1.

Economic concepts, basic economic problems and economic system

1.1 Economic concepts
Introduction
This chapter explains what economics is & how economists work. It also explains why studying
economics is important to you as a present or future employee, employer, entrepreneur,
consumer, saver, investor & citizen. By describing the use of economic models & the principles
of scarcity of resources, trade -off, opportunity costs & production possibilities.
The chapter introduces you to some basic economic principles that you will studying
throughout the text. Learning economic skill deal with reading tables & graphs .
Economics is the study of how individuals & nations make choices about how to use scarce
resources to fill their needs & wants.
A resource is anything that people can use to make or obtain what they need or want. You may
be asking yourself at this point how economics will help you, a student. Also you may be
wondering how scarce resources is a problem of for a nation like the united states that has
such abundant resources.
Economics can help you to understand both cost & benefits &, therefore, help you to make
better decisions.
Because economics examine facts in order to make choices, it can teach you some basic skills
for making decisions. Being able to make reason, well informed decisions will be important to
you as an employee, employer, entrepreneur, consumer, saver, investor, as well as a citizen.
Scarcity means that people don’t & can’t have enough income, time or resources to satisfy
their every desire. What you can buy with your income as a student is limited by the amount of
income you have. In this case, your income is the scarce resources.
Human Wants: Refers to all the goods, services & the conditions of life that individual desire.
That is, human wants refers to the quality, variety & quantity of goods we want. Human wants
vary, of course, among different people, over different periods of time, & in different locations.
However, human wants always seem to be greater than the goods & services available to satisfy
those wants.
The sum total of all human wants are insatiable or can never be fully satisfied.
Resources: are inputs, the factors or means of producing the goods & services we want.
Economic Resources can be classified broadly in to:-
1. Land (Natural resources):- fertility of the soil, the climate, forests, mineral deposits
2. Labor (human resources);- human effort b/n physical and mental to produce desires
goods & services.
3. Capital is all the “produced” means of production such as the machinery, factories
equipment, tools, inventories, drainage & irrigation on agricultural land,& the
transportation & communication networks. All of these greatly facilitate the production
of other goods & services.

1
 Money is not capital because money, as such, produces nothing but simply facilitates
the exchange of goods & services.
Scarcity: Economic resources are that they are scarce or limited in supply rather than
unlimited.
Free resources & free goods are those of which the quantity supplied exceeds the quantity
demanded at zero prices.
Society can only satisfy some wants rather than all wants, thus, every society faces
scarcity.
If human wants were limited or resources unlimited, there would be no scarcity & there
would be no need to study economics.

Economics as a Science and /or discipline can be defined as in a number of ways. However, On
the one hand, Human wants are unlimited. On the other, Economic resources available to
satisfy all these wants are scarce or limited. The insatiable nature of human material wants
and the corresponding scarcity of resources lead to the need for making choices. These Choices
are how to allocate scarce resources to maximize the satisfaction of human wants. Economics
as a discipline therefore gives rise to a way of reasoning on how to allocate scarce resources
efficiently.

1.1.1 Definition of economics

Definition of Economics According to Different Economists?
1. Economics as has been defined by Adam Smith.
Adam Smith the forefather of the economists regarded Economics as a science which studies
the process of production, Consumption, distribution and exchange of wealth. According to
him, Economics inquires into the factors those determine wealth of a country and its growth.
The definition of Economics as science of Wealth cased a great deal of confusion
and misunderstanding in 17th & 18th centuries. Actually at that time religion and ethics had a
strong hold. Wealthy and riches were looked upon as sordid and mean objects. Since science of
Economics was defined as a science of wealth, therefore it was several criticized by men of
letters of the 19th century, like Ruskin, Carlyle and Mathew Arnold.
2. Economics as has been defined by Prof. Marshall.
"Economics is the study of mankind in the ordinary business of life. It examines that part of
individual and social action which is not most closely connected with the attainment and use of
material requisites of well being."
Main Features
Firstly, it is a study of ordinary person living in a society. It does not study of isolated
individual.

2
Secondly, It studies only the economic aspect of human being and does not have any concern
with any other aspect like religious, social and political. Strictly speaking, it relates to how the
man earns his income and how he spends it.
Thirdly, it studies only material requisites of well-being or causes of material welfare.
Fourthly, it does not regard wealth as the be-all and the end-all of economics activities. Wealth
is sought only for promoting human welfare.
3. Economics as defined by Robbins.
"Economics is the science of Human Behavior as relationship between ends and a scarce
means which have alternative uses."
This definition is based on the following four basic propositions, i.e.

 Human wants are unlimited.

 Means (Resources) are limited to fulfill them.
 Wants are not equally important.
 Means have alternative uses.

Economics is the social science that analyzes the production, distribution, and consumption of
goods and services. The term economics comes from the Ancient Greek οἰκονομία from οἶκος +
νόμος, hence "rules of the house". Political economy was the earlier name for the subject, but
economists in the late 19th century suggested "economics" as a shorter term for "economic
science" that also avoided a narrow political-interest connotation and as similar in form to
"mathematics", "ethics", and so forth.
Economics is the study of choosing among alternative ways in which scarce resources may be
allocated to maximize the satisfaction of human wants. It can also be defined as a branch of
social science that is concerned with the efficient utilization and management of limited
productive resources for attaining maximum satisfaction of human material wants. Besides,
many economists have forwarded their own definition of economics, some are:

- It is the study of constrained maximization

- It is the study of choice.
- It is the study of how a society chooses to use its limited resources to produce,
exchange, and to consume goods and services.
- It is a science that studies as to how people use the things they have, to try to get
the most of what they want.
- It is the study of how scarce resources are allocated among competing ends


A good is any tangible thing that satisfies people’s wants and desires.
A service is any form of intangible but useful activity that is valued by people.

3
 1.1.2 Branches of economics

Economics is a broad subject concerned with the optimal distribution of resources in society.
Within the subject there are several different branches which focus on different aspects. Also,
there are different schools of thought which generally have different views on aspects of
economics.
The first way to split economics is Microeconomics and macroeconomics.
Microeconomics – concerned with individual markets and small aspects of the economy.
Macroeconomics – concerned with the whole aggregate economy. Issues such as inflation,
economic growth and trade.
Branches of economics

Branches of economics

Microeconomics Macroeconomics

Neo classical (free market) Classical (free market)

Development economics Keynesian gov’t intervention

Environmental Marxist (State control)

Behavioral (psychology) Australian (free market)

Econometrics (maths) Mercantilism (protectionism)

Labour economics
Monetarist (free market/control money)

1. Classical economics
Classical economics is often considered the foundation of modern economics. It was developed
by Adam Smith, David Ricardo, Classical economics is based on operation of free markets. How
the invisible hand and market mechanism can enable an efficient allocation of resources
Classical economics suggests that generally economies work most efficiently when government
intervention is minimal and concerned with the protection of private property, promotion of free
trade and limited government spending.

4
Classical economics does recognize that a government is needed for providing public goods,
such as defense, law and order and education.
2. Neo-classical economics
Key people: Leon Walrus, William Jevons, John Hicks, George Stigler and Alfred Marshall
Neo-classical economics built on the foundations of free-market based classical economics. It
included new ideas such as Utility maximization
Rational choice theory
Marginal analysis. How individuals will make decisions at the margin – choosing the best
option given marginal cost and benefit.
Neo-classical economics is often considered to be orthodox economics. It is the economics
taught in most text-books as the starting point for economics teaching. The tools of neo-
classical economics (supply and demand, rational choice, utility maximization) can be used in
new fields and also for critiques.
Keynesian economics
Key people: John Maynard Keynes
Keynesian economics was developed in the 1930s against a backdrop of the Great Depression.
The existing economic orthodoxy was at a loss to explain the persistent economic depression
and mass unemployment. Keynes suggested that markets failed to clear for many reasons (e.g.
paradox of thrift, negative multiplier, and low confidence). Therefore, Keynes advocated
government intervention to kick-start the economy.
Keynesian economics is credited with creating macroeconomics as a distinct study. Keynes
argued that the aggregate economy may operate in very different ways to individual markets
and different rules and policies were needed.
Keynes didn’t reject all elements of neo-classical economics but felt new ideas were needed for
the macro-economy – especially with the economy in recession.
Monetarist economics
Key people: Milton Friedman, Anna Schwartz.
Monetarism was partly a reaction to the dominance of Keynesian economics in the post-war
period. Monetarists, led by Milton Friedman argued that Keynesian fiscal policy was much less
effective than Keynesians suggested. Monetarists promoted previous classical ideals, such as
belief in the efficiency of markets. They also placed emphasis on the control of the money
supply as a way to control inflation.
Monetarist economics became influential in the 1970s and 1980s, in a period of high inflation –
which appeared to illustrate the breakdown of the post-war consensus
Monetarism
Austrian economics
Key people: Ludwig Von Mises, Carl Menger
This is another school of economics that was critical of state intervention, price controls. It is
broadly free-market. However, it criticized elements of classical school – placing greater

5
emphasis on the individual value and actions of an individual. For example, Austrian
economists argue the value of a good reflects the marginal utility of the good – rather than the
labor inputs.
Austrian economics
Marxist economics
Key people: Karl Marx
Emphasizes unequal and unstable nature of capitalism. Seeks radically different approach to
basic economic questions. Rather than relying on free-market advocate state intervention in
ownership, planning and distribution of resources.
Neo-liberalism/Neo-classical
A modern interpretation of classical economics. Considerable overlap with monetarism.
Essentially concerned with the promotion of free-markets, competition, free trade, privatization,
lower government involvement, but some minimal state intervention in public services like
health and education. Few identify as ‘neo-liberal’ – sometimes used as a term of abuse.
Neoliberals | Related terms: Washington Consensus
New Branches of economics
Environmental economics/welfare economics
Key people: Garrett Hardin, E.F. Schumacher, Arthur Pigou
This places greater emphasis on the environment. This can include:
Neo-classical analysis of external costs and external benefits. From this perspective, it is
rational for man to reduce pollution
Market failures – tragedy of the commons, Public goods, external costs, external benefits.
Environmental economics can take a more radical approach – questioning whether economic
growth is actually desirable.
Behavioral economics
Key people: Gary Becker, Amos Tversky, Daniel Kahneman, Richard Thaler, Robert J. Shiller,
Behavioral economics examines the psychology behind economic decision making and
economic activity. Behavioral economics examines the limitation of the assumption individuals
are perfectly rational. It includes
Bounded rationality – people make choices by rules of thumb
Irrational exuberance – People get carried away by asset bubbles.
Nudges/Choice architecture – how the framing of decisions affects the outcome
Development economics
Key people: Simon Kuznets and W. Arthur Lewis, Amartya Sen and Muhammad Yunus.
Concerned with issues of poverty and under-development in poorer countries of the world.
Development economics is concerned with both micro and macro aspects of economic
development.

6
 Labor economics
Key people: Knut Wicksell
Concentration on wages, Labor employment and Labor markets. Labor economics starts from
neo-classical premise of Labor supply and marginal revenue product of Labor
Recent developments in Labor economics have placed greater emphasis on non-monetary
factors, such as motivation, enjoyment and Labor market imperfections.
Other schools of economics
Chicago school – Based on neo-classical economics, rational choice and benefits of free
markets. Key people from Chicago university, include Frank Knight, Milton Friedman, Eugene
Fama and Gary Becker
Institutional economics – A look at how institutions, society and social trends can influence
economics. A forerunner of behavioral economics. Key people include: Thorstein Veblen, John
Kenneth Galbraith, Ha-Joon Chang.
Distributes/social democratic approach. Seeking a third way between capitalism and socialism.

1.1.3 The scope and method of economic analysis

By scope of Economics, we mean coverage or major areas of study. Economics when developed
in to a discipline, Comprises two main branches called microeconomics and macroeconomics.

A) Microeconomics
Microeconomics refers to more individual or company specific studies in economics. How
businesses establish prices, how taxes will impact individual decision making, the concept
of supply and demand. So Microeconomics looks at all the small economic decisions and
interactions that all add up to the big picture concepts that Macroeconomics looks at.

The study and application of macroeconomics is most commonly employed by businesses,

in establishing how they price their products through understanding the needs of
consumers. Central to this is the concept of supply and demand and how both factors
influence price setting.
Supply: If there is an overabundance of supply for a specific product, the price will
naturally be driven down (assuming demand for that product stays constant). People don't
want the product any more than they did before, but since there's so much of that product
out there people are only willing to pay a limited amount. Alternatively if supply drops, but
the demand stays the same, people are willing to pay a more for that same product.

Demand: If people want a product more than they previously did, say it's become the 'must
have' item of the year, the price for that product will go up if the supply of that product

7
 stays the same. People will pay more to obtain the product to make sure they get it. If
demand goes down, say something goes out of fashion, there can still be the same amount
of it on the market for sale but people don't want it anymore so the price goes down.

These relationships are the key focus of microeconomics and how various factors (i.e. taxes)
impact the supply and demand model for products in general. Companies also need to be
aware of these concepts in order to set an effective price for their products, to ensure they
can maximize their profits.

B) Macroeconomics
Macroeconomics refers to the 'big picture' study of economics, so looking at concepts like
industry, country, or global economic factors. Macroeconomics includes looking at concepts
like a nation's Gross Domestic Product (GDP), unemployment rates, growth rate, and how all
these concepts interact with each other.

Studying and applying macroeconomics is incredibly important at the government level as the
policy and economic decision and regulations enacted by government can have a major impact
on many aspects of the overall economy. To demonstrate macroeconomic theory in practice
we'll briefly look at how interest rates fit into macroeconomic policy.

Extensive study goes into establishing the appropriate interest rates in an economy, where the
government sets a base rate and banks work from there. If interest rates go up:

 People may save more money as they get a better return on their deposits.
 Business will invest in less expansion as borrowing money will cost relatively more.
 The local currency will go up in value because now deposits in that currency can earn
more compared to other currencies.
 Inflation will go down, because in general saving is up and spending is down and people
are buying less.

The opposite would be expected for each point if interest rates go down.

This gets very complex because 'relatively go up' or 'relatively go down' are very loose
relationships and many factors impact decision making also (i.e. taxes & employment rates).
Then the impact of the policy decisions of other countries have to be considered also as they
impact what happens to a countries economy also.

In theory, macroeconomics can be easy because for each change in a relevant figure it can be

8
assumed that if all other factors are constant, this is what would happen. In reality, all of the
factors are constantly shifting and enacting macroeconomic policy is very difficult to manage.

1.1.4 The use of graphs and equations

Economics is a social science that attempts to understand how supply and demand control the
distribution of limited resources. Since economies are dynamic and constantly changing,
economists must take snapshots of economic data at specified points in time and compare
them to other fixed timed data sets to understand trends and relationships. To understand the
relationships between these variables, economists use graphs to visually interpret and explain
complex ideas.
Time
Since economists take snapshots of data, a graph of these data points helps to illustrate the
movements and trends over time. Sets of information written on paper are hard to translate
into understandable bits of information. However, when economists put information on a
graph, it is easy to see if over time the data is increasing, decreasing or stagnant. For example,
a data set of gas prices over time could be plotted on a graph to quickly see when prices were
increasing and when they were decreasing.
Relationships
Graphs in economics can show the relationship between two variables. For example, a classic
economic graph would be the cost of a product on one axis and the amount purchased on the
other axis. This graph would illustrate how much goods would be purchased at different price
points. This graph could help a company determine how much of a good to produce and where
to price their product for maximum profit.

1.1.5 Production possibility frontier, efficiency and opportunity cost.

Once we understand the concept of Scarcity, Choice, and opportunity cost, let’s now see what
we mean by efficiency and production possibility. We are exactly at the center of truth to
conclude that economics is a science of efficiency. To realize efficiency, an economy must
achieve both full employment and full production.

Full employment: - refers to the maximum use of all available resources (factors of
production). It means that no labor (worker) should be involuntarily out of work (unemployed).
i.e., the economy should provide employment for all who are willing and able to work. In
addition, no capital and land should sit idle, ceteris paribus.

Full production: - The employment of all available resources is a necessary but not sufficient
condition to achieve efficiency. Full production must also be realized. By full production, we
mean that all the employed resources shall be used so that they provide the maximum possible
satisfaction of our material wants.

9
 In this case, two types of efficiency are considered:

- Productive efficiency is the production of any particular mix of goods and services in
the least costly way.
- Allocate efficiency is the production of that particular mix of goods and services that
the society wants most.
Since resources are scarce, a full employment, full production economy cannot have an
unlimited output of goods and services. Therefore, people must choose which goods and
services to produce and which to forgo. The necessity and consequence of these choices can
be best understood through the production possibility model.

Production possibility Curve (Frontier)-is a curve or graph that shows the various
combinations of goods and services that can be produced in a full employment, full
production economy in which case the available resources are fixed and technology is
constant. The PPF also depicts the maximum amount of one good that the society can
produces given the output level of the other good. Thus, it illustrated the scarcity, choice and
opportunity cost

Assumptions of the PPF model:

1. Two products: -for simplicity, the economy is assumed to produce only two products:
bread, a consumer good and machine, a capital good to produce (bake) the bread.
2. Fixed resources: - The quantity and quality of economic resources available for use
during a certain period are fixed. This means both the quantity and quality of labor,
Land, Capital, and Entrepreneurship are fixed.
3. Fixed technology: - the state of technology-the methods used to produce goods and
services-does not change during specific (given) period of time. However, it would be
unlikely for technology to remain fixed in the long run.
4. Efficiency: - The economy is operating at full employment and achieving full production.
I.e., No resource must sit idle and the employment of these resources must provide us the
maximum possible output level.
5. Possibility of reallocation/shifting of resources: Nevertheless, both the quality and the
quantity of economics resources are fixed, they, within limits, can be shifted or
reallocated among different uses. Example, a plot of land can be used for factory site or
food production. Relatively unskilled laborer can work on a farm, at a fast-food restaurant
or in a gas station.

As a starting point to plot the PPF, let’s see the production possibilities table. This shows
(refers to) the schedule of different combination of two commodities that can be produced by
fully employing available resources within the limits of fixed technology and resources.

10
 Table 1 Production Possibilities schedule

Commodity Production possibilities

type
A B C D E
Machine 100 90 70 40 0
Bread 0 10 20 30 40

Given the above hypothetical production possibilities schedule, the economy has five (5)
production possibilities. At alternative A, the economy would be devoting all its available
resources to the production of Bread (consumer good); at alternative E, the economy insists
in devoting all of its available resources to produce Machine (Capital good). While these are
un-realistic extremes (alternatives A and E), an economy typically produces both consumer
and capital goods (on alternatives B, C, and D).

Transforming the production possibilities schedule in to Production Possibilities Frontier

A
(Curve), we place capital goods (Machine) on the vertical axis and consumer goods (bread) on
the horizontal.
100
B
90
G
C
70
Machine
Units of

60

F
D
40

30
W

10 20 30 40
11
Bread
(No of Loaves)
Figure 1; ppf model
Each point on the production possibilities curve represents some maximum output of the two
products. The curve is a production frontier because it shows the limit of attainable outputs.
Given the PPF:
Any combinations of the two commodities ON or WITHIN (to the left of) the curve are attainable
combinations. Example points B with a combination of 10 Bread, and 90 Machine and point F
with combination of 20 Bread and 40 Machine are all attainable Combinations.
To produce ON the production possibilities frontier (points A, B, C, D, W and E), a society must
achieve both full employment and full production, i.e. a society is said to be efficient when it
cannot produce more of one good without producing less of another. This happens when the
society produces on the PPF. An efficient economy produces on the PPF because it cannot
produce more of one good without reducing production of another good. Example, point B lies
on the PPF (indicating a combination of 10 loaves of Bread and 90 machines); it means that the
society is producing efficiently. If the society wants to produce more bread, say 20 loaves
Bread, the society is forced to reduce its production of machine from 90 to 70. Thus, we say
that the society is efficient at point B (and also at points A, C, D, W and E)
Points inside the PPF (to the left of PPF) indicate that the combination is attainable but
inefficient. Points inside the PPF imply that the economy could have produced more of both
machine and bread (or at least one of them) if it achieved full employment and productive
efficiency. In other words, points that lie inside (With in) the PPF reveal that there are some idle
(unemployed) resources and /or the society is not producing at the least cost possible.
Example, Point F lies inside the curve, where the society produces 20 loaves of bread and 40
machines. In this case, the society is inefficient. Had there been full employment and full
production, the society could have produced more of at least one of the goods (say a shift from
point F to points C or D) or more of both goods (a shift from point F to point W).

Points outside the curve, such as point G, are unattainable within the premise of existing
technology and available resources. Point G is unattainable because either the resources are
not available or the state of technological progress prevents the resources from being used
efficiently. Point G can only be achieved by increases in resource supply and quality, and
technological advance, or in general economic growth.
On net, there are four important concepts embodied in the PPF or PPC illustrates four
important concepts:

12
 A) Scarcity: The frontier depicts the maximum combinations of two goods that the
society can produce given the resources and technology. Unattainable points, like
point G, outside the PPF indicate the inevitability of scarcity. The point is that society
cannot have unlimited amount of output even if it employs all of its resources and
utilizes them in the best possible way.
B) Choice: - choice among outputs is reflected in the need for society to select among
the variety of attainable combinations of goods lying along the curve. Any movement
on the curve indicates the change in choice. Taking the above PPF as a reference,
let’s consider points B and D. If the society chooses to produce at point B, at the same
time, it is choosing to have more machine and fewer loaves of bread. Similarly, if it
chooses to produce at point D, the society is choosing to have more bread and fewer
machines. Choice is indicated in the graph by the movement along the curve either
downward or upward (i.e. from point A to B to C to D or to E or vice verse).
C) Opportunity cost-: when the economy produces on the PPF, production of more of
one good requires sacrificing some of another good. The downward (Negative) slope of
the PPF implies the notion of opportunity cost. Opportunity cost of a given product
is the amount of some other product, which must be forgone or sacrificed to
obtain some amount of that given product. Example, In moving from point B to
point C in the above PPF, 20 units of machine must be given up (forgone) in order to
obtain 10 additional loaves of bread. Thus, the opportunity cost is given by:
Opp cost = Units given up of one good
Units obtained of another good
20
In our case, Opportunity cost = 10 =2
The Interpretation is: - In order to obtain 1 additional loaf of bread, 2 units of machine must
be sacrificed. I.e., the Opportunity cost of obtaining 1 additional loaf of bread is 2 units of
machine.
D. Increasing opportunity cost/concavity – The concavity of the PPF reveals increasing
opportunity cost. The Law of Increasing Opportunity cost indicates the shape of the PPF is
concave or bowed outward. This reveals that the slope is increasing in either direction, which
means the amount of one good we have to give up in order to obtain the other good increases
along the curve.

The Law of Increasing Opportunity Cost states as more and more of a particular commodity is
produced, the opportunity cost of each additional output increases.
What is the economic rationale for the law of increasing opportunity cost?
- Economic resources are not completely adaptable to alternative uses OR
- Resources are not perfectly substitutable.

13
Restating, it is important to note the rationale behind the Law of Increasing Opportunity Cost.
Increasing opportunity cost and the outward bowed shape (concavity) of the PPF arises from
the fact that scarce resources are not equally productive in all activities, i.e. economic
resources are not completely adaptable to alternative uses or many resources are better at
producing one good than at producing others.

Taking the above PPF as a reference, let’s exemplify the concept of increasing opportunity cost.

Table 2 the Law of Increasing Opportunity Cost

Movement Opportunity cost of Opportunity cost of producing
along the curve producing one loaf of bread one unit of machine
1
From: A to
B
B to 2
C
C to 3
D
D to 4
E
From: E to ¼
D
D to ⅓
C
C to ½
B
B to 1
A

Economic Growth and the PPF

By economic growth, we mean an increase in the real output level of an economy over time.
Causes/ingredients of economic growth
I. Supply factor/ ability to grow
-quantity and quality of economic resources
-stock of real capital
-state of technology
II. Demand factor-in order to realize its growing productive potential, a nation must
provide for the full employment of its expanding supplies of resources. This refers to
the aggregate demand.

14
 III. Allocative factor- to achieve its productive potential, a nation must provide not only
for the full employment of its resources but also for full production from them. It
refers to good and effective policy.

Thus, increases in total output level occurs when there is an increase in the quantity and /or
quality of economic resources such as labor, natural resources, capital, etc. and advance
(progress) in technology, i.e. when methods or techniques of production are improved.

Original PPF
Capital

New PPF
goods

Economic
Growth
PPF2
Recession

PPF1

Consumer goods

The increase in total real output (economic growth) is reflected by the outward (rightward) shift
of the PPF. When economic growth is realized, the production possibility frontier shifts outward
to the right (from PPF1 to PPF2).

1.2 Basic economic problems and the economic system

1.2.1 Basic economic problems.
There are three important economic problems/ questions

1. What / when/ where/ how much to produce? - This is the problem of choice between
commodities. Answering this question amounts to determining the type (kind) of goods and
services and their respective quantities that society chooses to produce with the limited
resources available.
This concept includes questions like what should the society produce? Should it produce
consumer goods (food, Television, Car, etc) or capital goods (machinery, building, etc)? Should
the scarce resources be allocated to civilian or military equipment?

15
 In a market economy (Capitalist economy) the function of what to produce is accomplished by
the price system (by the forces of demand and supply). In this case, consumer sovereignty is
guaranteed.

2. How to produce? – This is a question related to the technology and organization of

factors of production. This refers to the technology of production i.e., to the way in which
resources or inputs are organized to produce goods and services. The choice of optimum
technical process that makes the maximum use of abundant resource is the nucleus of this
concept. Should the society adopt labor-intensive technique of production (techniques that use
large labor) or capital-intensive (the technology that makes maximum use of capital) techniques?
While the price mechanism determines the solution in market economy, this question is
answered by the decision of central authorities in the command economy.
3. For whom to produce? – This is the problem of distribution and consumption. It refers
to the way through which the output produced can be distributed among the members of
society. This is concerned with the distribution of national output among the various
factors of production (Land, Labor, Capital, and entrepreneurship).
In the market economy (free-enterprise economy), the price system determines the
distribution pattern of national output among the various society’s members or factors of
production. As modern governments are welfare-oriented, they often interfere to make the
pattern of output (income) distribution more efficient and equitable.

1.2.2 Alternative economic systems

An economic system is a set of organizational and institutional arrangements and coordinating
mechanisms established to answer the three basic economic questions. There are three economic
systems.

i. Pure capitalism/ Laissez-faire system

ii. Command/ socialist/ planned system
iii. Mixed/ realism/ hybrid system

Pure capitalism. In such market system, each decision-making unit acts in its own self-interest.
The system allows private ownership of factors of production. In such an economic system, the
basic economic questions are solved by the price system (the forces of demand and supply).
Advocates of this system hold that there is no need for government to intervene in the smooth
operations of the economy rather government shall limit itself to the protection of private
property and to the provision of public goods such as defense, police protection, and provision of
appropriate environment for the operations of the market system. There is not any country in the
world that is purely capitalist. The specific characteristics of the system;
1. Market determination
2. Freedom of enterprises and consumer sovereignty
3. Private ownership of resources

Consumer sovereignty is the idea that consumers ultimately dictate what will and will not be produced by
deciding what to and not to purchase.

16
 4. No/little government intervention
5. Competition and independence
6. Specialization
7. Role of self-interest/ individualistic system
8. Profit motives
9. High inequality/ high marginality
10. High hidden unemployment

Command system: - this system is also known as communism. The synonyms are used to
describe the general doctrine that people (the government) should own and administer means of
production. Unlike capitalism, command economy is characterized by:
* Public ownership of property (factors of production)
* Economic activities are coordinated and directed by the government through central planning.

The fundamental economic questions are answered by the decisions of the central economic
planning board appointed by government. The former USSR (Soviet Union) and the then North
Korea and Cuba are the best examples of centrally planned economies. Our country during the
Dreg- regime had also more or less adopted command economy.

Fair distributions of income, Absence of private monopolistic exercise, absence of business

fluctuation are the advantages of this system while economic inefficiency through unnecessary
regulation of the market is the major disadvantage. Specific characteristics of the system;
1. Central planning board determination
2. Authoritarian/restrictive policy i.e. no freedom of enterprises and
consumer sovereignty
3. Public ownership of resources
4. High government intervention
5. No-competition and inter-dependence
6. No-Specialization
1. Role of social-interest/ collectivism system
2. social motives
3. High equity/ low marginality between the rich and the poor
4. low hidden unemployment

Mixed economy. “The market needs the state as much as the state needs the market” is the base
of mixed economy. In mixed economy, the strong elements of both capitalism and socialism are
hybridized.

In this system, the government actively participates in the distribution of income, correcting
market failures, provision of public goods, stabilizing and directing the economy by establishing
an appropriate environment for the private sector.

In such a system, both the government and the market mechanism answer the fundamental
economic questions. While the allocation of resources is largely determined by the price system
(market mechanism), government plays an important role in determining aggregate output,
employment, distribution of income, controlling inflation, and others through various policies. In
mixed and capitalist system, consumer sovereignty is guaranteed.

17
Most modern economies of the world are mixed; such as Germany, U.S.A, UK, South Africa,
Ethiopia, Japan, China, and many others.

1.2.3 Decision making units and the circular flow of economic activities
Households own the labor, the capital, the land & the natural resources that business
firms require to produce the goods & services households want.
Business firms pay to households’ wages, salaries, interest, rents & so on for the
services & resources that households provide.
Households then use the income that they receive from business firms to purchase the
goods & services produced by business firms. The incomes of households are the
production costs of business firms. The expenditures of households are the receipt of
business firms. The so called circular flow of economic activity is complete.

1.2.4 T
yp
es
of

Business organizations

2. Micro-economics
2.1 Supply and demand
2.1.1 Demand theory
Market analysis

A market is the network of communications between individual & firms for the purpose of
buying & selling goods & services.

A market can, but need not, be a specific place or location where buyers & sellers actually
come face to face for the purpose of transacting their business.

There is a market for each goods, service or resource bought & sold on the economy.

18
Some of the markets are local, some are regional and others are national or international in
character.

Perfectly competitive market & one in which no buyers & sellers can affect the price of the
product, all units of the products are homogeneous or identical, resources are mobile and
knowledge of the market is perfect.

A market demand schedule is a table showing the quantity of a commodity that consumers are
willing & able to purchase over a given period of time. At each price of the commodity, while
holding constant all other relevant economic variables on which demands depends (the ceteris
Paribas assumption).

Market demand curve D shows that the lower hamburger price, greater quantities are
demanded this is reflected on the negative slope of the demand curve & is referred to as the
“law of demand”.

The lower prices, greater quantities of hamburgers are demanded. This is true for most
commodities.

Lower commodity prices will also bring more consumers on to the market.

The inverse price – quantity relationship (indicating that a grater quantity of the commodity is
demanded at lower prices & smaller quantity at higher prices) is called the law of demand.

19
The price per unit of the commodity is usually measured along the vertical axis, while the
quantity demanded of the commodity per unit of time is measured along the horizontal axis.

- Definition of demand
Demand in economics has different meaning as compared to our day-to-day use. Demand is
different from a simple want. The list of goods consumers want is quite different from the list
of goods they demand. The conditions for a demand to exist are: desire (want) to use a
resource, willingness to buy, and ability to pay.

Demand in economics is defined as a schedule, which shows the various amounts of a

product which consumers are willing and able to purchase at each specific price in a series of
possible prices during some specified period of time in a specified market. It shows the
quantities of a product which will be demanded at various prices, all other things being equal
(ceteris paribus assumption). The quantity demanded is the amount of a good or service
consumers are prepared to buy at a given price (during a specified time period), holding
other factors constant. As we can see from the definition of demand, it is possible to identify
the following important elements:
 Purchaser or demander for goods and services.
 Seller or supplier of goods and services.
 Products/ goods and services.
 Time
 Prices
 Willingness and ability. Willingness alone is not effective in the market. Willingness
should be backed by ability. For instance, I may willing to buy a car but my ability
may not permit to do so.

- Demand schedule
- Demand schedule is a tabular presentation of the demand for a commodity. It shows
the quantities of product that a household would be willing to buy at different prices.

Price/hamburger Quantity
demanded/day

$ 2.00 2
$ 1.50 4
$ 1.00 6
$ .75 7
$ .50 8

A market demand schedule is a table showing the quantity of a commodity that consumers are
willing & able to purchase over a given period of time. At each price of the commodity, while
holding constant all other relevant economic variables on which demands depends (the ceteris
Paribas assumption).

20
Market demand curve D shows that the lower hamburger price, greater quantities are
demanded this is reflected on the negative slope of the demand curve & is referred to as the
“law of demand”.

The lower prices, greater quantities of hamburgers are demanded. This is true for most
commodities.

Lower commodity prices will also bring more consumers on to the market.

The inverse price – quantity relationship (indicating that a grater quantity of the commodity is
demanded at lower prices & smaller quantity at higher prices) is called the law of demand.

The price per unit of the commodity is usually measured along the vertical axis, while the
quantity demanded of the commodity per unit of time is measured along the horizontal axis.

Factors Influencing Demand

When we were taking about demand curve the assumption was that price is the most
important determinant of the amount of any product purchased. That is, price was the only
factor considered. It was assumed that other non-price (non-own-price) determinants of the
amount demanded are constant. When these non-price determinants of quantity demanded
are allowed to vary the location of the demand curve will be affected. Depending on the
nature of change these non-price determinants the new demand curve will shift either to the
left or to the right of the original demand curve. Generally, there are two determinants.
 Own-price determinant/demand mover-the price of the product
 Non- Own-price determinants/demand shifters
 Preference/tastes of consumers
 Money income of consumers
 Price of related goods
 Number of consumers
 Consumer expectation w.r.t. future price and income

21
  Culture, religion and government policy.
These determinants of demand are also called demand shifters. The major non-own-price
determinants of demand are:
1. The income of consumers (level of income of consumers)
It refers to the amount of money consumers has to spend in the market for a given period of
time. Since effective demand is the desire to buy a good backed by the ability to do so, it is
obvious that there must be a relationship between the demand for a firm’s product and the
consumer’s income (purchasing power).

The nature of the relationship between income and demand will depend upon the type of
product considered and the level of consumers’ income. Other things being equal, for most
commodities, an increase in income (purchasing power) will cause an increase in demand.
Conversely, the demand for such products will decline with a decrease in income. Such
goods or services whose demand varies directly with money income are called superior or
normal or luxury goods or services.

As income increases beyond some level, there are goods whose demand decreases. Such
goods are termed as inferior goods. The demand for inferior good is inversely related to
income. At low level of income people will tend to consume large amounts of these products
but, as their income rise, they will buy other quality goods, which are close substitutes. For
example, beans by meat, which is high protein food. However, the goods are not inferior by
nature, it is the commodity’s relationship with income which is inferior.
Quantity (Q)

Line a - Income-demand curve for normal goods. Demand Ccrises continuously with income.
The graph tends to flatten out at higher levels of income because people will not
want more and
0 more luxury goods. For normal goods the income demand curve will
Income (Y)
flatten very quickly as people reach their desired level of consumption.
Line c - Income-demand curve for inexpensive foodstuff such as salt, demand tends to
remain constant at all but the very lowest level of income.

Line b - is that demand will decline as income increases. Such products are termed inferior
goods. At low levels of income people will tend to consume large amounts of these
products but, as their income rise, they will buy other better substitutes. The
demand for inferior goods behaves like the demand for normal goods at lower levels

22
 of income. All inferior goods start out as normal goods and only become inferior as
income continues to rise.

2. Price of other related goods

The demand for all goods is interrelated in the sense that they all compete for consumes’
limited income. The effect of the change in the price of other related goods is dependent on
the nature of the relationships between the goods in consideration. The are two particular
interrelationships of demand which may be quantified,

a. Where goods are substitutes one for another

b. Where goods are complementary.

Two goods are substitutes if they satisfy similar needs or desires. With substitutes, the
demand for one rises as the price of the other rises or the demand for one falls as the price of
the other falls, assuming the other factors being constant. For example, for many people
butter is a substitute for cooking oil; thus if the price of butter rises, consumers will purchase
a smaller amount of butter, and this will cause the demand for cooking oil to increase or the
vice versa assuming the price of cooking oil and other factors are constant. Generally, when
goods are substitutes, the price of one good and the demand for the other are directly related.

Price of good Y Py
Price of good Y Py

Dx

Dx

0 Quantity demanded of X
0
Quantity demanded of X

A) If X and Y are Substitute goods B) if X and Y are complementary

goods

Complementary goods are those goods that are jointly consumed or demanded. With
complements, the demand for one rises when the price of the other falls and the demand for
one falls as the price of the other rises. Thus if two goods are complements, the price of one
good and the demand for the other are inversely related.
3. Tastes, preferences, habits and customs
These are usually subjective and changing. Positive taste and preference favor the demand
for a commodity. A change in favor of a good shifts the demand curve rightward. A change

23
in preferences away from the good shifts the demand curve leftward. This is only within the
limits of the market constraints, price and income constraint.

4. Change in number of buyers

The demand for a good or service in a particular area is related to the number of buyers in
the area. Since the market demand for a good or service is the sum of all individual demands,
an increase in the number of buyers in a market increases demand. Increase in the number of
buyers could be due to expansion of markets which could be caused by expansion of
transport system to rural areas and/or due to improvement in life expectancy, migration, and
increase birth rate and so on.

However, fewer buyers mean lower demand for a product. Number of buyers could be
reduced due to trade restriction.

5. Seasonal factors
The demand for many products is influenced by the season. Example, demand for cloth
during holidays; demand for meat during fasting period

6. Expectation of consumers about future income, price and product availability affects
demand. If consumers expect increase in price of a commodity in the future they will
buy more now though this is dependent on the cost of storage and the availability of
money to do the purchase now. Current demand depends heavily on long-term
expected income. Expectation of rise in future income may initiate consumers to
increase their current spending. It makes them more liberal in their spending
behavior.

7. Culture: Religious or traditional taboos for some products- either seasonal or

permanent.
8. Government influences: prohibitions or restrictions of some goods decrease the
demand.

In real life these and other factors act simultaneously to determine the demand for a
commodity.
Summary note:
Increase in the demand for a commodity “A” can be caused by:
1. A rise in income if “A” is a normal good or a fall in income if “A” is an inferior good
2. An increase in the price of related good “B” if “B” is a substitute for “A” or a decrease in
price of related good “B” if “B” is a complement to “A”.
3. A favorable change in consumer tastes or preferences
4. An increase in the number of buyers in the market
5. Expectation of future increase in incomes, prices, and expectation of shortage of a
commodity in the future.
Conversely, a decrease in the demand for “A” can be associated with:

24
1. A rise in income if “A” is an inferior good or a fall in income if “A” is a normal good.
2. An increase in the price of related good “B” if “B” is complementary to “A” or a decrease in
the price of related good “B” if “B” is a substitute for “A”.
3. An unfavorable change in tastes or preferences
4. A decrease in the number of buyers in the market.
5. Expectation of future price and income decline and expectation of future supply increase.
 The entire demand curve for a commodity would shift with a change in
1. Consumers incomes
2. Their tastes
3. The price of related commodities high or
4. The number of consumers on the market (the variables held constant in drawing a
market demand curve).
For example, with a rise in consumer income the demand curve for most commodities
(normal goods) shift to the right, because consumers can then afford to purchase more
of each commodity at each price.
 A demand curve also shifts to the right, if the price of a substitute commodity rise, or of
the price of complementary commodity falls.
 On the other hand, the demand curve for a commodity usually shifts to the left (so that
less of it is demanded at each price) with a decline in consumer income, the price of
substitute commodities, or the number of consumers in the market.
 The demand curve also shifts to the left of the prices of complementary commodities
rises or if consumer tastes change so that they demand less of the commodity at each
price.
 A shift in demand is referred to as a change in demand & must be clearly distinguished
from a change on the quantity demanded. Which refers instead to a movement along a
given demand curve as a result of a change in the commodity price.
 Thus, the shift demand from D to D 1 is an increase in demand, while the movement a
long D, say, from point E to point F, is a change in the quantity demanded.
 The change in demand is caused by the change in the economic variables that are held
constant in drawing a given demand curve (the ceteris paribus assumption), whereas a
change in the quantity demanded is a movement along a given demand curve as a
result of a change in the price of the commodity (with all the other economic variables
on which demand depends remaining constant).
 Consumers demand more hamburgers at each price when the demand curve shifts to
the right from D to D 1. Thus, at P=$1.00, consumers purchase 12 million hamburgers
with D1 instead of only 6 million with D.

25
 - Curve and functions
2.1.2 Theory of supply
- Definition of supply
- Supply schedule
- Curve and functions
2.1.3 Perfectly competitive market
2.1.4 Market equilibrium
2.1.5 Elasticity of demand and supply
2.2Theory of production and cost
2.2.1 The short and long-run
2.2.2 Short-run production functions (total, average and marginal

2.1.2 Theory of supply

- Definition of supply
Market Supply

Supply of a commodity can be defined as the quantity that producers are willing and able to
offer for sale in a given time period. In other words, from individual producer’s point of
view, supply is a schedule, which shows the various amounts of a product, which a producer
is willing and able to produce and make available for sale in the market at each specific price
in a series of possible prices during some specified time period.
Supply tells us the quantities of a product, which will be supplied at various prices, all other
factors being held constant. Like demand supply is a flow of goods and services.
The Supply Schedule:
It is a tabular presentation of the supply for a product. It shows a series of alternative price-
quantity supplied combinations. In other words, it lists the quantities supplied at each
different price, when other non-price factors are held constant.
It assures that technology, resource prices, and, for agricultural commodities, weather
conditions are held constant (the ceteris paribus assumption).

Higher hamburger prices allow producers to bid resources away from other uses & supply
schedule greater quantities of hamburgers.

The various price-quantity combinations of a supply schedule can be plotted on a graph to

obtain the market supply schedule curve for the commodity.

The positive slope of the supply schedule curve (i.e, its upward to the right inclination reflects
the fact that higher prices must be paid to producers to cover rising marginal, or extra, costs &
thus induce them to supply schedule greater quantities of the commodity.

26
At the price of $ 0.5 per hamburger, the quantity supplied is 2 million hamburgers per day
(point R)

If instead the price in $ 0.75, the quantity supplied is 4 million hamburgers (point N), and
soon.

A supply curve also shows the minimum price that the producers must receive to cover their
rising marginal cost & supply schedule each quantity of the commodity.

Market supply schedule for hamburgers

Price/hamburger Quantity
Supplied/day

$ 2.00 14
$ 1.50 10
$ 1.00 6
$ .75 4
$ .50 2

Figure: Market supply curve for hamburgers

 Marketing supply curve S shows that higher hamburger prices induce producers supply
greater quantities.

Law of Supply:
The law of supply shows the behavior of suppliers - those that at the receiving end in a
market. The law of supply can be stated as follows:

27
Other things being equal, the higher the price of a good, the greater is the quantity supplied,
i.e. price and quantity supplied is directly related. As price rises, the corresponding quantity
supplied rises; as price falls, the quantity supplied also falls. (See the hypothetical example
above). This means producers are willing to produce and offer for sale more of their products
at a high price than they are at a low price. Why? Possible reasons could be the profitability
argument, due to new suppliers coming in to the business, and due to diminishing marginal
returns occur in production process.

Suppliers are on the receiving end of the product’s price. To them, price is revenue per unit
and therefore, is an incentive or inducement to produce and sell a product. The higher the
price of the product, the greater will be the incentive to produce and offer it in the market.
Individual versus Aggregate (Market) Supply
So far the concept of supply was illustrated based on an individual producer of a product. An
individual supply curve represents the price-quantity combinations for a single seller (or
firm). However, in the real world markets there are many producers or suppliers of the same
product. Therefore, like in the case of demand, it is important to see at the aggregate or
market supply. The market supply is simply the horizontal sum of the individual supply
curves. The market supply curve represents the price-quantity combinations for all sellers of
a particular product.

Factors Influencing Supply

Like demand, supply depends on many factors besides the price of the product. The major
ones are the following:

1. Change in price of inputs (factors of production)

Inputs are the things that are used in the production of goods and services. Change in the
price of inputs directly affects the cost of production.
Input costs = cost of production = units of inputs used X Respective prices
Therefore, there is close relationship between cost of production and supply.

An increase in the price of a factor will increase the cost of production of a firm. For a
particular commodity, when the costs of production are low, relative to market price, then it
will be profitable for producers to produce a great amount. When production costs are
varying high relative to price, producers will produce little (or may stop producing). This
lowers supply. A decrease in supply is shown by a shift of supply curve to the left of the
original; where as an increase in supply is shown by shift to the right.

2. Change in the level of technology

The state of technology affects the efficiency of production. Usually advancement or
improvement in technology allows producers to reduce their cost of production per unit of
output. This would therefore, have the effect of shifting the supply curve to the right.
However, the effect of technology on supply tends to be a long-term.

28
3. Change in the price of other goods within the producer’s production plan
Most producers produce or have the capability to produce more than one product. The
decision of how much of each product to produce (how to allocate the available resources
among the different goods within the production plan) depends on the profitability of the
other (s).

The effect of change in price of one good on the supply of the other(s) depends on the nature
of the relationships between the goods under consideration. The goods can be production
substitutes or complements.

Production Substitutes are those that might compete with the good for the scarce resources
on the farm or during production process. So if the price of an alternative product rose we
could expect its profitability to rise and so the farmer or producer might move some of his
resources out of their present use into the production of alternative. Therefore, two products
are substitutes in production when an increase in the price of one product causes a reduction
in the price of the supply of the other product.

E.g. Wheat and Barley

Let a farmer allocates his 1ha of farmland for the production of these two products on 50-50
bases on the first instance. Any change in the price of one will have an effect on the supply
of the other, i.e., the quantity of wheat produced will depend on the price of barley and the
quantity of barley will depend on the price of wheat.

If the farmer is profit oriented, with an increase in the price of barley, the farmer will take
out some part of the wheat land for the production of barley. This leads to the decrease in
the supply of wheat assuming there are enough time for readjustment and no change in the
price of wheat. The reverse is also hold true.

Generally, if the price of one production substitute rises, this will decrease the supply of
other substitute.
Production Complements are those goods that are produced together or jointly, or one is a
by-product of the other product. Their production process is inseparable. Generally, two
products are complements in production when an increase in the price of one product causes
an increase in the supply of the other product. If for instance the quantity of beef increased
due to increase in the price of beef in a market, then we would expect the supply of hides to
rise as well. Similarly barley and straw; milk and butter; mutton and skin are produced
together.
4. Change in the level of taxes and subsidies
Taxes are deductions from the profit of producers or they are additional costs to producers.
So their effect is similar to increase in cost of production. Subsidies, however, are opposite of
taxes. Subsidies are expense for the government or society but deductions from the cost of

29
 production to the individual producer. The government, for instance, subsidies on fertilizer
products.
5. Number of Suppliers
The larger the number of suppliers the higher will be the volume of supply, other things
being constant.
6. Nature, especially weather and pests
Bad weather, pests and disease can greatly reduce supplies of agricultural products, while
good weather and absence of pests can greatly assist in increasing yields and hence supply.
7. Expectation of producers with regard to future price and other specific factors
Change in Supply versus Change in Quantity Supplied

Change in Supply
Change in supply is a total change in the location of the supply curve. The change or shift in
supply could be an increase or a decrease. It is caused by change in any of the non-price
supply shifters or determinants. An increase is shown using supply curve, by shift to the
right of the initial. An increase in supply happens when, due to changes in one or more of
the non-price supply shifters, the amount supplied increases at each market price.
Change in quantity supplied
This is movement from one point to another point on a stable supply curve (the original
supply curve). It is caused by a change in the price of the specific product under
consideration.

S2
C
P3
S3
P1
A
P1
P2
B

S1

0 q2 q1 q3 Qs q2 q1 q3 Qs
0

a) Change in supply (shift of the supply b) Change in quantity supplied

Curve from S1 to S2 or S3) (movement from A to C or B)
An improvement in technology, reduction in the price of resources used in the production of the
commodity, and, for agricultural commodities, more favorable weather conditions (i.e. a change in

30
the ceteris paribus assumptions) would cause the entire supply schedule curve of the commodity
to shift to the right.
The shift to the right from S to S1 is referred to as an increase in SS.
On the other hand, a decrease in supply schedule refers to a left ward shift in the supply curve &
must be clearly distinguished from a decrease in the quantity supplied of the commodity (which is a
movement down a supply schedule and results from a decline in the commodity price).
When the supply curve shifts to the right from s to s 1 products supply more hamburgers at each
price. Thus, at p = $ 1.00 producers supply 12 million hamburger with s 1 instead of only 6 million
with s.

2.1.3 Perfectly competitive market

Take a minute to imagine that your greatest desire is to own your own business.
Because you know that starting your own business is often a daunting task that
involves a lot of hard work and struggle, you decide to look for products that are
almost sure to sell, therefore, trying to minimize the risk of your business failing. After
hours of research, you realize that you must sell a product that has a perfectly
competitive market.

So what is a perfectly competitive market exactly? Well, a perfectly competitive

market is a market where businesses offer an identical product and where entry and
exit in and out of the market is easy because there are no barriers. In the example
from earlier, when starting your own business in a perfectly competitive market, you
would need to sell a product that is identical to the products that other businesses are
selling so that you can enter the market more easily.

Characteristics

31
 Let's look at a list of characteristics that are often found with a perfectly competitive
market:

1. In a perfectly competitive market, there are multiple firms.

2. Knowledge is available to everyone. Basically, for the new potential business
owner from earlier, when entering a perfectly competitive market, all of the
information is perfect, with no failure or time lags.
3. There are no barriers to enter the market. There are also no barriers to exit the
market. This means that a firm can enter and exit the market freely.
4. The products firms produce are identical. This means that every firm is creating
the exact same product.
5. One firm cannot control the market or its conditions. In other words, no firm
has the power to influence the market and therefore the price received for
products is the result of the whole industry.

2.1.4 Market equilibrium

When is a market in equilibrium?

Equilibrium Price
It is the price at which the wishes of buyers and sellers coincide. The price that exists when
the quantity demanded equals the quantity supplied in a given market for specific time
period. Graphically, this is represented by the level of price that exists at the point of
intersection of the demand curve and supply curve when they are superimposed on the same
graph ( PE on the above graph).
At any price above the equilibrium price, suppliers want to sell more than consumers want
to buy and a surplus will result; at any price below the equilibrium price, consumers want to
buy more than producers are willing to offer for sale as is evidenced by the consequent
shortage.

The equilibrium price level is also called the market-clearing price. Because at this price level
all what is supplied will be purchased by consumers and there will not be any surplus or
shortage.
The process by which equilibrium is reached in the market place can be shown with a table &
illustrated graphically.
Thus, p = $ 1.00 is the equilibrium price & Q = 6 million hamburgers per day is the equilibrium
quantity.

At price above the equilibrium price, the quantity supplied exceeds the quantity demanded & there
is a surplus of the commodity, which drives the price down.

32
At the lower prices, producers supply smaller quantities & consumers demand larger quantities
until the equilibrium price of $ 1.00 is reached, at which quantity supplied of 6 million hamburgers
per day equals the quantity demanded & the market clears. On the other hand, at prices below the
equilibrium price, the quantity supplied falls short of the quantity demanded & there is a shortage
of the commodity, which derives the price up.

The intersection of the market demand curve & the market supply curve of hamburgers at point E
defines the equilibrium price of $ 1.00 per hamburger & the equilibrium quantity of 6 million
hamburgers per day.
At higher prices, there is an excess supply or surplus of the commodity (the top shaded area in the
fig.). Suppliers then lower prices to sell their excess supplies.
The surplus is eliminated only when suppliers have lowered their price to the equilibrium level.
On the other hand, at below equilibrium prices, the excess demand or shortage (the bottom shaded
area in the fig. drives the price up to the equilibrium level. This results because consumers are
unable to purchase all of the commodity they want at below equilibrium prices & they bid up the
price.

Market supply, market demand schedule & equilibrium

Price/hamburger Q ssed/day Q dded/day Shortage(-)or Surplus(+) pressure on price

$ 2.00 14 2 12 down ward

$ 1.50 10 4 6

$ 1.00 6 6 0 Equilibrium

$ .75 4 7 -3

$ .50 2 8 -6 upward

Demand, supply & equilibrium

The intersection of demand & supply at point E defines the equilibrium price of $ 1.00
/hamburgers & the equilibrium quantity of 6 million hamburgers/ per day. At price larger than
$1.00, the resulting surplus will derive P down towards equilibrium. At price smaller than $
1.00, the resulting shortage will drive P upward
equilibrium.

33
Quantity supply = Quantity demand = 6 million hamburgers per day, & the market is in
equilibrium (clears). So both demand supply schedule play a role in determining price.
Equilibrium is the condition which, once achieved, tends to persist in time. That is, as long as
demand & supply don’t change, the equilibrium point remains the same.

Equilibrium Quantity
It is the quantity that corresponds the equilibrium price. In the above graph it is represented
by QE on the quantity axis. The quantity at which the amount of the good buyers are willing
to buy equals the amount sellers are willing to sell, and both equal the amount actually
bought and sold.
Disequilibria Price: A prices other than equilibrium price. A price at which quantity
demanded does not equal quantity supplied. A state of either surplus or shortage is in a
market

Effects of change in Demand and Supply on the Equilibrium State

Equilibrium price and quantity are determined by supply and demand. Any time either
demand or supply or both change, equilibrium price and quantity change. There are
different cases where this occurs.

Case I. Change in Demand Supply being Constant

i. Increase in demand, supply being constant
ii. Decrease in demand, supply being constant

Case II. Change in supply assuming that demand is constant

i. Increase in supply, demand being constant
ii. Decrease in supply, demand being constant

Case III. When both demand and supply change ( combined effect)
a. Supply and demand change in opposite direction ( in equal or unequal magnitude of
change)
i. When demand increases but supply decreases
ii. When demand decreases but supply increases
b. Supply and demand change in the same direction (in equal or unequal magnitude of
change)
I. Both demand and supply increase

34
 ii. Both demand and supply decrease

Limitation of the Market as a Resource Allocator

Is the market system the best means of responding to the fundamental questions? There is no
definite answer to the question.

There are cases in favor of the market system:

1. Allocate efficiency: the basic economic argument for the market system is that it
promotes an efficient allocation of resources.
- Resources are used to produce the most wanted goods from the
individuals point of view - forces producers to employ efficient technologies
2. Freedom- emphasis on personal freedom

However, there are also cases against the market system. These arguments stress on the
limitation of the market system:

1. Demise of competition: competition, the control mechanism of the system, tends to

decline overtime.
2. Inherent income inequalities, inability to register collective wants, and the presence of
external benefits and costs prevent the market system from producing that collection of
goods most wanted by society.
3. The competitive market system does not guarantee full employment or price level
stability.

These arguments emphasis that the pattern of consumption and production, which an
unhindered price mechanism, could result- in, is not optimum. Therefore, a preferable
pattern, preferable from society’s point of view, can be obtained by adjusting the solution
provided through the market to the fundamental problem of satisfying the wants of
consumers from the resources, which are available.

Example: Public Goods (Collective Goods)- these are goods and services wanted by the
society as a whole but which individuals through the market cannot finance. Highways,
national defense, education, etc. are commonly cited examples. The market system is
incapable of registering such social, or collective, wants.

35
 2.1.5 Elasticity of demand and supply
Definition:
Elasticity is a general concept that can be used to quantify the response in one variable when
another variable changes. It denotes the responsiveness of one variable to changes in
another. It is a measure of the responsiveness of a market to a stimuli (change in a variable).

Elasticity of Demand: Types and Determinants

So far the analysis has been concerned only with the direction of change in demand induced
by changes in either of its determinants (price, income, price of other related goods, etc.).
However, it is also important to determine how much the amount demanded will change in
response to a change in one of its determinants.

Elasticity is expressed numerically using an elasticity coefficient, an index independent of the

measurement units of the respective variables. This can be expressed for any explanatory
variable which can cause demand to change. There are various types of elasticity but here we
confined ourselves to two types only.
 Elasticity of demand
 Elasticity of supply

Most commonly, three types of elasticity of demand are computed:

1. Own-price elasticity of demand

2. Cross-price elasticity of demand
3. Income-elasticity of demand

In each case, the measure will be defined as the ratio of the proportionate change in the
quantity demanded for a particular good to the proportionate change in a specified
determinant of demand (price or income or price of related goods or services).

Own-price elasticity of demand: measures how sensitive or responsive consumers are to a

change in the price of the commodity under consideration other factors held constant. It is
the percent of change in the quantity of a good demanded that is induced by a one percent
change in price. It is the relative responsiveness of quantity demanded to changes in
commodity price; in other words, price elasticity is the proportional change in quantity
demanded divided by the proportional change in price.

Mathematically, the formula to calculate own-price elasticity of demand (Edp), or simply

called elasticity of demand, is given as follows:

Edp = Percentage change in quantity demanded

36
 Percentage change in price

Edp = Q / Qi = % Q
P /Pi %P

Where, Q = Change in quantity demanded

P = Change in price
Qi = Initial quantity
Pi = Initial price

This formula is called point-elasticity formula. It only applies to calculate elasticity when the
changes in price and quantity are infinitesimal (very small) change. The percentage changes
are calculated by dividing the change in price by the original price and the consequent
change in quantity demanded by the original quantity demanded.

Illustrative example: The use of percentage avoids the problem that can be caused by
different units of measurement.

The own-price elasticity will be non-positive (showing the fact that price and quantity are
inversely related) but the convention among economists is to ignore the sign and to simply
consider the absolute value of the elasticity coefficient. Its numerical value varies from zero
to infinity.

However, the point elasticity formula has problems in applying it for large changes (even for
changes from zero to any positive figure). Therefore, the mid-point (arc elasticity) formula is
used.

Mid- point formula

Edp = Change in quantity  Change in price

Average of quantities Average of prices

Edp = Q  P
(Qi + Qf)/2 (Pi + Pf)/2

Where, Q = Change in quantity demanded

P = Change in price
Qi = Initial quantity Qf = Quantity final
Pi = Initial price Pf = Price final

37
In this formula the averages of the prices and quantities under consideration are taken as
reference points in determining the percentages in price and quantity.

Numerical Calculations of Elasticity Coefficient

Price (P) Quantities

6 0

4 10

2 20

0 30

There are three categories of price elasticity of demand based on the size of the elasticity
coefficient:

1. Elastic 2. Inelastic 3. Unitary elastic

Elastic: (Edp > 1). Quantity changes by a larger percentage than price, i.e. it occurs when
some percent change in price results in a large percentage change in quantity. A change in
price induces a more than proportionate change in quantity demanded. Consumers are quite
responsive to a price change. The larger the elasticity, the larger the percentage change in
quantity for a given percentage changes in price. In this case total revenue rises when price
is reduced, falls when price is raised (increased).

Inelastic demand: (Edp < 1). When a decline in prices brings a smaller percentage increase in
quantity, i.e. quantity changes by a smaller percentage than price. Consumers are less
responsive to a price change. Generally, a change in price causes a less than proportionate
change in quantity consumed; from this it follows that total revenue will fall when price is
reduced, and will rise when price is raised.

Unitary elastic: (Edp = 1). This is the intermediate case. In this situation quantity changes by
the same percentage as price, i.e. both changes in the same proportion.

There are also two extreme cases:

38
a). Perfectly inelastic: quantity demanded does not change as price changes. Quantity
demanded is completely unresponsive to changes in price. Own-price elasticity of demand
(Edp) is zero. The demand curve in this case is a vertical line.
b). Perfectly elastic: consumers will purchase all they can at a particular price but none of the
product at a higher price (Edp = ). Here a slight change in price corresponds to an infinitely
large change in quantity. Quantity demanded is extremely responsive to even very small
changes in price (from buying îMt£ng to buying nothing). The demand curve in this case is a
horizontal line.

Cross-Price Elasticity of Demand

It measures the relative responsiveness of quantity demanded of a given commodity to
changes in the price of a related commodity. In other wards, it is the proportional change in
the quantity demanded of good X divided by the proportional change in the price of good Y.

Edx = Proportionate change in the quantity demanded of good X

Proportionate change in the price of good Y

Where, good X and good Y are related goods.

Edx = Qx   Py
(Qx1 + Qx2)/2 (Py1 + Py2)/2

Where, Q x = Change in quantity demanded of good X

Py = Change in price good Y
Qx1= Initial quantity of good X Qx2 = Final quantity of good X
Py1 = Initial price of good Y Py2 = Final price of good Y

The sign and the magnitude of cross-price elasticity coefficient have meanings. The sign of
cross-elasticity is negative if goods X and Y are complements ( Edx < 0) and positive (Edx >0)
if X and Y are substitutes. The larger the magnitude of the Edx, the higher is the degree of
substitution or complementarities’ between the two goods.

Income- elasticity of demand

It relates changes in the quantity demanded to changes in income. It measures the degree of
responsiveness of the quantity demanded of a product to changes in income. In other words,
it measures the responsiveness of consumers to income changes as the demand curve shifts
from one position to another. It is the proportional change in quantity demanded divided by
the proportional change in income.

Edy = Percentage change in quantity (%Q)

39
 Percentage in income (

Edy =Q Y
(Q1 + Q2)/2 (Y1 + Y2)/ 2

Where, Q = Change in quantity demanded

P = Change in price
Qi = Initial quantity Qf = Quantity final
Yi = Initial income Yf = Income final

This is from quantity approach.

If demand increases when income increases, the income elasticity is a positive number and
such goods are superior or normal goods. (Edy > 0)

If demand decreases with an increase income, the income elasticity is negative and such
goods are inferior goods. (Edy < 0).

Income elasticity of demand can be also calculated from expenditure measures.

Edy = % change in expenditure on good ‘X’

% Change in consumer income

In the same way as we did for the price elasticity of demand, income elasticity of demand can
be categorized in to three:

 Income elastic: the percentage change in quantity demanded of a good is greater than the
percentage change in income. Edy >1.
 Income inelastic: the percentage change in quantity demanded of a good is less than the
percentage change in income. Edy < 1.
 Income unit elastic: the percentage change in quantity demanded of a good is equal to the
percentage change in income. Edy = 1.

Determinants of Elasticity of Demand

Why does one commodity has an inelastic demand while another has very elastic? Several
factors influence the sensitivity of the quantity demanded to price:

1. Substitutability (the number of substitutes available):

The availability of closer and large number of substitutes determines the elasticity of demand
for a commodity. The demand for a commodity is more elastic if there are close substitutes

40
for it. That is, the larger the number and the better the substitutes that exists for a good or
service, the more elastic that particular good or service. This is because a small rise in price
will have a relatively large effect on consumption, as consumers switch to other
commodities, which are fairly similar but have not changed in price. On the other hand,
commodities that have few or poor substitutes tend to have inelastic demand.

In sum, the more substitutes for a good, the higher the price elasticity of demand; the fewer
substitutes for a good, the lower the price elasticity of demand.

2. The number of uses that the good can be put

The higher the number of uses a good has, the higher will be its elasticity of demand. In
other words, a commodity with several uses will be relatively more elastic because of the
range of markets in which the price change will exert an effect.

Example: Electricity- cooking, lighting, running factories, etc.

Coffee - as stimulant.
Commodities with few numbers of uses require a substantial change in price to affect total
demand.
3. The proportion of income spent on a particular product (percentage of one’s budget
spent on the good)
The larger the product’s share of the consumer’s budget, the more sensitive the consumer
will be to changes in its price. The products that take up small proportion of the budget tend
to be less elastic than product that ranks high in the budget. If a person spends high
proportion of his income on a product he or she is more sensitive to changes in its price. In
general, buyers are more responsive to price the larger the percentage of their budget that
goes for the purchase of the good.

Example: Good X A poor A rich

P1 1.25 1.25
P2 5.00 5.00
The poor is sensitive to change in the price of good X than the rich and will buy less or not at
all. Therefore, the demand for a particular commodity is likely to be less elastic among high-
income groups than is among low-income groups.

4. The extent to which the product is considered as luxury or necessity:

The demand for necessities tends to be inelastic. It is very difficult to get along without some
commodities like basic food; water, closing and shelter, so that if the price go up, the
quantity demanded will hardly change.

5. The definition of a product (the degree of commodity aggregation)

41
The price elasticity will depend to a large extent on how widely or narrowly a commodity is
defined.
Example:

The demand for beef is expected to be more elastic than the demand for all meat, which in
tern may be more prices elastic than the demand for all food. In general, the more broadly
we define a product, the lower its price elasticity. This is because there are fewer substitutes
for broadly defined products.

6. Time
In general, the demand for a product tends to be more elastic the longer the duration that the
price changes is expected to stay. As time passes, buyers have greater opportunities to be
responsive to a price change. Price elasticity of demand is larger in long run than short-run.
7. Habits:
The more the consumption of a good has a strong tradition and is very habitual, the less
likely are people to change consumption when price rises. That is, well-established habits
can make consumers’ buying patterns insensitive to increase in price.

Elasticity of Supply
As in the case of demand the elasticity concept is also applicable to measure the behavioral
changes of the supplier in response to the changes in the determinants.

I. Price Elasticity of Supply

Price elasticity of supply (ESP) is the measure of responsiveness of producers in terms of
output to changes in the price of their products. In other words, it measures the
responsiveness of the quantity supplied of a good to its market price. More precisely, the
price elasticity of supply measures the percentage change in quantity supplied in response to
a one percent change in the good’s price.

Esp = Percentage change in quantity supplied of commodity Y

Percentage change in price of Y

Esp = Q  P
(Qi + Qf)/2 (Pi + Pf)/2

Where, Q = Change in quantity supplied

P = Change in price
Qi = Initial quantity supplied Qf = Quantity supplied final
Pi = Initial price Pf = Price final

42
The Esp is a positive figure indicating the direct relationship between price and quantity
supplied. Esp is useful because it tells us the changes in quantify supplied resulting form a
given percent change in price.

E.g. If Esp is 3, a 5% increase in price will result in a 15% increase in quantity supplied.

As with the case of price elasticity of demand, depending on the magnitude of the
coefficient, price elasticity of supply can be categorized into three groups(types):

(I) Elastic-Esp >1, If the percentage rise in quantity supplied is greater than the percentage
rise in price that brought it about. That is, when a change in price causes a more than
proportionate change in quantity supplied. This means producers are relatively responsive to
price changes.

(II) Unitary elastic- Esp equal to one. This is that the percentage increase (change) of
quantity supplied is exactly equal to the percentage increase (change) in price.

(III) Inelastic- Esp < 1. If the percentage rise in quantity supplied is less than the percentage
rise in price that brought it about. That is, quantity changes by a smaller proportion than
price. This means producers are relatively insensitive to price changes.
There are also two extreme cases of elasticity of supply:

1. Perfectly elastic (Infinitely elastic)-Where changes in supply occur without any large
change in price being necessary. Where a small change in price changes quantity supplied
by an infinitely large amount. The supply curve for this case is a horizontal one.

2. Perfectly inelastic: The Esp is equal to zero (Where supply is fixed). Where a change in
price brings no change in quantity supplied. The supply curve for this case is vertical one.
E.g. Out of season demand, entrance ticket for some game.

II. Cross-elasticity of supply

Cross elasticity of supply (Esx) is defined as the percentage change in the supply of one good
in response to a one percent change in the price of alternative product (a product with in the
production possibility of the producer).

Esx = % change in quantity supplied of a good “X”

% Change in price of good “Y”

Where ‘X’ and ‘Y’ being production alternatives.

43
The value of the Esx can be negative or positive. If Esx is negative the two products under
consideration are production substitutes. If Esx is positive the two products under
consideration are complements in production (Complements in production means the two
goods are produced together.)

Determinants of Elasticity of supply

Why do different commodities have different elasticity of supply? What are the reasons
behind this? The major factors that influence the elasticity of supply are the following:

1. Time:- Time period under consideration and the length of the production cycle. The
longer the time period and/or the shorter the production cycle, then the easier it is to alter
the amount of that good produced, and so the more elastic is the supply likely to be. The
shorter the time for adjustment and/or the longer the production cycle, then the less elastic is
the supply likely to be. If the price change is expected to be temporary, there is little
incentive for a producer to change the level of output substantially because change in output
usually involves additional expense. In general the periods of supply are classified in to three:

I. Momentary (Esp = 0). In this period supply is fixed.

II. Short-run. In this period supply can be varied with the limit of the present fixed costs.
III. Long run. Costs may be varied and firms may enter or leave the market.

Elasticity of supply increases with time.

2. The availability of inputs

-Inputs available implies high production level which in turn implies elastic supply
-Inputs unavailable implies low production level which in turn less elastic supply.

The availability is affected by the specific nature of the inputs required for the production of
the commodity in question. If the production of a product utilizes inputs that are commonly
used to produce other products, it will tend to have a more elastic supply than if it uses
specialized inputs suited only for its production.

3. Factor mobility: The ease with which factors of production can be moved from one use
to another will affect elasticity of supply. The higher the degree of mobility the higher will
be the elasticity.

4. The extent to which production can be expanded or reduced in an industry. This is

dependent on the cost-structure of production process.

44
5. Natural restriction on the production process: E.g. seasonality of the production

6. Risk- taking. The more willing the producers are to take risks the greater will be the
elasticity of supply.

It’s Relevance to Agriculture

The relevance of the concept of elasticity in agriculture can be illustrated as following.

I. Price elasticity of demand in agriculture

E.g. Food: - It is mostly made from agricultural products. It is necessity means having
inelastic demand. Demand for food is mostly insensitive to price. Therefore, the implication
of increased level of production on the revenue of the industry from selling its products and
hence on the income of farmers can be analyzed based on the concept of elasticity.

II. Income elasticity of demand (Edy)

Edy of food is low compared with that of the product of most other industries. With an
increase in the income of society, the proportion of this income spent for the purchase of
necessities declines. This is developed in to a law called Engle’s Law. The law states that the
proportion of personal expenditure devoted to necessities declines as income rises.

2.2 Theory of production and cost

As we observed in the market model, the basic factor underlying the ability and
willingness of the firm to supply a product in the market is the cost of production.
Thus cost refers to the amount a firm spend on factors of production to produce goods
and services. Depending on various criteria, costs could be classified as

 Implicit Vs Explicit costs by structure

 Privates Vs social costs by owner
 Economic Vs Accounting cost by analysis
 Fixed Vs Variable cost by input
 Short run Vs long run cost

Explicit costs: are the actual out-of pocket expenditures of the firm to purchases or
hire the inputs it requires in production. In other words these are monetary payment
made to non –owner of the firm or to those outsiders who supply economic resources.
These expenditures include:
a. Wages & salaries of labor
b. Interest on borrowed capital
c. Rent on land & buildings
d. Expenditures or raw materials & semi finished materials
e. Payments made for utilities, taxes, machines etc.

45
Implicit costs: refer to the value of the inputs owned and used by the firm in its own
production processes. The value of these self –owned and self –employed inputs must
be implied or estimated from what these inputs could earn in their best alternative use
(the inputs owned & used by the firm in its own production processes are not free to
the firm). Implicit costs include:
_ Wages of labor rendered by the owner /entrepreneur
- Interest on capital supplied by the owner
- Rent of land and buildings belonging the owner
- Normal profit of the entrepreneur’s this refers to the minimum payment
needed to the entrepreneur in the business for the entrepreneurial talent
- Accountants traditionally include only actual expenditures in costs, while
economists always include both explicit & implicit costs.

Short run cost are expenditures incurred in the short run production process.
Long run costs are costs incurred in the long run production process.

Private costs: are the explicit and implicit opportunity costs incurred by individuals
and firms in the process of producing goods and services

Social costs: - Are costs incurred by society as a whole. Social costs are higher than
private costs, when firms are able to escape some of the economic costs (social costs).
Private costs can be made equal to social costs by public regulation requiring the firm
to pay for the negative effects (pollution, sound & vibration, etc) or to install
equipment to avoid the negative effects.

Economic cost: - this means opportunity cost, the cost to a firm in using any input
(hired or owned) is what the input could earn in its best alternative use. Opportunity
cost means best benefit forgone (scarified) or best alternative forgone
The notion, to economists, of cost goes back to the basic fact that resources are scarce
and have alternative uses. Thus to use a bundle of resources in the production of
some particular goods means that certain alternative production opportunities have
been forgone (scarified)

Economic cost =Explicit cost + Implicit cost

Accounting cost= explicit cost
Economic profit=Total Revenue-Economic cost
Accounting profit=Total Revenue-Explicit cost

Example. Gomez runs a small potter firm, the hires one helper at 12,000 per year,
pays an annual rent of Birr 5000 for his shop, and spends 20,000 per year on
materials, Gomez has 40,000 of his own funds invested in equipment which could
earn him 4000 per year alternatively invested. Gomez has been offered $ 15,000 per
year to work as a potter for a competitor. He estimated his entrepreneurial talents as
worth $ 3000 per year. Total annual revenue from sales is $ 72,000.

a. Calculate the accounting profit & economic profit for Gomez’s pottery.
b. What is his decision?
Solution

46
 a) Explicit cost =12000+5000+20000=37000
Implicit cost=4000+15000+3000=22000
Opportunity cost=4000+15000=19000
Economic cost =Explicit cost + Implicit cost=59000
Accounting cost= explicit cost=37000
Economic profit=Total Revenue-Economic cost
=72000-59000=
=13000
Accounting profit=Total Revenue-Explicit cost
=72000-37000
=350000
b) By comparing the opportunity cost and economic profit, it is possible to decide the
decision of the firm. If opportunity cost exceeds economic profit, the firm doesn’t have
to invest, otherwise. Thus here the firm has not to invest.

Generally cost functions are derived functions. They are derived from the production
function, which describes the available efficient methods of production at any one
time. Thus economic theory distinguishes between short-run costs and long –run
costs.

2.2.1 The short and long-run

Short –run Costs

Short –run costs are the costs over a period during which some factors of production
(usually capital equipment and management/entrepreneurship) are fixed. These costs
are also subdivided in to:
1. Totals
2. Units or averages
3. Marginal
Totals
Total Fixed costs (TFC): - are those costs do not vary with changes in output. They
are the payment for fixed inputs and independent of output. Sometimes they are
called indirect costs. These include:
-Salaries of top management -Insurance premiums
-Property taxes -Interests on borrowed capital
-Rental payments
-A portion of depreciation (wear & tear) on equipment & buildings

TFC= quantity of fixed inputs * price of fixed inputs

Fixed costs are associated with the very existence of the firms plant, and therefore
must be paid even the firms output is zero. Hence fixed costs are unavoidable costs.
The graphical representation of Total fixed cost is
Cost

TFC
-Where K is some fixed constant
k
for a given period of time
Quantity
47
Total variable cost (TVC): are those costs that change with the level of output. This
refers to the payment for variable inputs. It is also called avoidable cost or direct cost
These include: –Payment to row materials
-Payment Fuel
-Payment most labor
-Payment power & transportation etc

TVC= quantity of variable inputs * price of variable inputs

These costs are direct costs of output because when output increase, total variable
cost in creases, when output decreases total variable cost decrease, and when out put
is zero then total variable cost is zero.
Cost

TVC

Quantity

Total cost: it is the sum of fixed cost and variable cost at each level of output.
 At zero levels of output total cost is equal to the firm’s fixed cost.
TC=TFC+TVC
The distinction between fixed and variable cost is significant to the business manager.
Variable can be controlled or altered in the short run by changing production levels.
Fixed costs are beyond the business executive’, present control; they are incurred in
the short run and must be paid regardless of output level

 In defining these costs schedules and curves. All inputs

TC are valued at their opportunity cost which induces both
Cost

TVC implicit and explicit cost

 The shape of TVC curve follows directly from the law of
diminishing returns. Up to the point of inflection the firm
uses so little inputs with the fixed input that law of
diminishing returns is not yet operating. As a result the
TFC TVC curve faces downwards or rise at a decreasing rate
 When the law of diminishing return operates the TVC
Quantity faces upward and increases at an increasing rate
 Diminishing marginal returns is decreasing marginal
productivity
Per unit cost
From total cost we can drive per unit cost
AFC = TF/output, AVC = TVC/output, ATC = TC/Output
Marginal cost (MC) equals the change in TC or in TVC per unit change in TC or in TVC per unit
change in output.
Quantity of Total fixed Total Total Average Average Average Marginal

48
 output (1) costs (2) Variable Cost Fixed Variable Total Cost (8)
costs (3) (4) Cost (5) Cost (6) Cost (7)
1 $ 30 $ 20 $ 50 $ 30 $ 20 $ 50
2 30 30 60 15 15 30 10
3 30 45 75 10 15 25 15
4 30 80 110 7.50 20 27.50 35
5 30 145 175 6 29 35 65

Total & per unit costs

Average fixed cost (AFC) equals TFC/Q.
AVC equals TVC/Q.
Average total costs ATC = TC/Q.
Marginal cost (Mc) equals the change in TC or TVC per unit change in Q. Mc is plotted between
the various output levels. The AFC curve falls continuously, while the AVC, ATC, MC curves
are U-shaped. The AVC falls when the AP of the variable input rises, & AVC rises when the AP
falls. Mc & Mp are similarly related. The ATC curve falls as long as the decline in AFC exceeds
the rise in AVC. The rising portion of the Mc curve interests from below the AVC & the ATC
curves at their lowest point.
The U-shape of the Mc curve can similarly be explained as follows:
∆ TC ∆(WL) W (∆ L) W W
Mc = = = = =
∆Q ∆Q ∆Q ∆ Q/∆ L MPL

49
 2.2.2 Short-run production functions (total, average and marginal products) and
the law of Diminishing returns

Graphically Representation of Short –run Costs

Total Costs:
TC
TC, TVC, TFC

TVC

TFC

a. both the TC & TVC increase at a decreasing rate and then increase at an
Q
increasing rate as output increases. This is because of the law of diminishing

(marginal) returns

b. the vertical distance between TC &TVC is TFC

TVC starts from the origin and TC starts from the point at which the TFC cuts the y-

axis

Long Run Theory of costs

- Expansion path and the long run total cost curve
 With constant input prices & higher total cost outlays by the firm, Isocost lines will be
higher & parallel by then joining the origin with the points of tangency of Isoquants &
the Isocost lines, we derive the firm’s expansion path. Example the expansion path of
the firm & line GBDFHJN. Note that in this case, the expansion path & a straight line,
& this a constant capital – labor nafie (K/L) for all output levels. At the tangency points,
the slope of the Isoquant Is equal to the slope of the Isocost lines.

W
∧MPL MPK
That is, MRTSLK = MPL R = .
= r
MPK W
Thus, points along the expansion path show the least output in the long run. From the
expansion path, we can derive the long run total cost (LTC) curve of the firm. This shows
the minimum long run total costs of producing various levels of output. For example, point
B in m the top panel of the figure indicates that the minimum total cost of producing two
units of output (2 Q) is $60 ($30 to purchase 3L and $30 t purchase 3k).
This gives point B in the bottom panel of the fig. Where the vertical axis measures total
costs & the horizontal axis measures output. From point D in the top panel, we get point D

50
in the bottom pane. Other points in the LTC curve are similarly obtained. Note that the LTC
curve starts at the origin since in the long run there are no fixed costs.

51
 2.3 The profit-maximizing competitive firms
Perfect Competition
Perfect competition is a market structure characterized by a complete
absence of rivalry among the individual firms. In practice business use
the word competition as synonymous to rivalry. In theory, perfect
competition implies no rivalry among firms.
Assumptions of perfect competition
Large numbers of sellers and buyers
The industry or the market includes a large number of firms and buyers, so that each
individual firm, however large, supplies only a small part of the total quantity
offered in the market. The buyer are also numerous. Under these conditions each
firm alone cannot affect the price in the market by changing its output.
Product homogeneity
The industry is defined as a group of firms producing a homogeneous product. The
technical characteristics of the product as will as the services associated with its sale
and delivery are identical. The buyer couldn’t differentiate products of different
firms.
Price taker
The assumption of large numbers of sellers and of product homogeneity implies that
the individual firm pure completion is a price-taker: its demand curve is infinitely
elastic, indicating that the firm can sell any amount of output at the prevailing
market price. The demand curve of the individual firm is also its average revenue
and its marginal revenue curve.
Price

P P=AR=MR

Output

Figure 1: Price and output of a firm

Free entry and exit of firms
There is no barrier to entry or exit from the industry. Entry or exit may take time,
but firms have freedom of movement in and out of the industry
Profit maximization: the goal of all firms is profit maximization

52
 No government Regulation
There is no government intervention in the market, i.e. no tariffs, subsidies rationing of
production or demand
The above five assumption are sufficient for the firm to be price taker and have infinitely
elastic demand curve. It is different from perfect competition, which requires fulfillment
of the next additional assumption.
Perfect mobility of factors of production
The factors of production are free to move from one firm to another throughout the
economy. It is also assumed that workers can move between different jobs, which implies
skills can be learned easily. Finally raw materials and other factors are not monopolized
and labor is not unionized. In short there is perfect competition in the markets of factors
of production
Perfect knowledge
It is assumed that all sellers and buyers have perfect knowledge of the conditions of the
market. This knowledge refers to the condition of the prevailing market and also to the
future periods. Information is free and costless. Under this condition, there is no
uncertainty about the future developments in the market.
Using the above assumption we will examine the equilibrium of the firm and the industry
in the long run and short run.
Equilibrium of the firm in the short-run
The firm is in equilibrium when it maximizes its profit (∏ ¿¿), defined as the difference
between Total revenue and total cost(∏ ¿ TR−TC , Where TR-total revenue, and TC-
total cost). The equilibrium (profit maximization) of the firm may be expressed in two
ways,.
1. Total Approach (Using TR and TC curves)

TC
TR

53
 Figure2: The TR &TC curves of perfectly competitive firm
The TR curve is a straight line through the origin showing that the price is constant at all
levels of output. The firm is a price taker and can sell any amount of output at the
ongoing market price. TR is increasing proportionately with its sales. The slope of TR is
MR. It is constant and equal to the prevailing market price, that is MR=AR=P
The firm maximizes its profit at the output xe, where the distance between TR and TC
curves is the largest.
-At output levels smaller than X and larger than XB, the firm has losses.
The TR-TC approach is not simple to use when firms are combined together in the study
of the industry. The alternative approached. This is based on marginal cost and marginal
revenue, uses price as explicit variable and shows clearly the behavioral rule that leads to
profit maximization.
2. Marginal Approach (using MR & MC)
We said that demand curve is also the average revenue curve and the marginal revenue
curve of the firm in a perfectly competitive market –MC cuts the SATC at its minimum
point. The firm is in equilibrium (maximizes profit) at the level of output defined by the
intersection of MC and MR curves.
P, C

SMC
SATC
P
P = MR

X
Xe

Figure 3: SATC and MC curves together with the demand curve

From Figure 3 we can observe that:

i. to the left of e, profit has not reached its maximum level because each unit of
output to the left of Xe brings to the firm a revenue which is greater than its
marginal cost.
ii. To the right of Xe each additional unit of output costs more than the revenue
earned by its sale so that a loss is made and profit reduced
Summary, If
a. MC<MR total profit has not been maximized and it pays the firm to
expand its output
b. MC>MR total profit is reduced and it calls for the firm to cut production
54
 c. MC=MR short run profits are maximized.

The first condition for the equilibrium of the firm is that MC=MR. However, this
condition is not sufficient since it may be fulfilled and yet the firm may not be in
equilibrium observe figure4.
MC=MR is satisfied at both the points e’ and e, yet the firm is not in equilibrium at e’
'
since profit is maximized at xe> x e . The second condition for equilibrium requires that the
MC must be rising at the point of intersection with MR curve.
Price, cost

SMC
SATC
e’
e
P=MR

xe' Xe

Figure 4

This means that the MC must cut from below, that is, the slope of MC must be greater
/steeper than the slope of MR curve. Thus at point e both conditions for equilibrium are
satisfied:
i. MC=MR-necessary condition
ii. Slope of MC>slope of MC –sufficient condition
It is clear that MC is positive throughout, and then MR is positive at the intersection.

Whether the firm makes excess profit or losses depends on the level of ATC at the short –
run equilibrium (see figure5). If ATC lies below the price at equilibrium the firm earns
excess profit. If ATC is above the price the firm makes loss. In the latter case the firm
continuous to produce only if it covers its variable cost. Otherwise it will close down,
since by discontinuing its operation the firm will be better off: it minimizes its losses. The
point at which the firm covers its variable cost is called the closing down point.

SMC
SMC
SATC SATC
P MR
MR
55
X
Xe
 Excess profit = area(PABe) Loss = area (PFCe)

SMC
SATC

SAVC The shutting down point of the firm is

point w. if price falls below P w the firm
Pw does not cover its variable costs and is
AFC batter off if it closes down

Xw

Figure 5
Mathematical derivation of the equilibrium of the firm
∏ ¿ R−C , Clearly R=f 1 ( x ) and C=f 2 ( x ) , given price P.
a. The first order condition for the maximization of a function is that its first derivative
be equal to Zero. i.e

∂
∏ ¿ = ∂ R − ∂C =0 ⇒ ∂ R = ∂C ¿
∂x ∂x ∂x ∂x ∂x
∂R
∂ x is the slope of the total revenue curve, that is , the marginal revenue.
∂R
∂ x is the slope of the total cost curve, or marginal cost. Thus the first order condition
for profit maximization is MR=MC
Given MC >0 , MR must also be positive at equilibrium. Since MR= P the first order
condition may be written as MC=P

b. The second order condition for a maximum requires that the second derivative of the
function be negative (implying that after its highest point the curve turns
downwards).
∂2
∏ ¿ = ∂2 R − ∂2C <0 ¿
∂ x2 ∂ x2 ∂ x2

56
 ∂2 R ∂2 C ∂2 R ∂2 C
2
< 2 2 2
Which yields ∂ x ∂ x , but ∂ x is the slope of the MR, and ∂ x is the slope of MC.
Hence the second-order condition indicates the slope of MR is less than the slope of MC.
Thus Mc must have a steeper slope than MR or MC must cut the MR curve from below.
In pure competition the slope of MR curve is zero, hence the second-order condition is
∂2 C
0<
simplified as follows: ∂ x 2 , this indicates MC must have a positive slope, or MC
must be rising.
A. Supply Curve of The firm and The Industry
The supply curve of the firm may be derived by the points of intersection of its MC curve
with successive demand curves. Assume that the market price increases gradually. This
causes an upward shift of the demand curve of the firm (price curve). Given the positive
slope of the MC curve, each higher demand curve cuts the given MC to a point, which
lies to the right of the previous intersection. This implies that the quantity supplied by the
firm increases as price increase. The firm, given its cost structure, will not supply any
quantity if the price falls below Pw (figure below), because at a lower price the firm does
P, C S
not cover its variable cost. P, C

P2
P1
SMC
P2 Pw
SATC
P1 SAVC
Pw Firm Xw X1 X2

X
Xw X1 X2

Industry
Figure 6: supply curve of the firm and the industry
If we plot the successive points of intersection MC and demand curve to the right of the
closing-down point (point where MC=SAVC), below Pw the quantity supplied by the firm
is zero.
The industry-supply curve is the horizontal summation of the supply curves of the
individual firms. It is assumed that the factor prices and the technology are given and the
number of firms is very large. Under these conditions the total quantity supplied in the
market at each price is the sum of the quantities supplied by all firms at that price.

57
It should, however, be noted that the particular shape of the market –supply curve
depends on the technology and on factor prices, as well as the size distribution of the
firms in the industry. All firms are not usually of the same size. The particular size of
each firm in perfect competition depends on the entrepreneurial efficiency of the
businessman, which is traditionally considered as a random attribute.
C. Short-Run Equilibrium of the Industry
Given the market demand and the market supply the industry is in equilibrium at that
price which clears the market, that is at the price at which quantity demanded is equal to
the quantity supplied. As figure ’a’ below indicates the industry is in equilibrium at price
P and quantity supplied and demanded at Q . However, this will be a short-run
equilibrium, if at the prevailing price firms may be making excess profit or losses. In the
long-run firms that make losses and cannot readjust their plant will shot-down. Those that
make excess profit will expand their capacity, while excess profit will also attract new
firms into the industry. Entry, exit and readjustment of the remaining firms in the industry
will lead to a long-run equilibrium in which firms will just be earning normal profits and
there will be no entry or exit from the industry.

SMC

SMC SATC

SATC

Short-run industry Short-run equilibrium of a Short-run equilibrium of a

equilibrium firm. (excess profit) firm. (losses)

Figure 7

2.3.1 Revenue function of a competitive firm

The purely competitive firm and industry in the short run

- In a purely competitive market an individual firm can’t influence the market price for its
good or service by increasing or decreasing it output. Because each seller is only a small
part of the total market, its actions have no perceptible influence on the market. The
competitive firms is called a price taker. It must accept the going market price for its
product.

58
- Expansions or contractions of in an individual firms output with in a competitive
market have virtually no effect on the market price.

Short run profit maximization by the purely competitive firm

The added cost of producing an additional unit of output is the marginal cost. We know
from our analysis the short run marginal cost curve for a firm will eventually rise. This
is due to the law of diminishing marginal returns, which comes in to play as the firm
uses its fixed plant more intensively in the short run.
The extra revenue from producing an additional unit of output is marginal revenue
(MR). Simply, MR is the addition to total revenue from the production of one more unit
of output, or

Change o n totlal revenue

MR =
Charge ∈output

Marginal revenue equals market price, MR = P, for the purely competitive firms. The
purely competitive firm will decide how much to produce in the short run by comparing
marginal cost with marginal revenue. To maximize its profits, the firm will produce
additional units of output until marginal cost and marginal revenue are equal.
Firms & industry DD in a purely competitive market.
In a purely competitive industry, DD for an individual firms product is perfectly
elastic. The perfectly elastic demand curve facing one additional Virginia cotton
producer is shown in (a) at the level of P, which is also the equilibrium price for
the world market in (b) at an output of 65.3 million bales per year. Note that the
scale for price is the same for both the individual producer & the world market
but the scale for quantity is much difficult for the two .
S

P d ––––––––––––––––––E–––––––

0 200 Rate of output 65.3 Million

(bales per year)

59
 (a) individual (b) world cotton market

The purely competitive firm will decide how much to produce in the short-run by
comparing MC with MR. To maximize its profit, the firm will produce additional unit of
output until MC & MR are equal.
The firms perfectly elastic demand curve (d( in fig 2a is draw at the level of market price
(P) from fig 2b. as we have just seen, d is also the MR curve for the firm. Revenue will
increase by the market price each time output increases by one unit. In other words,
MR = P. we have also drawn the MC & average total cost (ATC) curves of the firm.

Short – Run output choice & profit maximization

a) The short run choice of output confronting the individual firm. At rates of output
less than q, additional production adds more to revenue than to cost. Beyond q,
additional production adds more to cost than to revenue. Therefore, the purely
competitive firm will produce at q. At this rate of output, the firm earns an economic
profit equal to the difference between TRs, & TCs, PAqO – Bcqo = PACB.
b) Prevailing Market conditions in the industry.
- The short run equilibrium level of production for the purely competitive firm is therefore
defined by the condition P = MC. Since we know that price & MR are the same for the
purely competitive firm, We can also write P = MR = MC.
- If additional production promises to add more to revenue than to cost, most business
will try to increase their production. If additional units will probably add more to cost
than to revenue, most business will cut back production. Such a behavior leads to the P

60
 = MR = MC result even when business people know nothing about the economic rule
involved.

A numerical illustration of profit maximization

Another way to understand how the choice of output levels allows a competitive firm to
maximize profits is to examine the specific costs & revenues at each level of production. The
firm’s output level is given in column [Link] 2. Shows that the firm confronts an
unvarying market price of $ 2.40 per Far for its output, Price equals MR (P = MR) since this
is purely competitive firm. The Mc & TC data in column 3 & 5 are taken from table 3 in the
previous chapter.
Rate of Price Marginal Total Total Cost Profit
output Jars MR cost revenue 4-5
per day 1x2

0 2.40 - 0.00 10.00 -10

1 2.40 1.60 2.40 11.60 -9.80

2 2.40 1.45 2.80 13.05 -8.25

3 2.40 1.35 7.20 14.40 -7.20

4 2.40 1.30 9.60 15.70 -6.10

5 2.40 1.20 12.00 16.90 -4.90

6 2.40 1.10 14.40 18.00 -3.60

7 2.40 1.00 16.80 19.00 -2.20

8 2.40 .90 19.20 19.90 -.07

9 2.40 .30 21.60 20.20 1.40

10 2.40 0.65 24.00 20.85 3.15

11 2.40 1.30 26.40 22.15 4.25

12 2.40 1.50 28.80 23.65 5.15

13 2.40 1.75 31.20 25.40 5.20

14 2.40 2.40 33.60 27.80 5.80

15 2.40 3.25 36.00 31.05 4.95

16 2.40 4.25 38.40 35.30 3.10

17 2.40 5.35 40.80 40.65 0.15

18 2.40 6.55 43.20 47.20 -4.0

19 2.40 7.80 45.60 55.00 -9.40

20 2.40 9.30 48.00 64.30 -16.30

MR= MC when the firm produces14 Jars per day,& profit is maximized at $ 5.80 per day.
There are two methods by which the firm will choose at rate of output to maximize profits.
Suppose, with reference to table 1, that managers don’t actually draw the cost curve of the

61
firm, as most real businesses do not. Instead, the operate the firm under simple rule produce &
sell output until profits begin to decrease.
Profits continue to rise as the firm expands output up to the 13 unit per day. Level, at which
profits are $5.80 per day. When the firm produces the 14 th unit of output, profits level off at $
5.80. with the firm’s production rule of producing & selling outputs as long as profits don’t fall,
we know that at least 14 units of output will be produced. If the firm were to continue to
expand output, profits would decrease. The production of 15 Jars instead of 14 would yield the
firm a profit of $ 4.95 rather than $ 5.80.
 The simple decision to stop production when profits begins to decrease leads to the
firms to produce a rate of output, 14 units per day in table 1, that maximizes profits for
the firm.
 By comparing the TR & TC of producing & selling additional amounts of output, the
firm will choose to produce that rate of output that maximizes profits.
 The following fig. illustrates the TR – TC approach to maximizing profit. the figure
groups columns ( 4&5) with respect to the output of the firm.
 The maximum profits possible in the short-run occur where the TR line (TR) exceeds the
TC curve (TC) by the largest vertical deference. That is 14 Jars.
 The 2nd way to find the profit maximizing rate of output using the numerical schedule in
Table 1 is to compare MR & MC, column 2 and 3.
As long as MR is greater than MC, it pays to produce additional units of output. Clearly
MR ($2.40) is > MC up to& including an output of 14 Jars. This means that the point of
maximum profit occurs at 14 jars per day. If the firm can run out jars only once at a
time, the firm will cease producing additional saves after 14 Jars, since the Mc of
producing the next Jar is $3.25 & the MR is only $2.40. Units of output beyond 14 add
more to costs than to revenue. That is, they cause profits to decline. Both the TR- TC&
the MR –MC approaches yield the same answer for the profit maximizing rate of output.
Fig 3b illustrates the MR –MC approach. Again note the equivalence of the two
approaches by comparing the optimal rate of output, at 14 Jars per day in both graphs.

62
 2.3.2 Rules of profit maximization.
Short run profit maximization by the purely competitive firm
The added cost of producing an additional unit of output is the marginal cost. We know
from our analysis the short run marginal cost curve for a firm will eventually rise. This
is due to the law of diminishing marginal returns, which comes in to play as the firm
uses its fixed plant more intensively in the short run.
The extra revenue from producing an additional unit of output is marginal revenue
(MR). Simply, MR is the addition to total revenue from the production of one more unit
of output, or

Change on totlal revenue

MR =
Charge ∈output

Marginal revenue equals market price, MR = P, for the purely competitive firms. The
purely competitive firm will decide how much to produce in the short run by comparing
marginal cost with marginal revenue. To maximize its profits, the firm will produce
additional units of output until marginal cost and marginal revenue are equal.
Firms & industry DD in a purely competitive market.

63
 In a purely competitive industry, DD for an individual firms product is perfectly
elastic. The perfectly elastic demand curve facing one additional Virginia cotton
producer is shown in (a) at the level of P, which is also the equilibrium price for
the world market in (b) at an output of 65.3 million bales per year. Note that the
scale for price is the same for both the individual producer & the world market
but the scale for quantity is much difficult for the two .
S

P d ––––––––––––––––––E–––––––

1 200 Rate of output 65.3 Million

(bales per year)
(b) individual (b) world cotton market

The purely competitive firm will decide how much to produce in the short-run by
comparing MC with MR. To maximize its profit, the firm will produce additional unit of
output until MC & MR are equal.
The firms perfectly elastic demand curve (d( in fig 2a is draw at the level of market price
(P) from fig 2b. as we have just seen, d is also the MR curve for the firm. Revenue will
increase by the market price each time output increases by one unit. In other words,
MR = P. we have also drawn the MC & average total cost (ATC) curves of the firm.

64
 Short – Run output choice & profit maximization
c) The short run choice of output confronting the individual firm. At rates of output
less than q, additional production adds more to revenue than to cost. Beyond q,
additional production adds more to cost than to revenue. Therefore, the purely
competitive firm will produce at q. At this rate of output, the firm earns an economic
profit equal to the difference between TRs, & TCs, PAqO – Bcqo = PACB.
d) Prevailing Market conditions in the industry.
- The short run equilibrium level of production for the purely competitive firm is therefore
defined by the condition P = MC. Since we know that price & MR are the same for the
purely competitive firm, We can also write P = MR = MC.
- If additional production promises to add more to revenue than to cost, most business
will try to increase their production. If additional units will probably add more to cost
than to revenue, most business will cut back production. Such a behavior leads to the P
= MR = MC result even when business people know nothing about the economic rule
involved.

A numerical illustration of profit maximization

Another way to understand how the choice of output levels allows a competitive firm to
maximize profits is to examine the specific costs & revenues at each level of production. The
firm’s output level is given in column [Link] 2. Shows that the firm confronts an
unvarying market price of $ 2.40 per Far for its output, Price equals MR (P = MR) since this
is purely competitive firm. The Mc & TC data in column 3 & 5 are taken from table 3 in the
previous chapter.

65
 Rate of Price Marginal Total Total Cost Profit
output Jars MR cost revenue 4-5
per day 1x2

0 2.40 - 0.00 10.00 -10

1 2.40 1.60 2.40 11.60 -9.80

2 2.40 1.45 2.80 13.05 -8.25

3 2.40 1.35 7.20 14.40 -7.20

4 2.40 1.30 9.60 15.70 -6.10

5 2.40 1.20 12.00 16.90 -4.90

6 2.40 1.10 14.40 18.00 -3.60

7 2.40 1.00 16.80 19.00 -2.20

8 2.40 .90 19.20 19.90 -.07

9 2.40 .30 21.60 20.20 1.40

10 2.40 0.65 24.00 20.85 3.15

11 2.40 1.30 26.40 22.15 4.25

12 2.40 1.50 28.80 23.65 5.15

13 2.40 1.75 31.20 25.40 5.20

14 2.40 2.40 33.60 27.80 5.80

15 2.40 3.25 36.00 31.05 4.95

16 2.40 4.25 38.40 35.30 3.10

17 2.40 5.35 40.80 40.65 0.15

18 2.40 6.55 43.20 47.20 -4.0

19 2.40 7.80 45.60 55.00 -9.40

20 2.40 9.30 48.00 64.30 -16.30

MR= MC when the firm produces14 Jars per day,& profit is maximized at $ 5.80 per day.
There are two methods by which the firm will choose at rate of output to maximize profits.
Suppose, with reference to table 1, that managers don’t actually draw the cost curve of the
firm, as most real businesses do not. Instead, the operate the firm under simple rule produce &
sell output until profits begin to decrease.
Profits continue to rise as the firm expands output up to the 13 unit per day. Level, at which
profits are $5.80 per day. When the firm produces the 14 th unit of output, profits level off at $
5.80. with the firm’s production rule of producing & selling outputs as long as profits don’t fall,
we know that at least 14 units of output will be produced. If the firm were to continue to
expand output, profits would decrease. The production of 15 Jars instead of 14 would yield the
firm a profit of $ 4.95 rather than $ 5.80.
 The simple decision to stop production when profits begins to decrease leads to the
firms to produce a rate of output, 14 units per day in table 1, that maximizes profits for
the firm.

66
  By comparing the TR & TC of producing & selling additional amounts of output, the
firm will choose to produce that rate of output that maximizes profits.
 The following fig. illustrates the TR – TC approach to maximizing profit. the figure
groups columns ( 4&5) with respect to the output of the firm.
 The maximum profits possible in the short-run occur where the TR line (TR) exceeds the
TC curve (TC) by the largest vertical deference. That is 14 Jars.
 The 2nd way to find the profit maximizing rate of output using the numerical schedule in
Table 1 is to compare MR & MC, column 2 and 3.
As long as MR is greater than MC, it pays to produce additional units of output. Clearly
MR ($2.40) is > MC up to& including an output of 14 Jars. This means that the point of
maximum profit occurs at 14 jars per day. If the firm can run out jars only once at a
time, the firm will cease producing additional saves after 14 Jars, since the Mc of
producing the next Jar is $3.25 & the MR is only $2.40. Units of output beyond 14 add
more to costs than to revenue. That is, they cause profits to decline. Both the TR- TC&
the MR –MC approaches yield the same answer for the profit maximizing rate of output.
Fig 3b illustrates the MR –MC approach. Again note the equivalence of the two
approaches by comparing the optimal rate of output, at 14 Jars per day in both graphs.

2.4 Review of market imperfection

2.4.1 Monopoly
Definition: The Monopoly is a market structure characterized by a single seller, selling the
unique product with the restriction for a new firm to enter the market. Simply, monopoly is a
form of market where there is a single seller selling a particular commodity for which there are

67
no close substitutes. In this scenario, the firm has the highest level of market power, as
consumers do not have any alternatives. As a result, monopolists often reduce output to increase
prices and earn more profit. The following assumptions are made when we talk about
monopolies: (1) the monopolist maximizes profit, (2) it can set the price, (3) there are high
barriers to entry and exit, (4) there is only one firm that dominates the entire market. From the
perspective of society, most monopolies are usually not desirable, because they result in lower
outputs and higher prices compared to competitive markets. Therefore, they are often regulated
by the government.

Features of Monopoly Market

 Under monopoly, the firm has full control over the supply of a product. The elasticity of
demand is zero for the products.
 There is a single seller or a producer of a particular product, and there is no difference
between the firm and the industry. The firm is itself an industry.
 The firms can influence the price of a product and hence, these are price makers, not the
price takers.
 There are barriers for the new entrants.
 The demand curve under monopoly market is downward sloping, which means the firm can
earn more profits only by increasing the sales which are possible by decreasing the price of a
product.
 There are no close substitutes for a monopolist’s product.
 Under a monopoly market, new firms cannot enter the market freely due to any of the
reasons such as Government license and regulations, huge capital requirement, complex
technology and economies of scale. These economic barriers restrict the entry of new firms.

68
 2.4.2 Monopolistic competition
Monopolistic competition also refers to a market structure, where a large number of small firms
compete against each other. However, unlike in perfect competition, the firms in monopolistic
competition sell similar, but slightly differentiated products. This gives them a certain degree of
market power which allows them to charge higher prices within a certain range.
Monopolistic competition builds on the following assumptions: (1) all firms maximize profits (2)
there is free entry and exit to the market; (3) firms sell differentiated products (4) consumers may
prefer one product over the other. Now, those assumptions are a bit closer to reality than the ones
we looked at in perfect competition. However, this market structure will no longer result in a
socially optimal level of output, because the firms have more power and can influence market
prices to a certain degree.
An example of monopolistic competition is the market for cereals. There is a huge number of
different brands ([Link]’n Crunch, Lucky Charms, Froot Loops, Apple Jacks). Most of them
probably taste slightly different, but at the end of the day, they are all breakfast cereals.

1. Product Differentiation: This is one of the major features of the firms operating under
the monopolistic competition, that produces the product which is not identical but is
slightly different from each other. The products being slightly different from each other
remain close substitutes of each other and hence cannot be priced very differently from
each other.
2. Large number of firms: A large number of firms operate under the monopolistic
competition, and there is a stiff competition between the existing firms. Unlike the
perfect competition, the firms produce the differentiated products which are substitutes
for each other, thus make the competition among the firms a real and a tough one.
3. Free Entry and Exit: With an intense competition among the firms, the entity incurring
the loss can move out of the industry at any time it wants. Similarly, the new firms can

69
 enter into the industry freely, provided it comes up with the unique feature and different
variety of products to outstand in the market and meet with the competition already
existing in the industry.
4. Some control over price: Since, the products are close substitutes for each other, if a
firm lowers the price of its product, then the customers of other products will switch over
to it. Conversely, with the increase in the price of the product, it will lose its customers to
others. Thus, under the monopolistic competition, an individual firm is not a price taker
but has some influence over the price of its product.
5. Heavy expenditure on Advertisement and other Selling Costs: Under the
monopolistic competition, the firms incur a huge cost on advertisements and other selling
costs to promote the sale of their products. Since the products are different and are close
substitutes for each other; the firms need to undertake the promotional activities to
capture a larger market share.
6. Product Variation: Under the monopolistic competition, there is a variation in the
products offered by several firms. To meet the needs of the customers, each firm tries to
adjust its product accordingly. The changes could be in the form of new design, better
quality, new packages or container, better materials, etc. Thus, the amount of product a
firm is selling in the market depends on the uniqueness of its product and the extent to
which it differs from the other products.

The monopolistic competition is also called as imperfect competition because this market
structure lies between the pure monopoly and the pure competition.

2.4.3 Oligopoly

Definition: The Oligopoly Market characterized by few sellers, selling the homogeneous or
differentiated products. In other words, the Oligopoly market structure lies between the pure
monopoly and monopolistic competition, where few sellers dominate the market and have
control over the price of the product.

Under the Oligopoly market, a firm either produces:

• Homogeneous product: The firms producing the homogeneous products are called as
Pure or Perfect Oligopoly. It is found in the producers of industrial products such as aluminum,
copper, steel, zinc, iron, etc.
• Heterogeneous Product: The firms producing the heterogeneous products are called as
Imperfect or Differentiated Oligopoly. Such type of Oligopoly is found in the producers of
consumer goods such as automobiles, soaps, detergents, television, refrigerators, etc.
There are five types of oligopoly market, for detailed description, click on the link below:
Types of Oligopoly Market
Features of Oligopoly Market

70
1. Few Sellers: Under the Oligopoly market, the sellers are few, and the customers are many.
Few firms dominating the market enjoys a considerable control over the price of the product.
2. Interdependence: it is one of the most important features of an Oligopoly market, wherein, the
seller has to be cautious with respect to any action taken by the competing firms. Since there are
few sellers in the market, if any firm makes the change in the price or promotional scheme, all
other firms in the industry have to comply with it, to remain in the competition.
Thus, every firm remains alert to the actions of others and plan their counterattack beforehand, to
escape the turmoil. Hence, there is a complete interdependence among the sellers with respect to
their price-output policies.
3. Advertising: Under Oligopoly market, every firm advertises their products on a frequent
basis, with the intention to reach more and more customers and increase their customer [Link]
is due to the advertising that makes the competition intense.
If any firm does a lot of advertisement while the other remained silent, then he will observe that
his customers are going to that firm who is continuously promoting its product. Thus, in order to
be in the race, each firm spends lots of money on advertisement activities.
4. Competition: It is genuine that with a few players in the market, there will be an intense
competition among the sellers. Any move taken by the firm will have a considerable impact on
its rivals. Thus, every seller keeps an eye over its rival and be ready with the counterattack.
5. Entry and Exit Barriers: The firms can easily exit the industry whenever it wants, but has to
face certain barriers to entering into it. These barriers could be Government license, Patent, large
firm’s economies of scale, high capital requirement, complex technology, etc. Also, sometimes
the government regulations favor the existing large firms, thereby acting as a barrier for the new
entrants.
6. Lack of Uniformity: There is a lack of uniformity among the firms in terms of their size, some
are big, and some are small.
Since there are less number of firms, any action taken by one firm has a considerable effect on
the other. Thus, every firm must keep a close eye on its counterpart and plan the promotional
activities accordingly.

71
Types of Oligopoly Market

Definition: The Oligopoly is a market structure wherein few sellers dominate the market and
sell the homogeneous or heterogeneous products.

Types of Oligopoly Market

1. Open Vs Closed Oligopoly: This classification is made on the basis of freedom to enter into
the new industry. An open Oligopoly is the market situation wherein firm can enter into the
industry any time it wants, whereas, in the case of a closed Oligopoly, there are certain
restrictions that act as a barrier for a new firm to enter into the industry.
2. Partial Vs Full Oligopoly: This classification is done on the basis of price leadership. The
partial Oligopoly refers to the market situation, wherein one large firm dominates the market and
is looked upon as a price leader. Whereas in full Oligopoly, the price leadership is conspicuous
by its absence.
3. Perfect (Pure) Vs Imperfect (Differential) Oligopoly: This classification is made on the basis
of product differentiation. The Oligopoly is perfect or pure when the firms deal in the
homogeneous products. Whereas the Oligopoly is said to be imperfect, when the firms deal in
heterogeneous products, i.e. products that are close but are not perfect substitutes.

72
4. Syndicated Vs Organized Oligopoly: This classification is done on the basis of a degree of
coordination found among the firms. When the firms come together and sell their products with
the common interest is called as a Syndicate Oligopoly. Whereas, in the case of an Organized
Oligopoly, the firms have a central association for fixing the prices, outputs, and quotas.
5. Collusive Vs Non-Collusive Oligopoly: This classification is made on the basis of agreement
or understanding between the firms. In Collusive Oligopoly, instead of competing with each
other, the firms come together and with the consensus of all fixes the price and the outputs.
Whereas in the case of a non-collusive Oligopoly, there is a lack of understanding among the
firms and they compete against each other to achieve their respective targets.
Thus, oligopoly market is a market structure that lies between the monopolistic competition and
a pure monopoly.

3. Macro-Economics
Meaning of Macroeconomics

Macroeconomics is focused on the movement and trends in the economy as a

whole. It is the field of economics that studies the behavior of the entire
economy. Thus we can say that it is that part of economic theory which studies
the economy in its totality or as a whole. Macroeconomics deals with the whole
economic system like national income, total savings and investment, total
employment, total demand, total supply, general price level etc. In this article
we are going to study how these aggregates of economy are determined and
what causes fluctuations in them. What we are going to understand the reason
for the fluctuations and how to ensure the maximum level of employment and
income in a country.

Importance of Macroeconomics

 It helps in understand the functioning of a complex modern

economic system. Macroeconomics gives us a clue on how the
economy functions on a whole and how the level of national
income and employment is determined on the basis of aggregate
demand and aggregate supply.
 In a certain way macroeconomics does helps in achieving the
goal of economic growth , higher level of GDP and higher level of
employment.
 It also analyses the forces which determine economic growth of
a country. Understanding the macroeconomic problems gives a
cue on how to reach the highest state of economic growth and
sustain it.
 Bringing stability in price level and analysis of the fluctuations
in business activities is another set of macroeconomic problems
that are taken care by better understanding of macroeconomics.

73
  Macroeconomics helps in suggesting policy measures to control
inflation and deflation.
 It explains factors affecting balance of payment. It also
identifies causes of deficit in balance of payment and suggests
measures for the same.
 It helps to solve economic problems like poverty,
unemployment, inflation, deflation etc. The solution for such
macroeconomic problem is possible at macro level only.
 Better understanding of the macroeconomics of the country
helps to formulate correct economic policies and also coordinate
with international economic policies.

3.1 Problems of macroeconomics

Now that we have understood the meaning and importance of

macroeconomics, let’s try to grasp some ideas about some
common macroeconomics problems. In the earlier paragraphs of
this article we have heard some terms that are related to
macroeconomics. Some of them were inflation , unemployment ,
balance of payment etc. So now let’s get to know them better. Have
you ever tried to think of when these macroeconomics problems
arise? To get your doubts clear let me share the answer with you.
 Macroeconomics problems arise when the economy does not
adequately achieve the goals of full employment, stability, and
economic growth. As a result of which there is a cascading effect
which follows.
 Unemployment results when full employment is not achieved.
Inflation creeps in when the economy falls short of the goal of
stability. The phase of stagnant growth arises when the economy
is not adequately attaining the goal of economic growth. All these
problems are either caused by too little or too much demand for
gross production. For instance, unemployment results from too
little demand and inflation emerges with too much demand.

Unemployment

Think that there are 4 boxes of a full sized pizza, and there are 10
hungry moths that are ready to grab a bite. But only 4 of them get
to have all the 4 boxes of pizza. So rests of the six people are not
utilized here in this eating completion. Though it’s a funny
scenario, it can exactly be related to why unemployment creeps in.
74
In the same way; unemployment arises when factors of production
that are willing and able to produce goods and services are not
actively engaged in production. Unemployment means the
economy is not attaining the macroeconomic goal of full
employment. Unemployment is a problem because:

 Less output is produced and thus arise the problem of

scarcity in the economy.
 Due to which the owners of unemployed resources receive
less income. This gradually reduces the standard of living.

Thus unemployment rate ultimately tells us how many people

from the available pool of labor force are unable to find work. It is
generally observed that when the economy witness growth from
period to period, which is indicated in the GDP growth rate,
unemployment levels tend to be low. This is because with rising
(GDP levels, the output is higher, and hence more laborers are
needed to keep up with the greater levels of production. Generally,
better the economy, lower is the unemployment rate and vice-
versa.

Inflation

The consistent and persistent rise in the average price level in the
economy leads to inflation. In simple words, during the Inflation
there is general rise in the price of goods and services over time.
In such case, prices generally rise from month to month and year
to year and thus with this burden of inflation the economy does
not attain its stability goal. Inflation leads to an average increase
in prices. Here, some prices rise more than the average, some
raising less, and some even declining. Inflation is a problem
because:

 Since there is rise in the price of goods and services, the

purchasing power of money declines. This in turn reduces
financial wealth and lowers living standards.
 Greater uncertainty surrounds long-run planning.
 Income and wealth tend to be haphazardly distributed among
various sectors of the economy and amongst the resource
owners.

75
The Business Cycle

Unemployment and inflation tend arise at different phases of the

business cycle. The probability of these problems will vary
accordingly. At some times, unemployment is less of a problem
and inflation is more. At other times, unemployment is more of a
problem and inflation is less. Now we will understand how these
two problems are connected to the two primary phases of the
business cycle. Contraction Phase: During the contraction phase
of the business cycle there is a general decline in economic
activity. The overall aggregate demand is less which means that
there is less output that is produced, and thus fewer resources are
employed for the same. For this reason, unemployment tends to be
a key problem here. But at the same time since markets tend to
have more surpluses than shortages, inflation tends to be less of a
problem during this phase. Expansion Phase: During the
expansion phase of the business cycle there is a general rise in the
economic activity. Thus the overall aggregate demand increases
leading to more production and the resources been employed at a
higher level. Demand is more than the supply. Hence markets are
more likely to have shortages than surpluses. Thus inflation tends
to be the primary problem during this phase. However, with
robust production, more people are needed to cope up with the
Job demand and thus unemployment tends to be less of a
problem.

Interest Rates

Interest rates are the charges which are levied by the banks for
lending a loan . As businesses borrow money from the banks from
time to time, increase in Interest rates will directly influence the
business. With the increase in interest rates will lead to increase
in interest expense. In such a case businesses will have to incur
higher costs to repay the loan. Along with the businesses, interest
rate changes also affect customers who in turn will affect the
business. Individuals in such cases have to pay higher amount to
borrow the money, ultimately declining the demand for large
products.

76
Stagnant Growth

Stagnant growth occurs when Supply of products is not increasing

or it is decreasing below the benchmark. An increase in the total
production of goods and services is generally needed for growth of
the economy. This is required to keep pace with an increase in the
population and expectations of rising living standards. Stagnant
growth exists if total production does not keep pace with these
expectations. Hence the macroeconomic goal of economic growth
is not attained. The probable reasons for stagnant growth can be
associated with the quantity and quality of the resources used for
production. So let’s understand the reasons in detail. The
quantities of the four factors of production can restrict the growth
of production. These factors are labor, capital, land, and
entrepreneurship . If a lazy person decides to quit his job and
spend his time doing nothing but sleeping on his parent’s living
room sofa, then the total quantity of labor declines. Thus the
quantity of labor is based on both the overall population and the
portion of the population willing and able to work. If for example,
Government regulations and High taxes discourage some
industries to build new factories in the manufacturing sector, it
will totally decline the quantity of capital. So this is all about the
Macroeconomics Problems.

3.2 National income accounting

National income accounting is a bookkeeping system that a government uses to

measure the level of the country's economic activity in a given time period.
Accounting records of this nature include data regarding total revenues earned
by domestic corporations, wages paid to foreign and domestic workers, and the
amount spent on sales and income taxes by corporations and individuals
residing in the country.
Although national income accounting is not an exact science, it provides useful
insight into how well an economy is functioning, and where monies are being
generated and spent. When combined with information regarding the
associated population, data regarding per capita income and growth can be
examined over a period of time.
Some of the metrics calculated by using national income accounting include
gross domestic product (GDP), gross national product (GNP) and gross national
income (GNI). The GDP is a widely used for economic analysis on the domestic
level and represents the total market value of the goods and service produced
within a specific nation over a selected period of time.

77
The information collected through national income accounting can be used for
a variety of purposes, such as assessing the current standard of living or the
distribution of income within a population. Additionally, national income
accounting provides a method for comparing activities within different sectors
in an economy, as well as changes within those sectors over time. A thorough
analysis can assist in determining overall economic stability within a nation.
As an example, the basic accounting identity for GDP, sometimes known as the
national income identity, is computed using the following formula:
GDP = consumption + investment + government spending + (exports −
imports).
The quantitative information associated with national income accounting can
be used to determine the effect of various economic policies. Considered an
aggregate of the economic activity within a nation, national income accounting
provides economists and statisticians with detailed information that can be
used to track the health of an economy and to forecast future growth and
development.
The data can provide guidance regarding inflation policy and can be especially
useful in the transitioning economies of developing nations, as well as statistics
regarding production levels as related to shifting labor forces. These data are
also used by central banks to set and adjust monetary policy and affect the
risk-free rate of interest that they set. Governments also look at figures such as
GDP growth and unemployment to set fiscal policy in terms of tax rates and
infrastructure spending.
3.2.1 Basic concepts:- Gross Domestic product (GDP), Gross National
Product (GNP)

GDP first came into use in 1937 in a report to the U.S. Congress in response to
the Great Depression after Russian economist Simon Kuznets conceived the
system of measurement. At the time, the preeminent system of measurement
was the Gross National Product (GNP) (see below). After the Bretton Woods
conference in 1944, GDP was widely adopted as the standard means for
measuring national economies, though the U.S. actually used GNP as its
official measure of economic welfare until 1991, after which it switched to GDP.
Beginning in the 1950s, however, some began to question the faith of
economists and policy makers in GDP internationally as a gauge of progress.
Some observed, for example, a tendency to accept GDP as an absolute
indicator of a nation’s failure or success, despite GDP’s failure to account for
health, distribution of wealth, discrimination and other constituent factors of
public welfare. In other words, these critics drew attention to a distinction
between economic progress and social progress. Others, like Arthur Okun, an
economist for President Kennedy’s Council of Economic Advisers, held firm to
the belief that GDP is as an absolute indicator of economic success, claiming
that for every increase in GDP there would be a corresponding drop in
unemployment.

78
In recent decades, governments have created various nuanced modifications in
attempts to increase GDP accuracy and specificity. Means of calculating GDP
have also evolved continually since its conception so as to keep up with
evolving measurements of industry activity and the generation and
consumption of new, emerging forms of intangible assets.

Gross domestic product (GDP) is the monetary value of all the finished goods
and services produced within a country's borders in a specific time period.
Though GDP is usually calculated on an annual basis, it can be calculated on
a quarterly basis as well (in the United States, for example, the government
releases an annualized GDP estimate for each quarter and also for an entire
year).

GDP includes all private and public consumption, government outlays,

investments, private inventories, paid-in construction costs and the foreign
balance of trade (exports are added, imports are subtracted). Put simply, GDP
is a broad measurement of a nation’s overall economic activity – the godfather
of the indicator world.

The Significance of GDP

GDP is commonly used as an indicator of the economic health of a country, as

well as a gauge of a country's standard of living. Since the mode of measuring
GDP is uniform from country to country, GDP can be used to compare the
productivity of various countries with a high degree of accuracy. Adjusting for
inflation from year to year allows for the seamless comparison of current GDP
measurements with measurements from previous years or quarters. In this
way, a nation’s GDP from any period can be measured as a percentage relative
to previous periods. An important statistic that indicates whether an economy
is expanding or contracting, GDP can be tracked over long spans of time and
used in measuring a nation’s economic growth or decline, as well as in
determining if an economy is in recession (generally defined as two consecutive
quarters of negative GDP growth).

How to Determine GDP

There are three primary methods by which GDP can be determined. All, when
correctly calculated, should yield the same figure. These three approaches are
often termed the expenditure approach, the output (or production) approach
and the income approach.
GDP Based on Spending
The expenditure approach or spending approach, which is the most common
method, calculates the monies spent by the different groups that participate in
the economy. For instance, consumers spend money to buy various goods and
services and businesses spend money as they invest in their business activities
(buying machinery, for instance). And governments also spend money. All these

79
activities contribute to the GDP of a country. In addition, some of the goods
and services that an economy makes are exported overseas, their net exports.
And some of the products and services that are consumed within the country
are imports from overseas. The GDP calculation also accounts for spending on
exports and imports.
A country's gross domestic product can be calculated using the following
formula: GDP = C + G + I + NX. C is equal to all private consumption, or
consumer spending, in a nation's economy, G is the sum of government
spending, I is the sum of all the country's investment, including businesses
capital expenditures and NX is the nation's total net exports, calculated as
total exports minus total imports (NX = Exports - Imports).
GDP Based on Production
The production approach is something like the reverse of the expenditure
approach. Instead of exclusively measuring input costs that feed economic
activity, the production approach estimates the total value of economic output
and deducts costs of intermediate goods that are consumed in the process, like
those of materials and services. Whereas the expenditure approach projects
forward beyond intermediate costs, the production approach looks backward
from the vantage of a state of completed economic activity.
GDP Based on Income
Considering that the other side of the spending coin is income, and since what
you spend is somebody else’s income, another approach to calculating GDP –
something of an intermediary between the two aforementioned approaches – is
based on a tally of the national income. Income earned by all the factors of
production in an economy includes the wages paid to labor, the rent earned by
land, the return on capital in the form of interest, as well as an entrepreneur’s
profits. An entrepreneur’s profits could be invested in his own business or it
could be an investment in any outside business. All this constitutes national
income, which is used both as an indicator of implied productivity and of
implied expenditure.
In addition, the income approach factors in some adjustments for some items
that don’t show up in these payments made to factors of production. For one,
there are some taxes – such as sales taxes and property taxes – that are
classified as indirect business taxes. In addition, depreciation – which is a
reserve that businesses set aside to account for the replacement of equipment
that tends to wear down with use – is also added to the national income.
GDP and GNI
With this approach, the GDP of a country is calculated as its national income
plus its indirect business taxes and depreciation, as well as its net foreign
factor income. GDP calculated in this way – incorporating income received
from overseas – is also referred to as gross domestic income (GDI), or as gross
national income (GNI). In an increasingly global economy, GNI is increasingly
being recognized as possibly a better metric for overall economic health than
GDP because it measures national income, regardless of whether the income is
earned by people within a country's borders or elsewhere in the world.

80
Because certain countries have most of their income withdrawn abroad by
foreign corporations and individuals, their GDP figures are much higher than
those of their GNI. For instance, in 2013, Luxembourg recorded $60.1 billion of
GDP, while its GNI was $38.2 billion due to large payments it made to the rest
of the world. In contrast, in 2013, the GDP in the United States was $16.8
trillion, while its GNI was $17 trillion, reflecting the fact U.S. corporations and
U.S. citizens received net income from abroad.
Impact of the Balance of Trade
The balance of trade is one of the key components of a country's (GDP)
formula. GDP increases when the total value of goods and services that
domestic producers sell to foreigners exceeds the total value of foreign goods
and services that domestic consumers buy, otherwise known as a trade
surplus. If domestic consumers spend more on foreign products than domestic
producers sell to foreign consumers – a trade deficit – then GDP decreases.
At first glance, it is tempting to believe protectionism leads to increased GDP.
However, fewer imports directly lead to fewer exports. The vast majority of
economic literature suggests that protectionist policies reduce the GDP of both
domestic and foreign nations. And, as a logical corollary, strong evidence
suggests trade liberalization, or the removal of protectionist barriers by a home
country, creates significant productive benefits and expands GDP.
Difference between GDP and GNP

GNP differs from GDP in that GNP measures the productivity of a nation’s
citizens regardless of their locales, as opposed to the GDP’s measurement of
production by geographic location. In other words, GDP refers to and
measures the domestic levels of production within the physical borders of a
country, whereas GNP measures the levels of production of a person or
corporation of a particular nationality both at home and abroad. For example,
the U.S.'s GNP measures the production levels of any American or American-
owned entity, regardless of where the actual production process is taking place,
and defines the economy in terms of the citizens.
Depending on circumstances, GNP can be either higher or lower than GDP.
This depends on the ratio of domestic to foreign manufacturers in a given
country. For example, China's GDP is $300 billion greater than its GNP,
according to Knoema, a public data platform, due to the large number of
foreign companies manufacturing in the country, whereas the GNP of the U.S.
is $250 billion greater than its GDP, because of the mass amounts of
production that take place outside of the country's borders.

Though both calculations attempt to measure the same thing, generally

speaking, GDP has become the more commonly utilized method of measuring a
country's economic success in the world, especially now that the global
economy is increasingly interconnected. It is possible for a citizen in one
country to produce goods and services in many countries simultaneously over
the Internet or through modern supply chains. This raises definitional and

81
accounting issues for GNP calculations. Still, GNP can be useful as well, and it
is important to reference both when trying to get an accurate sense of a given
country's economic worth.

3.2.2 Approaches to measuring GNP (product, expenditure and

income Product (GNP)

3.2.3 Nominal vs. Real GDP

Considering that GDP is based on a monetary value of an economy’s output, it

is subject to inflationary pressure. Over a period of time, prices typically tend
to go up in an economy and this is reflected in the GDP. Thus, just by looking
at an economy’s unadjusted GDP, it is difficult to tell whether the GDP went up
as a result of production expanding in the economy or because prices
escalated.
That’s why economists have come up with an adjustment for inflation to arrive
at an economy’s real GDP, rather than its nominal GDP, which ignores
inflation and deflation. By adjusting the output in any given year for inflation
so that it reflects the price levels that prevailed in a reference year, called “the
base year,” economists adjust for the inflation effect. This way, it is possible to
compare a country’s GDP from one year to another and see if there is any real
growth.
Real GDP is calculated using a GDP price deflator, which is the difference in
prices between the current year and the base year. For example, if prices rose
by 5% since the base year, the deflator would be 1.05. Nominal GDP is divided
by this deflator, yielding real GDP.
Nominal GDP is usually higher than real GDP because inflation is typically a
positive number. Real GDP accounts for the change in market value, which
narrows the difference between output figures from year to year. A large
discrepancy between a nation's real and nominal GDP signifies significant
inflationary forces (if the nominal is higher) or deflationary forces (if the real is
higher) in its economy.
Nominal GDP is used when comparing different quarters of output within the
same year. When comparing the GDP of two or more years, real GDP is used
because, by removing the effects of inflation, the comparison of the different
years focuses solely on volume.
Overall, real GDP is a much better index for expressing long-term national
economic performance. Take for example a hypothetical country which in the
year 2000 had a nominal GDP of $100 billion, which grew to $150 billion by
2010 its nominal GDP. Over the same period of time, inflation reduced the
relative value of the dollar by 50%. Looking at merely nominal GDP, the
economy appears to be performing well, whereas the real GDP expressed in
2000 dollars would be $75 billion, revealing that in fact an overall decline in
economic performance occurred.

82
 3.2.4 National product and the informal economy
The informal sector, informal economy, or grey economy is the part of an
economy that is neither taxed nor monitored by any form of government.
Unlike the formal economy, activities of the informal economy are not included
in a country's gross national product (GNP) or gross domestic product
(GDP).The informal sector can be described as a grey market in labour.

Other concepts that can be characterized as informal sector can include the
black market (shadow economy, underground economy) ".

The informal sector is largely characterized by several qualities: easy entry,

meaning anyone who wishes to join the sector can find some sort of work
which will result in cash earnings, a lack of stable employer-employee
relationships, a small scale of operations, and skills gained outside of a formal
education.]Workers who participate in the informal economy are typically
classified as employed. The type of work that makes up the informal economy
is diverse, particularly in terms of capital invested, technology used, and
income generated. The spectrum ranges from self-employment or unpaid family
labor]to street vendors, shoe shiners, and junk collectors.
The most prevalent types of work in the informal economy are home-based
workers and street vendors. Home-based workers are more numerous while
street vendors are more visible. Combined, the two fields make up about 10–
15% of the non-agricultural workforce in developing countries and over 5% of
the workforce in developed countries.

While participation in the informal sector can be stigmatized, many workers

engage in informal ventures by choice, for either economic or non-economic
reasons.

As the International Labour Organization defined the informal sector in 2002,

the informal sector does not include the criminal economy. While production or
employment arrangements in the informal economy may not be strictly legal,
the sector produces and distributes legal goods and services. The criminal
economy produces illegal goods and services. The informal economy also does
not include the reproductive or care economy, which is made up of unpaid
domestic work and care activities. The informal economy is part of the market
economy, meaning it produces goods and services for sale and profit. Unpaid
domestic work and care activities do not contribute to that, and as a result, are
not a part of the informal economy.
GNP or the Gross National Product of a nation means the aggregate gross value
of all the goods and services produced by that nation in a single fiscal year
minus the revenue of exports and imports.

3.2.5 GNP and economic welfare

Thus GNP is a measure of the national economic output. However, national

83
output is in itself a skewed concept. Initially Gross National Product was
conceived as a means of measuring a nation's economic activity. However,
since increased economic activity is usually associated with rising standards of
living or economic well-being, GNP growth has often been linked with increased
economic welfare. This article examines the general concept and definition of
GNP as currently computed and assesses its effectiveness as an indicator of
economic welfare. the spending approach, is shown in Table 1. Under this form
of GNP accounting, the value of goods produced closely approximates spending
on final goods and services.1 Estimates of four major categories— personal
consumption expenditures, gross private domestic investment, net exports, and
government purchases of goods and services— are summed to equal total GNP.

3.3 Fluctuations in economic activities: unemployment and

inflation
What Are Economic Fluctuations?

Economic fluctuations are simply fluctuations in the level of the national

income of a country representing growth or contraction. A market economy is
not static. It's dynamic. A rise in national income means an economy is
growing, while a decline in national income means that an economy is
contracting. The current economic model describing economic fluctuations in a
market economy is the business cycle.
Fluctuations in economic activity: there is only one cause

For a whole economy to trend upward or downward, it is necessary to look at the

aggregate demand side of the economy and that means looking at what is happening
to the rate of growth of monetary demand.

For a hundred years or more there has been an unresolved debate over what
causes fluctuations in economic activity. These fluctuations have been given
different names often associated with the length and amplitude of the cycle.
Some of the more quoted are:
•Tradecycle
•Businesscycle
•Stop-gocycle
• Kondratiev cycle

Unemployment and inflation

The Phillips curve relates the rate of inflation with the rate of unemployment. The Phillips curve
argues that unemployment and inflation are inversely related: as levels of unemployment
decrease, inflation increases. The relationship, however, is not linear. Graphically, the short-run
Phillips curve traces an L-shape when the unemployment rate is on the x-axis and the inflation
rate is on the y-axis.

84
Theoretical Phillips Curve: The Phillips curve shows the inverse trade-off between inflation
and unemployment. As one increases, the other must decrease. In this image, an economy can
either experience 3% unemployment at the cost of 6% of inflation, or increase unemployment to
5% to bring down the inflation levels to 2%.
The Phillips Curve Related to Aggregate Demand
The Phillips curve shows the inverse trade-off between rates of inflation and rates of
unemployment. If unemployment is high, inflation will be low; if unemployment is low, inflation
will be high.
The Phillips curve and aggregate demand share similar components. The Phillips curve is the
relationship between inflation, which affects the price level aspect of aggregate demand, and
unemployment, which is dependent on the real output portion of aggregate demand.
Consequently, it is not far-fetched to say that the Phillips curve and aggregate demand are
actually closely related.
To see the connection more clearly, consider the example illustrated by. Let’s assume that
aggregate supply, AS, is stationary, and that aggregate demand starts with the curve, AD1. There
is an initial equilibrium price level and real GDP output at point A. Now, imagine there are
increases in aggregate demand, causing the curve to shift right to curves AD2 through AD4. As
aggregate demand increases, unemployment decreases as more workers are hired, real GDP
output increases, and the price level increases; this situation describes a demand-pull inflation
scenario.

85
Phillips Curve and Aggregate Demand: As aggregate demand increases from AD1 to AD4, the
price level and real GDP increases. This translates to corresponding movements along the
Phillips curve as inflation increases and unemployment decreases.
As more workers are hired, unemployment decreases. Moreover, the price level increases,
leading to increases in inflation. These two factors are captured as equivalent movements along
the Phillips curve from points A to D. At the initial equilibrium point A in the aggregate demand
and supply graph, there is a corresponding inflation rate and unemployment rate represented by
point A in the Phillips curve graph. For every new equilibrium point (points B, C, and D) in the
aggregate graph, there is a corresponding point in the Phillips curve. This illustrates an important
point: changes in aggregate demand cause movements along the Phillips curve.

III.4. Aggregate demand and supply equilibrium

The Aggregate Demand and Aggregate Supply Equilibrium provides information
on price levels, real GDP and changes to unemployment, inflation, and growth
as a result of new economic policy. For example, if the government increases
government spending, then it would shift Aggregate Demand (AD) to the right
which would increase inflation, growth (real GDP) and employment. There are
differences in two extreme cases rises from the different views on the cause of
unemployment, Keynesian views unemployment as involuntary, while
Monetarists view unemployment as voluntary.
The equilibrium is initially assumed at P1 and Y1. An increase in Aggregate
Demand leads to an increase in real GDP from Y1 to Y2, but at the cost of an
increase in the rate of inflation. It shows that growth can be increased at the
expense of increasing inflation.

86
 Intermediate Case
The macroeconomic equilibrium means such a state in the
economy that does not cause a change of economic operator’s
behavior. Macroeconomic equilibrium represents equality of
aggregate demand to aggregate supply. Macroeconomic
equilibrium is shown in Fig 3.4.1 – by the point E and in this
picture the real product is located at the level of potential output
Q* (actual product equals the potential product).

P LRAS

SRAS

P E

AD

Q* Q

Fig. 3.4 Macroeconomic equilibrium - AS/AD model

87
Fig. 3.4.1 Macroeconomic equilibrium - AS/AD model
Macroeconomic equilibrium is usually illustrated by the AS/AD
model. This model depicts the economy as a whole, the x-axis re

presents real output (Q or Y, respectively real GDP) and the y-

axis indicates the aggregate price level, respectively price index
(P). Point E determines the equilibrium output Q* (here it is also
potential output of the economy) and the equilibrium price level
PE Equilibrium in AS/AD model contains equilibriums on the
aggregate: production market (or market of goods and services)
labor and land markets, financial markets (i.e. capital market
and money market). Conception of macroeconomic equilibrium
represents an important position to deal with macroeconomic
issues, in particular to define the role of government in the
economy. In macroeconomics, there is a distinction between the
classical conception and the Keynesian macroeconomic
approach.

A. The classical concept of macroeconomic equilibrium

The classical concept of equilibrium is historically older than the
Keynesian concept, occurs currently in theoretical concepts of
contemporary conservative streams of economics. This concept is
built on the assumptions of (neo) classical economics, on the
tradition of liberal economic thinking. The classical model
assumes flexible prices at the production market and flexible
prices at factor markets. Markets tend towards equilibrium when
changing prices. Savings and investment meet at the capital
market. Household savings are dependent on the size of the
interest rate (rising interest rate stimulates the formation of
household savings). Conversely, investments are indirectly
dependent. Rising interest rate reduces incentives to invest.
Changing interest rate ensures the equilibrium at the capital
market. Fig. 3.4.2 The capital market in the classical concept of
macroeconomic equilibrium

88
i S

i1 S>I

i E

I>S
i 2

S=I S, I

Fig. 3.4.2 illustrates the capital market.

3.5 Instruments of policy: monetary, fiscal and incomes.

Monetary policy affects the supply of money & the rate of interest. Fiscal
policy includes the rate of taxation & level of government spending. Incomes
policy consists of anti-inflation measures that depend on income & price
limitations, such as moderated wage increases.
Monetary policy and fiscal policy refer to the two most widely recognized tools
used to influence a nation's economic activity. Monetary policy is primarily
concerned with the management of interest rates and the total supply of money
in circulation and is generally carried out by central banks such as the U.S.
Federal Reserve. Fiscal policy is the collective term for the taxing and
spending actions of governments. In the United States, the national fiscal
policy is determined by the executive and legislative branches of the
government.
Monetary Policy

Central banks have typically used monetary policy to either stimulate an

economy or to check its growth. The theory is that, by incentivizing individuals
and businesses to borrow and spend, monetary policy can spur economic
activity. Conversely, by restricting spending and incentivizing savings,
monetary policy can act as a brake on inflation and other issues associated
with an overheated economy.

89
The Federal Reserve, also known as the "Fed," has frequently used three
different policy tools to influence the economy: opening market operations,
changing reserve requirements for banks and setting the discount rate. Open
market operations are carried out on a daily basis where the Fed buys and
sells U.S. government bonds to either inject money into the economy or pull
money out of circulation. By setting the reserve ratio, or the percentage of
deposits that banks are required to keep in reserve, the Fed directly influences
the amount of money created when banks make loans. The Fed can also target
changes in the discount rate (the interest rate it charges on loans it makes to
financial institutions), which is intended to impact short-term interest rates
across the entire economy.

Fiscal Policy

Generally speaking, the aim of most government fiscal policies is to target the
total level of spending, the total composition of spending, or both in an
economy. The two most widely used means of affecting fiscal policy are changes
in government spending policies or in government tax policies.
If a government believes there is not enough business activity in an economy, it
can increase the amount of money it spends, often referred to as "stimulus"
spending. If there are not enough tax receipts to pay for the spending
increases, governments borrow money by issuing debt securities such as
government bonds and, in the process, accumulate debt; this is referred to as
deficit spending.
By increasing taxes, governments pull money out of the economy and slow
business activity. But typically, fiscal policy is used when the government
seeks to stimulate the economy. It might lower taxes or offer tax rebates, in an
effort to encourage economic growth. Influencing economic outcomes via fiscal
policy is one of the core tenets of Keynesian economics.
When a government spends money or changes tax policy, it must choose where
to spend or what to tax. In doing so, government fiscal policy can target specific
communities, industries, investments, or commodities to either favor or
discourage production – and sometimes, its actions based on considerations
that are not entirely economic. For this reason, the numerous fiscal policy tools
are often hotly debated among economists and political observers.

Which is more effective: Monetary or Fiscal Policy?

In terms of improving the real economy, expansionary fiscal policy is more

effective. In terms of the financial economy, expansionary monetary policy is
the better choice. Both types work through different channels and impact
individuals and corporations in different ways.
Fiscal policy affects consumers positively for the most part, as it leads to
increased employment and income. Essentially, it is targeting aggregate
demand. Companies also benefit as they see increased revenues.

90
However, if the economy is near full capacity, expansionary fiscal policy risks
sparking inflation. This inflation eats away at the margins of certain
corporations in competitive industries that may not be able to easily pass on
costs to customers; it also eats away at the funds of people on a fixed income.
Fiscal policy can also have the effect of creating asset bubbles if the market
and incentives become too distorted.
Monetary policy has less impact on the real economy. Case in point: the Great
Depression, during which the Federal Reserve was particularly aggressive on a
historical scale. Its actions prevented deflation and economic collapse but did
not generate significant economic growth to reverse the lost output and jobs.
Expansionary monetary policy can have limited effects on growth by increasing
asset prices and lowering the costs of borrowing, making companies more
profitable. In addition, it has the psychological benefits of taking worse-case
economic scenarios off the table. As with fiscal policy, extended periods of low
borrowing costs can create asset bubbles that are only apparent in hindsight.
Another crucial difference between the two is that fiscal policy can be targeted,
while monetary policy is more of a blunt tool in terms of expanding and
contracting the money supply to influence inflation and growth.
Incomes policy
The instruments available to policymakers for supporting economic recovery
seem to have been limited after the crisis, especially in developed economies.
On the one hand, there is little scope for monetary policy to provide additional
stimulus, as interest rates has remained at historic lows, and quantitative
easing has become more difficult to defend politically. Further, the ongoing
deleveraging process associated to falling asset prices, made it extremely hard
to revive credit to boost domestic demand. On the other hand, higher public-
debt-to-GDP ratios have convinced many governments that they should shift to
fiscal tightening.
While there is more space for proactive fiscal policies than what is perceived by
policymakers, in addition, there are other policy tools, such as incomes policy,
that have been largely overlooked. These could play a strategic role in dealing
with the present challenges.
In the period of intensified globalization from the early 1980s until the global
crisis, the share of national income accruing to labor declined in most
developed and developing countries. If real wage growth fails to keep pace with
productivity growth, there is a lasting and insurmountable constraint on the
expansion of domestic demand and employment creation. To offset insufficient
domestic demand, one kind of national response has been an overreliance on
external demand. Another kind of response has taken the form of
compensatory stimulation of domestic demand through credit easing and
increasing asset prices. However, neither of these responses offers sustainable
outcomes.

91