is large in panel (b) than in (a). Accordingly, the changes in
equilibrium price and equilibrium quantity are larger in (b) than in (a).
Now consider the effect of difference in the slope of the demand curve on the changes in equilibrium
price and quantity.
P P S0
S0 S1 S1
P0 e0 P0 e0
P1 e1 P1 e1
D D
0 Q0 Q1 Q 0 Q0 Q1 Q
(a) (b)
Figure 2.15: Effects of Difference in the Slope of Demand
21
Suppose the shifts in supply in the above two diagrams are equal. For any given shift in supply,
therefore, the higher the change in equilibrium price and the lower the change in equilibrium quantity
will be, the steeper the demand curve. Demand is steeper in (b) than in (a). Accordingly, the change in
price is higher in (b) than in (a), while change in quantity is higher in (a) than in (b).
The change in price is higher and the change in quantity is lower for the former demand function
(which is steeper) than the latter (which is flatter). Therefore, for any given change in supply, the effect
on price is higher and the effect on quantity is lower the steeper the demand curve.
Simultaneous Shift in Demand and Supply
In the above two sections, we have seen how price and quantity change as demand shifts and supply
shifts under the ceteris paribus assumption. Under normal conditions, however, both may change
simultaneously. Such types of changes are analysed below.
Change in Demand and Supply in a Same Direction
Increase in demand shifts the demand curve to the right and exerts an upward pressure both on price
and quantity. Increase in supply, similarly, shifts the supply curve to the right and exerts a downward
pressure on price and an upward pressure on quantity (See the Figure below).
P S1 S2 P S1
S2
P2 e2
P1 e1 P1 e1
P2 e2
D1 D2 D1 D2
0 Q1 Q2 Q 0 Q1 Q2 Q
(a) (b)
Figure 2.16: Increase in Demand and Supply
In panel (a), the initial equilibrium is defined at e1. As both demand and supply rise, the equilibrium
point shifts from e1 to e2. Since the rise in demand is greater than the rise in supply, the net effect will
be rise in both price and quantity.
In panel (b), the initial equilibrium position occurs at e1. The shift demand and supply moves the
equilibrium from e1 to e2. Yet, the rise in supply is greater than the rise in demand resulting in net
increase in supply. This reduces the equilibrium price and increases the equilibrium quantity.
The magnitude by which price and quantity change depends on two factors: the size of change in
demand and supply and the slope of the demand and supply curves. If demand and supply increase
by an equal percentage, price will remain unchanged.
22
Example: Suppose the supply function has shifted from Qs  10  4P to Qs  28  4P , and the
demand function has shifted from Qd  100 2P to Qd  100  2P .
Case one below shows the equilibrium before the shift in demand and supply curves and case two
shows the equilibrium after the shift in demand and supply curves.
Case one Case two
Q Q
1 1
Q2  Q2
d s d S
100 2P  10  4P 100 2P  28  4P
6P  90 6P  72
P 15 P  12
Qd  100  2(15)  70  Qs Qd  100  2(12)  76  QS

The effect of the change in demand and supply is fall in price and rise in quantity. This indicates that
the rise in supply is greater than the rise in demand.
Exercise: Suppose the demand function that a firm faces shifted from Qd  120  3P to
Qd  90  3P and the supply function has shifted from QS  20  2P to QS  10  2P .
a) Find the effect of this change on price and quantity.
b) Which of the changes in demand and supply is higher?
Change in Demand and Supply in an Opposite Direction

Suppose demand increases while supply decreases. The rise in demand shifts the demand curve to the
right and the fall in supply shifts the supply curve to the left (See the following Figure).
P S2 S1 P S2 S1
P2 e2 P2 e2
P1 e1 P1 e1
D2
D1 D2 D1
0 Q2 Q1 Q 0 Q1Q2 Q
(a) (b) (b)
Figure 2.17: Increase in Demand and Decrease in Supply
In Figure above, two forces are operating against the equilibrium position.
23
The rise in demand pushes price up. If supply remained the same, the equilibrium would occur at the
intersection of D2 and S1. This raises the price level. On the other hand, if supply falls with demand
constant, equilibrium occurs at the intersection of D1 and S2. This pushes price up. Both rise in demand
and fall in supply act to raise price. As demand rises and supply falls simultaneously, price rises to an
even higher level (P2).
The effect on quantity, however, depends on the magnitude of the change in demand and the slope of
demand and supply curves. In panel (a) the rise in demand is less than the fall in supply, therefore,
quantity decreases. In panel (b) the rise in demand is greater than the fall in supply, therefore, quantity
increases. If the rise in demand is equal to the fall in supply quantity will remain unchanged.
ELASTICITY
Elasticity measures the percentage point responsiveness of demand and supply to a percentage point
in any of their determinants.
The determinants of demand and supply may change for a host of reasons. In studying the effects of
factors that affect demand and supply, we are interested not only in the direction of change but also in
the magnitude of the change. With regard to price, the slope of the demand and supply functions could
be considered.
Slope = dQ/dP,
Where, dQ is the change in output and dP is the change in price.
Slope measures by how much output changes for a very small (say a unit) change in price. In this sense,
slope is a measure of responsiveness but it presents some problems. The most important one is that the
slopes of demand or supply functions depend on the units in which price and quantity are
measured. Output could be measured in units, kilograms, litres, gallons etc while price is measured in
currency units such as Birr, Dollars etc. Therefore, slope measures certain kg per Birr, some liters per
Dollar etc. This, in turn, creates problem of comparison where responsiveness is measured in different
units. It is not possible to compare responsiveness measured as X kg/Birr with one measured as Y
pounds/Dollar.
Definition: Elasticity is a measure of the sensitivity or responsiveness of quantity demanded or quantity
supplied to changes in price (or other factors).
Elasticity measures the way one variable (dependent variable) responds to changes in other variables
(independent variables). We express the dependent variable (Y) as a function of the independent
variables (Xi) as in the following function:
Y = f(X1, X2, X3,…,Xn)
In this function, Y is given as a function of n variables. As any one of these variables (Xi) changes,
there will be consequent change in the value of Y.
The formula to determine the responsiveness of Y to changes in the Xi can be expressed as
24
%Y %Y %Y

1  ,  2  , ………..,  n 
%X1 %X 2 %Xn
Price Elasticity of Demand
The price elasticity of demand () is defined to be the percentage change in quantity demanded divided
by the percentage change in price.
Percentagechange in quantity demanded

Percentagechange in price
Q / Q
 , where Q is change in quantity and P is change in price.
P / P
Rearranging
Q P
 
P Q
The sign of the elasticity of demand is generally negative, since demand curves invariably have a
negative slope. Accordingly price elasticity of demand can be stated as:
P
  slope
Q
In elasticity, we consider the absolute value of the coefficients. The negative sign in front of an
elasticity coefficient indicates only that the relationship between price and quantity demanded is
negative. A demand with –2 elasticity coefficient is said to be ‘more elastic’ than the one with –1.
If a good has an elasticity of demand greater than 1 in absolute value, it is said to have an elastic
demand. Such values imply that a given percentage fall in price causes more than proportionate rise in
price.
Example
Assume that a consumer purchases 10 units of a good when price is Birr 4 and 18 units when price
falls to Birr 2. Compute price elasticity of demand.
18  10
Percentage change in quantity demanded is  100  80% and,
10
24
Percentage change in price is  100  50%
4
80%
Elasticity, therefore, is given as    1.6
 50%
This implies that for one percent fall in price quantity demanded rises by 1.6 percent. Here, since E is
greater than one, demand is said to be elastic.
25
If the elasticity is less than 1 in absolute value, on the other hand, it would be the case of inelastic
demand. This indicates that a given percentage fall in price causes a less than proportionate rise in
quantity demanded.
If, however, a given percentage change in price causes a proportionate percentage change in quantity
demanded the elasticity coefficient will be -1; and hence demand is referred to as unitary elastic.
With most demand curves, the elasticity coefficient varies along the curve. In this regard, a good
example is a linear demand curve. The coefficients of elasticity of such demand curves range from
perfectly elastic (at the intercept of y-axis) to perfectly inelastic (at the x-axis intercept).
Consider a linear demand function of the form, Q = a – bP, depicted in the figure below. The slope of
this demand curve is a constant -b.
The formula for price elasticity of demand is given as
dQ P
 
dP Q
P
 slope
Q
Substituting this into the formula for elasticity, we have
P  bP
  b  
Q Q
But Q=a - bP
 bP

a  bP
The horizontal intercept of the demand curve will be obtained by setting P=0. Accordingly it occurs
at Q=a. The vertical intercept, on the other hand, is obtained by setting Q=0. It is defined at P= a/b.
P
a/b e = 
e>1
a/2b e = 1
e<1
e = 0
0 a/2 a Q
Figure 2.18: Elasticity along a Linear Demand Curve
26
At the horizontal intercept the price elasticity of demand is zero.

 b(0)  0  0

a  b(0) a
When q = 0 at the vertical intercept, the elasticity of demand is infinity.
 bp
   
0
In between these two points, there must be a price-quantity combination at which price elasticity of
a
demand is unity or one. This point occurs at P  .
2b
Proof
The point at which elasticity is unity is defined as
 bP
  1
a  bP
By cross multiplication
 bP  bP  a
a  2bP
a 2bp a
 P
2b 2b 2b
a
At P  the quantity demanded will be obtained by substitution into the demand function Q = a –
2b
bP.
a
Q  a b
2b
a a
Q a Q 
2 2
a a
The price-quantity combination that yields unitary elasticity of demand is ( p  ,Q  )
2b 2
This result implies, therefore, that elasticity of demand for this linear demand function becomes unitary
just half way down the demand curve.
27
Numerical Coefficients of Price Elasticity of Demand

Table 2.8: Elasticity Coefficients
Numerical Responsiveness of quantity demanded to changes in Terminology
coefficients price
e=0 None Perfectly inelastic
0<e<1 Quantity demanded changes by a smaller percentage than Inelastic
the percentage change in price
e=1 Quantity demanded changes by a percentage equal to the Unit elastic
percentage change in price
1 < e < Quantity demanded changes by larger percentage than the Elastic
percentage change in price
e =  Quantity demanded goes to zero or to all that is available perfectly elastic
Determinants of Price Elasticity of Demand

Price elasticity of demand depends, in large part, on the number of substitutes a product has. If a
good has many close substitutes, it is generally held that its quantity demanded would be very
responsive to price changes. On the other hand, if there are a few close substitutes for a good, it will
exhibit a quite inelastic demand.
The elasticity coefficients for general groups of commodities will be lower than for specific
commodities. For example, the elasticity of demand for detergent soap will be higher than the elasticity
of demand for soap in general.
Another determinant of elasticity is time. The longer the period of time consumers have to adjust, the
more elastic the demand becomes. This is because there are more opportunities to modify behavior and
substitute different products over a longer time period.
A fourth determinant of price elasticity of demand is the nature of the need that the commodity
satisfies. Generally luxury goods are price elastic and necessities are price inelastic.
The proportion of income spent on the particular commodity also affects price elasticity. Goods like
car which take up a large proportion of income tend to have more elastic demand than goods like salt
which take up only small proportion of income.
Constant Elasticity Demands

Along a linear demand curve, as shown above, price elasticity of demand ranges between 0 and ∞. In
some exceptional cases, the demand curve may exhibit constant price elasticity throughout.
A demand curve given by a vertical line indicates a case in which the quantity demanded of a good is
totally unresponsive to changes in price. Consequently, the elasticity coefficient is zero. Such demand
curve is called perfectly inelastic demand curve. This is a limiting case, which violates the law of
demand.
28
dQ P P
   0 0
dP Q Q
P D
P2
P1
0 Q1 Q
Figure 2.19: Vertical Demand Curve
If a demand curve is given by a horizontal line, which is also a limiting case, a very small decrease in
price would cause an infinite quantity of the good to be demanded. If price rises, in contrary, the
quantity of the good falls to zero. Such a curve is referred to as a perfectly elastic demand curve.
P
P1 D
0 Q1 Q2 Q
Figure 2.20: Horizontal Demand Curve
A general way to characterize demand curves with constant elasticity is
Q  AP
where A is an arbitrary positive constant and  is a measure of price elasticity of demand.  being a
measure of elasticity, it will typically take a negative value.
A more convenient way to express a constant elasticity demand function is to take the logarithm of
both sides and write
ln Q = ln A +  ln P
In this expression, the logarithm of Q depends in a linear way on the logarithm of P.
An interesting case of such constant elasticity demand curves is a unit elastic demand curve. The
demand curve is a rectangular hyperbola. The demand function will, thus, be:
A
Q  AP1 or Q 
P
In its logarithmic form, it is stated as: ln q = ln A – ln P
29
P
P1
P2 D
0 Q1 Q2 Q
Figure 2.21: Rectangular Hyperbola Demand Curve
The price elasticity of demand of a rectangular hyperbola is unitary throughout the demand curve.
Price Elasticity of Demand and Total Revenue
When dealing with demand curves, the concern is with price and quantity relationships. Quantity, or
the number of items sold multiplied by price equals the total revenue generated.
TR  P  Q
In order to see how firms set and change prices, the relationship between total revenue and elasticity
could be considered.
It is important to recognize that a price change has two opposite effects on total revenue. The first is
that a price decrease, by itself, will decrease total revenue. The other is that with a price decrease,
quantity demanded increases, thus increasing total revenue. The net effect on total revenue depends on
whether the relative price decrease exceeds the relative increase in quantity demanded or vice versa. If
demand is elastic, fall in price causes increase in total revenue. If, on the other hand, demand is
inelastic, the effect of fall in price would be decrease in total revenue.
Price Price
P1 P1
P2 P2 D
0 Q1 Q2 Quantity 0 Q1 Q2 Quantity
(a) Relatively inelastic demand (b) Relatively elastic demand
Figure 2.22: Elasticity and Total Revenue
30
On both demand curves, the price falls from P1 to P2 and output increases from Q1 to Q2. This change
causes the total revenue to change. Some revenue is lost and some revenue is gained due to the price
change. In Figure 2.22 above, the lightly shaded areas represent the revenue that has been lost and the
darkly shaded areas represent revenue that has been gained. In the case of the relatively elastic curve,
panel (b) of the figure, the decrease in price has brought about an increase in total revenue; in panel
(a), the decrease in price has brought about a decrease in total revenue.
These relationships are summarized in the table below.
Table 2.9: Relationship between Elasticity and Revenue

Price change Quantity demanded change Elasticity Total Revenue
Rise Decrease >1 Decrease
Rise Decrease =1 Unchanged
Rise Decrease <1 Increase
Fall Increase >1 Increase
Fall Increase =1 Unchanged
Fall Increase <1 Decrease
Example
Price .50 1.00 1.20 1.40 1.60 1.80 2.00 2.20 2.40 2.60 2.80 3.00
Quantity 25 20 18 16 14 12 10 8 6 4 2 0
demanded
In the table above, at a price of Birr 2.00, the total revenue (TR) is Birr 20.00. An increase in price
from Birr 2.00 to Birr 2.20 causes TR to fall from Birr 20.00 to Birr 17.60. This is because the 10
percent increase in price caused an even greater percentage decrease in quantity demanded. The
elasticity is greater than one. Conversely, if price rises from Birr 1.00 to Birr 1.20, TR increases from
Birr 20.00 to Birr 21.60 because the percentage increase in price is greater than the percentage decrease
in quantity demanded. The elasticity is less than one.
Total revenue, being the product of price and quantity, its function can be obtained by multiplying the
inverse demand function by the quantity.
A demand function that gives quantity as a function of price (Q = f (P)) is called direct demand
function. If the demand function gives price as function of quantity (P = f (Q)), it is called inverse
demand function.
31
An inverse demand function is given as P  a  bQ
TR  P  Q
TR  (a  bQ)Q
TR  aQ  bQ2
Here, total revenue is a quadratic function. At the maximum point of the function its slope is zero.
The slope of any function is the first derivative of that function.
dTR
Slope of TR =  a  2bQ
dQ
At the maximum point of TR, a  2bQ  0
a
Q
2b
Let’s show the relationship between TR and price mathematically.
TR  P  Q
TR P Q
 Q  P
P P P
TR Q
Q P
P P
TR  Q P 
 Q1   
P 
  P Q 
Q P
But   
P Q
TR
 Q(1  e )
P
TR
If e  1,  0 . This implies that rise in price leads to fall in TR.
P
TR
If e  1,  0 . This implies that rise in price leads to rise in TR.
P
TR
If e  1,  0 . This implies that rise in price will not affect TR.
P
32
Example
1
Suppose a demand function is given as Q d  50  P . Let’s show that total revenue is maximum when
2
 = -1.
The inverse demand function is P  100  2Qd .
TR  100Q  2Q2
d d
dTR
Slope of TR =  100  4Q
d
dQd
At the maximum point of TR:
100 4Qd  0
Qd  25
At Qd  25 price obtained by substitution into the inverse demand function.
P  100  2(25)  50
Price elasticity of demand is defined as:

P
  slope
Q
1 50
    1
2 25
Therefore,  = -1 when TR is maximum.
Approaches to Elasticity Measurement

There are two main approaches to elasticity computation: the arc elasticity and point elasticity. If we
are measuring the elasticity between points, we are actually calculating the average elasticity over the
space between the points. This is called arc elasticity.
Elasticity between two points:
Q
(Q1  Q2 ) / 2 Q P1  P2
  
P P Q1  Q2
(P1  P2 ) / 2
33
P1 a
P2 b
D
0 Q1 Q2 Q
Figure 2.23: Arc Elasticity
Suppose you wish to measure price elasticity of demand as price falls from P1 and P2. In this case you
are, in a way, measuring the average elasticity between point a and point b.
When measuring the responsiveness of quantity demanded to changes in price at a particular point on
a curve, you are actually measuring point elasticity.
Elasticity at a point is measured by assuming infinitesimally small changes in price and quantity
demanded. When dealing with the concept of arc elasticity, however, we are working with sizable,
discrete changes.
Elasticity at a particular point:
Q P
 
P Q
P1 a
D
0 Q1 Q
Figure 2.24: Point Elasticity
Price elasticity of demand at a particular point, such as point a, can be obtained by multiplying the
slope of the demand curve at that point by the corresponding price/output ratio.
P
  slope
Q
34
Cross Elasticity of Demand

The responsiveness of quantity demanded for one commodity to the changes in the prices of other
commodities, ceteris paribus, is called cross elasticity of demand. It is denoted as:
Percentagechange in quantity demanded of one commodity(X)
 XY 
Percentagechange in the priceof another commodity(Y)
In this case (where the demand of a given good does not depend solely on its price), the demand
function is modified in such a way it includes the prices of related goods.
QX = f(PX, PY)
The cross elasticity formula is given as:

QX  PY ’
 XY 
PY QX
Where QX is the quantity demanded of good X and PY is the price of good Y.
The cross elasticity of demand coefficient may take different values depending on the type of
relationship between the two goods. If cross elasticity demand coefficient is equal to zero, it would
mean the two goods under consideration are unrelated. In this case, any increase or decrease in price
of one of the two goods has no effect on the quantity demanded of the other good.
On the other hand, if the goods have a relationship of some sort, this value would be different from
zero. The two goods could be substitutes or complements depending on whether the cross elasticity
coefficient is positive or negative.
Definition: two goods are said to be substitutes if one good can be consumed in place of the other.
Complementary goods, in contrast, are goods that are consumed together so that fall in consumption
of one implies reduction in consumption of the other.
If the cross elasticity of demand coefficient has a positive sign it indicates that a rise in the price of one
of the two goods results in rise in the quantity demanded of the other good. As a result the two goods
are substitutes. If, however, the cross elasticity of demand coefficient has a negative sign, it reflects
that a rise in the price of one of the goods results in decline in the demand for the other indicating that
the goods are complements.
The size (magnitude) of the cross elasticity of demand coefficient shows strength of the substitution or
complementary relationship between the goods under consideration. i.e., the higher the value of cross
elasticity, the stronger will be the degree of substitutability or complementarity, depending on the sign.
Example: The quantity demanded of good X before change in the price of good Y was 25 units. As
good Y’s price changes from Birr 5 to Birr 10, the quantity demanded of good X has increased to 75
units.
35
QX PY
 XY  
PY QX
50 5  2
 XY  
5 25
The two goods, therefore, are substitute products.
Income Elasticity of Demand: - Income elasticity of demand is a measure of the responsiveness of

quantity demanded to changes in income assuming all other things, including price, constant.
Percentagechange in quantity demanded
I
Percentagechange in income
Q I
I  
I Q
Where, Q represents output and I represents consumers’ income.
In measuring income elasticity of demand, the sign of the elasticity coefficient is important. The sign
of the coefficient indicates the nature of the products; whether the products are normal or inferior.
Definition: normal goods are goods whose quantity demanded increases with rise in consumers’
income, while inferior goods are those goods whose quantity demanded decreases with rise in income.
The income elasticity of normal goods is positive reflecting the positive relationship between income
and quantity demanded. For inferior goods, however, income elasticity is negative.
Income elasticity of demand of a good depends mainly on the importance of the product to a consumer.
The more basic a good is in the consumption pattern of a consumer, such as food stuff, the lower is its
income elasticity. The more luxury a good is, the higher its income elasticity will be. Income elasticity
also depends on the time period; because consumption patterns adjust with time-lag to changes in
income.
36
Elasticity of Supply
Price elasticity of Supply: - Price elasticity of supply measures the responsiveness of the quantity
supplied to a change in the commodity’s price, ceteris paribus. It is defined as:
Percentagechange in quantity supplied
S
Percentagechange in price
Qs P
s  
P Q
s
Where, QS is quantity supplied of a good and P is price.

As with price elasticity of demand, if s = 1, supply is unit elastic. If s> 1, it is elastic; and if s< 1, it
is inelastic.
The coefficients of price elasticity of supply are often positive because normally supply curves are
positively sloped. But there are exceptions in which the supply curve is either vertical or horizontal. If
the supply curve is verticalthe quantity supplied does not change as price changesthen elasticity
is zero. This is the case in the very short run where it is difficult to produce more of a good
regardless of what happens to price. Similarly, a horizontal supply curve has an infinitely high
elasticity of supply: a small drop in price would reduce the quantity producers are willing to supply
from an indefinitely large amount to zero. Between these extremes the elasticity of supply varies with
the shape of the supply curve.
Example: A firm produces 100 units of output and sells each unit for Birr 20 at equilibrium. Suppose
the demand for the firm’s product has increased and caused a rise in price to Birr 25 a unit. After the
rise in price the quantity that the firm sells has increased to 120 units.
Qs P
s  
P Q
s
20 20
s    0.8
5 100
This implies that the supply of the firm is price inelastic.
Exercise: The price elasticity of supply of a firm is 0.5. A rise in price to Birr 6 has induced a 10
percent rise in quantity supplied by the firm. Find the initial level of price.
37
CHAPTER THREE
THEORY OF UTILITY AND PREFERENCES

Introduction
An individual demands a particular commodity because of the satisfaction or utility received from
consuming it. In analyzing an individual consumer’s decision making process, economists use two
approaches. The first is the cardinal utility approach, which involves the concept of measurable utility.
The second approach, the ordinal utility approach, requires only the ranking of preferences as a basis
of making decisions.
Why does a person demand a certain commodity? An obvious reason is that the commodity is expected
to satisfy some need or desire of the consumer. Economists call the satisfaction from consumption of
commodities utility.
Utility is the satisfaction that an individual receives from consuming goods or services. Utility is strictly
an ex ante concept; that is, it measures the way an individual feels about a commodity before the
individual buys or consumes it. Utility is the satisfaction that an individual expects to get, not what he
actually gets.
Consumers are generally assumed to be rational and hence, as an objective, seek to maximize their
satisfaction or utility from the consumption of goods and services for given money income. The
complete list of these goods and services is called consumption bundle. To achieve the maximization
of their objective, consumers, then, must be able to compare different consumption bundles according
to their desirability.
In relation to the comparison of the utility from different consumption bundles, cardinal approach and
ordinal approach take different views.
Cardinal Utility Approach

This approach took the view that utility is measurable and additive. In this regard a measure called util
can be employed. On the basis of the amount of utility consumers derive from consumption of
commodities; comparison of the number of utils of different people and addition of the utility of
different people is, therefore, possible. By comparing different bundles according to the number of
utils they yield, a consumer will choose that bundle which gives him the highest possible number of
utils.
Assumptions of Cardinal Utility Theory
The Cardinal utility approach builds on certain assumptions. The basic assumptions of the approach
are given below.
1. The total utility of a ‘basket of goods’ depends on the quantities of the individual commodities.
If there are n commodities in the bundle with quantities X1 , X 2 ,..., Xn the total utility is
U  f ( X 1 , X 2 ,..., X n ) .
38
This assumption implies that as the quantity of goods consumed increases the total utility of
the consumer accordingly increases.
2. Rationality: the consumer is rational. He/she aims at the maximization of his/her utility subject
to the constraint imposed by his/her given income. Total utility being
the function of the quantity of goods consumed, a consumer would wish to have more of
everything. Yet his/her desire is constrained by his/her limited income. This brings forth the
need to prioritize consumption bundles according to their desirability.
3. Utility is cardinal: the utility derived from each commodity is measurable. The most
convenient measure is money: the monetary units that a consumer is prepared to pay for another
unit of the commodity measure utility.
4. Constant marginal utility of money: this assumption is necessary if monetary units are to be
used as the measure of utility. If the marginal utility of money changes with the level of income
(wealth) of the consumer, then money cannot be considered as a measuring rod of utility.
5. Diminishing marginal utility: the extra satisfaction gained from successive units of a
commodity diminishes. In other words, the marginal utility of a commodity diminishes as the
consumer acquires larger quantities of it.
Total Utility and Marginal Utility

Total utility is the total amount of utility that consumers receive from consumption of commodities.
Utility being measurable, it is given as the sum of the utilities obtained from consumption of each unit
of the commodity consumed. Total utility changes as the quantity of the commodity consumed
changes. The change in total utility for a one unit change in the quantity of the commodity consumed
is referred to as marginal utility.
Marginal utility is the amount of satisfaction added by an additional unit of consumption. This is the
change in total utility for a one unit change in the quantity of the commodity consumed.
The formula for marginal utility (MU) is
Change in total utility U Un1
MU   n .
Change in quantity consumed Qn  Qn1
Where, Un is the total utility from consumption of n units of a good, while Un-1 is the total utility from
consuming n-1 units of the good. Un – Un-1, therefore, measures the extra satisfaction from consuming
the nth unit.
Though total utility increases as the consumption increases, the additions to total utility from each
additional unit consumed become smaller. This feature–the fact that additional, or marginal utility
declines as consumption increases–is called diminishing marginal utility (Consider the following
table).
39
Table 3.1: Utility Schedule for Coca Cola

Quantity of Coca Cola Total Utility Marginal Utility
0 0 –
1 20 20
2 38 18
3 54 16
4 67 13
5 77 10
6 84 7
7 88 4
8 89 1
9 87 -2
10 82 -5
In Table 3.1 above, marginal utility is determined by calculating how much each additional bottle of
Coca Cola adds to total utility. For example, the first bottle adds 20 units to total utility. The fourth
bottle adds 13 units to total utility. And this is found by subtracting the total utility of consuming n-1
bottles from the total utility of consuming n bottles of Coca Cola.
Principle of Diminishing Marginal Utility

The principle of diminishing marginal utility holds that for a given time period, the greater the level of
consumption of a particular commodity, the lower the marginal utility. For instance, the seventh bottle
is expected to provide less additional pleasure than the sixth bottle. This principle is reflected in table
3.1 and figure 3.1 below. In table 3.1 marginal utility falls from 20 units for the first bottle to 18 units
for the second bottle. The seventh bottle adds only four units to total utility.
Panel (a) of figure 3.1 below shows the total utility curve derived from the utility schedule in table 3.1.
Panel (b) shows the marginal utility curve that corresponds to the total utility curve.
Marginal utility is zero when total utility reaches its maximum. To the left of this point marginal utility
is positive and total revenue rises. To the right of this point marginal utility is negative and total utility
falls.
Graphically, MU is the slope of the total utility curve. The slope of total utility curve decreases until it
reaches its maximum point at 8 bottles of Coca Cola. MU, therefore, falls in this range. At the
maximum point of the total utility curve slope is zero, and hence MU will be zero. Beyond the eighth
unit, however, since the total utility curve is falling MU is negative.
Mathematically, MU is given as
dU
MU  , where dU is change in total utility and dQ is change in the quantity of the commodity.
dQ
Total
40
Utility
100
80
60 Total Utility
40
20
0 1 2 3 4 5 6 7 8 9 10 Quantity of Coca Cola
Marginal
Utility
20
16
12
8
4
0 1 2 3 4 5 6 7 8 9 10 Quantity of Coca Cola
-4
-8 Marginal Utility
Figure 3.1: Total and Marginal Utility
Utility and Consumer Behavior

When choosing, consumers are confronted with a range of items and also a range of prices. A consumer
may not choose the item which has the greatest utility because price and income are also important
factors. In other words, consumers don’t always buy their first choice. You may prefer Teff to
Sorghum, but you may purchase the Sorghum. This is rational behavior, and we can see the reason by
looking at price and utility.
Suppose, for example, you are considering purchasing a soft drink. You are presented with three
possibilities given in table 3.2. Coca Cola is your first choice because it yields the most utility. But the
relevant question is not which soft drink has the most utility, but which has the most utility per Birr.
Therefore, you choose to buy a Pepsi. This choice implies that the extra satisfaction of Coca Cola over
Pepsi is not worth 1.5 Birr, but the extra satisfaction of Pepsi over Sprite is worth the extra 50 cents it
costs. Thus, in deciding how to spend your money, you look at marginal utility per Birr rather than
marginal utility alone. By buying the commodity with the highest marginal utility per Birr, you
economize on your money.
41
Table 3.2: Hypothetical Utility per Birr Comparisons

Choice Marginal Utility Price MU per Birr
Coca Cola 70 7 10
Pepsi 66 5.5 12
Sprite 50 5 10
Equilibrium of the Consumer
A consumer is said to be at equilibrium when he/she maximizes his/her utility from the consumption
of commodities for a given price and income. In the simplest case, where the consumer buys just a
single commodity X, he/she is faced with the choice of either spending his income on the purchase of
good X or retaining his/her income. The decision of the consumer depends on the satisfaction he/she
derives from consuming additional unit of the commodity and the satisfaction he/she derives from
keeping his/her income. If consumption gives him/her more satisfaction than saving, he/she would buy
the commodity. If consumption yields relatively lower satisfaction to the consumer compared to the
satisfaction from saving, then the consumer would keep his/her income. The equilibrium quantity of
the commodity is, then, defined at the equality of the additional utility (marginal utility) of the
commodity and the marginal utility of money (which is assumed to be constant).
Table 3.3: Utility Schedule for a Single Commodity
Quantity Total utility Marginal Marginal utility per Birr Marginal utility of
utility (P = Birr 2) money
1 10 - - 1
2 36 26 13 1
3 56 20 10 1
4 70 14 7 1
5 78 8 4 1
6 80 2 1 1
7 76 -4 -2 1
8 68 -8 -4 1
Table 3.3 above presents the utility schedule of a consumer that makes decision on consumption of
beer. Initially each consumed Bottle of beer gives the consumer higher satisfaction. As the quantity of
beer consumed increases, the additional satisfaction received falls.
42
For consumption level higher than six bottles, since MU per Birr is higher than the MU of a unit of
Birr, the consumer can increase his/her welfare by consuming more bottles of beer. For consumption
level higher than six bottles, the consumer can improve welfare by reducing consumption because MU
per Birr is less than the MU of a unit of Birr. The equality of the marginal utility of beer and that of
money occurs at the sixth bottle of beer. This represents the equilibrium of the consumer.
Mathematically, the equilibrium condition of a firm that consumes a single good X occurs when the
marginal utility of X is equal to its market price Px.
MUx = Px
Proof
The utility function is
U  f (X )
If utility is measured in monetary terms and the consumer buys Qx quantity of the commodity, his
expenditure is Qx.Px. The consumer wishes to maximize his utility for any Birr spent. In a way,
therefore, the consumer wishes to maximize the difference between his utility and his expenditure:
Max (U  Qx .PX )
The necessary condition for maximum is that the partial derivative with respect to Qx be zero. This is
because, at the maximum point, the slope of the total utility function is equal to zero.
dU d (Qx Px )
 0
dQx dQx
Rearranging we obtain
dU
 Px or MUx = Px
dQx
If MUx is greater than Px, the consumer can increase his welfare by purchasing more units of X. If, on
the other hand, MUx is less than Px, the consumer can increase its welfare by reducing the quantity of
x he purchases. Utility is maximized when the condition MUx = Px is satisfied.
43
Suppose now the consumer faces two commodities in his utility function, Pepsi and Pizza. The price
of Pepsi is Birr 2 a unit and that of Pizza is Birr 3 a unit. The utility schedule of the consumer is given
below (See Table 3.4).
Table 3.4: Utility Schedule for Two Commodities
Pepsi Pizza
Quantity TU MU MU/P (P Quantity TU MU MU/P (P
= 2) = 3)
1 32 32 16 1 45 45 15
2 58 26 13 2 87 42 14
3 78 20 10 3 120 33 11
4 92 14 7 4 147 27 9
5 100 8 4 5 165 18 6
6 102 2 1 6 177 12 4
7 98 -4 -2 7 183 6 2
8 90 -8 -4 8 183 0 0
Budget Constraint
The consumer has a given amount of income and hence we call he has a budget constraint.
Definition: budget constraint shows the given level of income that determines the maximum amount
of goods that may be purchased by an individual.
For example, let’s consider the consumer with Birr 28 worth of purchasing power, and see how that
income will be allocated between the two goods so as to achieve maximum utility.
The consumer first buys a unit of Pepsi, because the first unit of Pepsi yields 16 units of satisfaction
per Birr. The next commodity purchased would be pizza, because it yields 15 units of satisfaction
compared with the 13 units for Pepsi. The third commodity purchased will be pizza, because it yields
higher satisfaction per Birr than the second unit of Pepsi. This process continues until the income of
Birr 28 is spent. In maximizing utility, the consumer will buy 5 units of Pepsi (spends Birr 10 on Pepsi)
and 6 units of pizza (spends Birr 18 on pizza). This allocation gives a total of 277 units of satisfaction–
the maximum utility that can be obtained for an expenditure of Birr 28.
At this level of allocation the marginal utility per Birr is equal for the two commodities. If there is any
difference in the MU/P, the consumer can increase its welfare (total utility) by consuming more of the
44
commodity that gives him/her more MU/P, and consuming less of the commodity that gives him/her
less MU/P.
This condition can be defined in algebraic form as:
MU Pepsi MU pizza

PPepsi Ppizza
Thus, the marginal utility of a bottle of Pepsi, when 5 bottles of Pepsi are consumed is 8 units, and the
price of Pepsi is Birr 2, so
MU Pepsi  8  4 ,
PPepsi 2
Or 4 units per Birr. For pizza, at the optimum consumption rate MU is 12 units and the price is Birr 3,
so
MU pizza 12
 4.
Ppizza 3
This can be generalized to show the consumption decision involving n commodities. In this case, the
condition for the consumer’s equilibrium is defined by the equality of the ratios of marginal utilities of
individual commodities to their prices.
MU x MU y  ...  MU z

Px Py Pz
The utility derived from spending an additional unit of money must be the same for all commodities.
If the consumer derives greater utility from any one commodity, he/she can increase his welfare by
spending more on that commodity and less on others.
Weaknesses of Cardinal Utility Approach:
The cardinal approach involves two serious weaknesses, namely:
 The assumption of cardinal (measurable) utility is doubtful. The satisfaction derived from the
consumption of various commodities cannot be objectively measured.
 The assumption of constant utility of money is also unrealistic. The utility derived from a unit
of money varies with the level of income of the consumer. The additional satisfaction that a
45
poor person derives from a unit of money is by far higher than the marginal utility of a rich
person. Thus, money cannot be used as a measuring rod since its own utility changes.
Ordinal Utility Approach

The ordinal utility approach emphasizes that for decision making it suffices if consumers can rank their
preferences according to their desirability, rather than specify the quantity of utility they derive from
consumption of a commodity. For example, instead of saying that a unit of Pepsi gives me 30 units of
utility and a unit of pizza gives me 20 units of utility, therefore I prefer Pepsi to pizza; the consumer
needs only to be able to say “I prefer a unit of Pepsi to a unit of Pizza.” Ordinal utility involves a utility
ranking that only requires that choices be ranked, rather than assigned numerical values.
Assumptions of Ordinal Utility Theory
The assumptions are the following:

1. The consumers are assumed to be rational- they aim at the maximization of their utility, given
their income and market prices.
2. Utility is ordinal- it is assumed that consumers can rank their preferences according to the
satisfaction of each bundle. They need not know precisely the amount of satisfaction. It suffices
that they express their preference for the various bundles of commodities.
3. The total utility of the consumer depends on the quantities of the commodities consumed. The
utility function is, thus, given asU  f (Q1,Q2 ,..., Qn ) .
4. For any two consumption bundles A and B, the consumers are able to determine the bundle that
provides the most satisfaction:
 A is preferred to B if it provides more satisfaction than B. Conversely B is preferred to A if
it provides more satisfaction than A.
 If both bundles provide equal level of satisfaction the consumer would be indifferent
between the two bundles.
5. Preferences are transitive- if A is preferred to B and B is preferred to C, then A is preferred to
C. Similarly if the consumer is indifferent between A and B and if he is indifferent between B
and C, then he is indifferent between A and C.
Preference Ranking
The basis of ordinal utility approach is its assumption that objective measurement of utility is largely
impossible and unnecessary as long as people are able to rank one consumption bundle ahead of
another. Table 3.5 below shows the ranking of eight consumption bundles by a consumer that consumes
two goods X and Y. The consumer assigns rank to each bundle according to the importance of the
bundles to his satisfaction. In this example, more preferred bundles are assigned higher values. A
commodity space is obtained by plotting the table on a two dimensional plane. Each point in the
commodity space describes an allocation of X and Y. So at point F, the consumer is considering the
46
allocation of one unit of X and four units of Y. To say that the consumer is indifferent between F and
G implies that he is indifferent between the bundle 1X and 4Y and bundle 2X and 2Y. It does not imply
that he is indifferent between 4Y and 1X (See the table).
Table 3.5: Rank Ordering of Commodity Bundles

Bundle Amount of X Amount of Y Rank order
A 6 6 4
B 3 5 3
C 4 3 3
D 5 2 3
E 3 4 2
F 1 4 1
G 2 2 1
H 3 1 1
From the table, we can see that consumption bundle A has more of both goods X and Y, and hence, is
preferred to all other bundles. The consumer is indifferent among consumption bundles B, C, and D,
indicating that the consumer is willing to take less Y if he gets enough more X in return. Bundle B is
preferred to E (the latter has less Y and the same amount of X). The consumer is also indifferent between
bundles G, H, and F.
7
6  A(6, 6)
Quantity of Y
5 B(3, 5)
4 F(1, 4) E(3, 4)
3 C(4, 3)
2 G(2, 2) D(5, 2)
1 H(3, 1)
0 1 2 3 4 5 6 Quantity of X
Figure 3.2: Commodity Space
Utility Functions
Definition: utility function is a preference function ordering a consumer’s desire to consume differing
amounts of commodities.
The use of utility functions, that assign numerical value or utility level to consumption bundles,
facilitates the analysis of consumer behavior. Utility functions provide ordinal measurement of the
utility provided by consumption bundles, i.e., the particular values assigned to consumption bundles
do not have significance on their own right. They are simply used for the purpose of ranking different
consumption bundles. If the consumer prefers bundle A to bundle B, the utility function has to assign
a larger numerical value to bundle A than to bundle B, but the actual numerical values so assigned are
47
themselves irrelevant. Similarly, if the consumer is indifferent between bundle A and bundle B, the
utility function must assign the same numerical value to each bundle, but the particular value so
assigned is irrelevant. For example, the rank order assigned to consumption bundles A through H in
Table 3.5 can be thought of as the numerical values assigned to these bundles by some utility function.
Any other set of numbers such as 50, 20, 20, 20, 5, 3, 3, 3, which preserved this ranking would do
equally good.
If a utility function is defined asU  XY , utility is the product of the quantities of X and Y consumed
by consumers. In this case, the consumer derives 100 units of utility from a bundle consisting of 10
units of X and 10 units of Y. And he/she is indifferent between a bundle, which consists of 1 unit of X
and 100 units of Y and 10 units of X and 10 units of Y. A bundle with 1 unit of X and 100 units of Y is
preferred to a bundle with 8 units of X and 10 units of Y.
The Indifference Curve
Consumers’ preferences are such that they choose the best things they can afford. Consumers have
consumption bundle which represents the complete list of the goods they prefer. These consumption
bundles are represented by (X, Y), where X represents the good of our particular interest and Y all other
goods. This enables us to focus on the tradeoff between one good and everything else. Consumers can
rank these bundles according to their desirability.
In a consumer choice problem involving two consumption bundles (X1, Y1) and (X2, Y2), if the
individual
 always prefers the former bundle to the latter, we say (X1, Y1) is preferred to (X2, Y2).
 is equally satisfied with both bundles, then the consumer is indifferent between the two
bundles.
An indifference curve is a locus of points–particular combinations or bundles of goods–in a
commodity space, which yield the same utility to the consumer, so that he is indifferent between the
different consumption bundles. Each point on an indifference curve yields the same total utility as any
other point on that same indifference curve.
An indifference map is a set of indifference curves each corresponding to a different level of
satisfaction for the consumers.
Y Y
III
II
I
0 X 0 X
(a) Indifference curve (b) Indifference map
Figure 3.3: Indifference curve and Indifference map
48
The indifference curves in an indifference map rank the preferences of the consumer. Different
combinations of goods situated on an indifference curve yield the same utility. Combinations of goods
lying on a higher indifference curve yield higher level of satisfaction and are preferred.
Characteristics of typical Indifference Curves

The following are the major characteristics of an indifference curve:
1. An indifference curve has negative slope, which denotes that if the quantity of one commodity (Y)
decreases, the quantity of the other (X) must increase, if the consumer is to stay on the same level of
satisfaction. If the quantity of one commodity increases with the quantity of the other remaining the
same, the total utility of the consumer increases. In order to keep the utility of the consumer constant,
as the quantity of one commodity is increased, the quantity of the other must be reduced.
2. Consumers can compare any two bundles in the commodity space and decide that he prefers one
ofthem or is indifferent between them. Therefore, there is an indifference curve passing through each
point in the commodity space. In a commodity space, there are infinite points that represent
consumption bundles. Some of these bundles yield equal amount of satisfaction to the consumer, and
hence are located on the same indifference curve. Each point gives some amount of satisfaction to the
consumer, therefore, must be located on certain indifference curve.
3. The farther from the origin an indifference curve lies, the higher the level of utility it denotes: bundles
of goods on a higher indifference curve are preferred by the rational consumer. Consumption bundles
on a relatively lower indifference curve, in contrary, represent lower level of satisfaction and are not
preferred by a rational consumer.
4. Indifference curves do not intersect each other. If they did, the point of their intersection would
imply two different level of satisfaction, which is impossible.
Y
a d
b
c I
e II
0 X
Figure 3.4: Intersection of Indifference Curves
Points a, b and c are located on the same indifference curve, therefore must represent the same level
of utility. Similarly, points d, b and e are located on the same indifference curve, therefore must yield
the same level of utility. Bundle b is located at the intersection of two indifference curves implying
two different levels of satisfaction. Bundle a has equal quantity of Y as bundle d, but it has less X than
d, therefore represents lower level of utility. Both a and d, however, yield the same level of satisfaction
as bundle b. This implies that a and d yield the same level of utility, which is not true.
49
5. 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. In other
words, convexity implies that the consumer is prepared to sacrifice decreasing quantities of one output
(K) for each given increase in quantities of the other output (L).
Marginal Rate of Substitution

Marginal rate of substitution is a measure of substitution of two commodities in consumption.
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 consumer maintains the same
level of satisfaction.
Number of units of Y given up
MRS X ,Y 
Number of units of X gained
Graphically, it is measured by the slope of an indifference curve. As we move from left to right on an
indifference curve, the marginal rate of substitution decreases in absolute value; this is referred to as
the decreasing marginal rate of substitution (See the figure below). As a consumer receives more and
more of a particular good, its value in terms of other goods declines. This implies that the number of
units of commodity Y that the consumer is willing to sacrifice for additional unit of commodity X
declines as the quantity of X increases.
Figure 3.5: Marginal Rate of Substitution

At point a in Figure 3.5, the consumer consumes 1 units of X and 20 units of Y. At this point X is
relatively scarce and Y is relatively abundant. Therefore, the consumer is willing to give larger
quantities of Y in exchange for a unit of X, or, in other words, the consumer is willing to trade 10 units
of Y for a unit of X. At point e, however, the consumer has more of X and less of Y, thus he is willing
to exchange fewer quantities of Y in exchange for a unit of X. Now, he is willing to trade a unit of X
for fewer unit of Y. Any movement along the indifference curve from left to right results in reduction
in the rate of exchange between the two commodities.
Y
Slope of =  = MRS
X
X ,Y
indifference
curve
50
Here, it is important to note that MRSX ,Y is different from MRSY , X . The former measures the quantity
of Y that must be sacrificed for a unit of X so as to keep the consumer at the same level of satisfaction.
The latter measures the quantity of X that must be given up for a unit of Y in consumption such that the
consumer will remain at the same level of utility.
The concept of marginal utility is implicit in the definition of marginal rate of substitution, since
marginal rate of substitution is defined by the ratio of marginal utilities of the commodities
involved. This reflects the fact that the consumer takes into account the additional (marginal) utility
of the two commodities when making the exchange.
MU X MUY
MRS  or MRS 
X ,Y Y ,X
MUY MU X
Proof:
The utility function involving two commodities X and Y is defined as
U = f (X, Y).
Along an indifference curve utility is constant, therefore
U = f (X, Y) = C
The total differential of the utility function is
U U
dU  dX  dY  0
X Y
MU X  dX  MUY  dY  0
MU X dY
  MRS X ,Y
MUY dX
Similarly,
MUY dX
  MRS Y , X
MU X dY
The ratio of the marginal utilities of the two commodities defines the rate at which one is substituted
for the other in consumption.
Example
Suppose a consumer’s utility function is given asU  20X 0.4Y 0.6 and we are required to find MRSX, Y.
MU X
MRS 
X ,Y
MUY
dU dU
MU X  , and MU Y

dX dY
51
MU X  0.4(20X (0.41)Y 0.6 ) , and MU Y  0.6(20X 0.4 Y (0.61) )

0.6 0.6 0.4 0.4
MU X  8X Y , and MU Y  12X Y
MU X 8X 0.6Y 0.6
MRSX ,Y   0.4 0.4
MUY 12X Y
2Y
MRS X ,Y 
3X
The Budget Constraint

As seen in the preceding sections, the utility of a consumer depends on the quantities of the
commodities consumed. If so, then, a rational consumer must wish to acquire as much quantities of the
commodities as possible. Yet, the quantity of the commodities that a consumer can acquire at a given
time is limited by his income. Given the infinite consumption bundles in a commodity space, those
bundles that can be afforded by a consumer for a given money income constitute the affordable
consumption bundle of the consumer. The size of the consumer’s income, therefore, defines the
consumer’s affordable consumption bundle.
Suppose the consumer consumes two goods X1 and X2 with their prices given as P1 and P2. If the total
income of the consumer is M, the total expenditure of the consumer cannot exceed his total income.
P1 X1  P2 X 2  M
The set of all affordable consumption bundles at a given income M and prices P1and P2 is referred to
as the budged set of the consumer. The relationship between expenditure and income above defines
the consumer’s budget set. The boundary of this set is called the consumer’s budget constraint.
Budget constraint is the set of consumption bundles that can be purchased if the entire money income
is spent, at a given commodity prices. It is shown by the equality of expenditure with income.
P1 X1  P2 X 2  M
Solving for X2 gives the equation of the budget constraint.
P2 X 2  M  P1 X1
1 P
X 2  M  1 X 1
P2 P2
The budget constraint establishes the maximum possible combination of goods X1 and X2 that the
consumer can acquire for income M and prices P1 and P2. The slope of the budget line is the negative
P
of the ratio of the prices of the commodities involved ( 1 ) . The negative sign reflects the downward
P2
slope of the budget line, which implies that when the entire income is used so as to increase the
consumption of one commodity, the consumer must reduce the consumption of the other.
The shaded area in Figure 3.6 shows the different consumption bundles that the consumer can afford
to purchase for a given income M, while the boundary of this region, the budget constraint, shows the
highest possible bundles that can be afforded for the given income M. The budget line has the following
characteristics.
52
 Points on the budget line, such as point a, indicate consumption bundles that use up the household’s
entire income. Once a consumer locates himself on any one point on the budget line, he can only
increase the consumption of one commodity by reducing the consumption of the other, because the
entire income has been spent.
X2
M/P2 b
a
Budget constraint
c
Budget set
0 M/P1 X1
Figure 3.6 Budget Set and Budget Line
 Points below the budget line, such as c, indicate combinations of commodities that cost less than
the household’s income. When an individual consumes a consumption bundle inside the budget
set, since there is income which is not spent, it is possible to improve utility by increasing
consumption.
 Points above the budget line, such as b, indicate combinations of commodities that cost more than
the household’s income. Points outside the budget set are not attainable for a given income, and
are irrelevant for decision making.
Shifts in the Budget Line

The budget constraint sets upper limit to the quantities that a consumer wishes to buy. This constraint
gets relaxed or tightened as certain conditions change. Such changes are reflected by shift of the budget
constraint and these shifts may result from two sources, namely:
 Changes in the consumer’s income. As the income of the consumer changes, the consumer can
buy more of or less of both commodities depending on the direction of the change.
 Changes in the prices of the commodities. Such changes have the effect of making the
commodity whose price has fallen relatively attractive and at the same time raising the real
income of the consumer.
Changes in Money Income
With two goods, X1 and X2 involved, increase in income enables the consumer to purchase more of
good 1, more of good 2 or more of both goods. Increase in income changes the vertical intercept and
the horizontal intercept. It does not affect the slope of the budget line (the ratio of prices). As a result,
change in consumer’s income causes an outward shift of the budget line in a parallel fashion.
53
X2
M*/P2
M/P2
X 22 b
X 21 a
0 X1 X2 M/P1 M*/P1 X1
1 1
Figure 3.7: Change in Money Income
Example
Suppose a consumer’s income is Birr 280 and uses this income to buy two goods X and Y. If the price
of X is Birr 2 a unit and that of Y is Birr 5 a unit, the budget equation can be stated as
2X  5Y  280
Solving for Y,
Y  56 0.4X
The slope of the budget line is, then -0.4. The vertical intercept is obtained by setting X = 0, and it is
defined at Y = 56. The horizontal intercept, similarly, is obtained by setting Y = 0, and it is X = 140.
Now if the consumer’s income increases to Birr 350, with commodity prices remaining the same, the
new budget equation is given as
2X  5Y  350.
Solving for Y,
Y  70 0.4X
The slope of the budget line is unchanged, but the vertical intercept has increased to Y = 70 and the
horizontal intercept has increased to X = 175. Here both the vertical intercept and the horizontal
intercept have risen by 25 percent. Therefore, the budget line must have shifted in a parallel fashion.
Exercise 3.5
? A consumer’s income is Birr 400. The consumer uses his entire income to buy two goods X
and Y. If the price of X is Birr 2 and the price of Y is Birr 4, derive the consumer’s budget equation.
Find the effect of fall in income to Birr 300 on the vertical intercept, horizontal intercept and slope of
the budget line.
Changes in Price
We have discussed that the prices of the commodities determine the quantities of the commodities
purchased for a given money income. This fact is reflected in the budget constraint. The slope and
intercepts of the budget line are affected by changes in the prices of the commodities. The changes in
price could be of two types: proportional change in price, in which the prices of the two commodities
54
rise or fall by the same percentage such as by change in the general price level, or relative change in
price, in which the prices of the two commodities change by different percentages.
Proportional Change in Prices
Proportional rise in the prices of both goods (good 1 and good 2), with income remaining unchanged,
will reduce the total quantity of the two goods that the consumer can buy for a given income. For
example, if the prices of the two goods under consideration double, this would halve the quantities of
the two goods purchased to be reduced by half. Before the rise in price, if the consumer decides to
spend his entire income on X1, the total quantity purchased is M/P1. But after the doubling of prices,
the new quantity will be M/2P1. The new quantity is half that of the pre change quantity. Its effect is
the same as that of reducing the consumer’s income by half. This causes a parallel shift in the budget
line towards the origin.
Proportional rise in the prices of the two commodities, X1 and X2 causes fall in the intercepts but leaves
the slope of the budget line unchanged.
X2
M / P2 ''
M/P2
M / P2 '
0 M / P ' M/P1 M / P '' X1

1 1
Figure 3.8: Proportional Changes in Price

Suppose the initial budget constraint is the one with intercepts M/P1 and M/P2. Proportional fall in
price shifts the budget line to the right to the one with intercepts M / P'' and M / P'' .On the other hand,
1 2
a proportionate fall in price is shown by shift of the budget line to the right. In this case, with income
remaining the same, the intercepts increase but the slope remains unchanged. In Figure 3.8, a
proportional rise in price is shown by shift of the budget line from the one with intercepts M/P2 and
M/P1 to the one with intercepts M / P' and M / P' .
1 2
Example
Suppose a consumer’s income is Birr 300. The consumer spends his income in the consumption of two
goods X and Y with prices Birr 5 and birr 10 respectively. Assume further that the consumer buys equal
quantity of both goods. In this case, by exhausting his entire income the consumer can buy 20 units of
X and 20 units of Y.
5(20) + 10(20) = 300
If the price of both goods doubles; i.e., Px = 10 and Py= 20, the quantity that the consumer is able to
buy when the entire income is spent is reduced to 10 units of X and 10 units of Y.
10(10) + 20(10) = 300
55
Changes in Relative Prices

A change in relative price can occur, and often does, as a result of changes in only one of the prices or
changes in both prices in different proportions.
First, assume that the price of good-1 changes (increases) with price of good-2 and income remaining
fixed. Slope being the ratio of prices, this would make the budget line steeper. The vertical intercept
'
P
does not change, but the horizontal intercept will change. The resulting new slope would be  1
where
P2
'
P1 is the new price of good 1.
X2
M/P2
Slope= -P1/P2
Slope=  P1' /P2
0 M / P1' M/P1 X1
Figure 3.9 Relative Changes in Price
In Figure 3.9 above, the initial budget constraint is the one with intercepts M/P1 and M/P2 and slope -
P1/P2. With the price of X2 and income (M) remaining unchanged, if the price of X1 rises, the budget
line rotates towards the origin. The horizontal intercept of the budget line decreases, reflecting the fact
that as the price of X1rises the quantity of X1 that can be bought by the consumer declines if he decides
to spend the entire income on X1. Thus, the new horizontal intercept is M / P1' . Similarly slope decreases
to  P1' /P2. The vertical intercept remains unchanged, however.
The effect of simultaneous change in the prices of the two goods in different proportions can be shown
in the same way as the previous case. In this case, however, both the vertical and horizontal intercepts
change.
X2
M/P2
Figure 3.10: Relative Changes in Price
M / P2'
56
0 M/P1 M / P1' X1
In Figure 3.10 above, the initial budget constraint is given by steeper budget line. Given this initial
condition, if the price of X1 rises and the price of X2 falls, the position of the budget constraint changes.
That is, the vertical intercept increases from M / P2' to M/P2 and the vertical intercept decreases from
M / P1' to M/P1.
The Equilibrium of the Consumer

The consumer is in equilibrium when he maximizes his utility, given his income and the commodity
prices. The maximization of utility can now be shown by combining a set of indifference curves with
the budget line. For the consumer to maximize his utility two conditions must be satisfied.
1. The marginal rate of substitution (the slope of indifference curve) must be equal to the ratio of
commodity prices (the slope of budget constraint).
MU x Px
MRS x, y  
MU y Py
This is necessary but not sufficient condition for equilibrium.
2. The indifference curve must be convex to the origin. This condition is satisfied by the axiom
of diminishing marginal rate of substitution, which states that the slope of the indifference
curve declines as we move from left to right.
Given an indifference map and the consumer’s budget constraint, the consumer’s equilibrium is
defined by the tangency of the budget line with the highest possible indifference curve. As can be seen
in Figure 3.11 below, at point e on indifference curve II, the budget line and indifference curve II are
tangent. Any point on III such as point d, is preferred to point e, because higher indifference curves
represent higher levels of utility. However, point d is not attainable because it is outside the budget set
(affordable region). Point c on I is attainable, and point e on indifference curve II also is attainable,
and any point on II represents more satisfaction than any point on I.
Y
A d
c
Y* e III
II
I
0 X* B X
Figure 3.11: Consumer’s Equilibrium
57
The consumer wants to reach the highest attainable indifference curve. The highest attainable curve is
the one which is tangent to the budget line because no higher indifference curve can be reached with
the given income and prices. In Figure 3.11 above, the consumer maximizes his utility at point e. At
the point of tangency (point e), the slope of the budget line, the ratio of the price of X to the price Y, is
equal to the slope of indifference curve II, marginal rate of substitution.
P
MRS  x
x, y
Py
This equality satisfies the first order condition for equilibrium. The second order condition is also
satisfied since the indifference curve is convex at the tangency. Anywhere to the left of the tangency,
MRSx, y is higher than at the tangency; and anywhere to the right of the tangency, MRSx, y is lower than
at the tangency. In Figure 3.16, the consumer maximizes his utility by consuming X* amount of good
X and Y* amount of good Y.
The marginal rate of substitution expresses the willingness of the consumer to trade a certain amount
of X for a certain amount of Y, and the slope of the budget line reflects the market’s willingness to trade
a certain amount of X for a certain amount of Y. The impersonal forces of the market impose the relative
price on the consumer, so the consumer adjusts consumption amounts in such a way that his tradeoff
is the same as that of the market.
The consumer’s utility maximizing behavior can be generalized to n goods case. With n goods involved
in a consumer’s decision, the equilibrium condition is defined by the equality of the ratio of marginal
utility to price of all commodities.
MU1 MU2    MUn

P1 P2 Pn
58
CHAPTER FOUR
THEORY OF PRODUCTION
Introduction
We have discussed the details of consumer’s behavior in terms of utility and preferences. In this unit,
however, we will discuss production theory from the point of view of producers. This unit sets the
stage for examining the behavior of firms as producers and sellers of goods and services. In the
production process, firms use inputs also called factors of production. Therefore, we may conceive of
firms as being sellers of goods and services and buyers of factors of production. Firms buy factors of
production and transform them into goods and services. This process of transformation is called
production. This process of transformation is influenced by the time horizons involved. Production is
more flexible in the long run than in the short run.
The Short run Production Function

In the short run, the firm has relatively short time to adjust the size of its plant in accordance with
developments in the market. The firm’s problem in the short run is finding the best way of employing
existing plant and equipment.
The Production Function

A production function shows the technical relationship between factor inputs and output. It describes
the amount of output expected from different combination of input usage. It can be expressed in tabular
or graphic form or by a mathematical formula.
A production function reflects the best technology available for a given level of output in the
production process. Inferior combinations of factors of production (i.e., combinations involving more
of all inputs) to produce the same output are ignored. Suppose a firm uses labor (L) and capital (K) to
produce a given level of output. Let A and B be two different combinations of factor inputs:
A B
L 5 4
C 4 4
Both A and B use the same quantity of capital but A uses more labor than B. Then, input combination
A will not be represented on the production function. Only methods that use the fewest inputs would
be captured by the production function.
Factors of production could be fixed or variable. The difference between fixed and variable factors
relates to the time horizon involved. In economics, there are two main horizons; the short run and the
long run. The short run is a relatively short period of time in which the quantity of some factors of
production such as equipments and buildings cannot be varied. Such factors are called fixed factors.
Factors of production whose quantity can be varied in the short run are called variable factors. The
long run, on the other hand, is a relatively long period which allows the variation of all factors of
production including plants and equipments.
In this section, we will focus on a production process in which there are only two factors of production;
labor and capital, where capital is the fixed factor and labor is the variable factor.
59
The production function in this case is defined by

Y  f L K
The bar on K indicates that capital is constant and variation in output depends on variation in labor L.
Output
Production function
0 Labor
Figure 4.1: Short run Production Function
As more and more units of a variable factor (L) are combined with fixed factors (in our case K), we
may initially obtain increasingly larger additions to output, but we eventually obtain smaller increments
in output (Look at the above figure). This economic phenomenon is referred to as the principle of
diminishing returns (also called the law of variable proportions).
Consider, for example, a firm increased the level of labor employed with a unit of capital. At early
stage, since lower level of labor employment does not allow the realization of full capacity of the
machinery; therefore increase in labor employment increases productivity. Eventually as more and
more labor is combined with the single unit of capital, the machinery will fail to support the large
number of workers; therefore the productivity of labor will fall.
Note, however, that diminishing returns is a short run phenomenon because it is defined with at least
one fixed factor.
Average and Marginal Product Curves

Given the production function which transforms a set of inputs into output, the technical relationship
between inputs and output could further be analyzed by deriving marginal and average product curves.
Total product (TP) is the total amount that is produced during a given period of time. If the inputs of
all but one factor are held constant, total product will change as the quantity of the variable factor used
changes.
Suppose capital is fixed at 5 units. By applying varying quantity of labor, the firm can produce different
levels of output (See the figure below).
60
Table 4.1: Total Product, Average Product and Marginal Product

Qty of capital Qty of Labor (L) Total product Average product Marginal
(K) (TP) (AP) product (MP)
5 0 0 - -
5 1 15 15.0 15
5 2 34 17.0 19
5 3 48 16.0 14
5 4 60 15.0 12
5 5 62 12.4 2
5 6 60 10 -2
Capital being held fixed at 5 units, as the quantity of labor increases, the level of output (TP) increases.
Average product (AP) increases at first and then declines. The same is true of marginal product.
Average product (AP) is the total product divided by the number of units of the variable factor used to
produce it. If we let the number of units of labor be denoted by L, the average product can be written
as
TP
AP 
L
In Table 4.1 above, as more of the variable factor (labor) is used, AP first rises and then falls. The level
of output at which AP reaches maximum is called the point of diminishing average productivity. Up
to that point, average productivity is increasing; beyond that point, average productivity is decreasing.
Marginal Product (MP) – is the change in total product resulting from the use of one unit more of a
variable factor. In the above table, as the first unit of labor is employed, total product increases by 15
units. This increase in TP is the marginal product of the first unit of labor. The second unit of labor
adds 19 more units of output to TP; therefore, its MP is 19 units. The fifth unit of labor’s MP is just 2
units of output, while the last unit of labor’s contribution to output is negative.
dTP
MP  , where dTP is the change in TP, and dL is the change in L.
dL
At initial stages, MP increases as additional variable factors (labor) are employed. Then reaches
maximum and declines. After certain range, it becomes negative with employment of additional
variable factors. The level of output at which, marginal product reaches its maximum level is called
point of diminishing marginal productivity (inflection point).
Example: Suppose the production function that a firm faces is given as
2
Q  f (L)K  8L 
2
L3
3
This production function shows the maximum output that can be produced from various levels of labor
employment, therefore represents TP. The AP is, then, derived as
2
8L2  L3
TP 3  8L  2 L2
AP  
L L 3
61
Given the AP function, the point of diminishing average productivity occurs where the slope AP is
zero.
dAC 4 4
The slope of AP = 8 L0  L 8 L 6
dL 3 3
Similarly, MP is derived as
2
d (8L2  L3 )
dTP
MP   3  16L  2L2
dL dL
Given the MP function, the point of diminishing marginal productivity occurs where the slope of MP
is zero.
dMP
The slope of MP =  16  4L  0  4L 16  L  4.
dL
The Relationship between MP and AP: Graphic approach

The principle of diminishing returns yields an interesting relationship between AP and MP.
Graphically, AP at a particular level of labor employment is given by the slope of a line from the origin
to a point on the TP curve which corresponds to the given level of employment.
Output
d
c TP
b
a
0 Labor
Figure 4.2: Graphic Derivation of Average Product
In Figure 4.2, AP at point a is the slope of a ray from the origin to a; while AP at b is the slope of a ray
from the origin to b. As we move along TP curve from left to right up to point c, the ray from the origin
becomes steeper and steeper. Beyond point c, however, the ray from the origin becomes flatter and
flatter. The steepest possible ray from the origin to any point on the TP curve is 0c. Therefore, AP
reaches maximum at point c.
MP at a particular point on the TP curve is graphically given as the slope of the TP curve at that
particular point. In Figure 4.3 below, MP at point a is the slope of the tangent line at that particular
62
point. Up to point b, the slope of the tangent line increases as the level of employment increases.
Anywhere to the right of b, the slope of the tangent lines gets flatter and flatter; and eventually slope
is zero at point d. Employment beyond L2 is associated with less steeper tangent lines. The MP,
therefore, reaches its maximum point at b and becomes zero at point d.
Output
d
c TP
a
0 L1 L2 L3 L4 Labor
Figure 4.3: Graphic Derivation of Marginal Product
In Figure 4.4, for employment level between 0 and L1 units, TP increases at an increasing rate (slope
of the TP becomes steeper and steeper), and this means that MP and AP are also increasing. At L1,
MP reaches its maximum. Between L1 and L2 units of labor, TP increases at a decreasing rate and
MP declines, but is above AP. As a result, AP increases. At L2, AP reaches maximum and is cut by
MP. Between L2 and L3, TP still increases at a decreasing rate, but MP is below AP. This pulls the
AP down and AP falls. At L3, MP is zero and TP reaches maximum. Beyond L3, MP is negative, and
therefore, TP declines.
63
Output
Maximum AP
TP
0 L1 L2 L3 Labor
Output Point of diminishing MP.
Point of diminishing AP.
0 L1 L2 L3 Labor
MP
Figure 4.2: The Relationship between AP and MP
1
Exercise: Suppose a firm faces the production function Q  5L2  L3 .
6
a) Derive the AP and MP functions.
b) Determine the point of diminishing average productivity and the point of diminishing
marginal productivity.
64
The Stages of Production

TP
Q = f(L)
Stage I Stage II Stage III
0 A B L
MP
Point of diminishing MP.
Point of diminishing AP.
Stage I Stage II Stage III
0 A B L
MPL
Figure 5: Stages of Production
The marginal product of a factor may assume a positive, zero or a negative value. However, basic
production theory concentrates only on the efficient part of the production function, that is, on the
range of output over which the marginal product of a factor (labor in our case) is positive. No rational
firm would employ labor beyond B as in Figure 4.5, since the increase in labor beyond this level would
result in reduction of total output (MP is negative). Ranges of output over which marginal product of
a factor is negative imply irrational behavior.
We may split the whole production functions into three segments (or stages). Stage I represents a range
over which output grows at an increasing rate causing the MP to rise, and therefore, there is no
rationale for a firm to stop its employment over this range because an additional unit of labor produces
more than the previous units. Stage III is one on which output decreases, implying that employment of
additional units reduces output, i.e., MP is negative.
65
The basic theory of production usually concentrates on the range of output over which the MP of a
variable factor (labor) decreases, but is positive, i.e., the range of diminishing (but non- negative)
productivity of the factor. This range of production is given by AB, which defines Stage II.
Formally, the efficient stage of production is defined by the condition:
Q
MPL   0 MP of labor should be positive.
L
MP 2 Q
L
 < 0  the slope of MP should be negative.
L L2
The Long run Production Function

In the long run, all factors of production are variable. Firms, therefore, can alter their output by varying
all factors. At its simplest case with just two factors involved, the production function of a firm is
defined by a set of isoquants each of which representing certain level of output. The acquisition of
factors of production, however, involves costs. The cost constraint that the firm faces is given by
isocost lines. The firm determines its equilibrium by combining isoquants and isocost lines.
Suppose that a production process involves just two factors, labor (L) and capital (K). In this case the
production function is defined as:
Q  f (L, K )
The production function we saw under previous section was drawn on the assumption that all other
factors of production except labor are fixed. However, with two variable factors L and K, the relevant
production function is defined by a set of isoquants. The word isoquant simply means equal quantities.
An isoquant is defined as the locus of points indicating different combination of two inputs; say labour
(L) and capital (K), which yield a specific level of output.
Suppose a firm can produce a given level of output of 200 units by employing any one of the alternative
combinations of the two inputs, labour (L) and capital (K) as shown in Table 4.2 and Figure 4.6.
Table 4.2: The combination of Labor and Capital for production of 200 units of output
Combination Units of labour (L) Units of Capital (K) Total Product (TP)
A 1 20 200
B 2 15 200
C 3 11 200
D 4 8 200
Table 1.4 indicates that an output of 200 units of goods can be produced either by one unit of labour
and 20 units of capital or 2 units of labour and 15 units of capital or by any combinations mentioned
in the table. All combinations are equally likely because all of them produce the same level of output.
If we plot these combinations on a diagram and join the points of various combinations of L and K, we
get a curve, which is known as Isoquant curve.
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Figure 4.6: Isoquant curve

Characteristics of Isoquants
 Given a set of isoquants, the higher to the right an isoquant, the higher the level of output it
represents. Conversely, the lower an isoquant the lower the level of output it represents. This
is because higher isoquants are associated with higher quantity of factors while lower isoquants
are associated with lower quantity of factors.
 Isoquants do not intersect each other. The point at which two isoquants cross each other implies
two different levels of output, which is not possible.
 Isoquants are convex to the origin. Like indifference curves, isoquants are convex to the origin.
Convexity of an isoquant implies that the MRS (Marginal rate of substitution) declines along
the isoquant curve. The MRS between L and K is defined as the quantity of K which can be
given up in exchange for one additional unit of L. It can also be defined as the slope of an
isoquant. Algebraically,
K
MRSLK =  where: Δ K is the change in capital and ΔL is the change in labour.
L
 The slope of an Isoquant is negative. A negativity sloping isoquant indicates the substitutability
of the two factors, say labour (L) and capital (K), which will yield the same level of output. This means
that as we increase the unit of labour, we decrease the use of capital. At both points the outputs remain
the same.
The Efficient Stage of Production

A production function shows the different levels of output that can be produced using different
combinations of inputs. Hence, it is defined by a set of isoquants each of which representing a different
level of output. It shows how output varies as the factor inputs change.
K
K1 a
K2 b Q1
K3 c Q2
Q3
0 L1 L2 L3 L
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Figure 4.8: Long run Production Function

Each of the three isoquants in Figure 4.8 above represents distinct level of output with Q1 greater than
Q2 which in turn is greater than Q3.
We have said that the general theory of production concentrates on ranges over which marginal product
of factors is positive but decreasing. With two variable factors involved in the production process, the
efficient stage of production is that the marginal product of labor and the marginal product of capital
are both positive but decreasing.
Consider isoquant Q2 in Figure 4.8 above. At point a, the firm uses L1 labor and K1 capital to produce
Q2output. At point b, the firm uses more labor and less capital to produce the same amount of output.
At point c, the amount of labor required to produce Q2further increases while the amount of capital
decreases.
As we move along an isoquant from left to right, the quantity of labor increases while that of capital
decreases; implying increase in productivity of capital and decrease in the productivity of labor.
Eventually, the marginal productivity of labor becomes zero. As we move from right, in order to
produce the same level of output, the firm uses more and more units of capital and less and less units
of labor. This implies that the productivity of labor increases and that of capital decreases. Eventually
the marginal productivity of capital becomes zero.
Isocost Lines
In order to show the production decision of a firm we need to see the constraint that the firm faces.
This constraint is given by isocost lines.
If the production function of a firm is defined as Q = f (L, K), the total cost of the firm consists of cost
on labor and capital. This cost is summarized by the isocost line.
Isocost line is a locus of all combination of factors a firm can purchase with a given monetary outlay.
It is given by the cost equation: C  wL  rK
where, w is price of labor (wages) and r is price of capital (interest rate). The bar over C indicates
constant level of cost.
Isocost lines have the feature that cost of production is constant along an isocost line and that a higher
isocost line represents a higher cost condition than a lower isocost line.
The equation of the isocost line is obtained by solving for K.
C w
K=  L
r r
The slope of the isocost line is the ratio of the prices of labor and capital.
K w
Slope of isocost line is 
L r
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K
C /r
Isocost line
0 C /w L
Figure 4.9: Isocost Line

Equilibrium of the Firm
The firm’s objective is the maximization of its profit, which is defined as the difference between
revenue and costs, for given factor prices and price of the product.
A firm is said to be at equilibrium when it maximizes its profit.
Max  = R – C, where  is profit, R is total revenue, and C is total cost.
To maximize its profit, a firm can adopt two approaches;
 Maximizing output for a given cost, factor prices and price of the product and this involves
determining the best combination of L and K. which enables the firm achieve the highest
possible output for any constant level of monetary outlay.
 Minimizing cost for a given output and output price − this one involves finding the L and K
combination which costs the firm the least for any constant level of output.
Let us see each approach one by one as follows:
Output Maximization
In this case, the equilibrium of the firm is defined at the tangency of the isocost curve with the highest
possible isoquant. For any given cost condition represented by the isocost curve, the highest attainable
level of output is the one represented by the isoquant tangent to the isocost curve.
The optimal combination of the two factors L&K is, consequently, given by L* and K* in Figure 4.10
below. Other points along the isocost line such as a and b lie below isoquant II; and hence correspond
to lower levels of output. Operation on isoquant III is desirable but is not attainable. Thus, given isocost
AB, the optimal level of output is reached at point e.
K
A
a
K* e III
II
b I
0 L* B L
Figure 4.10: Equilibrium of the Firm: Output Maximization.

w
At point e, the slope of the isoquant (MRSL, K) is equal to the slope of the isocost line ( ).
r
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Cost Minimization for a Given Level of Output

Students, like the case with output maximization, the equilibrium of the firm in the case of cost
minimization is defined by the tangency of an isoquant with an isocost line.
The firm wants to produce a given level of output with the least possible cost. Thus, we have a single
isoquant representing a given output level and a set of isocosts each denoting different cost conditions.
These isocosts are parallel to one another (have the same slope) because they are drawn on the
assumption of a given factor price.
K
K* e
Q1
0 L* L
Figure 4.11: Equilibrium of the Firm: Cost Minimization.

The least cost combination of L and K is defined at the tangency e of Figure 4.11 above. Cost conditions
below e are preferred by a rational producer, but they are not compatible with output level Q1. Points
above e, on the other hand, represent higher cost conditions, therefore, are not preferred. The least cost
combination of factors is defined at point e with K* amount of capital and L* amount of labor.
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UNIT FIVE
THEORY OF COSTS
Introduction
Basic Concepts of Costs
Introduction
Cost of production refers to the total amount of fund used for purchase of different (fixed and/or
variable) inputs employed (used) in the production process. Cost of production exists because the
supplies of productive resources are scarce and have market value. The costs of production usually
calculated in relation to a particular amount of product (per unit of output) in a particular time period
because of the costs of production in any particular period include the value of the resource services
transformed into a product in that single period rather than the value of the resource itself. The
resources used in the production may be:
1. Poly period resources-only a part of their services is transformed into product in each distinct
production period (example tractor services).
2. Mono-period resources- represent a stock of services (example seed, fertilizer), where the
entire stock of their services is transformed into production in a single period.
Explicit and Implicit costs

The basic factor underlying the ability and willingness of firms to supply a product is the cost of making
that product. The words cost and price are often confusing, especially for non-economists. When we
discuss costs we mean how much does something cost to produce? This might be expressed as an
opportunity cost, or in a currency such as dollars, birr, etc…. When a price is mentioned, we mean the
amount that the consumer pays. So, cost is a payment made by producers whereas price is a payment
made by consumers.
Before moving to the details of cost theory, it is important to make a distinction between explicit and
implicit costs.
Explicit Cost: those expenses that are actually paid by the producers for purchase of different inputs
in the production process.The term explicit cost refers to the payments made to those outsiders who
will supply labor services, raw materials, fuel, transportation services, power, etc., to the firm. It is also
called money costs.
Implicit Cost: refers to the cost/value of self-owned or self-employed resources and it is also called
imputed costs. The value of non-purchased inputs owned and used by a firm in its own production
activity. This a cost that is usually unrecognized by the accounting records of the firm. Example: the
salary of owner manager (farmer) of the farm; depreciation cost of a building, tractor and other fixed
farm equipment which belongs to the owner of the farm ;interest foregone when the owner uses his
capital in his farm, etc.
The total cost of production is the sum of explicit and implicit costs.
Economic and Accounting Costs

An accountant, while calculating the cost of production may just take into account the explicit cost
items only. Economists, on the other hand, base their estimate of production costs on the concept of
opportunity cost which is measured in terms of forgone alternatives. As we have defined in unit one,
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Opportunity cost is the most attractive alternative forgone or the next best choice sacrificed in the event
of producing goods or rendering services.
To illustrate the distinction between accounting costs and economic costs, consider the case of a market
trader who sells umbrellas. For simplicity, assume that the trader sells the umbrellas he/she purchases
during the relevant period. The accountant might prepare the simplified accounts in the following way.
If the total sale of the umbrellas is birr 30,000, the costs include purchase price of, say birr 20,000, and
overhead expenses incurred by the trader of, say birr 4,000 for hiring market place and cost of transport.
From the accountant’s viewpoint, therefore, the trader has made a net profit of birr 6,000.
The economist, adopting the opportunity cost principle, would argue that account must also take the
opportunity cost to the market trader of using capital and labor in this particular way. Suppose that the
trader has funds worth birr 5,000 tied up in the business, the trader could have lend this amount at the
market rate of interest, say 10 per cent per annum, and would have received birr 500 per annum. This
sum is the opportunity cost of tying up funds in the business of selling umbrellas. The trader might
also have taken up employment elsewhere and earned, say birr 8,000 per annum. These additional
opportunity costs, totaling birr 8,500 per annum, which are not included in the accountant’s
calculations, are added to the cost of sales and expenses in the economist’s calculation of opportunity
costs. Thus, the total opportunity cost of being a market trader is birr 32,500 per annum. With the
revenue from sales of only birr 30,000, from economists point of view, the trader has made a loss of
birr 2,500 over the relevant period.
Students, look at the following figure for the simplified presentation of economic and accounting costs.
Economic
Profit
Accounting
Opportunity
Profit
cost of capital
+ any other
implicit costs Total Revenues
Economic Costs
Explicit Accounting
(Accounting) Costs
Costs
Figure 5.1: Simplified View of Economic and Accounting Costs
Example: suppose that, by using 3 quintal of fertilizer, a farmer can add birr 300 to the total revenue
from wheat production and birr 250 to the total revenue from maize production. If that farmer fertilizes
his maize, his opportunity cost is birr 300, which he has foregone by not fertilizing his wheat. On the
contrary, if that farmer fertilizes his wheat, his opportunity cost will be birr 250, which he has foregone
by not fertilizing his maize.
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The Short-run and Long-run Periods

In order to clearly understand the nature of costs, it is better to make distinctions between the short-
run and the long-run periods.
Short-run is that period of time over which the amount of at least one input cannot be changed. That
means we have two major categories of inputs in this period: fixed inputs and variable inputs. Usually
capital equipment and entrepreneurship are considered as fixed inputs and labor and raw materials can
be taken as variable inputs in the short-run. Consequently costs are of two types: fixed costs and
variable costs. During this period, the firm can expand or decrease its output only by varying the
amounts of variable inputs.
Long-run, on the other hand, is that period of time over which all factors of production can be varied.
That means, in the long-run, all inputs are variable, and hence all costs are also variable.
Since costs will vary quite differently in the long-run and in the short-run, we have to study costs under
two different cases: short-run theory of costs and long-run theory of costs as it is presented in the
following two consecutive sections.
Short-run Theory of Costs

Fixed Costs and Variable Costs
Total Fixed Cost (TFC)
Fixed costs are the costs of the investment goods used by the firm on the idea that these reflect a long-
term commitment that can be recovered only by wearing them out in the production of goods and
services for sale. If cement is to be produced, then a factory is required. The land, the factory building,
the machinery and office equipment must be bought or rented. These costs are called fixed costs and
must be paid even when the factory has not produced anything. Fixed costs in total do not vary with
the changes in the level of output of a firm. Fixed costs are associated with the existence of a firm’s
plant itself, and they have got to be paid even if the firm’s rate of output is zero.
Salaries paid to the top management and key personnel, rent paid to the factory building, interest paid
on loans raised, and insurance premiums, etc., are examples of fixed costs.
C (Cost)
TFC Curve
Q (Output)
Figure 5.2: Total Fixed Cost Curve

As it is indicated in Figure 5.2, the fixed cost curve starts at some point above the origin (at Ĉ) and it
is horizontal. It indicates that the firm incurs fixed costs even when its level of output is zero.
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Total Variable Cost (TVC)

Variable costs are costs that can be varied flexibly as conditions change. Variable cost increases with
the increase in the level of output of a firm. The variable costs of production are incurred by a firm
only when there is an output.
Wages paid to laborers, payments made to the raw material suppliers, payments made to the fuel
suppliers and transportation agencies, etc., can be cited as examples of variable costs of production.
As indicated in Figure 5.3 below, the TVC curve starts from the origin and it slopes positively upwards.
It indicates that the variable cost is zero when the level of output of a firm is zero and these costs
increase with the increase in the level of output (Q).
TVC Curve
C
Q
O
Figure 5.3: Total Variable Cost Curve
Total Cost (TC)

Colleague, can you compute total cost, given fixed and variable costs? Good. Total cost is simply the
sum of total fixed cost and total variable cost (i.e., TC = TFC + TVC). In Figure 5.4 below, the TC and
TVC curves are ‘parallel’ and it reflects that the total cost of production in a firm increases in proportion
to the increase in total variable cost with an increase in the level of output. The distance between the
two curves (TC and TVC) is the amount of total fixed cost.
C TC
TVC
TFC
Q
Figure 5.4: TC, TVC, and TFC Curves
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Unit Costs and a Marginal Cost

Unit Costs (Average Costs)
Costs may be more meaningful if they are expressed on a per-unit basis as averages per unit of output
(Q). In cost theory, we have three averages: average total cost (ATC), average variable cost (AVC),
and average fixed cost (AFC). ATC is the sum of AVC and AFC. These three averages can be
computed from their respective totals as follows:
TC TVC TFC
ATC  AVC  AFC  ATC  AVC  AFC
Q Q Q
C
ATC
AVC
AFC
Figure 5.5: The Three Average Cost Curves
As you can see in the above figure, ATC and AVC curves are ‘U-shaped. It means that the AC and
AVC curves first of all reach minimum and then begin to rise. The AFC is a rectangular hyperbola in
shape because AC multiplied by output is always exactly the same amount.
AFC will become smaller and smaller as the level of output increases because of the TFC is the same
and will spread over for more units of output. AFC is downward sloping/decrease throughout its entire
length.
For a given production function, AVC will initially decrease and then increase as output increases. The
AVC curve is U-shaped.
ATC has a U-shape curve. This U-shape depends on the efficiency of both the fixed and variable input
used. At the initial stage, the ATC decreases because AFC is decreasing rapidly and AVC is also
decreasing. However, at larger output level, AFC will be decreasing less rapidly and AVC will
eventually increase and be increasing at faster rate than the rate of decrease in AFC. This leads ATC
to increase.
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Marginal Cost (MC)

Marginal cost of production is nothing but an extra cost incurred by a firm while producing an extra
unit of output, or it is the change in total cost as a result of the change in output by one unit. That
means, it is the cost of producing one extra unit.
the change in total cost TC
Marginal cost  MC 
thechangein output Q
For a very small change, marginal cost is computed as a derivative of the total cost function with
dTC
respect to change in output as MC  = ΔTC/ΔQ
dQ
Now, let us introduce and overlay marginal cost curve over the three average cost curves.
C
MC
ATC
AVC
AFC
Q
Figure 5.6: Marginal Cost Curve and the Three Average Cost Curves
The shape of a marginal cost curve is also ‘U-shaped’ as it is indicated in the above figure.
The following table indicates how the short-run cost curves vary with the level of output, and how
these costs can be computed.
Table 5.1: Variation of Short-run Cost with Output
Output (Q) TFC TVC TC AFC AVC ATC MC
0 48 0 48 - - - -
1 48 25 73 48 25 73 25
2 48 46 94 24 23 47 21
3 48 66 114 16 22 38 20
4 48 82 130 12 20.5 32.5 16
5 48 100 148 9.6 20 29.6 18
6 48 120 168 8 20 28 20
7 48 141 189 6.9 20.1 27 21
8 48 168 216 6 21 27 27
9 48 198 246 5.3 22 27.3 30
10 48 230 278 4.8 23 27.8 32
11 48 272 320 4.4 24.7 29.1 42
12 48 321 369 4 26.8 30.8 49
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MC depends in no way upon TFC. It depends on the change of TVC.
TC (TFC  TVC ) TFC TVC TVC

MC     
Q Q Q Q Q
MC can be given by the slope of TVC or the slope of TC curves (since TVC and TC curves are
‘parallel’) at a given output level. As we move from left to right on these two curves, the slope initially
decreases, reaches a minimum, and then increases and hence is the shape of MC curve which is ‘U-
shaped’.
Nature and Relations among ATC, AVC, AFC and MC
Based on the discussions made earlier, we can state the following nature of the cost curves and
relationships among these curves:
1. AFC approaches both axes asymptotically.
2. AVC, ATC and MC curves first decline, then reach a minimum point, and finally rise. The U-
shapes of AVC and ATC reflect the law of variable proportions discussed in unit four.
However, the minimum point of the ATC curve occurs to the right of the minimum point of
AVC. This is due to the fact that ATC includes AFC, and the latter falls continuously with
increases in output. After the AVC has reached its lowest point and starts rising, its rise over a
certain range is offset by the fall in the AFC so that the ATC continues to fall over that range
despite the increase in the AVC. However, the rise in AVC eventually becomes greater than
the fall in the AFC so that the ATC curve starts increasing.
3. As AFC approaches asymptotically close to the horizontal axis, AVC approaches ATC
asymptotically.
4. MC equals both AVC and ATC when these curves attain their minimum values; it lies below
both AVC and ATC curves over the range in which these curves decline; and it lies above these
curves when the curves are rising.
Product and Cost Curves: A Comparison
In order to simplify our analysis, let us assume that we have one variable input labor (L) with labor
price of wage (w). Hence, total variable cost is the product of L and w (i.e., TVC = wL).
TVC wL  L   1  Q
AVC  Q   w   w  , because average product of labor APL 
Q  Q L
  APL 
w
 AVC 
APL
This implies that we have inverse relationships between AP and AVC. As AP first increases, reaches
a maximum and then declines, AVC first declines, reaches a minimum and then rises.
Can you relate marginal cost with marginal product in a similar way? Ok.
Similarly,
TVC  wL  w L . This is because wage (w) is assumed to be constant.
MC 
Q Q Q
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 1  w Q
 MC  w MP   MP , because marginal product of labor MPL 
 L  L
L
This also implies that MC and MP are inversely related. As MP first increases, reaches a maximum
and then declines, MC first decreases, reaches a minimum and then increases. Look at Figure 5.10
below.
AP
&
AP
MP
MP Labor
MC
AVC
Cost
Output
Figure 5.10: Relationship between Product and Cost Curves
Generally, falling marginal cost reflects rising marginal product and rising MC reflects falling MP.
Falling AVC indicates rising AP, and rising AVC indicates falling AP. AP is equal to MP at the point
where MC is equal to AVC. At these equality points, average product is at its maximum and AVC is
at its minimum.
The marginal product curve lies above the average product curve in the region, where the MC lies
below AVC. The marginal product curve lies below average product curve in the region, where the
AVC curve lies below the MC curve.
Long-run Theory of Costs

Colleague, in the previous section, we have discussed the theory of costs in the short-run situation,
where at least one factor is assumed to be constant. What will happen if all inputs, and hence all costs,
are variable? It is the concern of this section. Under this section, long-run average cost will first be
discussed followed by long-run marginal cost. Finally, the concept of economies and diseconomies of
scale and their causes will be discussed.
Long-run Average Cost (LRAC)

Dear learner, so far, we have not considered the long-run in cost theory. We have defined the long-run
as a period long enough so that all inputs are variable. In other words, a business can vary all of its
inputs and change the whole scale of production in the long-run. In particular, this includes capital,
plant, equipment, and other investments that represent long-term commitments.
We will now think a bit about the long run, using the concept of average cost.
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Suppose you were planning to build a new plant, perhaps to set up a whole new company and you
know about how much output you will be producing. Then you want to build your plant so as to produce
that amount at the lowest possible average cost.
To make it a little bit simpler, we will suppose that you have to pick just one of the three plant sizes:
small, medium, and large. Average cost curves for the small (AC s), medium (ACm), and large (ACL)
plant sizes are as indicated in Figure 5.11 below:
ACs ACm
C
ACL
Cm
Cs
LRAC
Q
Q1 Q2 Q3
Figure 5.11: Short-run Average Cost Curves for Different Plant Sizes and the LRAC
If you produce Q1 units, the small plant size gives the lowest cost as compared to medium sized one
(i.e., Cs<Cm). If you produce Q2 units, the medium plant size gives the lowest cost and if you produce
Q3 units, the large plant size gives you the lowest cost. Now, we can join these lowest points of average
cost curves for different plant sizes with a line, called long-run average cost curve (LRAC).
The long run average cost, the lowest average cost for each output range, is described by the lower
envelope curve, shown by the thick curve (in Figure 5.11 above) that follows the lowest of the three
short run curves in each range.
More realistically, an investment planner will have to choose between many different plant sizes or
firm scales of operation, and so the long-run average cost curve will be smooth, as illustrated below:
Figure 5.12: Long-run Average Cost Curve
79
As shown in the above figure, each point on the LRAC curve corresponds to a point on the short-run
average cost (SRAC) for the plant size or scale of operation that gives the lowest average cost for that
scale of operation. The LRAC curve envelopes a number of short-run average cost curves, and hence
it is also called an envelope curve.
Generally, the LRAC is more or less ‘u-shaped’, and the idea is that:
 for small outputs, indivisibilities predominate, and so long-run average cost declines with
increasing output;
 for intermediate outputs, operations can be expanded roughly proportionately, while tendencies
to increasing and decreasing costs, if any, offset one another; and
 for large outputs, the problems of management predominate, and hence long-run average cost
increases with increasing output.
Long-run Marginal Cost (LRMC)

Colleague, can you draw the long-run marginal cost curve based on short-run marginal cost curves?
Ok. In fact, it is not simple as in the case for LRAC. Let us see it.
The long-run marginal cost is derived from the short-run marginal cost curves, but it does not
‘envelope’ them. It is formed from points of intersection of the short-run marginal cost (SMC) curves
with vertical lines (to the x-axis) drawn from the point of tangency of the corresponding short-run
average cost (SAC) curves and LRAC curve. The LRMC curve crosses the LRAC curve when the
latter attains its minimum value. Look at the following figure.
Cost
LRMC
SAC1
SMC1
LRAC
Output
Figure 5.13: Derivation of Long-run Marginal Cost Curve
Economies of Scale and Cost

Colleague, can you say something about economies of scale before looking into this concept together?
Can you remember the concept of returns to scale discussed in unit four? What are increasing returns
to scale, constant returns to scale, and decreasing returns to scale? Please try to discuss.
In our pictures of long run average cost, we see that the cost per unit changes as the scale of operation
or output size changes. Terminologies for describing these changes are increasing returns to scale,
constant returns to scale, and decreasing returns to scale.
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Increasing returns to scale: This is the case of decreasing cost. Average cost decreases as output
increases in the long-run, and it is in the declining part of the LRAC curve. Economists usually explain
increasing returns to scale by indivisibility, i.e., some methods of production can only work on a large
scale, either because they require large-scale machinery, or because they require a great deal of division
of labor. Since these large-scale methods cannot be divided up to produce small amounts of output, it
is necessary to use less productive methods (indivisible plant) to produce the smaller amounts. Thus,
costs increase less than in proportion to output and average costs decline as output increases. Increasing
Returns to Scale is also known as economies of scale or decreasing costs.
Constant returns to scale: This is the case of constant costs. Average cost remains constant as output
varies in the long-run. We would expect to observe constant returns where the typical firm (or industry)
consists of a large number of units doing pretty much the same thing, so that output can be expanded
or contracted by increasing or decreasing the number of units. Consider the case where we need one
machinist to do a series of operations to produce one item of a specific kind. If you want to double the
output you had to double the number of machinists and machine tools. Constant Returns to Scale is
also known as constant costs.
Decreasing returns to scale: This is the case of increasing costs. Average cost increases as output
increases in the long-run, and it is in the rising part of the LRAC curve. Decreasing returns to scale are
associated with problems of management of large, multi-unit firms. Again think of a firm in which
production takes place by a large number of units doing pretty much the same thing, but the different
units need to be coordinated by a central management. The management faces a trade-off. If they don't
spend much on management, the coordination will be poor, leading to waste of resources, and higher
cost. If they do spend a lot on management, that will raise costs in itself. The idea is that the bigger the
output is, the more units there are, and the worse this trade-off becomes. So, the costs rise either way.
Decreasing Returns to Scale is also known as diseconomies of scale or increasing costs.
Have you understand the concept of economies of scale? Good. Now, let us illustrate the same concept,
but pictorially (Figure 5.14 below).
Diseconomies of scale LRAC
Economies of scale
Constant costs
Figure 5.14: Long-run Average Cost and Economies of Scale of production
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Causes for Economies and Diseconomies of Scale

A. Causes for Economies of Scale
Dear learner, we have said that economies of scale occur when long-run average costs are falling as
output is increasing. Please try to list the different causes for economies of scale. What are the causes
for internal economies and for external economies? Try to list them and compare it with our list
indicated below.
Indeed, there are different causes of economies of scale and they are usually listed under two broad
headings: internal economies and external economies.
i) Internal Economies of Scale
Internal economies of scale occur as the output of the individual firm increases and the causes for
internal economies can be the following:
1. Fixed Costs are shared
Assume that the fixed cost of producing a car at a factory is birr120 million. If only one car was made,
all of the fixed costs are born by this car alone. If two cars are produced the average fixed cost falls
rapidly. Therefore, the greater the level of output the lower are the average fixed costs. The average
fixed cost curve continues to fall, but note that it will never reach the horizontal axis, as AFC will
always be a positive number (Table 5.2 below).
Table 5.2: Variation of AFC with the level of output
Quantity Fixed Cost Average Fixed Cost
(number of car) (in million Birr) (in million Birr)
1 120 120
2 120 60
3 120 40
4 120 30
5 120 24
6 120 20
Thus, decline in the fixed costs as output expands is one cause for economies of scale.
1. Financial Economies
Assume two firms, one large and the other small. Where do you expect a lower interest rate for
borrowing? Where do you expect a better purchase discount?
A large firm might be able to borrow at lower rates of interest than a smaller one. Again, when raw
materials, components, office supplies, etc. are bought, it is usual to receive a discount for large
quantities bought. The larger the quantity purchased the bigger the percentage discount. The office
work needed for a big order is the same as that for a small order. These are sometimes called bulk-
buying or purchasing economies.
3. Managerial Economies
The greater the output of a firm is, the greater the revenue will be. This allows the firm to hire more
workers, and therefore gain advantages from the division of labour. Small firms cannot afford to
permanently hire lawyers, accountants, human resource managers, etc., whereas larger firms can. Note
82
for your understanding that a large ship and a small ship both need a captain with maritime skills. This
means large firms will have better managerial economies.
4. Container Principle
Look at the following cubes with sides of 1cm and sides of 3cm. A cube with sides of 1cm length has
a surface area of 6cm squared (1cm x 1cm x 6), and a volume of 1 cm cube (1cm x 1cm x 1cm). A
cube with sides of 3cm has a surface area of 54cm squared (3cm x 3cm x6) and a volume of 27cm
cubed (3cm x 3cm x 3cm).
1
3
1
(a) 1 (b)
3
Figure 5.15: Demonstration of Container Principle
Expressed as a ratio of surface area to volume for the cube with sides of 3cm, this is 54: 27 which is
the same as 2 to 1. This means, if we want to construct a container using metal sheet, we need 2cm
squared metal sheet for every 1 cm cubed volume. For a cube with sides of 1cm, however, area to
volume ratio is 6:1. This, again, means we need 6cm squared metal sheet for every 1 cm cubed volume.
We can now compare the required area for the same volume of 1 cm cubed. We require smaller area
of 2 cm squared for the larger cube with sides of 3 cm long as compared to area of 6 cm squared for
the smaller cube with sides of 1 cm long.
What this demonstrates is that the 3cm sided cube can hold a greater proportionate volume than a 1cm
sided cube. This principle helps explain why large oil tankers, factory buildings, chemical plants, etc.,
are more economical to build than small ones.
5. Indivisibilities
Some machinery or processes only make sense for large firms. For example, assume we have two farm
owners; one with large farm size and the other with very small land size. Where do you expect is
purchasing a tractor economical? Good. A small farm of only a few acres cannot make use of a big
combine harvester.
ii) External Economies of Scale
Based on the definition we provide for internal economies, can you explain external economies of scale
and provide its possible causes? Anyhow, external economies of scale occur as the output of the
industry increases, and the possible causes for external economies can be the following:
1. Labour
As an industry builds in size, a pool of trained labor emerges that each individual firm can make use
of. This means, because of emergence of trained man power in the industry, firms in that industry will
benefit economies of scale.
83
2. Cooperation
Colleague, can you guess how cooperation brings external economies of scale? Good. Firms in
industries often cooperate so as to get more advantage over individual firms. For example, farmers’
cooperatives arise to buy or sell products more cheaply than the farmers could do alone, and as a result,
they will benefit more as compared to individual farmers.
B. Causes for Diseconomies of Scale
Can you indicate causes for diseconomies of scale? Anyway, diseconomies of scale occur when long-
run average costs are rising as output is rising. It can also be of internal diseconomies or external
diseconomies. The possible causes for these diseconomies are indicated below.
i) Internal Diseconomies of Scale
Internal diseconomies occur when long-run average costs are rising as the output of the firm is rising.
It can be caused by the following:
1. Interdependency
Colleague, can you explain the disadvantages of having many departments in a given firm? Good that
is internal diseconomies. In large firms with many different departments, eachpart of the company
becomes interdependent, and hence, a machine failure in the packaging department may result in
stopping the whole production line, for example.
2. Coordination and Communication
Large firms have long chains of command. What do you think is the negative effect of having long
chains of command? The possible consequence can be information from the top management may not
be communicated to the production line properly and vice-versa.
3. Industrial Relations
Colleague, can you depict the effect of unhealthy relationship between the management and the work
force in the production process? Anyhow, because of the lack of contact between senior management
and the work force, the workers may feel insignificant or uncared for, and as a result industrial disputes
may arise and production may suffer.
ii) External Diseconomies of Scale
As output increases in an industry, each of the factors of production becomes scarcer, and as they
become scarcer, their prices increase. This will adversely affect the operation of individual firms in
that industry.
84

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Arsi University, College of Agriculture and Environmental Sciences, Department of Agricultural Economics

Definition and Scope of Economics

Microeconomics: - deals with micro/individual issues. In other words, microeconomics is concerned

Behavioural, Public, Monetary, Institutional, Development, Mathematical and Quantitative, Urban,

Scarcity and Opportunity Cost

Decision making units and Economic Systems. The

Figure 1.1: The Circular Flow

THEORY OF DEMAND AND SUPPLY

Table 2.1: Demand schedule of Mr.Bayu for bread

10 Figure 2.1: The Demand Curve

0 50 100 150 200 250 Quantity

Y axis = the sacrifices that must be made to obtain a commodity - price

X axis = the quantity demanded per unit of time

Figure 2.2: Market Demand Curve

It is defined as: Q = f (P)

Individual Firm’s Supply

Market (Industry) Supply

Table 2.6: Market Supply Schedule

S( p)   Si ( p) , where Si is the supply function of individual firms.

The slope of the supply function is d.

Movement along the Supply Curve

Graphic Approach to Equilibrium

Table 2.7: Supply of and Demand for Coffee

Numerical Approach to Equilibrium

Effects of Change in Demand

 The slope (elasticity) of supply

Effects of Change in Supply

Figure 2.14: Shifts in Supply in Different Magnitude

Simultaneous Shift in Demand and Supply

Change in Demand and Supply in a Same Direction

Qd  100  2(15)  70  Qs Qd  100  2(12)  76  QS

Change in Demand and Supply in an Opposite Direction

%Y %Y %Y

At the horizontal intercept the price elasticity of demand is zero.

Numerical Coefficients of Price Elasticity of Demand

Determinants of Price Elasticity of Demand

Constant Elasticity Demands

A general way to characterize demand curves with constant elasticity is

(a) Relatively inelastic demand (b) Relatively elastic demand

Figure 2.22: Elasticity and Total Revenue

Table 2.9: Relationship between Elasticity and Revenue

An inverse demand function is given as P  a  bQ

At Qd  25 price obtained by substitution into the inverse demand function.

Price elasticity of demand is defined as:

Approaches to Elasticity Measurement

Cross Elasticity of Demand

The cross elasticity formula is given as:

Income Elasticity of Demand: - Income elasticity of demand is a measure of the responsiveness of

Where, QS is quantity supplied of a good and P is price.

THEORY OF UTILITY AND PREFERENCES

Cardinal Utility Approach

Assumptions of Cardinal Utility Theory

Total Utility and Marginal Utility

Table 3.1: Utility Schedule for Coca Cola

Principle of Diminishing Marginal Utility

Utility and Consumer Behavior

Table 3.2: Hypothetical Utility per Birr Comparisons

Equilibrium of the Consumer