Microeconomics (AgEc 211)

nd
Course material for 2 Year

Agribusiness and Value Chain Management program

January, 2025

Haramaya University
 CHAPTER ONE

INTRODUCTION TO ECONOMICS

1.1. Definition and Scope of Economics

1. Economics is a social study of production, distribution and consumption of wealth or
output. This definition emphasizes three major economic activities. First the output
must be produced (production); second, the product must be distributed to potential
consumers (distribution); and finally, consumers must choose from the available goods
for consumption (consumption).

2. Economics is the study of choice. Economic agents (producers and consumers of

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

1.2. Classification/Branches of economics

Economists have classified economics in to different branches. They follow different
classification based on different perspectives.
i. From the point of view of elements of analysis, economics has two major branches:
Macroeconomics and Microeconomics.

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

is concerned with behaviours of individual economic units such as producers,
consumers, business firms and other economic decision making units. It is the study of
transactions between people and businesses and how the flow of money operates
between these basic entities. Microeconomics also focuses on the supply and demand
relationship between buyer and seller and how this ultimately determines equilibrium
prices of goods and services.
Macroeconomics: - is concerned with the aggregate performance of the entire
economic system. The scale of macroeconomic discussions are typically on a country
level and utilizes facts from that country's economic performance (gross domestic
product, inflation, government interest rates, unemployment, international trade and
the overall impact of imports and exports on a country's economic growth).

ii. From the view point of interest whether to deal with economic explanations/
understandings/ or with what should be done to change or improve the existing
economic conditions (whether to deal with value judgement or not), we can divide
economics as positive economics and normative economics.

Positive economics: - is concerned with the explanations of economic conditions. It

answers the question ‘what is?’ i.e., Positive economics tries to understand the existing
economic situation. E.g. what is the price of agricultural produces in market A? What is
the inflation rate this year?

Normative economics: - deals with value judgement on economic situation. It answers

the question ‘what should be?’ as in what should be done to increase employment and
to reduce price?

iii. One way of dividing the world economy is on the basis of the economic policies a
country follows. From this perspective, we can divide world economy in to three:
Command economy, mixed economy and market economy.

iv. We can also classify economics into different areas of economic specializations.
Some of these are: Agricultural, Natural Resources, Environmental, Health, Education,
Welfare, Labour, Industrial, Behavioural, Public, Monetary, Institutional, Development,
Mathematical and Quantitative, Urban, Rural, Regional, International, Law and
Economics, etc.

1.3. Methods of Economics

Inductive and deductive reasoning in economics

The fundamental objective of economics, like any science, is the establishment of valid
generalizations about certain aspects of human behaviour. Those generalizations are
known as
theories. A theory is a simplified picture of reality. Economic theory provides the basis
for
economic analysis which uses logical reasoning. There are two methods of logical
reasoning:
inductiveanddeductive.

a) Inductive reasoning is a logical method of reaching at a correct general statement or

theory based on several independent and specific correct statements. In short, it is the
process of deriving a principle or theory by moving from facts to theories and from
particular to general economic analysis.

Inductive method involves the following steps.

1. Selecting problem for analysis
2. Collection, classification, and analysis of data
3. Establishing cause and effect relationship between economic phenomena.
b) Deductive reasoning is a logical way of arriving at a particular or specific correct
statement starting from a correct general statement. In short, it deals with conclusions
about
economic phenomenon from certain fundamental assumptions or truths or axioms
through
a process of logical arguments. The theory may agree or disagree with the real world
and
we should check the validity of the theory to facts by moving from general to particular.

Major steps in the deductive approach include:

1. Problem identification
2. Specification of the assumptions
3. Formulating hypotheses
4. Testing the validity of the hypotheses
1.4. Basic economic questions andEconomic Systems
Economic problems faced by an economic system due to scarcity of resources are
known as basic economic problems. These problems are common to all economic
systems. They are also known as central problems of an economy. Therefore, any human
society should answer the following three basic questions.
1. What to Produce?
This problem is also known as the problem of allocation of resources. It implies that
every economy must decide which goods and in what quantities are to be produced. The
economy must make choices such as consumption goods versus capital goods, civil
goods versus military goods, and necessity goods versus luxury goods. As economic
resources are limited we must reduce the production of one type of good if we want
more of another type. Generally, the final choice of any economy is a combination of
the various types of goods but the exact nature of the combination depends upon the
specific circumstances and objectives of the economy.
2. How to Produce?
This problem is also known as the problem of choice of technique. Once an economy
has reached a decision regarding the types of goods to be produced, and has
determined their respective quantities, the economy must decide how to produce them
- choosing between alternative methods or techniques of production. For example,
cotton cloth can be produced with hand looms, power looms, or automatic looms.
Similarly, wheat can be grown with primitive tools and manual labour, or with modern
machinery and little labour.
Broadly speaking, the various techniques of production can be classified into two
groups: labour-intensive techniques and capital-intensive techniques. A labour-
intensive technique involves the use of more labour relative to capital, per unit of
output. A capital-intensive technique involves the use of more capital relative to labour,
per unit of output. The choice between different techniques depends on the available
supplies of different factors of production and their relative prices. Making good
choices is essential for making the best possible use of limited resources to produce
maximum amounts of goods and services.

3. For Whom to Produce?

This problem is also known as the problem of distribution of national product. It relates
to how a material product is to be distributed among the members of a society. The
economy must decide, for example, whether to produce for the benefit of the few rich
people or for the large number of poor people. An economy that wants to benefit the
maximum number of persons would first try to produce the necessities of the whole
population and then to proceed to the production of luxury goods. All these and other
fundamental economic problems center around human needs and wants. Many human
efforts in society are directed towards the production of goods and services to satisfy
human needs and wants. These human efforts result in economic activities that occur
within the framework of an economic system.
1.4.1. Economic Systems
Economists divide economic systems into four major groupsthe traditional economy,
the planned (command) economy, the market economy, and the mixed economy.

1) The Traditional Economy: The traditional economy answers the fundamental

economic questions by appeal to tradition. What is produced is what the young have
been taught by their parents to hunt, to gather, or to plant. The techniques of
production of how to produce are also passed on, often without change, from
generation to generation. The amount of production is, of course, highly dependent on
good fortune. The last question, concerning distribution, is also traditionally
determined. In fact, traditional societies may have rules on how output is to be divided.

2) The Planned Economy: It answers the fundamental economic questions through

planning or through central command and control. The decisions regarding what, how,
and how much to produce are spelled out and documented. Detailed plans and orders
are sent to producers, and these instructions carry the weight of the law. A large part of
the question of ‘who gets what’ is determined in the same way, because planners
determine wage rates and the amount of production of consumer goods. Economists
use the term planned economy to refer to one in which the government plays a larger
role in answering the production and consumption questions of the society.

3) The Market Economy: The organizing principles, here, are the forces of demand and
supply. The determination of what to produce is made by consumers, and the force of
demand causes prices to go up for certain products when consumers desire more of
them.

In a sense, consumers vote with their money. The result of this voting process
determines what will be produced. Suppliers combine resources, determining how
things are to be produced. Assuming suppliers are self-interested and seek to maximize
their profits, they tend to combine inputs to produce any good or service at the lowest
possible cost. This determination depends on the prices of resources. Suppliers will use
more of relatively abundant resources because they are relatively cheap. This, in turn,
helps conserve the scarcer (more expensive) resources. The goods are then distributed
to consumers who have the purchasing power to buy them. Those who have more
purchasing power receive more goods and services.

4) The Mixed Economic System: In the real world we find that economies are the blend
of traditional, planned and market economic systems. In practice every economy is a
mixed economy in the sense that it combines significant elements of all three systems.

When we speak of a particular economy as being a centrally planned economy, we

mean only that the degree of the mix is weighted heavily toward the command
principle. When we speak of an economy as being a market economy, we mean only
that the degree of the mix is weighted heavily toward decentralized decision making in
response to market signals. It is important to realize that such distinctions are always
matters of degree, and that almost every conceivable mix can be found across the
world’s economies.

1.5. Scarcity Choice and Opportunity Cost

A society’s resources consist of natural endowments such as land, forests, and minerals;
human resources, both mental and physical; and manufactured aids to production such
as tools, machinery, and buildings. Such resources are called factors of production in
economics, because they are used to produce output that people desire. These outputs
could be goods or services. Goods are tangible (e.g., shoes, bread), and services are
intangible (e.g., education, entertainment).
People use these goods and services to satisfy their wants. The act of making goods and
services is called production and the act of using them is called consumption.
The quantity of factors of production and the goods and services they help produce is
not infinite. The existing resources are inadequate to satisfy the unlimited desires of
people. Since resources are insufficient to satisfy all desired uses, then there is scarcity,
which is the core problem.

Scarcity

The fundamental economic problem that any human society faces is the problem of
scarcity. Scarcity refers to the fact that all economic resources that a society needs to
produce goods and services are finite or limited in supply. But their being limited
should be expressed in relation to human wants.

Thus, the term scarcity reflects the imbalance between our wants and the means to
satisfy those wants.

Scarcity is the imbalance between our desires and available resources. Then economic
scarcity forces us to make economic choices. Wants are insatiable, because no matter
how much people have, they always want more of them. Since not all wants can be
satisfied, individuals have to pick and choose among the possibilities open to them.
Every society is faced with the same problems of scarcity and choice.

Choice

If resources are scarce, then output will be limited. If output is limited, then we cannot
satisfy all of our wants. Thus, choice must be made. Due to the problem of scarcity,
individuals, firms and government are forced to choose as to what output to produce, in
what quantity, and what output not to produce. In short, scarcity implies choice. Choice,
in turn, implies cost. That means whenever choice is made, an alternative opportunity is
sacrificed. This cost is known as opportunity cost. Scarcity limited resource limited
output we might not satisfy all our wants choice involves costs opportunity cost.

Opportunity cost

In a world of scarcity, a decision to have more of one thing, at the same time, means a
decision to have less of another thing. The value of the next best alternative that must
be sacrificed is, therefore, the opportunity cost of the decision.

Scarcity forces individuals to economize on their use of resources. Every decision to

produce or to consume something means that we must forego producing or consuming
something else. The cost of engaging in certain activity, say, going to cinema, includes
cost of the ticket and the value of what is given up in order to participate in that
activity. The time spent watching movie could have been spent in other activities, such
as work. You are therefore giving up the opportunity of working in order to watch
movie. The value of this foregone opportunity is called opportunity cost.
Definition: Opportunity cost is the value of the next best opportunity given up in order
to enjoy a particular good or service.
Suppose the person in the above example could have earned an hourly wage of Birr 20
had he decided to work rather than go to the cinema. For the individual, the opportunity
cost of enjoying a 1 hour and 45 minutes movie is Birr 35.
 CHAPTER TWO
THEORY OF DEMAND AND SUPPLY
2.1. Theory of Demand

Demand- refers to the desire and ability of buyers/consumers to purchase/consume a

given amount of goods or services, over a range of prices, over a given period of time.
Demand refers to the whole set of price-quantity combinations, i.e., demand defines the
whole set of relationship between price and quantity.

Quantity Demanded- the specific amount of a commodity that people are willing and
able to buy at a particular price, i.e., the quantity of a good or service that consumers
demand at price Birr 1, the quantity they demand at price Birr 2, etc.

Demand Schedule- a tabular listing that shows the quantity demanded at various
prices, ceteris paribusThe phrase ceteris paribus means other things remain the same.

Table 2.1: Demand schedule of Mr.Bonsa for bread

Price Quantity
0 250
5 200
10 150
15 100
20 50
25 0

Demand curve- a graphical representation of demand schedule showing the

relationship between the quantities demanded and its own price, ceteris paribus. It is
the relationship showing the various amounts of a commodity that buyers would be
willing and able to purchase at possible alternative prices during a given time period, all
other things remaining constant. Plotting the price-quantity relationships from the
demand schedule on a two-axis plane derives the demand curve for a good or service
given in figure 2.1 below.
 Price
25

20 Demand curve

15

5

50 100 150 200 250 Quantity

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

X axis = the quantity demanded per unit of time

Individual’s demand for a product is the quantity of the good that consumer would buy
at various prices.
Table 2.2: Individual Demand Schedules

Demand schedule of Price 0 1 2 3 4 5

A Quantit 50 40 30 20 10 0
y
Demand schedule of Price 0 1 2 3 4 5
B Quantit 30 20 25 20 15 10
y

Market Demand- is a function of individual’s demand curve and can be obtained by

horizontal summation of individual demand curves. It tells us the total amount of
goods and services purchased in an economy.
Market demand is the sum of individual demands. It is the total quantity of a good or
service consumers are willing to purchase at different prices in a given period. Suppose
there are three consumers in the market. The market demand is the sum of the three
quantities purchased by these consumers at each possible price.

In a more general case, in which the market consists of n consumers with individual
demand functions for goods X is defined as:
 Xi = f (PX)
Where Xi represents the quantity demanded of good X by individual i.
The market demand for good X (Xm) is given as:

The market demand curve (see Figure 2.2), therefore, could be considered to show the
relationship between market demand (Xm) and price PX , other things remaining constant.
Table 2.3: Market Demand Schedule

Price 0 1 2 3 4 5
Quantit 80 60 55 40 25 10
y

The market demand curves are similarly obtained from simple horizontal summation of
individual demand curves as given below:

Price
6
5 Market demand curve
4
3
2

1

0 10 25 40 55 60 80 Quantity

Figure 2.2: Market Demand Curve

Determinants of demand:
Demand for goods and services is affected by several factors. These include:
i. The price of the good and service (own price)-negative
ii. The tastes and preferences of the group demanding the good. -ve or +veEg.
Animal fat leads to a higher risk of heart attacks. This results in low demand for
red meat.
iii. The income and wealth of the group. +ve or -ve
Normal goods: An increase in disposable income leads to the increase in demand for
these goods.
Inferior goods: An increase in disposable income leads to a decrease in demand for
these goods. Can you give any example of such good?
iv. The Price of related goods and services (i.e. substitute goods. +ve and
complements (negative)
v. The size of the group (population).
vi. Expectations about the future (eg. Of higher price)
vii. Others (Changes in the population, weather, length of adjustment period,
availability of substitutes, proportion of the consumer’s budget that a particular
good represents, etc.). The less of a consumers budget a commodity represents,
the more inelastic the demand be. For e.g. Salt….Even if price doubles, the
consumption will not be affected very much).
Demand is, therefore, a multivariate function:
Qd = f(P, Po T, S, I, E,Z)
Where: P is output price
Pois the price of other goods and services.
T is the taste of consumers toward the good.
S is the size of the population in the market.
Iis the income of consumers.
E is the expectation of consumers about future market conditions.
Z is other factors.
All things that affect demand work through one of these factors. When studying
demand all factors that affect demand, except one, are kept constant (ceteris paribus)
and we determine what happens to demand when the factor under consideration
changes.

Law of Demand- is a principle stating that as the price of a commodity increases, the
fewer consumers will purchase per unit of time, ceteris paribus. As price increases, the
quantity demanded decreases per unit of time, ceteris paribus. Why?
● Substitution Effect- When a price of a good starts to increase relative to the
price of other goods, then people start to buy less of that good and more of its
substitutes.
● Income Effect- When price increases relative to income, people begin to buy
less of the good whose price has increased.

Demand function- shows the functional relationship between the quantity demanded of
a good and its price, ceteris paribus.
It is defined as: Q = f (P)

The demand function gives quantity demanded as a negative function of price. The
most widely used functional form is a linear demand curve, which is given as:
Q = a- bp Where, a is the intercept and -b is the slope (- ve).

Movement along the demand curve and shift in the demand curve
Changes in the determinants of demand cause changes in demand. These changes in
demand which result from changes in its determinants can be classified into movement
along the demand curve and shift of the demand curve.
Movement along demand curve- refers to that change in the quantity demanded of a
good because of changes in the prices of that good while other factors affecting
demand (such as price of other goods, income etc.) remaining the same (unchanged). In
this case it is the Qd that changes. This represents what is called change in quantity
demanded.

P D
P1 a

P2b

0 Q1 Q2 Q
Figure 2.3: Movement along the Demand Curve
Example 2.1
Suppose a demand function for a theater ticket is given as . If now price
changes from Birr 2 to Birr 2.50, its effect will be a decline in quantity demanded from
96 tickets to 95 tickets. On a demand curve this can be shown by a movement from
coordinate (2, 96) to coordinate (2.50, 95).

Shift in the demand curve- The demand curve is drawn on the assumption that other
things remain the same. If, however, the factors assumed constant change, their effect
would be shifting the demand curve. Shift in demand curve results from changes in one
or more of the factors that affect demand except the price of the commodity. Increase
in demand is shown by the outward shift of the demand curve whereas inward shift of
the demand curve represents decrease in demand. Eg. When income of consumers
change (positive), when price of other substitutes change (positive). Here, the demand
changes.

Look at the following figure for illustration.

P

P1

D D1
D 2
0 Q2 Q Q1 Q
Figure 2.4: Shift of the Demand Curve

When the tastes of the people change in favor of bread, it would be reflected by an
increase in demand for bread. At every price, consumers demand a larger amount than
before. This, as shown in Figure 2.4, shifts the demand curve from D to D 1. The opposite
would have occurred if tastes change against bread, in which case there would be
decrease in demand, represented by a shift from D to D 2.
The price of related goods and services also has effect on demand depending on the
nature of the other goods. There are two classes of such goods:
Substitute goods- such goods are substitute to one another. As a result, an increase
in the price of such related goods leads to increase in demand for the other good.
Consider Pepsi Cola and Coca Cola. If the price of Coca Cola increases consumers will
shift from the consumption of Coca Cola to Pepsi Cola. This implies increase in the
price of Coca Cola results in the increase of the demand for Pepsi Cola.
 Complementary goods- these are goods that are jointly consumed. As a result, a rise
in the price of one such good results in decline in demand of the other good.
Consider the case of sugar and coffee. Coffee is consumed together with sugar. Thus,
increase in the price of sugar causes decline in demand for coffee. The converse is
true for decrease in the price of sugar.

2.2. Theory of supply

Supply: - refers to the quantity of goods offered for sale at a particular time or a
particular place at alternative prices. Supply defines the whole set of price-quantity
relationship. It shows the quantities that producers are willing and able to supply at
alternative prices, ceteris paribus.
Supply schedule: is a tabular listing that shows quantity supplied at various prices,
ceteris paribus. Look at the table below.
Table 2.4: Supply Schedule
Price 5 10 15 20 25

Quantit 10 20 30 40 50

y

Supply curve: is a graphical representation of a supply schedule showing the quantity

supplied at various prices, ceteris paribus (see Figure below).
PSupply curve
25
20
15
10
5

0 10 20 30 40 50Q
 Figure 2.5: Supply Curve
Determinants of Supply
The supply of goods or services is affected by several factors. The factors that influence
supply include:
1. The price of the good (P).
2. The level of technology (T).
3. The price of factors of production (Pf).
4. The number of suppliers/firms (S).
5. Expectations (E).
6. Others (Weather, Price of other commodities that use the same or similar set
(bundle) of inputs: Eg. Land to use for Corn or Wheat..If E(profit) from corn is
greater than E(profit) from Wheat, we expect the supply of corn to increase,
Producer Expectations of price change).
Everything that affects supply works through one of these determinants. Supply
function is, then, defined as
Qs = f (P, T, Pf, S, E, Z)

The Law of Supply

The supply curve shows the relationship between the quantity supplied of a good and
its price. Therefore, in order to see what happens when the price of the good under
considerations changes, everything but the price of the good must be held constant.
Given these conditions, the law of supply states that the quantity supplied of a good or
service is usually a positive function of price, ceteris paribus.
Individual Firm’s Supply
An individual firm’s supply shows the different quantities that the firm would supply at
various prices. So as to derive an individual firm’s supply schedule, just ask the firm the
quantities it would supply at alternative prices, and if it is able to state, then the
different price-quantity supplied combinations define the individual firm’s supply.
Market (Industry) Supply
The market supply curve is obtained by horizontal summation of the individual (firm)
supply curves. This curve represents the sum of the quantities supplied by each firm at
different prices. If there are just two firms in the market, for example, the market supply
schedule can be derived from the simple horizontal summation of the quantity supplied
by the two firms at each price.
Table 2.5: Individual Supply Schedules

Supply Price 0 1 2 3 4
schedule of
firm 1 Quantity 0 10 20 30 40

Supply Price 0 1 2 3 4
schedule of
firm 2 Quantity 0 15 30 45 60

Table 2.6: Market Supply Schedule

Price 0 1 2 3 4
Quantit 0 25 50 75 100
y

Suppose in the above example, firm 1 has a larger market share and firm 2 has a
relatively lower market share. Accordingly, firm 1 has larger supply curve while firm 2
has a lower supply curve. In this case, the industry (market) supply curve is given in
Figure 2.6 below.

P S2 S1
(S1+S2)=market supply

P2

P1

0 Y
Figure 2.6: Market Supply Curve
The market supply is the horizontal summation of individual supply curves. For price
level less than P2 firm 2 supplies no output at all. As a result the market supply curve
coincides with firm 1’s supply curve. For price level less than P1 since firm 1’s level of
output is zero, market supply will also be zero. Such market supply curve is a graphical
depiction of how much will be offered for sale in the market at various prices.
In a more general case with n number of firms in the industry (market), the market
supply function S(p) is given as:
 , where Si is the supply function of individual firms.
Supply Function- shows the functional relationship between price and quantity
supplied, ceteris paribus. And it is generally defined as:
Q = f (P)
The most widely used functional form is the linear supply curve, which is given as:

The slope of the supply function is d.

Movement along the Supply Curve
Movement along any supply curve occurs because of changes of the price of the good
or service under study while holding other factors constant. These changes in quantity
supplied result as a positive function of changes in price. Because producers are willing
to sell more units if the price rises to cover the additional costs of production, we
observe movement along the same curve.
Graphically, the effect of change in the price of the product concerned is shown by
movement from one point on the supply curve to another point on the same curve. In
the figure below fall in price from P1 to P2 leads to decrease in quantity supplied from Q2
to Q1.
Price
Supply
P1 b

P2 a

0 Q 1 Q2 Quantity
Figure 2.7: Movement along the supply curve

Example: Suppose the supply function of a grocery is given as . The effect

of rise in price from Birr 6 to Birr 7 would be rise of quantity supplied from Birr 10 to
Birr 15. On a supply curve, this would be shown by movement from coordinate (6, 10)
to coordinate (7, 15).
Shifts in the Supply Curve- occur as any one of the ceteris paribus factors (factors kept
constant earlier) is altered. These constitute what is called change in supply (not change
in quantity supplied). Change in quantity supplied results from change in the price of
the good with other things remaining the same.
Suppose technology changes, and this change has a positive effect. For instance,
assume we are looking at the supply of beef and that agricultural researchers develop a
very inexpensive pill that causes a young steer to double in weight rapidly. This
technological advance means that more beef will be supplied at each price. There will
be increase in supply. Such an increase in supply is represented by a rightward shift of
the supply curve. In the figure below such effects are shown by shift of the supply curve
from S to S1 (see Figure 2.8).
P
S2 S
S1
P2
P1

0 Q2 Q1 Q
Figure 2.8: Shift of the supply curve

2.3. Market Equilibrium

In a free-market system output price as well as the level of output in a market are
determined by the forces of demand and supply. The condition of equality of demand
and supply is called equilibrium.
Demand is a negative function of price while supply is a positive function of price.
Coexistence of buyers and sellers in a given market implies that if there is to be any
exchange, there must be a price at which the quantity that sellers are willing and able
to sell must be equal to the quantity that buyers are willing and able to buy.
Market equilibrium is a price-quantity combination that results from the interaction of
the supply curve and the demand curve such that at the indicated price, the quantity
demanded equals the quantity supplied.
The equilibrium has the property that once the market settles on that point it stays
there unless either supply or demand shifts. Additionally, a market that is not at the
equilibrium position moves toward that point. These two points can be made clear by
considering the graphic representation of equilibrium discussed below.
Graphic Approach to Equilibrium
To see how equilibrium comes about, consider the following hypothetical demand and
supply of coffee in a given market given by Table 2.7 and its corresponding figure
(Figure 2.9).
Table 2.7: Supply of and Demand for Coffee

Price per Kg Kg supplied Kg demanded Difference

per month per month

Br 1.00 2 thousand 10 thousand 8 thousand excess quantity

demanded

Br 2.00 4 thousand 8 thousand 4 thousand excess quantity

demanded

Br 3.00 6 thousand 6 thousand Equilibrium (no excess )

Br 4.00 8 thousand 4 thousand 4 thousand excess quantity supplied

Br 5.00 10 thousand 2 thousand 8 thousand excess quantity supplied

Price/kg
5.00 4 thousand excess supply S
4.00

3.00
2.00
1.00 4 thousand excess demand D
0 1 2 3 4 5 6 7 8 9 10 Thousand Kg
Figure 2.9: Market Equilibrium

At a price of Birr 2.00, suppliers want to supply 4 thousand kg of coffee and demanders
want to purchase 8 thousand kg. The quantity demanded exceeds quantity supplied by 4
thousand kg. This means that some consumers do not get the desired amount at price
Birr 2.00. Some of these consumers will offer more and bid the price up. As the price
rises, the quantity supplied, being a positive function of price will rise and the quantity
demanded, being a negative function of price, will fall. This will continue until the price
reaches Birr 3.00. At Birr 3.00, the amount consumers wish to purchase is exactly equal
to the amount suppliers wish to sell. This is the equilibrium price (market clearing
price). The output which corresponds to the equilibrium price is called the equilibrium
quantity.
It is important to note that the point representing equilibrium price and equilibrium
quantity is not the same thing as the point where the amount sold equals the amount
bought. Quantities bought and quantities sold are always equal. But at equilibrium the
quantity that suppliers wish to sell is exactly equal to the quantity demanders wish to
purchase, i.e., the equilibrium represents coincidence of wishes on the part of
consumers and producers.
● Excess demand causes an upward pressure on price. Thus price converges to the
equilibrium price.
● Excess supply causes a downward pressure on price. Thus, price follows a path
towards the equilibrium.
Once equilibrium is reached at the point of equality of the demand curve with the
supply curve, it remains there as long as demand and supply remain unchanged.
Numerical Approach to Equilibrium
At the equilibrium position, the demand function is exactly equal to the supply

function. If demand is given as and supply is given as , the

equilibrium condition is
Supply = Demand

Example: Suppose the demand and supply functions in a particular market are given as:

At equilibrium Qd = Qs

Rearranging
The equilibrium Price is, therefore, P = 15.

The equilibrium quantity is obtained by substitution.

Market equilibrium condition is determined by the interaction of demand and supply
forces. This means, any change on one of the two or on both will affect the equilibrium
condition. Now, let us discuss how the equilibrium condition is affected by changes in
demand or in supply or in both.

Effects of Change in Demand

When the ceteris paribus conditions (price of other goods, consumers’ income, taste,
population size, expectation etc.) change, there will be a shift in the demand curve.
Such changes (shifts) in demand result in a shift of the equilibrium position.
Assume first, there is increase in demand, for any one reason, represented by an upward
(rightward) shift in the demand curve. Such rise in demand, with supply constant,
creates shortage at the initial equilibrium price, and the unsatisfied buyers bid up the
price. This causes a larger quantity to be produced, with the result that at the new
equilibrium more is bought and sold at a higher price. This change, with supply
remaining the same, shifts the equilibrium position from e0 to e1. The equilibrium price
rises from P0 to P1and equilibrium quantity rises from Q0 to Q1. That means, consumers
are now demanding larger quantities of the good at every price than before (See the
figure below).
P
S0
P1 e1
P0e0
P2 e2D 1
D 0
D 2
0 Q2 Q0 Q1 Q
Figure 2.10: Effects of change in demand
On the other hand, fall in demand, ceteris paribus, creates surplus, and the
unsuccessful sellers bid the price downwards to clear the surplus. As a result, less of
the commodity is produced and offered for sale. At the new equilibrium, both price and
quantity bought and sold are lower than they were originally.
Such fall in demand is represented by a leftward (downward) shift of the demand curve,
and causes the equilibrium position to shift from e0 to e2. Accordingly, equilibrium price
falls from P0 to P2 and equilibrium quantity falls from Q0 to Q2.
With regard to change in demand the equilibrium price and quantity change in the same
direction. The magnitude of the change in price and quantity demanded depends on:
● The size (magnitude) of demand change
● The slope (elasticity) of supply
For any given supply curve, the higher the size of change in demand the higher the
change in equilibrium price and quantity (See Figure below). The size of change in
demand is high in panel (b) than in panel (a). Therefore, the changes in equilibrium price
and quantity are high in the former than in the later.
P SP S
P1 e1
P1 e1
P0 e0P0 e0
D1D 1
D 0D 0
0 Q0 Q 1 Q 0 Q0 Q1 Q
(a) (b)
Figure 2.11: Shifts in demand in Different Magnitudes

For any given change in demand, the change in equilibrium price is higher and the
change in equilibrium quantity is lower the steeper the supply curve (the higher the
slope of the supply curve). The converse would be true if supply curve is flatter.
P S P
P1 e1 S
P0e0 P1 e1
P0 e0
D 1
D0 D 0 D1
0 Q0 Q 1 Q 0 Q0 Q1 Q
(a) (b)
Figure 2.12: Effects of Difference in the Slope of Supply
In the figure above, the supply curve in (a) is much steeper than the supply curve in (b).
Accordingly, the resulting changes in equilibrium price and quantity for any given shift
of the demand curve are different.
Assume the changes in demand in the two cases are equal. As demand shifts from D 0 to
D 1, the changes in equilibrium price and quantity are given by (P1- P0) and (Q 1- Q0)
respectively. Yet (P1- P0) is higher in (a) than in (b), and (Q 1- Q0) is higher in (b) than in (a).
As the demand curve shifts, the change in equilibrium price is higher and the change in
equilibrium quantity is lower for the steeper supply curve than for the flatter one.
This implies, therefore, that for any given change in demand, change in price will be
higher and change in quantity lower the steeper the supply curve.

Effects of Change in Supply

Shift in the supply curve resulting from changes in the ceteris paribus conditions,
causes shift of the equilibrium position (point). An increase in supply for one or the
other reason would shift the supply curve rightward from s0 to s1. With demand
remaining the same, this shift causes shift of the equilibrium point from e0 to e1.
Accordingly, there will be shifts in equilibrium price and quantity.
P D S2 S0
S1
P2 e2
P0 e0
P1e1

D

0 Q2 Q0 Q1 Q
Figure 2.13: Effects of Shift in Supply
The effect of such shift in supply would be decline in equilibrium price because the
increase in supply exerts downward pressure on price, and increase in equilibrium
quantity because now that the total supply at each price is higher compared to the
initial condition, producers wish to sell off their products at lower prices. Accordingly,
the equilibrium price and quantity change from P0 to P1 and from Q0to Q1 respectively.

If, on the other hand, supply decreases as given by the leftward shift of the supply curve
from S0 to S2, there will be consequent shift of the equilibrium point from e0 to e2. The
effect of such change in supply is increase in equilibrium price and fall in equilibrium
quantity because, with demand remaining the same, producers are willing to sell lower
quantities at each price. The equilibrium price and quantity change from P0 to P2 and
from Q0 to Q2 respectively.

The magnitude (size) of the changes in equilibrium price and equilibrium quantity due
to change in supply depend on:
 ● The size (magnitude) of supply change
● The slope (elasticity) of demand
First, let us consider changes in supply of different magnitude for any given demand
curve. Large change in supply causes large changes in equilibrium price and quantity
than a small change in supply (See the Figure below).
(a) (b)
P S0 P S0
S 1 S1
P0e0P0 e0
P1 e1
P1e1

0 Q0Q1 Q 0 Q0 Q1 Q
Figure 2.14: Shifts in Supply in Different Magnitude
In Figure above, the change in supply is large in panel (b) than in (a). Accordingly, the
changes in equilibrium price and equilibrium quantity are larger in (b) than in (a).
Now consider the effect of difference in the slope of the demand curve on the changes
in equilibrium price and quantity.
P P S0
S0 S1S1
P0e0P0 e0
P1e1P1 e1
D D

0 Q0Q1 Q 0 Q0 Q1Q
(a) (b)
Figure 2.15: Effects of Difference in the Slope of Demand
Suppose the shifts in supply in the above two diagrams are equal. For any given shift in
supply, therefore, the higher the change in equilibrium price and the lower the change
in equilibrium quantity will be, the steeper the demand curve. Demand is steeper in (b)
than in (a). Accordingly, the change in price is higher in (b) than in (a), while change in
quantity is higher in (a) than in (b).
The change in price is higher and the change in quantity is lower for the former demand
function (which is steeper) than the latter (which is flatter). Therefore, for any given
change in supply, the effect on price is higher and the effect on quantity is lower the
steeper the demand curve.

ELASTICITY
Elasticity measures the percentage point responsiveness of demand and supply to a
percentage point in any of their determinants.
The determinants of demand and supply may change for a host of reasons. In studying
the effects of factors that affect demand and supply, we are interested not only in the
direction of change but also in the magnitude of the change. With regard to price, the
slope of the demand and supply functions could be considered.
Slope = dQ/dP,
Where, dQ is the change in output and dP is the change in price.
Slope measures by how much output changes for a very small (say a unit) change in
price. In this sense, slope is a measure of responsiveness but it presents some problems.
The most important one is that the slopes of demand or supply functions depend on the
units in which price and quantity are measured. Output could be measured in units,
kilograms, litres, gallons etc while price is measured in currency units such as Birr,
Dollars etc. Therefore, slope measures certain kg per Birr, some liters per Dollar etc.
This, in turn, creates problem of comparison where responsiveness is measured in
different units. It is not possible to compare responsiveness measured as X kg/Birr with
one measured as Y pounds/Dollar.
Definition: Elasticity is a measure of the sensitivity or responsiveness of quantity
demanded or quantity supplied to changes in price (or other factors).
Elasticity measures the way one variable (dependent variable) responds to changes in
other variables (independent variables). We express the dependent variable (Y) as a
function of the independent variables (Xi) as in the following function:
Y = f(X1, X2, X3,…,Xn )
In this function, Y is given as a function of n variables. As any one of these variables (Xi)
changes, there will be consequent change in the value of Y.
The formula to determine the responsiveness of Y to changes in the Xi can be expressed
as

………..,
Price Elasticity of Demand
The price elasticity of demand () is defined to be the percentage change in quantity
demanded divided by the percentage change in price.

, where Q is change in quantity and P is change in price.

Rearranging

The sign of the elasticity of demand is generally negative, since demand curves
invariably have a negative slope. Accordingly price elasticity of demand can be stated as:

In elasticity, we consider the absolute value of the coefficients. The negative sign in
front of an elasticity coefficient indicates only that the relationship between price and
quantity demanded is negative. A demand with –2 elasticity coefficient is said to be
‘more elastic’ than the one with –1.
If a good has an elasticity of demand greater than 1 in absolute value, it is said to have
an elastic demand. Such values imply that a given percentage fall in price causes more
than proportionate rise in price.
Example
Assume that a consumer purchases 10 units of a good when price is Birr 4 and 18 units
when price falls to Birr 2. Compute price elasticity of demand.

Percentage change in quantity demanded is and,

Percentage change in price is

Elasticity, therefore, is given as

This implies that for one percent fall in price quantity demanded rises by 1.6 percent.
Here, since E is greater than one, demand is said to be elastic.
If the elasticity is less than 1 in absolute value, on the other hand, it would be the case
of inelastic demand. This indicates that a given percentage fall in price causes a less
than proportionate rise in quantity demanded.
If, however, a given percentage change in price causes a proportionate percentage
change in quantity demanded the elasticity coefficient will be -1; and hence demand is
referred to as unitary elastic.
With most demand curves, the elasticity coefficient varies along the curve. In this
regard, a good example is a linear demand curve. The coefficients of elasticity of such
demand curves range from perfectly elastic (at the intercept of y-axis) to perfectly
inelastic (at the x-axis intercept).
Consider a linear demand function of the form, Q = a – bP, depicted in the figure below.
The slope of this demand curve is a constant - b.
The formula for price elasticity of demand is given as

Substituting this into the formula for elasticity, we have

But Q=a - bP

The horizontal intercept of the demand curve will be obtained by setting P=0.
Accordingly it occurs at Q=a. The vertical intercept, on the other hand, is obtained by
setting Q=0. It is defined at P= a/b.
P
a/be =
e>1
a/2be = 1
e<1

e = 0
0 a/2 a Q
Figure 2.18: Elasticity along a Linear Demand Curve
At the horizontal intercept the price elasticity of demand is zero.

When q = 0 at the vertical intercept, the elasticity of demand is infinity.

In between these two points, there must be a price-quantity combination at which price

elasticity of demand is unity or one. This point occurs at .

Proof
The point at which elasticity is unity is defined as

By cross multiplication

At the quantity demanded will be obtained by substitution into the demand

function Q = a – bP.

The price-quantity combination that yields unitary elasticity of demand is ( ,

)
This result implies, therefore, that elasticity of demand for this linear demand function
becomes unitary just half way down the demand curve.
Numerical Coefficients of Price Elasticity of Demand
Table 2.8: Elasticity Coefficients

Numerical Responsiveness of quantity demanded to Terminology

coefficients changes in price

e = 0 None Perfectly
inelastic

0 < e < 1 Quantity demanded changes by a smaller Inelastic

percentage than the percentage change in price

e = 1 Quantity demanded changes by a percentage Unit elastic

equal to the percentage change in price

1 < e < Quantity demanded changes by larger Elastic

percentage than the percentage change in price

e= Quantity demanded goes to zero or to all that is perfectly elastic

available

Determinants of Price Elasticity of Demand

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

Constant Elasticity Demands

Along a linear demand curve, as shown above, price elasticity of demand ranges
between 0 and ∞. In some exceptional cases, the demand curve may exhibit constant
price elasticity throughout.
A demand curve given by a vertical line indicates a case in which the quantity
demanded of a good is totally unresponsive to changes in price. Consequently, the
elasticity coefficient is zero. Such demand curve is called perfectly inelastic demand
curve. This is a limiting case, which violates the law of demand.

PD
P2

P1

0 Q1 Q
Figure 2.19: Vertical Demand Curve
If a demand curve is given by a horizontal line, which is also a limiting case, a very small
decrease in price would cause an infinite quantity of the good to be demanded. If price
rises, in contrary, the quantity of the good falls to zero. Such a curve is referred to as a
perfectly elastic demand curve.
P

P1 D

0 Q1 Q2 Q
Figure 2.20: Horizontal Demand Curve

A general way to characterize demand curves with constant elasticity is

where A is an arbitrary positive constant and is a measure of price elasticity of
demand. being a measure of elasticity, it will typically take a negative value.
A more convenient way to express a constant elasticity demand function is to take the
logarithm of both sides and write
ln Q = ln A + ln P
In this expression, the logarithm of Q depends in a linear way on the logarithm of P.
An interesting case of such constant elasticity demand curves is a unit elastic demand
curve. The demand curve is a rectangular hyperbola. The demand function will, thus, be:

or
In its logarithmic form, it is stated as: ln q = ln A – ln P

P
P1

P2 D

0 Q1 Q2 Q
Figure 2.21: Rectangular Hyperbola Demand Curve
The price elasticity of demand of a rectangular hyperbola is unitary throughout the
demand curve.
Price Elasticity of Demand and Total Revenue
When dealing with demand curves, the concern is with price and quantity relationships.
Quantity, or the number of items sold multiplied by price equals the total revenue
generated.

In order to see how firms set and change prices, the relationship between total revenue
and elasticity could be considered.
It is important to recognize that a price change has two opposite effects on total
revenue. The first is that a price decrease, by itself, will decrease total revenue. The
other is that with a price decrease, quantity demanded increases, thus increasing total
revenue. The net effect on total revenue depends on whether the relative price decrease
exceeds the relative increase in quantity demanded or vice versa.If demand is elastic,
fall in price causes increase in total revenue. If, on the other hand, demand is inelastic,
the effect of fall in price would be decrease in total revenue.

Price Price

P1 P1

P2 P2 D

0 Q1 Q2 Quantity 0 Q1 Q2Quantity

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

Figure 2.22: Elasticity and Total Revenue

On both demand curves, the price falls from P1 to P2 and output increases from Q1 to Q2.
This change causes the total revenue to change. Some revenue is lost and some revenue
is gained due to the price change. In Figure 2.22 above, the lightly shaded areas
represent the revenue that has been lost and the darkly shaded areas represent revenue
that has been gained. In the case of the relatively elastic curve, panel (b) of the figure,
the decrease in price has brought about an increase in total revenue; in panel (a), the
decrease in price has brought about a decrease in total revenue.
These relationships are summarized in the table below.

Table 2.9: Relationship between Elasticity and Revenue

Price changeQuantity demanded changeElasticityTotal Revenue
Rise Decrease > 1 Decrease
Rise Decrease = 1 Unchanged
Rise Decrease <1 Increase
Fall Increase > 1 Increase
Fall Increase =1 Unchanged
Fall Increase <1 Decrease

Example

Price .50 1.0 1.2 1.4 1.6 1.8 2.0 2.2 2.4 2.6 2.8 3.0
0 0 0 0 0 0 0 0 0 0 0

Quantity 25 20 18 16 14 12 10 8 6 4 2 0

demande
d

In the table above, at a price of Birr 2.00, the total revenue (TR) is Birr 20.00. An
increase in price from Birr 2.00 to Birr 2.20 causes TR to fall from Birr 20.00 to Birr
17.60. This is because the 10 percent increase in price caused an even greater
percentage decrease in quantity demanded. The elasticity is greater than one.
Conversely, if price rises from Birr 1.00 to Birr 1.20, TR increases from Birr 20.00 to Birr
21.60 because the percentage increase in price is greater than the percentage decrease
in quantity demanded. The elasticity is less than one.
Total revenue, being the product of price and quantity, its function can be obtained by
multiplying the inverse demand function by the quantity.
Approaches to Elasticity Measurement
There are two main approaches to elasticity computation: the arc elasticity and point
elasticity. If we are measuring the elasticity between points, we are actually calculating
the average elasticity over the space between the points. This is called arc elasticity.
Elasticity between two points:
P

P1 a

P2 b
D
0 Q1 Q2 Q
Figure 2.23: Arc Elasticity
Suppose you wish to measure price elasticity of demand as price falls from P1 and P2. In
this case you are, in a way, measuring the average elasticity between point a and point b.

When measuring the responsiveness of quantity demanded to changes in price at a

particular point on a curve, you are actually measuring point elasticity.
Elasticity at a point is measured by assuming infinitesimally small changes in price and
quantity demanded. When dealing with the concept of arc elasticity, however, we are
working with sizable, discrete changes.
Elasticity at a particular point:

P

P1 a

D
0 Q1 Q
Figure 2.24: Point Elasticity
Price elasticity of demand at a particular point, such as point a, can be obtained by
multiplying the slope of the demand curve at that point by the corresponding price/
output ratio.

Cross Elasticity of Demand

The responsiveness of quantity demanded for one commodity to the changes in the
prices of other commodities, ceteris paribus, is called cross elasticity of demand. It is
denoted as:

In this case (where the demand of a given good does not depend solely on its price), the
demand function is modified in such a way it includes the prices of related goods.

QX = f(PX, PY)

The cross elasticity formula is given as:

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

The two goods, therefore, are substitute products.

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

responsiveness of quantity demanded to changes in income assuming all other things,
including price, constant.

Where, Q represents output and I represents consumers’ income.

In measuring income elasticity of demand, the sign of the elasticity coefficient is
important. The sign of the coefficient indicates the nature of the products; whether the
products are normal or inferior.

Definition: normal goods are goods whose quantity demanded increases with rise in
consumers’ income, while inferior goods are those goods whose quantity demanded
decreases with rise in income.

The income elasticity of normal goods is positive reflecting the positive relationship
between income and quantity demanded. For inferior goods, however, income
elasticityis negative.
For normal goods, the same designation for the elasticity coefficients that is used for
price elasticity of demand can be used. If the coefficient is greater than one, I>1, the
good is income elastic, whereas if I <1, the good is said to be income inelastic.
Example
When the income of the consumer is Birr 1000, the consumer buys 100 units of a good.
If income increases to Birr 1200, the resulting quantity demanded would be 130 units.
The income elasticity demand of the consumer is given as:

The consumer’s demand is income elastic.

Goods with high positive income elasticity are considered as luxury goods. Necessities
in contrast have low income elasticity. It is important to note at this point that there is
no clear cut range of the income elasticity of demand coefficient for distinguishing
between necessities and luxury goods.
Definition: Luxury goods are normal goods for which quantity demanded changes by a
very high magnitude for a given change in income. Necessities are normal goods whose
quantity demanded changes by a smaller percentage for any given change in income.
Income elasticity of demand of a good depends mainly on the importance of the
product to a consumer. The more basic a good is in the consumption pattern of a
consumer, such as food stuff, the lower is its income elasticity. The more luxury a good
is, the higher its income elasticity will be. Income elasticity also depends on the time
period; because consumption patterns adjust with time-lag to changes in income.
Elasticity of Supply
Price elasticity of Supply: - Price elasticity of supply measures the responsiveness of the
quantity supplied to a change in the commodity’s price, ceteris paribus. It is defined as:

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

As with price elasticity of demand, if s = 1, supply is unit elastic. If s> 1, it is elastic; and if s
< 1, it is inelastic.
The coefficients of price elasticity of supply are often positive because normally supply
curves are positively sloped. But there are exceptions in which the supply curve is either
vertical or horizontal. If the supply curve is verticalthe quantity supplied does not
change as price changesthen elasticity is zero. This is the case in the very short run
where it is difficult to produce more of a good regardless of what happens to price.
Similarly, a horizontal supply curve has an infinitely high elasticity of supply: a small
drop in price would reduce the quantity producers are willing to supply from an
indefinitely large amount to zero. Between these extremes the elasticity of supply varies
with the shape of the supply curve.
Example: A firm produces 100 units of output and sells each unit for Birr 20 at
equilibrium. Suppose the demand for the firm’s product has increased and caused a rise
in price to Birr 25 a unit. After the rise in price the quantity that the firm sells has
increased to 120 units.

This implies that the supply of the firm is price inelastic.