INTRODUCTION TO ECONOMICS

2023
 INTRODUCTION TO ECONOMICS

TABLE OF CONTENTS

1. CHAPTER ONE: INTRODUCTION: BASIC CONCEPTS OF

ECONOMICS ...................................................................... 1
2. CHAPTER TWO: DEMAND, SUPPLY, ELASTICITY AND UTILITY
THEORIES........................................................................... 9
3. CHAPTER THREE: THEORIES OF PRODUCTION AND COSTS IN
RELATION TO FIRMS ....... Error! Bookmark not defined.
4. CHAPTER FOUR: THEORIES OF MARKET STRUCTURES ........... Error!
Bookmark not defined.
5. CHAPTER FIVE: NATIONAL INCOME ACCOUNTING . Error! Bookmark
not defined.
6. CHAPTER SIX: THE TOOLS OF MACROECONOMIC PROBLEMS
AND POLICIES ..................... Error! Bookmark not defined.

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1. SECTION ONE: INTRODUCTION: BASIC CONCEPTS OF
ECONOMICS

Pre tests
 What is economics?
 State economic problems?

DEFINITION AND SCOPE OF ECONOMICS

The word economics comes from the Greek word ‘Economicous’ meaning, one who
manages a household. There are two fundamental facts that provide the foundation for the
field of economics: Human or society’s material wants are unlimited and Economic
resources are scarce or limited in supply.

Society’s material wants refers to the desire of consumers, businesses, and government to
get those things that help them realize their respective goals. Note that goal of consumers
is to get maximum satisfaction, the goal of businesses is to produce goods and services
and get profit, and the goal of the government is to satisfy the collective wants of its
citizens. All of these wants are not only numerous but also multiply (e.g. Television,
Mobile apparatus etc.) through time.

Economic resources refer to anything natural or manmade that can be used in production
of goods and services. By economic resources, we refer the various types of labors,
minerals, buildings, trucks, oil deposits, communication facilities, etc., that can be used in
production of goods and services. And all these resources are scarce or limited in supply.
So, on the one hand, society’s material wants are unlimited; on the other hand, economic
resources are limited. These contradictory facts lay the foundation for the field of
economics.

“Definition: Economics is, thus, defined as a science and art, which studies how
societies allocate scarce resources in the production and distribution of goods and
services so as to attain the maximum fulfillment of society’s material wants.”

Generally, Economics can be divided into two main branches: - macroeconomics and
microeconomics, where ‘macro’ means big and ‘micro’ means small.

A. Microeconomics: is concerned with economic behavior (action) of individual

economic units, well-defined groups of individual economic units, and how markets of
individual commodities function: These individual economic units can be households or a
firm. It studies the interrelationships between these units in determining the pattern of
production and distribution of goods and services. It is concerned with the decisions taken
by individual consumers and firms and with the way these decisions contribute to the
setting of prices and output in various kinds of market. For example, questions like how
 INTRODUCTION TO ECONOMICS

does a particular person or household maximize satisfaction? How does a particular

business enterprise strive to get maximum possible profit by producing and selling a
product? etc are studied in microeconomics.

B. Macroeconomics: is the branch of economic analysis that studies economy as whole

and sub aggregates of the economy: It does not deal with household, firm, or industry. It
deals with magnitudes such as the total output level in an economy, national income of a
country, the overall level of prices, total output and total employment in the economy,
general price level of goods and services in the economy, etc. For example, in
microeconomics we can study why the price of ‘teff’ increase or decrease in Addis Ababa.
But this increase or decrease in the price level of ‘teff’ is not the concern of
macroeconomics. Macroeconomics rather concerned with whether the average level of
prices of goods and services in the economy as whole is increasing or decreasing. In
short, in microeconomics we study a tree in a forest; but in macroeconomics we study the
forest, not a tree. Remember that, like macroeconomics, microeconomics also uses
aggregates. For example, we talk of the total market demand for wheat, total market
demand for maize, etc. In microeconomics, we aggregate over homogenous product, but in
macroeconomics, the aggregation is at the economy level. In microeconomics we cannot
aggregate the total market demand for wheat and maize together. In macroeconomics we
can aggregate the total of several products and talk about the total level of outputs
currently produced in a country this year.

SCARCITY, CHOICE AND OPPORTUNITY COST

Scarcity

What is the crucial ingredient that makes a problem an economic one? The answer is that
there is one central problem faced by all individuals and all societies and from this
problem all the other economic problems stem. This central economic problem is the
problem of scarcity. At any one time the world can only produce a limited amount of
goods and services. This is because the world only has a limited amount of resources. The
reasons for scarce economic resource is human wants are virtually unlimited, whereas the
resources available to satisfy these wants are limited. We can thus define scarcity is the
excess of human wants over what can actually be produced. Because of scarcity, various
choices have to be made between alternatives.

Economics is the study of scarcity – the study of the allocation of scarce resources to
satisfy human wants. People’s material wants, for the most part, are unlimited. Output, on
the other hand, is limited by the state of technology and the quantity and quality of the
economy’s resources. Thus, the production of each good and service involves a cost. A
good is usually defined as a physical item such as a car or a hamburger, and a service is
something provided to you such as insurance or a haircut.

Scarcity is a fundamental problem for every society. Decisions must be made regarding
what to produce, how to produce it, and for whom to produce. What to produce involves

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 INTRODUCTION TO ECONOMICS

decisions about the kinds and quantities of goods and services to produce. How to produce
requires decisions about what techniques to use and how economic resources (or factors of
production) are to be combined in producing output. The economic resources used to
produce goods and services include: land: (the economy’s natural resources-such as land,
trees, and minerals.); labor (The mental and physical skills of individuals in a society);
capital (Goods – such as tools, machines, and factories used in production or to facilitate
production); entrepreneurship (ability –innovative and management capacity). For whom
to produce involves decisions on the distribution of output among members of a society.

Economics helps to solve the three important questions of what to produce, how to
produce it, and for whom to produce. These decisions involve opportunity costs. An
opportunity cost is what is sacrificed to implement an alternative action, i.e., what is given
up to produce or obtain a particular good or service.

Choice and opportunity cost

Choice involves sacrifice. The more food you choose to buy, the less money you will have
to spend on other goods. The more food a nation produces the fewer resources will there
be for producing other goods. In other words, the production or consumption of one thing
involves the sacrifice of alternatives. This sacrifice of alternatives in the production (or
consumption) of a good is known as its opportunity cost. Opportunity cost is the cost of
any activity measured in terms of the best alternative forgone. Example; if the workers on
a farm can produce either 1000 tons of wheat or 2000 tons of barley, then the opportunity
cost of producing 1 tons of wheat is the 2 tons of barley forgone.

PRODUCTION POSSIBILITIES

Let us classify factors of production discussed earlier. In their production process, firms
use factors of production. These factors of production are often divided into four
categories: entrepreneurship, labor, land, and capital. Can you differentiate among these
factors of production? Don’t worry. You can differentiate among these factors after careful
reading of the following.

Land  land refers to all natural resources that can be used as inputs to production, for
example, minerals, water, air, forests, oil, and even such intangibles as rainfall,
temperature, and soil quality. The key distinction between land and certain kinds of capital
is that land consists of natural resources or conditions unimproved by labor or capital
expenditure. For example, land in Afar region that has been irrigated represents more than
land. It also represents capital. The income payment to land is called rent.

Labor  labor is defined as the physical and intellectual exertion of human beings. The
efforts of a teacher, factory worker, clerk, and a carpenter are all called labor. For its

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 INTRODUCTION TO ECONOMICS

contribution in production, labor is remunerated in the form of wages; i.e., the resource
payments that entrepreneurs make for the use of labor.

Capital capital is defined as all man-made aids to production. Capital includes tools,
factories, warehouses, stocks of inventories, and the like. We should be clear to distinguish
capital from money. Capital, as a factor of production, refers to physical things. In
essence, capital goods are the tools of production. Capital, like other factors of production,
receives income. The payment to capital is called interest. Investment is the act of adding
to capital stock. Money, on the other hand, is any asset that is generally acceptable in
transactions and in settlement of debts.

Entrepreneurship  entrepreneurs combine the other factors of production by buying these

factors to produce a saleable product. When they put money into their production process,
entrepreneurs are taking risks. The return for entrepreneurship is called profit.

To see the production possibilities open to a firm (or any production unit), consider the
choice between the production of food and clothing. It is possible to increase the
production of both only if there are some unused resources. That is, if there is some
unemployed labor, unused land, idle capital etc., the production of both food and clothing
could be increased. But if factors of production are fully employed, it is not possible to
have more of both.

Assuming that factors of production are fully employed, there are only two goods, food
and clothing, and factors of production are homogenous; the production possibility open to
a production unit can be presented using the production possibility curve (PPC).

The assumption of homogenous factors of production implies that all units of labor, capital
and land are identical. This assumption, in fact, contrasts with reality. Do you think that
the productivity of two pieces of land, one in a highland area and one in a desert, can be
the same? Definitely no.

There are three important regions in Figure 1.1 below. Can you identify them? If yes,
good. If no, don’t worry. We will see it together. If resources are fully employed, the firm
will be able to produce combinations of food and clothing on the PPC such as point a. If
there are some unused resources (if there is underutilization) the firm will produce
combinations to the left of the PPC such points like b. For any given quantity of factors of
production, the attainable region of production is that on and below the PPC.
Food

10 a
8  b Production Possibility Curve
4 c

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 INTRODUCTION TO ECONOMICS

0 7 10 Clothing

Figure 1.1: Production Possibility Curve

Production above the PPC at points like c is impossible for any given quantity of factors
of production, and therefore is called unattainable region. However, if there was a change
in technology whiles the level of land, labour and capital remained the same, the time
required to produce food and cloth would be reduced. As figure 1.2 shows, output would
increase, and the PPC would be pushed outwards. A new curve, on which e would appear,
that represent the new efficient allocation of resources.

Food
e
10 a
8  b Production Possibility Curve
4 c

0 7 10 Clothing

Figure 1.2: Production Possibility Curve after technological advancement

When the PPC shifts outwards, we know there is growth in an economy. Alternatively,
when the PPC shifts inwards it indicates that the economy is shrinking as a result of a
decline in its most efficient allocation of resources and optimal production capability. A
shrinking economy could be a result of a decrease in supplies or a deficiency in
technology.

The production possibility curve illustrates three concepts: scarcity, choice, and
opportunity cost. Scarcity is indicated by the unattainable combinations above the PPC;
choice, by the need to choose among the alternative attainable points along the PPC; and
opportunity cost, by the negative slope of the PPC.

COMPARATIVE ADVANTAGE AND ABSOLUTE ADVANTAGE

SPECIALIZATION AND COMPARATIVE ADVANTAGE

An economy can focus on producing all of the goods and services it needs to function, but
this may lead to an inefficient allocation of resources and hinder future growth. By using
specialization, a country can concentrate on the production of one thing that it can do best,
rather than dividing up its resources.

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 INTRODUCTION TO ECONOMICS

For example, let's look at a hypothetical world that has only two countries (Country A and
Country B) and two products (cars and cotton). Each country can make cars and/or cotton.
Now suppose that Country A has very little fertile land and an abundance of steel for car
production. Country B, on the other hand, has an abundance of fertile land but very little
steel. If Country A were to try to produce both cars and cotton, it would need to divide up
its resources. Because it requires a lot of effort to produce cotton by irrigating the land,
Country A would have to sacrifice producing cotton. The opportunity cost of producing
both cars and cotton is high for Country A, which will have to give up a lot of capital in
order to produce both. Similarly, for Country B, the opportunity cost of producing both
products is high because the effort required to produce cars is greater than that of
producing cotton.

COMPARATIVE ADVANTAGE

Each country can produce one of the products more efficiently (at a lower cost) than the
other. Country A, which has an abundance of steel, would need to give up more cars than
Country B would to produce the same amount of cotton. Country B would need to give up
more cotton than Country A to produce the same amount of cars. Therefore, County A has
a comparative advantage over Country B in the production of cars, and Country B has a
comparative advantage over Country A in the production of cotton.

Now let's say that both countries (A and B) specialize in producing the goods with which
they have a comparative advantage. If they trade the goods that they produce for other
goods in which they do not have a comparative advantage, both countries will be able to
enjoy both products at a lower opportunity cost. Furthermore, each country will be
exchanging the best product it can make for another good or service that is the best that the
other country can produce. Specialization and trade also works when several different
countries are involved. For example, if Country C specializes in the production of corn, it
can trade its corn for cars from Country A and cotton from Country B.

Determining how countries exchange goods produced by a comparative advantage ("the

best for the best") is the backbone of international trade theory. This method of exchange
is considered an optimal allocation of resources, whereby economies, in theory, will no
longer be lacking anything that they need. Like opportunity cost, specialization and
comparative advantage also apply to the way in which individuals interact within an
economy.

ABSOLUTE ADVANTAGE

Sometimes a country or an individual can produce more than another country, even though
countries both have the same amount of inputs. For example, Country A may have a
technological advantage that, with the same amount of inputs (arable land, steel, labour),
enables the country to manufacture more of both cars and cotton than Country B. A
country that can produce more of both goods is said to have an absolute advantage. Better

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 INTRODUCTION TO ECONOMICS

quality resources can give a country an absolute advantage as can a higher level of
education and overall technological advancement. It is not possible, however, for a
country to have an absolute advantage in everything that it produces, so it will always be
able to benefit from trade.

ECONOMIC SYSTEM

One important difference between societies is in the degree of government control of the
economy. Based on this we have three types of economic systems: Free market economy;
command or planned economy and mixed economy. It is useful to analyze the extremes, in
order to put the different mixed economies of the real world into perspective.

Free market economy: is an economy where all economic decisions are taken by
individual households and firms and with no government intervention at all. Households
decide how much labor and other factors to supply, and what goods to consume. Firms
decide what goods to produce and what factors to employ. The pattern of production and
consumption that results depends on the interactions of all these individual demand and
supply decisions.

Command or centrally planned economy: is an economy where all economic decisions

are taken by the central authorities/government, for example Derg regime in Ethiopia,
socialist economies around the world (e.g. USSR, Cuba, etc).

Mixed economy: is a market economy where there is some government intervention.

Because of the problems of both free-market and command economies, all real-world
economies are a mixture of the two systems. Government intervention can be used to
rectify various failings of the market. Note, however, that governments are not perfect and
their actions may bring adverse as well as beneficial consequences.

LEARNING ACTIVITIES

 Explain what economics study is about.

 Explain the reason for scarcity?
 Distinguish the relationship between scarcity, choice and opportunity cost?
 Distinguish between a free-market and a command economy.

CONTINUOUS ASSESSMENT

Assessment plan for continuous assessment will be: quiz, individual assignment and group
work, written tests. Student should explain concepts of economics, economic problems
and economic systems.

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 INTRODUCTION TO ECONOMICS

SUMMARY

Economics is the study of how societies choose to use scarce resources to produce
valuable commodities and distributes among different groups. The four types of factor of
production economics include land, labor, capital and managerial ability. The scarcity of
these resources compels the society to choose the best way of using limited resources so as
to achieve maximum level of economic welfare. There are three universal fundamental
choices to be made. These are: what to produce? How to produce? and for whom to
produce? Economics is usually divided into microeconomics and macroeconomics.
Microeconomics deals with the behavior and operations of individual components like
households, firms and industries. Macroeconomics analyzes the functioning of the
economy at national level. Microeconomics and macroeconomics can never be separated
from each other. A macroeconomics result is the sum of microeconomics. We live in an
economic systems in which millions of economic decisions are made daily by consumers,
producers, and the government. These economic systems are; Free market economy,
Command or planned economy and Mixed economy.

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 INTRODUCTION TO ECONOMICS

2. SECTION TWO: DEMAND, SUPPLY, ELASTICITY AND

UTILITY THEORIES

Pre tests
 What is meant by demand and supply?

2.1. DEMAND AND SUPPLY

MEANING OF DEMAND

In our day-to-day life, we use the word demand in a loose sense to mean the desire of a
person to purchase a commodity or service. But, in economics it has specific meaning.
Demand implies more than a mare desire to purchase a commodity. It states that the
consumer must be willing and able to purchase the commodity, which he desire. His desire
should be backed by purchasing power. A poor person is willing to buy a car; it has no
ability to pay for it. On other hand, his desire to buy the care must be backed by the
purchasing power constituting demand. Demand thus, means the desire of consumer for
commodity backed by the purchasing power. These two factors are essential. If consumer
is willing to buy but is not able to pay, his desire will not become demand. If consumer
has ability to pay but is not willing to pay, his desire will not be called demand. Demand
refers to the amount that consumers are willing and able to purchase at an alternative price
over a given period (e.g. a week, or a month, or a year). Quantity demanded refers to the
amount that consumers are willing and able to purchase at a given price over a given
period (e.g. a week, or a month, or a year). They do not refer to what people would simply
like to consume.

LAW OF DEMAND

Law of demand states that there is an inverse relationship between price of a commodity
and its quantity demand in the markets, keeping other factors constant. It means that it
shows us an inverse relationship between the above two variables (price and quantity
demanded). The quantity of a good demanded per period of time will fall as price rises and
will rise as price falls, other things being equal (ceteris paribus). The two explanations to
the law of demand are income effect and substitution effect. The reasons for law of
demand are:

 People will feel poorer. They will not be able to afford to buy so much of the good
with their money. The purchasing power of their income (their real income) has
fallen. This is called the income effect of a price rise.
 The good will now cost more than alternative or ‘substitute’ goods, and people will
switch to those goods. This is called the substitution effect of a price rise.

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 INTRODUCTION TO ECONOMICS

But the above law operates only under the assumption that “other things remain constant”.
The above phrase implies that when we state the law of demand, we assume the
determinants of demand constant. These are:

 Tastes and preference remain constant.

 The number and price of substitute goods.
 The number and price of complementary goods.
 Income of consumer.
 Distribution of income.
 Expectations of future price changes.
 Advertisement.
 Past demand.
 Consumer future price and income.

The demand curve slopes downward from left to right. The downward slope of demand
curve reflects the law of demand. In the next section you will elaborate the law of demand
in terms of curve, equations and tables.

THE DEMAND CURVE, SCHEDULE AND FUNCTION

Demand Schedule

A demand schedule is defined as a table which presents the quantity demanded at each
price level during a specific time period. Assuming that all other factors are constant by
varying the price of the goods itself, we get an individual demand schedule for the good
(see Table 2.1). The table shows how many kilograms of potatoes per month, would be
purchased at various prices. Columns (2) and (3) show the demand schedules for two
individuals, Tracey and Darren. Column (4) by contrast, shows the total market demand
schedule. This is the total demand by all consumers. To obtain the market demand
schedule for potatoes, we simply add up the quantities demanded at each price by all
consumers: i.e. Tracey, Darren and everyone else who demands potatoes.

Table 2.1: The demand for potatoes (monthly)

(1) (2) (3) (4)

Price Tracey's Darren's Total market
(pence per demand demand demand
kg) (kg) (kg) (tonnes: 000s)

A 20 28 16 700
B 40 15 11 500
C 60 5 9 350
D 80 1 7 200
E 100 0 6 100

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Demand schedule for an individual is refers to a table showing the different quantities of
a good that a person is willing and able to buy at various prices over a given period of
time.
Market demand schedule is defined as a table showing the different total quantities of a
good that consumers are willing and able to buy at various prices over a given period of
time.
Demand Curve

The demand schedule can be represented graphically as a demand curve. Demand curve
is graph showing the relationship between the price of a good and the quantity of the good
demanded over a given time period. Price is measured on the vertical axis; quantity
demanded is measured on the horizontal axis. A demand curve can be for an individual
consumer or group of consumers, or more usually for the whole market. It slopes
downward from left to right: they have negative slope. This indicate the lower the price of
the product, the more is the person likely to buy.

Figure 2.1 shows the market demand curve for rice corresponding to the schedule in Table
2.1. Point E shows that at a price of 100p per kilo, 100,000 tons of rice is demanded each
month. When the price falls to 80p we move down the curve to point D. This shows that
the quantity demanded has now risen to 200,000 tons per month. Similarly, if the price
falls to 60p we move down the curve again to point C: 350,000 tones are now demanded.
The five points on the graph (A–E) correspond to the figures in columns (1) and (4) of
Table 2.1.

Market demand for potatoes (monthly)

E
100

D
Price(penceper kg)

80

C
60

B
40

A
20
Demand

0
0 100 200 300 400 500 600 700 800
Quantity (tonnes: 000s)

Fig 2.1 Market demand for rice (month)

Demand Function

We can represent the relationship between the market demand for a good and the
determinants of demand in the form of an equation. This is called a demand function. It

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can be expressed either in general terms or with specific values attached to the
determinants. Simple demand functions. Demand equations are often used to relate
quantity demanded to just one determinant. Thus an equation relating quantity demanded
to price could be in the form:

qd  a  bp (1)
For example, the actual equation might be: Qd=10, 000 - 200P. In a More complex demand
functions, we can relate the quantity demanded to two or more determinants. For example,
a demand function could be of the form:

q d  a  bp  cY  dPs  ePc (2)

Where Qd = quantity demanded; p = price of the good; Y= income; Ps= price of substitute
good; Pc= price of complement

DETERMINANTS OF DEMAND

The extent of the demand for a good is determined by two factors. These factors are:
1. Price factor and
2. Non price (The condition of demand) factors

Price factor (The conditions of demand remain constant)

Price is the most important factor that determines how much of a good people will buy
(demand), while the condition of demand is remain constant.
The condition of demand (price is assumed to be constant or given)

Price is not the only factor that determines how much of a good people will buy. Demand
is also affected by the following.

 Tastes: the more desirable people find the good, the more they will demand. Tastes
are affected by advertising, by fashion, by observing other consumers, by
considerations of health and by the experiences from consuming the good on
previous occasions.
 The number and price of substitute goods: (i.e. competitive goods or goods
considered by consumers to be alternatives to each other e.g. Coffee & Tea): the
higher the price of substitute goods, the higher will be the demand for this good as
people switch from the substitutes.
 The number and price of complementary goods: Complementary goods are those
that are consumed together: e.g. cars and petrol, shoes and polish. The higher the
price of complementary goods, the fewer of them will be bought and hence the less
will be the demand for this good.

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 Income: As people’s incomes rise, their demand for most goods will rise. Such
goods are called normal goods. There are exceptions to this general rule, however.
As people get richer, they spend less on inferior goods, such as cheap margarine, and
switch to better quality goods. N.B Normal goods whose demand increases as
consumer incomes increase. Inferior goods whose demand decreases as consumer
incomes increase.
 Distribution of income: If national income were redistributed from the poor to the
rich, the demand for luxury goods would rise. At the same time, as the poor got
poorer they might have to turn to buying inferior goods, whose demand would thus
rise too.
 Expectations of future price changes: If people think that prices are going to rise in
the future, they are likely to buy more now before the price does go up.

Movements along and shifts in the demand curve

A demand curve is constructed on the assumption that ‘other things remain constant
(ceteris paribus). In other words, it is assumed that none of the determinants of demand,
other than price, changes. The effect of a change in price is then simply illustrated by a
movement along the demand curve: for example, from point B to point D in Figure 2.1
when the price of potatoes rises from 40p to 80p per kilo.

What happens, then, when one of these other determinants does change? The answer is
that we have to construct a whole new demand curve: the curve shifts. If a change in one
of the other determinants causes demand to rise – say, income rises – the whole curve will
shift to the right. This shows that at each price more will be demanded than before. Thus
in Figure 2.2 at a price of P, a quantity of Qo was originally demanded. But now, after the
increase in demand, Q1 is demanded. (Note that D1 is not necessarily parallel to D0.) If a
change in a determinant other than price causes demand to fall, the whole curve will shift
to the left.

An increase in demand

P
Price

D0 D1

O Q0 Q1
Quantity

Fig 2.2 Shift in demand curve

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To distinguish between shifts in and movements along demand curves, it is usual to

distinguish between a change in demand and a change in the quantity demanded. A shift in
the demand curve is referred to as a change in demand, whereas a movement along the
demand curve as a result of a change in price is referred to as a change in the quantity
demanded.

DEFINITION OF SUPPLY

Supply refers to the various quantities of a product that sellers (producers) are willing and
able to provide at various prices in a given period of time, ceteris paribus. Note that
quantity supplied and supply are two different concepts. Quantity supplied refers to a
specific quantity that a supplier is willing and able to provide at a specific price. But
supply refers to the whole relationship between possible prices of a product and the
corresponding quantities supplied.

LAW OF SUPPLY

Law of supply states that, other things remain unchanged, as price of a product increases
quantity supplied of the product increases, and as price decreases, quantity supplied of the
product decreases. From law of supply, we understand that sellers are motivated to sell
more at higher prices than at lower prices.

THE SUPPLY CURVE, SCHEDULE AND FUNCTION

Supply Schedule

The amount that producers would like to supply at various prices can be shown in a supply
schedule. Table 2.2 shows a monthly supply schedule for potatoes, both for an individual
farmer (farmer X) and for all farmers together (the whole market). The supply schedule
can be represented graphically as a supply curve. A supply curve may be an individual
firm’s supply curve or a market curve (i.e. that of the whole industry). Take the same
definition for supply schedule and supply curve as we defined for demand.

Table 2.2: Individual producer’s supply of potatoes per monthly

The supply schedule:

The supply of potatoes (monthly)

Price of Farmer X's Total Market

potatoes supply supply
(pence per kg) ( tonnes) ( tonnes: 000s)

a 20 50 100

b 40 70 200

c 60 100 350

d 80 120 530

e 100 130 700

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From the above table we notice that as price rises, the respective quantity supplied rises,
and as price decreases, the respective quantity supplied decreases. The direct relationship
between price of a product and quantity supplied, holding other things constant, is called
the law of supply.

“Law of supply states that, other things remain unchanged, as price of a product
increases quantity supplied of the product increases, and as price decreases, quantity
supplied of the product decreases. From law of supply, we understand that sellers are
motivated to sell more at higher prices than at lower prices.”

Supply Curve

Market supply of potatoes (monthly)

100 e
Supply
d
80
Price(penceper kg)

c
60

b
40

a
20

0
0 100 200 300 400 500 600 700 800
Quantity (tonnes: 000s)

Fig 2.3 Market supply of potatoes (monthly)

Figure 2.3 shows the market supply curve of potatoes. Like the demand curves, price is
plotted on the vertical axis and quantity on the horizontal axis. Each of the point’s a–e
corresponds to a figure in Table 2.2. Thus, for example, as price rise from 60p per
kilogram to 80p per kilogram will cause a movement along the supply curve from point c
to point d: total market supply will rise from 350,000 tons per month to 530,000 tons per
month. Not all supply curves will be upward sloping (positively sloped). Sometimes they
will be vertical or horizontal or\ even downward sloping. This will depend largely on the
time period over which firms’ response to price changes is considered.

Supply Function

The simplest form of supply equation relates supply to just one determinant. Thus a
function relating supply to price would be of the form:

q s  c  dp (3)

Thus an actual supply equation might be something like: Qs  500  1000 p

15 24 Mar. 24
 INTRODUCTION TO ECONOMICS

More complex supply equations would relate supply to more than one determinant.

q s  c  dp  ea1  fa 2  gj (4)

Where P is the price of the good, a1 and a2 are the profitability’s of two alternative goods
that could be supplied instead, and j is the profitability of a good in joint supply. Explain
why the P and j terms have a positive sign, whereas the a1 and a2 terms have a negative
sign.

DETERMINANTS OF SUPPLY

Like demand, supply is not simply determined by price. The other determinants of supply
(supply shifter) are as follows.

 The costs of production (price of inputs): the higher the costs of production, the
less profit will be made at any price. As costs rise, firms will cut back on production,
probably switching to alternative products whose costs have not raised so much.
 The profitability of alternative products (substitutes in supply): If a product
which is a substitute in supply becomes more profitable to supply than before,
producers are likely to switch from the first good to this alternative. Supply of the
first good falls. Other goods are likely to become more profitable if their prices rise
and their costs of production fall.
 The profitability of goods in joint supply: Sometimes when one good is produced,
another good is also produced at the same time. These are said to be goods in joint
supply. An example is the refining of crude oil to produce petrol. Other grade fuels
will be produced as well, such as diesel and paraffin. If more petrol is produced, due to
a rise in demand and hence its price, then the supply of these other fuels will rise too.
 Nature, ‘random shocks’ and other unpredictable events: In this category we
would include the weather and diseases affecting farm output, wars affecting the
supply of imported raw materials, the breakdown of machinery, industrial disputes,
earthquakes, floods and fire, etc.
 The aims of producers: A profit-maximizing firm will supply a different quantity
from a firm that has a different aim, such as maximizing sales. For most of the time
we shall assume that firms are profit maximizes.
 Expectations of future price changes: If price is expected to rise, producers may
temporarily reduce the amount they sell. Instead they are likely to build up their
stocks and only release them on to the market when the price does rise. At the same
time they may install new machines or take on more labour, so that they can be ready
to supply more when the price has risen.
 The number of suppliers: If new firms enter the market, supply is likely to increase.

MOVEMENTS ALONG AND SHIFTS IN THE SUPPLY CURVE

The principle here is the same as with demand curves. The effect of a change in price is
illustrated by a movement along the supply curve: for example, from point d to point e in

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 INTRODUCTION TO ECONOMICS

Figure 2.3 when price rises from 80p to 100p. Quantity supplied rises from 530,000 to
700,000 tons per month. If any other determinant of supply changes, the whole supply
curve will shift. A rightward shift illustrates an increase in supply. A leftward shift
illustrates a decrease in supply. Thus in Figure 2.4, if the original curve is S0, the curve S1
represents an increase in supply (more is supplied at each price); whereas the curve S2
represents a decrease in supply (less is supplied at each price).

Shifts in the supply curve

P
S2 S0 S1

Decrease Increase

O Q

Figure 2.4 Shifts in supply

A movement along a supply curve is often referred to as a change in the quantity

supplied, whereas a shift in the supply curve is simply referred to as a change in supply.

MARKET EQUILIBRIUM

This will show how the actual price of a product and the actual quantity bought and sold
are determined in a free and competitive market. Equilibrium is the point where
conflicting interests are balanced; only at this point is the amount that demanders are
willing to purchase the same as the amount that suppliers are willing to supply. It is a point
that will be automatically reached in a free market through the operation of the price
mechanism. The price where demand equals supply is called the equilibrium price and the
quantity where demand equals supply is called the equilibrium quantity. Let us return to
the example of the market demand and market supply of potatoes, and use the data from
Tables 2.1 and 2.2. These figures are given again in Table 2.3.

The determination of equilibrium price and output can be shown using demand and supply
curves. Equilibrium is where the two curves intersect. Figure 2.5 shows the demand and
supply curves of potatoes corresponding to the data in Table 2.3. Equilibrium price is Pe
(60p) and equilibrium quantity is Qe (350,000 tones).

At any price above 60p, there would be a surplus. Thus at 80p there is a surplus of
330,000 tones (d-D). More is supplied than consumers are willing and able to purchase at
that price. Thus a price of 80p fails to clear the market. Price will fall to the equilibrium
price of 60p. As it does so, there will be a movement along the demand curve from point
D to point C, and a movement along the supply curve from point d to point c.

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 INTRODUCTION TO ECONOMICS

Table 2.3: The market demand and supply of potatoes (monthly)

Equilibrium price and output:

The Market Demand
Demand and Supply of Potatoes (Monthly)

P ric e o f P o ta to e s T o ta l M a rk e t D e m a n d T o ta l M a rk e t S u p p ly
( p e n c e p e r k ilo ) (T o n n e s : 0 0 0 s ) (T o n n e s : 0 0 0 s )

20 700 (A ) 100 (a )
40 500 (B ) 200 (b )
60 350 (C ) 350 (c )
80 200 (D ) 530 (d )
100 100 (E ) 700 (e )

The determination of market equilibrium

(potatoes: monthly)
E e
100
Supply
D SURPLUS d
80
Price(penceper kg)

(330 000)

60

b SHORTAGE B
40
(300 000)
a A
20

Demand
0
0 100 200 300 Qe 400 500 600 700 800
Quantity (tonnes: 000s)

Fig 2.5 the determination of market equilibrium (potatoes: monthly)

At any price below 60p, there would be a shortage. Thus at 40p there is a shortage of
300,000 tonnes (B-b). Price will rise to 60p. This will cause a movement along the supply
curve from point b to point c and along the demand curve from point B to point C. Point
Cc is the equilibrium: where demand equals supply. In fact, only one price is sustainable –
the price where demand equals supply: namely, 60p per kilogram, where both demand and
supply are 350,000 tones. When supply matches demand the market is said to clear. There
is no shortage and no surplus.

Movement to a new equilibrium

The equilibrium price will remain unchanged only so long as the demand and supply
curves remain unchanged. If either of the curves shifts, a new equilibrium will be formed.
A change in demand; If one of the determinants of demand changes (other than price),
the whole demand curve will shift. This will lead to a movement along the supply curve to
the new intersection point.

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 INTRODUCTION TO ECONOMICS

Effect of a shift in the demand curve

P
S

i New equilibrium at
Pe point i
2

g h
Pe
1

D2

D1
O Qe1 Qe2 Q

Fig 2.6 Effect of a shift in the demand curve

A Change in Supply

Likewise, if one of the determinants of supply changes (other than price), the whole
supply curve will shift. This will lead to a movement along the demand curve to the new
intersection point. For example, in Figure 2.7, if costs of production rose, the supply curve
would shift to the left: to S2. There would be a shortage of g j at the old price of Pe1. Price
would rise from Pe1 to Pe3. Quantity would fall from Qe1 to Qe3. In other words, there
would be a movement along the demand curve from point g to point k, and along the new
supply curve (S2) from point j to point k.
Effect of a shift in the supply curve
P
S2

S1

k
Pe
3

j g New equilibrium at
Pe point k
1

D
O Qe Qe Q
3 1

Fig 2.7 Effect of a shift in the supply curve

To summaries: a shift in one curve leads to a movement along the other curve to the new
intersection point. Sometimes a number of determinants might change. This might lead to
a shift in both curves. When this happens, equilibrium simply moves from the point where
the old curves intersected to the point where the new ones intersect.

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 INTRODUCTION TO ECONOMICS

LEARNING ACTIVITIES

 What are the determinants of demand and supply?

 Differentiate between law of demand and supply?
 What does the law of demand and supply states?
 What determines the extent of the demand for a good?
 Enumerate the demand shifter?
 Explain factors that cause movements along and shifts in the demand curve?
 List and discuss determinants of supply other than own price?

CONTINUOUS ASSESSMENT

Assessment plan for continuous assessment will be: quiz, individual assignment and group
work, written tests, rubrics. Competence of the student is proved by problem analysis,
calculating and explaining

SUMMARY

Economists use the model of supply and demand to analyze competitive markets. In a
competitive market, there are many buyers and sellers, each of whom has little or no
influence on the market price. According to the law of demand, as the price of a good falls
the quantity demanded rises, other things remain constant. Therefore, the demand curve
slopes downward. In addition to price, other determinants of the quantity demanded
include income, tastes, expectations, and the prices of substitutes and complements. If one
of these others determinants changes, the demand curve shifts.

The supply curve shows how the quantity of a good supplied depends on the price.
According to the law of supply, as the price of a good rises, the quantity supplied rises.
Therefore, the supply curve slopes upward. In addition to price, other determinants of the
quantity supplied include input prices, technology, and expectations. If one of these others
determinants changes, the supply curve shifts.

The intersection of the supply and demand curves determines the market equilibrium. At
the equilibrium price, the quantity demanded equals the quantity supplied. To analyze how
any event influences a market, we use the supply-and-demand diagram to examine how
the event affects the equilibrium price and quantity. To do this we follow three steps. First,
we decide whether the event shifts the supply curve or the demand curve (or both).
Second, we decide which direction the curve shifts. Third, we compare the new
equilibrium with the old equilibrium.

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 INTRODUCTION TO ECONOMICS

2.2. THEORY OF ELASTICITY

Pre tests
 What do you mean by elasticity?

INTRODUCTION

In the previous section, we have discussed the concept of market equilibrium and factors
contributing to changes in equilibrium. In this section, however, we will emphasis on the
responsiveness of demand and supply to changes in their major determinants.

Both demand and supply are multivariate functions. Any change in their determinants
causes either movement along the curve or shift of the curve. It is often of interest to be
able to measure how demand and supply respond to changes in their determinants. There
are various measures of such responsiveness of demand and supply. The most widely used
of these measures is called elasticity.

Elasticity measures the percentage point responsiveness of demand and supply to a

percentage point in any of their determinants.

CONCEPT OF ELASTICITY

Let us discuss the concept of elasticity: another important concept in the theory of demand
and supply. 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 ETB, Dollars etc.
Therefore, slope measures certain kg per ETB, 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/ETB with one measured as Y
pounds/Dollar. Rather than specify units all the time, it is convenient to consider a unit
free measure of responsiveness for this purpose, thus, a measure known as elasticity is
often used.

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 INTRODUCTION TO ECONOMICS

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 (Xn)
changes, there will be consequent change in the value of Y. The formula to determine the
responsiveness of Y to changes in the Xn can be expressed as

%Y %Y %Y

1  , 2  , ..., n 
%X 1 %X 2 %X n

This formula states that elasticity is the percentage change in the dependent variable
divided by the percentage change in the particular independent variable whose effect is
being examined.

ELASTICITY OF DEMAND

In examining demand, it would be interesting to measure how quantity demanded

responds to changes in price and changes in other factors that affect demand such as price
of other goods and income. Depending on the variables involved, three measures of
elasticity of demand could be considered:

 Price elasticity of demand measures the responsiveness of quantity demanded to

changes in output price, ceteris paribus.
 Cross elasticity of demand measures the responsiveness of quantity demanded to
changes in the price of other goods, ceteris paribus.
 Income elasticity of demand measures the responsiveness of quantity demanded to
changes in consumers’ income, ceteris paribus.

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.

Percentage change in quantity demanded

 (5)
Percentage change in price
Q / Q
 , where Q is change in quantity and P is change in price.
P / P
Rearranging
Q P
 
P Q

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 INTRODUCTION TO ECONOMICS

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 quantity demanded.

Example 2.1: Assume that a consumer purchases 10 units of a good when price is ETB 4
and 18 units when price falls to ETB 2. Compute price elasticity of demand.
18  10
Percentage change in quantity demanded is  100  80% and percentage change
10
24 80%
in price is  100  50% . Elasticity, therefore, is given as     1 .6 .
4  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.

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.

Example 2.2: Again, assume that a consumer purchases 10 units of a good when price is
ETB 4 and 14 units when price falls to ETB 2. Compute price elasticity of demand.
14  10
Percentage change in quantity demanded is  100  40% and percentage change in
10
24 40%
price is  100  50% . Price elasticity of demand is     0 .8 .
4  50%

This implies that a one percent fall in price causes a 0.8 percent rise in quantity demanded.
Since elasticity is less than one, therefore, demand is said to be inelastic.

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.

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 INTRODUCTION TO ECONOMICS

Example 2.3: Assume now a consumer purchases 10 units of a good when price is ETB 4
and 15 units when price falls to ETB 2. Compute price elasticity of demand.
15  10
Percentage change in quantity demanded is  100  50% and percentage change in
10
24 50%
price is  100  50% . Then, price elasticity of demand is, therefore,    1 .
4 50%

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
 bP
But, Q=a – bP, which is,  
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 2.8: Elasticity along a Linear Demand Curve

 b(0) 0
At the horizontal intercept the price elasticity of demand is zero,    0.
a  b(0) a

24 24 Mar. 24
 INTRODUCTION TO ECONOMICS

 bp
When q = 0 at the vertical intercept, the elasticity of demand is infinity,    .
0

In between these two points, there must be a price-quantity combination at which price
a
elasticity of 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
2b
function Q = a – 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.

NUMERICAL COEFFICIENTS OF PRICE ELASTICITY OF DEMAND

Depending on the magnitude (size) of the elasticity coefficient, five types of price elasticity
could be traced along a linear demand curve. Each of these is given in Table 2.4 below.

Table 2.4: Elasticity Coefficients

Numerical
Responsiveness of quantity demanded to changes in price Terminology
coefficients
e=0 none Perfectly inelastic
Quantity demanded changes by a smaller percentage than the percentage
0<e<1 Inelastic
change in price
Quantity demanded changes by a percentage equal to the percentage
e=1 Unit elastic
change in price
Quantity demanded changes by larger percentage than the percentage
1<e< Elastic
change in price
e= Quantity demanded goes to zero or to all that is available perfectly elastic

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 INTRODUCTION TO ECONOMICS

Exercise 2.1:
The price elasticity of demand for a 10 percent decrease in price of a commodity is –5. If the
quantity demanded of a commodity by a consumer before price change is 8 units, what will be the
quantity of a commodity demanded by a consumer after a price change in units?

DETERMINANTS OF PRICE ELASTICITY OF DEMAND

Can you list the major determinants of elasticity? 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.

P D
P2

P1

0 Q1 Q

Figure 2.9: Vertical Demand Curve

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 INTRODUCTION TO ECONOMICS

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. E.g. some pharmaceutical products like insulin.

dQ P P
   0  0
dP Q Q

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.

P1 D

0 Q1 Q2 Q

Figure 2.10: Horizontal Demand Curve

PRICE ELASTICITY OF DEMAND AND TOTAL REVENUE

Here, we are going to discuss about the concept of revenue and its relationship with
elasticity. 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 (6)

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. To see
the principle, consider the figure below.

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 INTRODUCTION TO ECONOMICS

Price Price

P1 P1

P2 P2 D

0 Q1 Q2 Quantity 0 Q1 Q2 Quantity

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

Figure 2.11: Elasticity and Total Revenue

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 2.11 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 2.5: Relationship between Elasticity and Revenu

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 2.4

Price 0.50 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 ETB 2.00, the total revenue (TR) is ETB 20.00. An
increase in price form ETB 2.00 to ETB 2.20 causes TR to fall from ETB 20.00 to ETB

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 INTRODUCTION TO ECONOMICS

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 ETB 1.00 to ETB 1.20, TR increases from ETB 20.00 to ETB 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. An inverse demand function is given as P  a  bQ
TR  P  Q
TR  (a  bQ )Q
TR  aQ  bQ 2
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

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 INTRODUCTION TO ECONOMICS

1
Example 2.5: Suppose a demand function is given as Qd  50  P . Let’s show that total
2
revenue is maximum when  = -1.
The inverse demand function is P  100  2Qd .
TR  100Qd  2Qd2
dTR
Slope of TR =  100  4Qd
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

Exercise 2.2
Given the demand function Qd  100  2 P
a) What is price elasticity of demand when TR reaches maximum. Prove your result
mathematically.
b) Find the price and quantity which correspond to this maximum total revenue.

APPROACHES TO ELASTICITY MEASUREMENT

Now, let us look at the different approaches for measuring elasticity. 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:
P

P1 a

P2 b
D

0 Q1 Q2 Q
Figure 2.12: Arc Elasticity

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Q
(Q  Q 2 ) / 2 Q P1  P2
 1  
P P Q1  Q 2
( P1  P2 ) / 2

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.

Exercise 2.3
Find the price elasticity of demand for the demand curve in Example 2.5 if price changes from
ETB 10 to ETB 20. Is demand elastic or inelastic? Explain.

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 infinitely 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
P

P1 a

0 Q1 Q

Figure 2.13: 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

Exercise 2.4
For the demand function in Example 2.5, find elasticity at price ETB 30.

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CROSS ELASTICITY OF DEMAND

If you remember, we have said that price of other commodities will affect quantity
demanded of a given product. Now, let us discuss the responsiveness of quantity
demanded to changes in prices of other commodities.

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:

Percentage change in quantity demanded of one commodity (X)

 XY  (7)
Percentage change in the price of 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)

Q X PY
The cross elasticity formula is given as:  XY   ’
PY Q X

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.

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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 2.6: The quantity demanded of good X before change in the price of good Y was
25 units. As good Y’s price changes from ETB 5 to ETB 10, the quantity demanded of
good X has increased to 75 units.

Q X PY
 XY  
PY Q X
50 5
 XY   2
5 25
The two goods, therefore, are substitute products.

Exercise 2.5
Use the information in the table below to answer the questions thereof.
Price of Y Quantity of X
ETB 5 50 units
ETB 10 25 units
Find the cross elasticity of demand and explain the relationship between the goods.

INCOME ELASTICITY OF DEMAND

Let us turn our discussion to the responsiveness of quantity demanded to changes in

income of the buyer.

Income elasticity of demand is a measure of the responsiveness of quantity demanded to

changes in income assuming all other things, including price, constant.

Percentage change in quantity demanded

I  (8)
Percentage change 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.

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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.

For normal goods, the same designation for the elasticity coefficients that is used for price
elasticity of demand can be used. If the coefficient is greater than one, I >1, the good is
income elastic, whereas if I <1, the good is said to be income inelastic.

Example 2.7: When the income of the consumer is ETB 1000, the consumer buys 100
units of a good. If income increases to ETB 1200, the resulting quantity demanded would
be 130 units. The income elasticity demand of the consumer is given as:
Q I
I  
I Q
30 1000
 I 
 1 .5
200 100
The consumer’s demand is income elastic.

Goods with high positive income elasticity are considered as luxury goods. Necessities in
contrast have low income elasticity. It is important to note at this point that there is no
clear cut range of the income elasticity of demand coefficient for distinguishing between
necessities and luxury goods.

Definition: Luxury goods are normal goods for which quantity demanded changes by a
very high magnitude for a given change in income. Necessities are normal goods whose
quantity demanded changes by a smaller percentage for any given change in income.

Look at the following diagrammatical presentation of the difference in income elasticity

across commodities.
Quantity demanded
Quantity demanded

Quantity demanded

D D

0 Income 0 M Income 0 M Income

(a) Normal good: (b) Normal good: (c) Inferior good
Income inelastic Income elastic beyond M

Figure 2.14: Income Elasticity of Demand

Look at the above figures carefully. In panel a, as income increases, quantity demanded
increases at a decreasing rate. This is reflected by the increasingly flatter demand curve as
the income level increases. In panel b, as the level of income increases, the demand curve

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becomes steeper and steeper implying increase in quantity demanded at an increasing rate.
In panel c, however, the demand curve has two segments, a rising segment and a falling
segment. At its rising segment, the demand curve represents the case of income inelastic
normal good. Beyond point M, further increase in income causes fall in quantity demanded
representing a case of inferior goods.

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.

ELASTICITY OF SUPPLY

As we did for demand, let us now discuss the responsiveness of quantity supplied to
changes in its price.

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:

Percentage change in quantity supplied

S  (9)
Percentage change in price
Q s 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 2.8: A firm produces 100 units of output and sells each unit for ETB 20 at
equilibrium. Suppose the demand for the firm’s product has increased and caused a rise in
price to ETB 25 a unit. After the rise in price the quantity that the firm sells has increased
to 120 units.

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Q s P
s  
P Q s
20 20
s    0 .8
5 100
This implies that the supply of the firm is price inelastic.

Exercise 2.6
The price elasticity of supply of a firm is 0.5. A rise in price to ETB 6 has induced a 10 percent
rise in quantity supplied by the firm. Find the initial level of price.

DETERMINANTS OF PRICE ELASTICITY OF SUPPLY

The elasticity of supply depends on:

 How costs behave as output is varied. If the costs of producing a unit of output rise
rapidly as output rises, then the stimulus to expand production in response to rise
in price will quickly be obstructed by increases in costs. In this case, supply will
tend to be rather inelastic. If, however, the costs of producing a unit of output rise
only slowly as production increases, a rise in price that raises profits will bring
forth a large increase in quantity supplied before the rise in costs puts a halt to the
expansion of output. In this case, supply will tend to be rather elastic.
 Time involved. Since as the time period increases, the possibility of obtaining new
and different inputs to increase the supply increases, elasticity of supply tends to be
more elastic over longer periods than over shorter periods.
 Excess capacity and unsold stocks. It may be possible to increase supplies if there
is a pool of unemployed labor and unused machinery. Again, if the industry has
accumulated a large stock of unsold goods, supplies can quickly be increased.
These mean, it is possible to quickly respond to an increase in price by increasing
quantity supplied and hence, supply becomes more elastic.

LEARNING ACTIVITIES

 Suppose you were the manager of a particular firm. What factors do you think will affect
your decision of how much to produce? How do you relate these to the determinants of
supply discussed above?
 Try to assess the price elasticity of demand for different products in a market in your
locality. Is there any difference in price elasticity of demand for different products? If yes,
what do you think explains this difference in relation to the determinants of price elasticity
of demand listed above?
 How do you categorize jewelries and salt in relation to income elasticity of demand?
Explain.

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CONTINUOUS ASSESSMENT

Assessment plan for continuous assessment will be: quiz, individual assignment and group
work, written tests. Competence of the student is proved by problem analysis, calculating
and explaining

SUMMARY

 The amount of a commodity that households wish to purchase is called the quantity
demanded. It is determined by commodity’s own price, the price of related commodities,
consumers’ income, tastes, and size of population.
 Quantity demanded is negatively related to price, ceteris paribus. The relationship between
price and quantity demanded is graphically shown by the demand curve. The effect of change
in price is given by movement along the demand curve.
 Any change in all factors that affect demand except commodity’s own price cause shift of the
demand curve. This represents a change in demand. The demand curve of a normal good
shifts to the right (an increase in demand) if income rises, population size rises, if price of
substitutes rises, if price of complements falls, or if there is a change in tastes in favor of the
product. The opposite changes shift the demand curve to the left (a decrease in demand).
 The amount of a commodity that firms wish to sell is called the quantity supplied. It depends
on the commodity’s own price, the costs of inputs, the number of firms, and the state of
technology.
 Quantity supplied is positively related to price, ceteris paribus. The relationship between price
and quantity supplied is graphically shown by the supply curve. The effect of change in price
is given by movement along the supply curve.
 A shift in supply curve indicates a change in the quantity supplied at each price and is referred
to as a change in supply. The supply curve shifts to the right (an increase in supply) if the
costs of producing the commodity fall or if, for any reason, producers become more willing to
produce the commodity.
 The equilibrium price is the one at which the quantity demanded equals the quantity supplied.
Graphically, it is shown by the point of equality of the demand curve with the supply curve.
 At any price below the equilibrium price, there will be excess demand and at any price above
the equilibrium price, there will be excess supply.
 With supply remaining the same, increase in demand causes rise in equilibrium price. Fall in
demand, on the contrary, causes fall in equilibrium price.
 With demand remaining the same, increase in supply causes fall in equilibrium price while
decrease in supply brings forth rise in equilibrium price.
 Price elasticity of demand measures the extent to which the quantity demanded of a
commodity responds to a change in its price. It is defined as the percentage change in quantity
demanded divided by the percentage change in price. It ranges between zero and infinity.
 The main determinants of price elasticity of demand are the availability of substitutes for the
commodity and the time period involved for adjustment. A commodity that has close
substitutes will have elastic demand. Similarly, the longer the time for adjustment, the higher
will be elasticity.
 Cross elasticity of demand is the percentage change in quantity demanded divided by the
percentage change in the price of some other commodity. Positive cross elasticity implies that
the products are substitutes while a negative cross elasticity indicates that the products are
complementary.
 Income elasticity of demand measures the percentage change in quantity demanded due to a
given percentage change in consumers’ income. If a commodity has positive income
elasticity, it is referred to as a normal good. If income elasticity is negative, then, the
commodity is inferior.

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2.3. THEORY OF UTILITY AND PREFERENCE

Pre tests
 What do you mean by utility?
 How utility can be measured?

CONSUMER PREFERENCES AND CHOICES

In this section you will see how consumers allocate their limited income among different
number of goods and services Moreover, you will learn how consumer’s allocation
decisions determine quantity demand of goods and services.

CONSUMER PREFERENCE

Given any two consumption bundles (groups of goods) available for purchase, how a
consumer compares the goods? Does he prefer one good to another, or does he indifferent
between the two groups. Given any two consumption bundles, the consumer can either
decide that one of consumption bundles is strictly better than the other, or decide that he is
indifferent between the two bundles.

Strict preference: Given any two consumption bundles (X1,X2) and (Y1,Y2), if
(X1,X2)>(Y1,Y2) or if he chooses (X1,X2) when (Y1,Y2) is available. The consumer
definitely wants the X-bundle than Y. E.g.

Weak preference: Given any two consumption bundles (X1,X2) and (Y1,Y2), if the
consumer is indifferent between the two commodity bundles or if (X1,X2)  (Y1,Y2). The
consumer would be equally satisfied if he consumes (X1,X2) or (Y1,Y2). E.g.

Completeness: For any two commodity bundles X and Y, a consumer will prefer X to Y,
Y to X or will be indifferent between the two. E.g.

Transitivity: It means that if a consumer prefers basket A to basket B and to basket C.

Then the consumer also prefers A to C. E.g.

More is better than less: Consumers always prefer more of any good to less and they are
never satisfied or satiated. However, bad goods are not desirable and consumers will
always prefer less of them. E.g.

THEORY OF UTILITY

Economists use the term utility to describe the satisfaction or enjoyment derived from the
consumption of a good or service.

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DEFINITION

Utility is the level of satisfaction that is obtained by consuming a commodity or undertaking

an activity. In defining strict preference, we said that given any two consumption bundles
(X1,X2) and (Y1,Y2),the consumer definitely wants the X bundle than the Y bundle if
(X1,X2) > (Y1,Y2). This means, the consumer preferred bundle (X1,X2) to bundle (Y1,Y2)
if and only if the utility (X1,X2) is larger than the utility of (Y1,Y2).

The concept of utility is characterized with the following properties:

 ‘Utility’ and ‘Usefulness’ are not synonymous: For example, paintings by Picasso
may be useless functionally but offer great utility to art lovers.
 Utility is subjective: The utility of a product will vary from person to person. That
means, the utility that two individuals derive from consuming the same level of a
product may not be the same. For example, non-smokers do not derive any utility
from cigarettes.
 The utility of a product can be different at different places and time.
 A consumer considers the following points to get maximum utility or level of
satisfaction:
 How much satisfaction he gets from buying and then consuming an extra unit of
a good or service.
 The price he pays to get the good.
 The satisfaction he gets from consuming alternative products.
 The prices of alternative goods and services.

APPROACHES TO MEASURE UTILITY

There are two major approaches of measuring utility. These are Cardinal and Ordinal
approaches. This section is divided into two sub sections. In section one the Cardinal
Utility approach will be discussed while in section two the concept of Ordinal Utility will
be addressed.

THE CARDINAL UTILITY THEORY

Utility maximization theories are important to deal with consumer behavior. Thus, in this
section, you will learn about the Cardinal Utility Theory. Neo classical economists argued
that utility is measurable like weight, height, temperature and they suggested a unit of
measurement of satisfaction called utils. A util is a cardinal number like 1,2,3 etc simply
attached to utility. Hence, utility can be quantitatively measured.

ASSUMPTIONS OF CARDINAL UTILITY THEORY

1) Rationality of Consumers: The main objective of the consumer is to maximize

his/her satisfaction given his/her limited budget or income. Thus, in order to maximize
his/her satisfaction, the consumer has to be rational.

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2) Utility is Cardinally Measurable: According to this approach, the utility or

satisfaction of each commodity is measurable. Money is the most convenient
measurement of utility. In other words, the monetary unit that the consumer is
prepared to pay for another unit of commodity measures utility or satisfaction.
3) Constant Marginal Utility of Money: According to assumption number two, money
is the most convenient measurement of utility. However, if the marginal utility of
money changes with the level of income (wealth) of the consumer, then money cannot
be considered as a measurement of utility.
4) Limited Money Income: The consumer has limited money income to spend on the
goods and services he/she chooses to consume.
5) Diminishing Marginal Utility (DMU): The utility derived from each from each
successive units of a commodity diminishes. In other words, the marginal utility of a
commodity diminishes as the consumer acquires larger quantities of it.
6) The total utility of a basket of goods depends on the quantities of the individual
commodities.
7) If there are n commodities in the bundle with quantities, X 1 , X 2 ,... X n , the total utility
is given by: TU = f ( X 1 , X 2 ...... X n )

TOTAL AND MARGINAL UTILITY

Total Utility (TU): It refers to the total amount of satisfaction a consumer gets from
consuming or possessing some specific quantities of a commodity at a particular time. As
the consumer consumes more of a good per time period, his/her total utility increases.
However, there is a saturation point for that commodity in which the consumer will not be
capable of enjoying any greater satisfaction from it.

Marginal Utility (MU): It refers to the additional utility obtained from consuming an
additional unit of a commodity. In other words, marginal utility is the change in total
utility resulting from the consumption of one or more unit of a product per unit of time.
Graphically, it is the slope of total utility.
TU
Mathematically, the formula for marginal utility is: MU  (10)
Q
Where: TU is the change in Total Utility, and
Q is change in the amount of product consumed.

LAW OF DIMINISHING MARGINAL UTILITY (LDMU)

Is the utility you get from consumption of the first orange is the same as the second
orange? The utility that a consumer gets by consuming a commodity for the first time is
not the same as the consumption of the good for the second, third, fourth time, etc. The
LDMU states that as the quantity consumed of a commodity increases per unit of time, the
utility derived from each successive unit decreases, consumption of all other commodities
remaining constant. The LDMU is best explained by the MU curve that is derived from
the relationship between the TU and total quantity consumed.

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Table 2.6: Hypothetical table showing TU and MU of consuming Oranges (X)

Units of
Quantity(x) 0 Unit 1st Unit 2nd unit 3rd unit 4th unit 5th Unit 6th Unit
consumed
TUX 0 util 10 utils 16 utils 20 utils 22 utils 22 utils 20 utils
MUX 0 10 6 4 2 0 -2

EQUILIBRIUM OF A CONSUMER

A consumer that maximizes utility reaches his/her equilibrium position when allocation of
his/her expenditure is such that the last birr spent on each commodity yields the same
utility and his/her income is totally exhausted. For example, if the consumer consumes a
bundle of n commodities i.e., X 1 , X 2 ,…, X n , he/she would be in equilibrium or utility is
maximized if and only if:

MU X 1 MU X 2 MU X n
  ...  MU m (11)
PX1 PX 2 PX n
Where: MU m – Marginal Utility of Money
And, income is totally exhausted. That is:

MU X 1 * PX 1  MU X 2 * PX 2  . . .  MU X n * PX n  M (12)
Where: M – Total Income

Diagrammatically,

P
A

C
PX

 B

MUX

QX
Figure 2.15: Marginal Utility of a Consumer

Note that: at any point above point C like point A where MUX> PX, it pays the consumer
to consume more. At any point below point C like point B where MUX< PX the consumer
consumes less of X. However, at point C where MUX=PX the consumer is at equilibrium.

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Table 2.7: Utility schedule for a single commodity

Quantity of Price of MU per ETB MU of

TU MU
Orange Orange (Price=2 ETB) Money
0 0 - 2 - 1
1st 6 6 2 3 1
2nd 10 4 2 2 1
3rd 12 2 2 1 1
4th 13 1 2 0.5 1
5th 13 0 2 0 1
6th 11 -2 2 -1 1

For consumption level lower than three quantities of oranges, since the marginal utility of
orange is higher than the price, the consumer can increase his/her utility by consuming
more quantities of oranges. On the other hand, for quantities higher than three, since the
marginal utility of orange is lower than the price, the consumer can increase his/her utility
by reducing its consumption of oranges. Mathematically, the equilibrium condition of a
consumer that consumes a single good X occurs when the marginal utility of X is equal to
its market price.

MU X  PX (13)

LIMITATION OF THE CARDINALIST APPROACH

The Cardinalist approach involves the following three weaknesses:

1) The assumption of cardinal utility is doubtful because utility may not be quantified.
2) Utility cannot be measured absolutely (objectively). The satisfaction obtained from
different commodities cannot be measured objectively.
3) The assumption of constant MU of money is unrealistic because as income increases,
the marginal utility of money changes.

THE ORDINAL UTILITY THEORY

In the ordinal utility approach, utility cannot be measured absolutely but different
consumption bundles are ranked according to preferences. The concept is based on the fact
that it may not be possible for consumers to express the utility of various commodities
they consume in absolute terms, like, 1 util, 2 utils, or 3 utils, but it is always possible for
the consumers to express the utility in relative terms. It is practically possible for the
consumers to rank commodities in the order of their preference as 1st, 2nd, 3rd and so on.

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ASSUMPTIONS OF ORDINAL UTILITY THEORY

Like the previous approach, this approach is based on the following assumptions:

1) The Consumers are rational: they aim at maximizing their satisfaction or utility
given their income and market prices.
2) Utility is ordinal: i.e. utility is not absolutely (cardinally) measurable. Consumers
are required only to order or rank their preference for various bundles of
commodities.
3) Diminishing Marginal Rate of Substitution (MRS): The marginal rate of
substitution is the rate at which a consumer is willing to substitute one commodity
(x) for another commodity (y) so that his total satisfaction remains the same. When
a consumer continues to substitute X for Y the rate goes decreasing and it is the
slope of the Indifference Curve.
4) The total utility of the consumer depends on the quantities of the commodities
consumed: i.e., U  f ( X 1 , X 2 ,... X n )
5) Preferences are transitive or consistent: It is transitive in the senses that if the
consumer prefers market basket X to market basket Y, and prefers Y to Z, and then the
consumer also prefers X to Z. When we said consistent it means that if market basket
X is greater than market basket Y (X>Y) then Y not greater than X (Y not >X).

The ordinal utility approach is expressed or explained with the help of indifference curves.
An indifference curve is a concept used to represent an ordinal measure of the tastes and
preferences of the consumer and to show how he/she maximizes utility in spending
income. Since it uses ICs to study the consumer’s behavior, the ordinal utility theory is
also known as the Indifference Curve Analysis.

INDIFFERENCE SET, CURVE AND MAP

Indifference Set/Schedule: It is a combination of goods for which the consumer is

indifferent, preferring none of any others. It shows the various combinations of goods
from which the consumer derives the same level of utility.

Indifference Curves: an indifference curve shows the various combinations of two goods
that provide the consumer the same level of utility or satisfaction. It is the locus of points
(particular combinations or bundles of good), which yield the same utility (level of
satisfaction) to the consumer, so that the consumer is indifferent as to the particular
combination he/she consumes.

Indifference Map: To describe a person’s preferences for all combinations of potato and
meat. We can graph a set of indifference curves called an indifference map. In other words
it is the entire set of indifference curves is known as an indifference map, which reflects
the entire set of tastes and preferences of the consumer. A higher indifference curve refers
to a higher level of satisfaction and a lower indifference curve shows lesser satisfaction.

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PROPERTIES OF INDIFFERENCE CURVES:

1) Indifference curves have negative slope (downward sloping to the right):

Indifference curves are negatively sloped because the consumption level of one
commodity can be increased only by reducing the consumption level of the other
commodity. That means, if the quantity of one commodity increases with the
quantity of the other remaining constant, the total utility of the consumer increases.
On the other hand, if the quantity of one commodity decreases with the quantity of
the other remaining constant, the total utility of the consumer reduces. Hence, 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 decreased.

2) Indifference curves do not intersect each other: Intersection between two

indifference curves is inconsistent with the reflection of indifference curves. If they
did, the point of their intersection would mean two different levels of satisfaction,
which is impossible.

3) A higher indifference curve is always preferred to a lower one: The further

away from the origin an IC lies, the higher the level of utility it denotes: baskets of
goods on a higher indifference curve are preferred by the rational consumer,
because they contain more of the two commodities than the lower ones.

4) Indifference curves are convex to the origin: This implies that the slope of an
indifference curve decreases (in absolute terms) as we move along the curve from
the left downwards to the right. This assumption implies that the commodities can
substitute one another at any point on an indifference curve, but are not perfect
substitutes.

B
Banana
Banana

E

D IC2
C
A
IC1
X

Orange Orange

Figure 2.16: Positively sloped and intersected indifference curves

As we discussed earlier, ICs cannot intersect each other. If they did, the consumer would
be indifferent between C and E, (Right panel of figure 2.16) since both are on indifference
curve one (IC1). Similarly, the consumer would be indifferent between points D and E,
since they are on the same indifference curve, IC2. By transitivity, the consumer must also
be indifferent between C and D. However, a rational consumer would prefer D to C
because he/she can have more Orange at point D (more Orange by an amount of X).

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THE MARGINAL RATE OF SUBSTITUTION (MRS)

Definition: 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 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

It is the negative of the slope of an indifference curve at any point of any two commodities
such as X and Y, and is given by the slope of the tangent at that point: i.e., slope of IC is:

y
 MRS X ,Y (14)
x

In other words, MRS refers to the amount of one commodity that an individual is willing
to give up to get an additional unit of another good while maintaining the same level of
satisfaction or remaining on the same indifference curve. The diminishing slope of the
indifference curve means the willingness to substitute X for Y diminishes as one move
down the curve.

Note that ( MRS X ,Y ) measures the downward vertical distance (the amount of y that the
individual is willing to give up) per unit of horizontal distance (i.e. per additional unit of x
Y
required) to remain on the same indifference curve. That is, MRS X ,Y   because of
X
the reduction in Y, MRS is negative. However, we multiply by negative one and express
MRS X ,Y as a positive value.

The rationale behind the convexity, that is, diminishing MRS, is that a consumer’s
subjective willingness to substitute A for B (or B for A) will depend on the amounts of B
and A he/she possesses.

Table 2.8: Level of consumption of good X and Y

Bundle (Combination) A B C D
Orange(X) 1 2 4 7
Banana (Y) 10 6 2 1
MRS X ,Y  Y / X - 4 2 1
3

Y 4
MRS X ,Y (between points A and B    4)
X 1
In the above case the consumer is willing to forgo 4 units of Banana to obtain 1 more unit
of Orange. If the consumer moves from point B to point C, he is willing to give up only 2

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 INTRODUCTION TO ECONOMICS

units of Banana(Y) to obtain 1 unit of Orange (X), so the MRS is 2(∆Y/∆X =4/2). Having
still less of Banana and more of Orange at point D, the consumer is willing to give up only
1 unit of Banana so as to obtain 3 units of Orange. In this case, the MRS falls to ⅓. In
general, as the amount of Y increases, the marginal utility of additional units of Y
decreases. Similarly, as the quantity of X decreases, its marginal utility increases. In
addition, the MRS decreases as one move downwards to the right.

MARGINAL UTILITY AND MARGINAL RATE OF SUBSTITUTION

The MRS X ,Y , which is related to the MU X and the MU y is:

MU X
MRS X ,Y  (15)
MU Y

THE BUDGET LINE OR THE PRICE LINE

The budget line is a line or graph indicating different combinations of two goods that a
consumer can buy with a given income at a given prices. In other words, the budget line
shows the market basket that the consumer can purchase, given the consumer’s income
and prevailing market prices.

ASSUMPTIONS FOR THE USE OF THE BUDGET LINE

In order to draw the budget line facing the consumer, we consider the following
assumptions:

1) There are only two goods, X and Y, bought in quantities of X and Y;

2) Each consumer is confronted with market determined prices, Px and Py, of good X
and good Y respectivley; and
3) The consumer has a known and fixed money income (M).

By assuming that the consumer spends all his/her income on two goods (X and Y), we can
express the budget constraint as:

M  PX X  PY Y (16)

Where, PX=Price of good X, PY=Price of good Y; X=quantity of good X; Y=quantity

of good Y; M=consumer’s money income

This means that the amount of money spent on X plus the amount spent on Y equals the
consumer’s money income.

Suppose for example a household with 30 ETB per day to spend on banana(X) at 5 ETB
each and Orange(Y) at 2 ETB each. That is, PX  5, PY  2, M  30birr . Therefore, our
budget line equation will be: 5 X  2 Y  30

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 INTRODUCTION TO ECONOMICS

Table 2.9: Alternative purchase possibilities of the two goods

Consumption
A B C D E F
Alternatives
Kgs of Banana (X) 0 1 2 3 4 6
Kgs of Orange(Y) 15 12.5 10 7.5 5 0
Total Expenditure 30 30 30 30 30 30

At alternative A, the consumer is using all of his /her income for good Y. Mathematically
it is the y-intercept (0, 15). And at alternative F, the consumer is spending all his income
for good X. mathematically; it is the x-intercept (6, 0). We may present the income
constraint graphically by the budget line whose equation is derived from the budget
equation.

M  PX X  PY Y
M  XPX  YPY

By rearranging the above equation we can derive the general equation of a budget line,

M PX
Y  X
PY PY
M
= Vertical Intercept (Y-intercept), when X=0.
PY
PX
 = slope of the budget line (the ratio of the prices of the two goods)
PY

The horizontal intercept (i.e., the maximum amount of X the individual can consume or
purchase given his income) is given by:

M PX M PX M
 X 0  X X 
PY PY PY PY PX

M/PY

B


A


M/PX
Figure 2.17: Derivation of the Budget Line

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 INTRODUCTION TO ECONOMICS

Therefore, the budget line is the locus of combinations or bundle of goods that can be
purchased if the entire money income is spent.

OPTIMUM OF THE CONSUMER

A rational consumer seeks to maximize his utility or satisfaction by spending his or her
income. It maximizes the utility by trying to attain the highest possible indifference curve,
given the budget line. This occurs where an indifference curve is tangent to the budget line
so that the slope of the indifference curve ( MRS XY ) is equal to the slope of the budget line
( PX / PY ). Thus, the condition for utility maximization, consumer optimization, or
consumer equilibrium occurs where the consumer spends all income (i.e. he/she is on the
budget line) and the slope of the indifference curve equals to the slope of the budget
line MRS XY  PX / PY . The preferences of the consumer (what he/she wishes) are indicated
by the indifference curve and the budget line specifies the different combinations of X and
Y the consumer can purchase with the limited income. Therefore, the consumer tries to
obtain the highest possible satisfaction with in his budget line.

However, the consumer cannot purchase any bundle lying above and to the right of the
budget line. Because Indifference curves above the region of the budget line are beyond
the reach of the consumer and are irrelevant for equilibrium consideration. The question
then arises as to which combinations of X and Y the rational consumer will purchase.
Graphically, the consumer optimum or equilibrium is depicted as follows:

Figure 2.18: Consumer equilibrium

At point ‘A’ on the budget line, the consumer gets IC1 level of satisfaction. When he/she
moves down to point ‘B’ by reallocating his total income in favor of X he/she derives
greater level of satisfaction that is indicated by IC2. Thus, point ‘B’ is preferred to point
‘A’. Moving further down to point ‘E’, the consumer obtains the greatest level of
satisfaction (IC3) relative to other indifference curves.

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 INTRODUCTION TO ECONOMICS

Therefore, point ‘E’ (which represents combination X and Y) is the most preferred
position by the consumer since he/she attains the highest level of satisfaction within
his/her reach and point ’E’ is known as the point of consumer equilibrium (or consumer
optimum). This equilibrium occurs at the point of tangency between the highest possible
indifference curve and the budget line. Put differently, equilibrium is established at the
point where the slope of the budget line is equal to the slope of the indifference curve.
Mathematically, consumer optimum (equilibrium) is attained at the point where:

PX MU X MU Y MU X P
MRS XY  , But we know   .......MU X PY  MU Y PX ...,  X
PY PX PY MU Y PY

LEARNING ACTIVITIES

 Distinguish between marginal rate of substitution and marginal utility.

 Explain why we study the theory of consumer behavior.
 What does it mean by marginal utility of a commodity is diminishing?
 Explain the meaning of MUx =4.
 Explain the difference between equilibrium conditions of the consumer under
cardinal utility approach and ordinal utility (indifference curve) approach.
 Suppose the total utility function of a consumer is given as TU(X) = 2X2. What is the
marginal utility of X?

CONTINUOUS ASSESSMENT

The planned assessment method will be tests and quizzes, Assignments.

SUMMARY

Consumers given their income and prices of the commodities, they spend their income so
as to attain the highest possible satisfaction or utility from commodities. Utility is thus the
satisfaction obtained from the consumption of a good. The maximization of utility is
referred to as the axiom of utility maximization. To attain this utility maximization
objective, the consumer must be able to compare the utility of the various baskets of
goods, which they can buy with their income. In order to explain the comparison of these
commodities we have two approaches. These are: Cardinal Approach and the Ordinal
Approach. Cardinalist believed that cardinal numbers could be used to express the utility
derived from the consumption of a commodity while ordinalists believed that utility is not
measureable, but is an ordinal magnitude. The main ordinal theories are the indifferece
curves approache and the revealed preferences hypothesis.These approaches are also
known as the indifference curve theories .

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