Chapter Four Theory of Production and Cost Introduction

This chapter has two major sections. The first part will introduce you to the basic concepts of
production and production function, classification of inputs, essential features of short run
production functions and the stages of short run production. The second part mainly deals with
the difference between economic cost and accounting cost, the characteristics of short run cost
functions
Chapter objectives
After successful completion of this chapter, you will be able to:
 define production and production function
 differentiate between fixed and variable inputs
 describe short run total product, average product and marginal product
 compare and contrast the three stages of production in the short run
 explain the difference between accounting cost and economic cost
 describe total cost, average cost and marginal cost functions
4.1Theory of production in the short run
4.1.1 Definition of production
Raw materials yield less satisfaction to the consumer by themselves. In order to get better utility
from raw materials, they must be transformed into outputs. However, transforming raw materials
into outputs requires inputs such as land, labour, capital and entrepreneurial ability. Production is
the process of transforming inputs into outputs. It can also be defined as an act of creating value
or utility. The end products of the production process are outputs which could be tangible
(goods) or intangible (services).
4.1.2 Production function
Production function is a technical relationship between inputs and outputs. It shows the
maximum output that can be produced with fixed amount of inputs and the existing
technology. A production function may take the form of an algebraic equation, table or graph. A
general equation for production function can, for instance be described as:
Q= f(X1 , X 2 , X 3 ,..., X n )

Where, Q is output and X1, X2, X3,…, Xn are different types of inputs.
Inputs are commonly classified as fixed inputs or variable inputs.

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Fixed inputs are those inputs whose quantity cannot readily be changed when market
conditions indicate that an immediate adjustment in output is required. In fact, no input is ever
absolutely fixed but may be fixed during an immediate requirement. For example, if the demand
for Beer rises suddenly in a week, the brewery factories cannot plant additional machinery
overnight and respond to the increased demand. Buildings, land and machineries are examples of
fixed inputs because their quantity cannot be manipulated easily in a short period of time.
Variable inputs are those inputs whose quantity can be altered almost instantaneously in
response to desired changes in output. That is, their quantities can easily be diminished when the
market demand for the product decreases and vice versa. The best example of variable input is
unskilled laour.

Does a short run refer to specific period of time that is applicable to every firm or industry?
If this condition is rather unique to the firm, industry or economic variable being studied,
what is our basis to classify production as a short run?

In economics, short run refers to a period of time in which the quantity of at least one input is
fixed. In other words, short run is a time period which is not sufficient to change the quantities of
all inputs so that at least one input remains fixed. Here it should be noted that short run
periods of different firms have different durations. Some firms can change the quantity of all
their inputs within a month while it takes more than a year for other types of firms. This sub-
section is confined to production with one variable input and one fixed input.
Consider a firm that uses two inputs: capital (fixed input) and labour (variable input). Given
the assumptions of short run production, the firm can increase output only by increasing the
amount of labour it uses. Hence, its production function can be given by:
Q = f (L)
Where, Q is output and L is the quantity of labour.
The production function shows different levels of output that the firm can produce by efficiently
utilizing different units of labour and the fixed capital. In the above short run production
function, the quantity of capital is fixed. Thus, output can change only when the amount of
labour changes
4.1.3 Total, average, and marginal product

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In production, the contribution of a variable input can be described in terms of total, average and
marginal product.
Total product (TP): it is the total amount of output that can be produced by efficiently utilizing
specific combinations of the variable input and fixed input. Increasing the variable input (while
some other inputs are fixed) can increase the total product only up to a certain point. Initially, as
we combine more and more units of the variable input with the fixed input, output continues to
increase, but eventually if we employ more and more unit of the variable input beyond the
carrying capacity of the fixed input, output tends to decline. In general, the TP function in the
short-run follows a certain trend: it initially increases at an increasing rate, then increases at a
decreasing rate, reaches a maximum point and eventually falls as the quantity of the variable
input rises. This tells us what shape a total product curve assumes.
Marginal Product (MP): it is the change in output attributed to the addition of one unit of the
variable input to the production process, other inputs being constant. For instance, the change
in total output resulting from employing additional worker (holding other inputs constant) is the
marginal product of labour (MPL). In other words, MPL measures the slope of the total product
curve at a given point.

In the short run, the marginal product of the variable input first increases, reaches its maximum
and then decreases to the extent of being negative. That is, as we continue to combine more
and more of the variable input with the fixed input, the marginal product of the variable input
increases initially and then declines.
Average Product (AP): Average product of an input is the level of output that each unit of input
produces, on the average. It tells us the mean contribution of each variable input to the total
product. Mathematically, it is the ratio of total output to the number of the variable input. The
average product of labour (APL), for instance, is given by:

Average product of labour first increases, reaches its maximum value and eventually declines.
The AP curve can be measured by the slope of rays originating from the origin to a point on the
TP curve (see figure 4.1). For example, the APL at L2 is the ratio of TP2 to L2

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Figure 4.1: Total product, average product and marginal product curves
The relationship between MPL and APL can be stated as follows.
 When APL is increasing, MPL > APL.
 When APL is at its maximum, MPL = APL.
 When APL is decreasing, MPL < APL.

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4.1.4 The law of variable proportions
The law of variable proportions states that as successive units of a variable input(say, labour) are
added to a fixed input (say, capital or land), beyond some point the extra, or marginal product
that can be attributed to each additional unit of the variable resource will decline. For example, if
additional workers are hired to work with a constant amount of capital equipment, output will
eventually rise by smaller and smaller amounts as more workers are hired.
This law assumes that technology is fixed and thus the techniques of production do not change.
Moreover, all units of labour are assumed to be of equal quality. Each successive worker is
presumed to have the same innate ability, education, training, and work experience. The law
starts to operate after the marginal product curve reaches its maximum (this happens when the
number of workers exceeds L1 in figure 4.1). This law is also called the law of diminishing
returns.

4.1.5 Stages of production

We are not in a position to determine the specific number of the variable input (labour) that the
firm should employ because this depends on several other factors than the productivity of labour.
However, it is possible to determine the ranges over which the variable input (labour) be
employed. To this end, economists have defined three stages of short run production.

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Stage I: This stage of production covers the range of variable input levels over which the
average product (APL) continues to increase. It goes from the origin to the point where the AP L is
maximum, which is the equality of MP L and APL (up to L2 level of labour employment in figure
4.1). This stage is not an efficient region of production though the MP of variable input is
positive. The reason is that the variable input (the number of workers) is too small to efficiently
run the fixe d input so that the fixed input is under utilized (not efficiently utilized).
Stage II: It ranges from the point where AP L is at its maximum (MPL=APL) to the point where
MPL is zero (from L2 to L3 in figure 4.1). Here, as the labour input increases by one unit, output
still increases but at a decreasing rate. Due to this, the second stage of production is termed as the
stage of diminishing marginal returns. The reason for decreasing average and marginal
products is due to the scarcity of the fixed factor. That is, once the optimum capital-labour
combination is achieved, employment of additional unit of the variable input will cause the
output to increase at a slower rate. As a result, the marginal product diminishes. This stage is the
efficient region of production. Additional inputs are contributing positively to the total product
and MP of successive units of variable input is declining (indicating that the fixed input is
being optimally used). Hence, the efficient region of production is where the marginal product
of the variable input is declining but positive.
Stage III: In this stage, an increase in the variable input is accompanied by decline in the total
product. Thus, the total product curve slopes downwards, and the marginal product of labour
becomes negative. This stage is also known as the stage of negative marginal returns to the
variable input. The cause of negative marginal returns is the fact that the volume of the variable
inputs is quite excessive relative to the fixed input; the fixed input is over-utilized. Obviously, a
rational firm should not operate in stage III because additional units of variable input are
contributing negatively to the total product (MP of the variable input is negative). In figure 4.1,
this stage is indicated by the employment of labour beyond L3.
4.2 Theory of costs in the short run
4.2.1 Definition and types of costs
To produce goods and services, firms need factors of production or simply inputs. To acquire
these inputs, they have to buy them from resource suppliers. Cost is, therefore, the monetary
value of inputs used in the production of an item.

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Economists use the term profit differently from the way accountants use it. To the accountant,
profit is the firm‘s total revenue less its explicit costs (accounting costs). To the economist,
economic profit is total revenue less economic costs (explicit and implicit costs).
Accounting cost is the monetary value of all purchased inputs used in production; it ignores the
cost of non-purchased (self-owned) inputs. It considers only direct expenses such as
wages/salaries, cost of raw materials, depreciation allowances, interest on borrowed funds and
utility expenses (electricity, water, telephone, etc.). These costs are said to be explicit costs.
Explicit costs are out of pocket expenses for the purchased inputs. If a producer calculates her
cost by considering only the costs incurred for purchased inputs, then her profit will be an
accounting profit.
Accounting profit = Total revenue – Accounting cost = Total revenue – Explicit cost
In the real world economy, entrepreneurs may use some resources which may not have direct
monetary expense since the entrepreneur can own these inputs himself or herself. Economic cost
of producing a commodity considers the monetary value of all inputs (purchased and non-
purchased). Calculating economic costs will be difficult since there are no direct monetary
expenses for non-purchased inputs. The monetary value of these inputs is obtained by estimating
their opportunity costs in monetary terms. The estimated monetary cost for non- purchased
inputs is known as implicit cost. For example, if Mr. X quits a job which pays him Birr 10,
000.00 per month in order to run a firm he has established, then the opportunity cost of his
labour is taken to be Birr 10,000.00 per month (the salary he has forgone in order to run his own
business). Therefore, economic cost is given by the sum of implicit cost and explicit cost.
Economic profit =Total revenue – Economic cost (Explicit cost + Implicit cost)
Economic profit will give the real profit of the firm since all costs are taken into account.
Accounting profit of a firm will be greater than economic profit by the amount of implicit cost. If
all inputs are purchased from the market, accounting and economic profit will be the same.
However, if implicit costs exist, then accounting profit will be larger than economic profit.

4.2.2 Total, average and marginal costs in the short run

A cost function shows the total cost of producing a given level of output. It can be described
using equations, tables or curves. A cost function can be represented using an equation as
follows.

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C = f (Q), where C is the total cost of production and Q is the level of output.
In the short run, total cost (TC) can be broken down in to two total fixed cost (TFC) and total
variable cost (TVC). By fixed costs we mean costs which do not vary with the level of output.
They are regarded as fixed because these costs are unavoidable regardless of the level of output.
The firm can avoid fixed costs only if he/she stops operation (shuts down the business). The
fixed costs may include salaries of administrative staff, expenses for building depreciation and
repairs, expenses for land maintenance and the rent of building used for production. Variable
costs, on the other hand, include all costs which directly vary with the level of output. For
example, if the firm produces zero output, the variable cost is zero. These costs may include the
cost of raw materials, the cost of direct labour and the running expenses of fuel, water,
electricity, etc.
In general, the short run total cost is given by the sum of total fixed cost and total variable cost.
That is,

Based on the definition of the short run cost functions, let‘s see what their shapes look like.
Total fixed cost (TFC): Total fixed cost is denoted by a straight line parallel to the output axis.
This is because such costs do not vary with the level of output.
Total variable cost (TVC): The total variable cost of a firm has an inverse S-shape. The shape
indicates the law of variable proportions in production. At the initial stage of production with a
given plant, as more of the variable factor is employed, its productivity increases. Hence, the
TVC increases at a decreasing rate. This continues until the optimal combination of the fixed and
variable factor is reached. Beyond this point, as increased quantities of the variable factor are
combined with the fixed factor, the productivity of the variable factor declines, and the TVC
increases at an increasing rate.
Total Cost (TC): The total cost curve is obtained by vertically adding TFC and TVC at each
level of output. The shape of the TC curve follows the shape of the TVC curve, i.e. the TC has
also an inverse S-shape. It should be noted that when the level of output is zero, TVC is also zero
which implies TC = TFC.

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Figure 4.2: Short run TC, TFC and TVC curves

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Figure 4.3: Short run AFC, AVC, AC and MC Curves
In the above figure, the AVC curve reaches its minimum point at Q 1 level of output and AC
reaches its minimum point at Q2 level of output. The vertical distance between AC and AVC,
that is, AFC decreases continuously as output increases. It can also be noted that the MC curve
passes through the minimum points of both AVC and AC curves.

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Chapter Five Market Structure
Introduction
This chapter discusses how a particular firm makes a decision to achieve its profit maximization
objective. A firm‘s decision to achieve this goal is dependent on the type of market in which it
operates. To this effect we distinguish between four major types of markets: perfectly
competitive market, monopolistically competitive market, oligopolistic market, and pure
monopoly market.
Chapter objectives:
At the end of this chapter you will be able to:
 differentiate market in physical and digital space
 explain the characteristics and equilibrium condition of perfectly competitive market
 differentiate between different types of imperfect market structures
5.1 The concept of market in physical and digital space
Comprehensive definition of market according to American Marketing Association (1985) is
the process of planning and executing the conception, pricing, promotion, and distribution of
goods, services and ideas to create exchanges that satisfy individual and organizational
objectives. So market describes place or digital space by which goods, services and ideas are
exchanged to satisfy consumer need.
Digital marketing is the marketing of products or services using digital technologies, mainly on
the internet but also including mobile phones, display advertising, and any other digital media.
Digital marketing channels are systems on the internet that can create, accelerate and transmit
product value from producer to the terminal consumer by digital networks.
Physical market is a set up where buyers can physically meet their sellers and purchase the
desired merchandise from them in exchange of money. In physical marketing, marketers will
effortlessly reach their target local customers and thus they have more personal approach to show
about their brands. The choice of the marketing mainly depends on the nature of the products and
services.
5.2 Perfectly competitive market
Perfect competition is a market structure characterized by a complete absence of rivalry among
the individual firms.
5.2.1 Assumptions of perfectly competitive market

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A market is said to be pure competition (perfectly competitive market) if the following
assumptions are satisfied.
Large number of sellers and buyers: under perfect competition the number of sellers is
assumed to be too large that the share of each seller in the total supply of a product is very small.
Therefore, no single seller can influence the market price by changing the quantity supply.
Similarly, the number of buyers is so large that the share of each buyer in the total demand is
very small and that no single buyer or a group of buyers can influence the market price by
changing their individual or group demand for a product. Therefore, in such a market structure,
sellers and buyers are not price makers rather they are price takers, i.e., the price is determined
by the interaction of the market supply and demand forces.
Homogeneous product: homogeneity of the product implies that buyers do not distinguish
between products supplied by the various firms of an industry. Product of each firm is regarded
as a perfect substitute for the products of other firms. Therefore, no firm can gain any
competitive advantage over the other firm.
Perfect mobility of factors of production: factors of production are free to move from one firm
to another throughout the economy. This means that labour can move from one job to another
and from one region to another. Capital, raw materials, and other factors are not monopolized.
Free entry and exit: there is no restriction or market barrier on entry of new firms to the
industry, and no restriction on exit of firms from the industry. A firm may enter the industry or
quit it on its accord.
Perfect knowledge about market conditions: all the buyers and sellers have full information
regarding the prevailing and future prices and availability of the commodity.
No government interference:- government does not interfere in any way with the functioning
of the market. There are no discriminator taxes or subsidies, no allocation of inputs by the
procurement, or any kind of direct or indirect control. That is, the government follows the free
enterprise policy. Where there is intervention by the government, it is intended to correct the
market imperfection.
From these assumptions, a single producer under perfectly competitive market is a price-taker.
That is, at the market price, the firm can supply whatever quantity it would like to sell. Once the
price of the product is determined in the market, the producer takes the price (Pm in the figure

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below) as given. Hence, the demand curve (Df) that the firm faces in this market situation is a
horizontal line drawn at the equilibrium price, Pm.

Figure 5.1: Individual and market demand curve

5.3. Monopoly market
5.3.1. Definition and characteristics
This is at the opposite end of the spectrum of market structures. Pure monopoly exists when a
single firm is the only producer of a product for which there are no close substitutes. The main
characteristics of this market structure include:
Single seller: A pure or absolute monopoly is a one firm industry. A single firm is the only
producer of a specific product or the sole supplier of the product; the firm and the industry are
synonymous.
No close substitutes: the monopolist‘s product is unique in that there are no good or close
substitutes. From the buyer‘s view point, there are no reasonable alternatives.
Price maker: the individual firm exercises a considerable control over price because it is
responsible for, and therefore controls, the total quantity supplied. Confronted with the usual
down ward sloping demand curve for its product, the monopolist can change product price by
changing the quantity of the product supplied.
Blocked entry: A pure monopolist has no immediate competitors because there are barriers,
which keep potential competitors from entering in to the industry. These barriers may be
economic, legal, technological etc. Under conditions of pure monopoly, entry is totally blocked.
5.3.2. Sources of monopoly

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The emergence and survival of monopoly is attributed to the factors which prevent the entry of
other firms in to the industry. The barriers to entry are therefore the sources of monopoly power.
The major sources of barriers to entry are:
Legal restriction: Some monopolies are created by law in public interest. Such monopoly may
be created in both public and private sectors. Most of the state monopolies in the public
utility sector, including postal service, telegraph, telephone services, radio and TV services,
generation and distribution of electricity, rail ways, airlines etc… are public monopolies.
Control over key raw materials: Some firms acquire monopoly power from their traditional
control over certain scarce and key raw materials that are essential for the production of certain
other goods. For example, Aluminum Company of America had monopolized the aluminum
industry because it had acquired control over almost all sources of bauxite supply; such
monopolies are often called raw material monopolies.
Efficiency: a primary and technical reason for growth of monopolies is economies of scale. The
most efficient plant (probably large size firm,) which produces at minimum cost, can eliminate
the competitors by curbing down its price for a short period and can acquire monopoly power.
Monopolies created through efficiency are known as natural monopolies.
Patent rights: Patent rights are granted by the government to a firm to produce commodity of
specified quality and character or to use specified rights to produce the specified commodity or
to use the specified technique of production. Such monopolies are called to patent monopolies.
5.4. Monopolistically competitive market
This market model can be defined as the market organization in which there are relatively many
firms selling differentiated products. It is the blend of competition and monopoly. The
competitive element arises from the existence of large number of firms and no barrier to entry
or exit. The monopoly element results from differentiated products, i.e. similar but not identical
products.
A seller of a differentiated product has limited monopoly power over customers who prefer his
product to others. His monopoly is limited because the difference between his product and
others are small enough that they are close substitutes for one another.
This market is characterized by:
Differentiated product: the product produced and supplied by many sellers in the market is
similar but not identical in the eyes of the buyers. There is a variety of the same product. The

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difference could be in style, brand name, in quality, or others. Hence, the differentiation of the
product could be real (eg. quality) or fancied (e.g. difference in packing).
Many sellers and buyers: there are many sellers and buyers of the product, but their number is
not as large as that of the perfectly competitive market.
Easy entry and exit: like the PCM, there is no barrier on new firms that are willing and able to
produce and supply the product in the market. On the other hand, if any firm believes that it is
not worth to stay in the business, it may exit.
Existence of non-price competition: Economic rivals take the form of non-price competition in
terms of product quality, advertisement, brand name, service to customers, etc. A firm spends
money in advertisement to reach the consumers about the relatively unique character of its
product and thereby get new buyers and develop brand loyalty. Many retail trade activities
such as clothing, shoes, soap, etc are in this type of market structure.
5.5. Oligopoly market
Oligopoly market structure is another type of market structure which is defined as a few sellers
available in the market. This is a market structure characterized by:
Few dominant firms: there are few firms although the exact number of firms is undefined. Each
firm produces a significant portion of the total output.
Interdependence: since few firms hold a significant share in the total output of the industry, each
firm is affected by the price and output decisions of rival firms. Therefore, the distinguishing
characteristic of oligopoly is the interdependence among firms in the industry.
Entry barrier: there are considerable obstacles that hinder a new firm from producing and
supplying the product. The barriers may include economies of scale, legal, control of strategic
inputs, etc.
Products may be homogenous or differentiated. If the product is homogeneous, we have a
pure oligopoly. If the product is differentiated, it will be a differentiated oligopoly.
Lack of uniformity in the size of firms: Firms differ considerably in size. Some may be small,
others very large. Such a situation is asymmetrical.
Non-price competition: firms try to avoid price competition due to the fear of price wars and
hence depend on non-price methods like advertising, after sales services, warranties, etc. This
ensures that firms can influence demand and build brand recognition.

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A special type of oligopoly in which there are only two firms in the market is known as
Duopoly.
Chapter Six Fundamental Concepts of Macroeconomics
Introduction
Conventionally, economics is divided into microeconomics and macroeconomics.
Microeconomics studies about the individual decision making behaviour of different
economic units such as households, firms, and government at a disaggregated level.
Whereas, macroeconomics, studies about overall or aggregate behaviour of the economy,
such as economic growth, employment, inflation, distribution of income, macroeconomic
policies and international trade.
This chapter discusses major macroeconomic issues such as measurement of a country‘s
economic performance, macroeconomic problems (fluctuations in economic system mainly
reflected by inflation and unemployment) and macroeconomic policies applied to cure the
macroeconomic problems.
Chapter objectives
After completing this chapter, you will be able to:
 define GNP and GDP and able to measure national income by using the
expenditure or income or product approach;
 differentiate between nominal GDP and real GDP and decide which is better to
measure economic performance;
 explain the concept of business cycle;
 briefly discuss the types of unemployment;
 understand about inflation, causes of inflation and its impact on the economy and
6.1. Goals of macroeconomics
Macroeconomics studies the working of an economy in aggregation or as a whole. And it
aimed at how;
 To achieve high economic growth
 To reduce unemployment
 To attain stable prices
 To reduce budget deficit and balance of payment (BoP) deficit
 To ensure fair distribution of income

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In other words, the goals of macroeconomics can be given as ways towards full
employment, price stability, economic growth and fair distribution of income among
citizens of a country.
6.2. The National Income Accounting
National Income Accounting (NIA) is an accounting record of the level of economic
activities of an economy. It is a measure of an aggregate output, income and expenditure in
an economy.
Why do we need to study NIA?
 It enables us to measure the level of total output in a given period of time, and to
explain the causes for such level of performance.
 It enables us to observe the long run trend of the economy.
 It provides information to formulate policies and design plans.
6.2.1. Approaches to measure national income (GDP/GNP)
Before discussing different approaches of national income, it is important to understand
about the measure of the economic performance of a given country at large. Generally it is
named as GDP or GNP.
Gross Domestic Product (GDP): it is the total value of currently produced final goods and
services that are produced within a country‘s boundary during a given period of time,
usually one year. From this definition, we can infer that:
 It measures the current production only.
 It takes in to account final goods and services only (only the end products of various
production processes) or we do not include the intermediate products in our GDP
calculations. Intermediate goods are goods that are completely used up in the
production of other products in the same period that they themselves are produced.
 It measures the values of final goods and services produced within the
boundary/territory of a country irrespective of who owns that output.
 In measuring GDP, we take the market values of goods and services
Where:
Pi = series of prices of outputs produced in different sectors of an economy in certain
period
Qi = the quantity of various final goods and services produced in an economy

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 Gross National Product (GNP): is the total value of final goods and services currently
produced by domestically owned factors of production in a given period of time, usually
one year, irrespective of their geographical locations.
GDP and GNP are related as follows:
GNP=GDP + NFI
NFI denotes Net Factor Income received from abroad which is equal to factor income
received from abroad by a country‘s citizens less factor income paid for foreigners
to abroad. Thus, NFI could be negative, positive or zero depending on the amount of
factor income received by the two parties.
If NFI >0, then GNP > GDP
If NFI<0, then GNP < GDP
If NFI =0, then GNP =GDP
Basically, there are three approaches to measure GDP/GNP. These are:
1. Product/value added approach,
2. Expenditure approach and
3. Income approach
Product Approach: In this approach, GDP is calculated by adding the market value of
goods and services currently produced by each sector of the economy. In this case, GDP
includes only the values of final goods and services in order to avoid double counting.
Double counting will arise when the output of some firms are used as intermediate inputs of
other firms. For example, we would not include the full price of an automobile in GDP and
then also include as part of GDP the value of the tires that were sold to the automobile
producer. The components of the car that are sold to the manufacturers are called
intermediate goods, and their value is not included in GDP.
There are two possible ways of avoiding double counting.
 Taking only the value of final goods and services
 Taking the sum of the valued added by all firms at each stage of production
We can illustrate the two scenarios using some hypothetical examples as follows.

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Note: If all values in the economy were added, GDP would be 5000= (2500+2500). The
problem of double counting is 2500, because of considering intermediate input in the calculation.
Expenditure Approach: here GDP is measured by adding all expenditures on final goods and
services produced in the country by all sectors of the economy. Thus, GDP can be estimated by

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summing up personal consumption of households (C), gross private domestic investment (I),
government purchases of goods and services (G) and net exports (NE).
Personal consumption expenditure includes expenditures by households on durable consumer
goods (automobiles, refrigerators, video recorders, etc), non-durable consumer goods (clothes,
shoes, pens, etc) and services.
Gross private domestic investment is defined as the sum of all spending of firms on plants,
equipment, and inventories, and the spending of households on new houses. Investment is broken
down into three categories: residential investment (the spending of households on the
construction of new houses), business fixed investment (the spending of firms on buildings and
equipment for business use), and inventory investment (the change in inventories of firms).

Note that gross private domestic investment differs from net private domestic investment in that
the former includes both replacement and added investment whereas the latter refers only to
added investment. Replacement means the production of all investment goods, which replace
machinery, equipment and buildings used up in the production process. In short, net private
domestic investment = gross private domestic investment minus depreciation.
Government purchases of goods and services include all government spending on finished
products and direct purchases of resources less government transfer payments because transfer
payments do not reflect current production although they are part of government expenditure.
Net exports refer to total value of exports less total value of imports. Note that net export is
different from the terms of trade in that the latter refers to the ratio of the value of exports to the
value of imports.
Example: GDP at current market price measured using expenditure approach for a hypothetical
economy.

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Income approach: in this approach, GDP is calculated by adding all the incomes accruing to
all factors of production used in producing the national output. It is crucial, however, to note that
some forms of personal incomes are not incorporated in the national income. For instance,
transfer payments (payments which are made to the recipients who have not contributed to the
production of current goods and services in exchange for these payments) are excluded from
national income, as these are mere redistribution of income from taxpayers to the recipients of
transfer payments. Transfer payments may take the form of old age pension, unemployment
benefit, subsidies, etc.
According to the income approach, GDP is the sum incomes to owners of factors of production
plus some other claims on the value of output (depreciation and indirect business tax) less
subsidies and transfer payments.

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Limitation of GDP measurement:
The calculation of national income is not an easy task. We face a number of problems in the
estimation of national income, especially in under-developed countries like Ethiopia.

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 Definition of a nation: while calculating national income, nation does not mean only the
political or geographical boundaries of a country for calculating the value of final goods
and services produced in the country. It includes income earned by the nationals abroad.
Stages of economic activities: it is also difficult to determine the stages of economic
activity at which the national income is determined i.e. whether the income should be
calculated at the stage of production or distribution or consumption. It has, therefore,
been agreed that the stage of economic activity may be decided by the objective for
which the national income is being calculated. If the objective is to measure economic
progress, then the production stage can be considered. To measure the welfare of the
people, then the consumption stage should be taken into consideration.
Underground economy: no imputation is made for the value of goods and services sold
in the illegal market. The underground economy is the part of the economy that people
hide from the government either because they wish to evade taxation or because the
activity is illegal. The parallel exchange rate market is one example.
Inadequate data: in all most all the countries, difficulty has been faced in the calculation
of national income due to lack of adequate data. Sometimes, the data are not reliable.
Non-monetized sector: this difficulty is special to developing countries where a
substantial portion of the total produce is not brought to the market for sale. It is either
retained for self-consumption or exchanged for other goods and services.
Valuation of depreciation: the value of depreciation is deducted from the gross national
product to get net national product. But the valuation of such depreciation is full of
difficulties.
Changes in price levels: since the national income is in terms of money whose value
itself keeps on changing, it is difficult to make a stable calculation which is assessed in
terms of prices of the base year.
No focus on quality: it is difficult to account correctly for improvements in the quality of
goods. This has been the case for computers, whose quality has improved dramatically
while their price has fallen sharply. It also applies to other goods such as cars whose
quality changes over time.
6.3. Nominal versus Real GDP

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Nominal GDP is the value of all final goods and services produced in a given year when valued
at the prices of that year. That is, nominal GDP = ∑𝑃i𝑄i where, P is the general price level
and Q is the quantity of final goods and services produced. Therefore, any change that can
happen in the country‘s GDP is due to changes in price, quantity or both. For example, if prices
are doubled over one year, then GDP will also double even though exactly the same goods and
services are produced as the year before. Hence, GDP that is not adjusted for inflation is called
Nominal GDP.
Real GDP is the value of final goods and services produced in a given year when valued at the
prices of a reference base year. By comparing the value of production in the two years at the
same prices, we reveal the change in output. Hence, to be able to make reasonable comparisons
of GDP overtime we must adjust for inflation.

6.4 The Business Cycle

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Business cycle refers to the recurrent ups and downs in the level of economic activity.
Countries usually experience ups and downs in the level of total output and employment over
time. For some period of time the total output level may increase and other times it may
decline. With the fluctuation in the overall economic activity, the level of unemployment also
moves up and down.

Figure 6.9: The business cycle

A business cycle is a fluctuation in overall economic activity, which is characterized by the
simultaneous expansion or contraction of output in most sectors. We can identify four phases in
the business cycle.
Boom/peak: it is a phase in which the economy is producing the highest level of output in the
business cycle. It is the point which marks the end of economic expansion and the beginning of
recession. In this phase, the economy‘s output is growing faster than its long-term (potential)
trend and is therefore unsustainable. Due to very high degree of utilization of resources,
unemployment level is low; business is good; and it is a period of prosperity.
Recession/contraction: during a recession phase, the level of economic performance generally
declines. Total output declines, national income falls, and business generally decline. As a
result, unemployment problem rises. When the recession becomes particularly severe, we say

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the economy reaches depression or trough. This period can cause hardship on business and
citizens. Trough/Depression: - this phase is the lowest point in a business cycle. It marks the
end of a recession and the beginning of economic recovery/expansion. During this period, there
is an excessive amount of unemployment and idle productive capacity.
Recovery/Expansion: - during this phase, the economy starts to grow or recover, i.e. there is an
option of economic activity between a trough and a peak. In this phase, more and more
resources are employed in the production process; output increases, unemployment level
diminishes and national income rises. When this expansion of the economy reaches its
maximum, the economy once again comes to another boom or peak.
6.5. Macroeconomic Problems
6.5.1 Unemployment

Can we say that every person who does not have a job is unemployed?

Problem of unemployment is one of the major issues dealt in macroeconomics. Unemployment

refers to group of people who are in a specified age (labour force), who are without a job but are
actively searching for a job. In the Ethiopia context, the specified age is between 14 and 60
which are normally named as productive population. To better understand what unemployment
is, it is important to begin with classifying the whole population of a country into two major
groups: those in the labour force and those outside the labour force.

Labor force includes group of people within a specified age (for instance, people whose ages are
greater than 14 are considered as job seekers though formal employment requires a minimum of
18 years of age bracket) who are actually employed and those who are without a job but are
actively searching for a job, according to the Ethiopian labour law. Therefore, the labour force
does not include: Children <14 and retired people age >60, and also people in mental and
correctional institutions, and very sick and disabled people etc.

A person in the labour force is said to be unemployed if he/she is without a job but is actively
searching for a job.

Labour force = Employed + Unemployed

Types of unemployment

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Frictional unemployment: refers to a brief period of unemployment experienced due to.
 Seasonality of work E.g. Construction workers
 Voluntary switching of jobs in search of better jobs
 Entrance to the labor force E.g. A student immediately after graduation
 Re-entering to the labor force
Structural unemployment: results from mismatch between the skills or locations of job seekers
and the requirements or locations of the vacancies. E.g. An agricultural graduate looking for a
job at Piassa. The causes could be change in demand pattern or technological change.
Cyclical unemployment: results due to absence of vacancies. This usually happens due to
deficiency in demand for commodities/ the low performance of the economy to create jobs.
E.g. During recession
Note: Frictional and structural unemployment are more or less unavoidable; hence, they are
known as natural level of unemployment.
Measurement of rates of unemployment

Total unemployment = Frictional + Structural + Cyclical unemployment

Natural level of unemployment = Frictional unemployment + Structural unemployment

= Total unemployment - Cyclical unemployment

Natural rate of unemployment = Natural unemployment /labor force
Unemployment rate = total unemployment / labor force
When the unemployment rate is equal to the natural rate of unemployment, we say the economy
is at full employment. Therefore, full employment does not mean zero unemployment.
Computing the unemployment rate and labor force participation for the month of July 2003:
Labor force: 141.39 million
Employed: 133.47 million
Unemployed: 7.92 million
Not in the labor force: 91.2 million
6.5.2 Inflation
It is the sustainable increase in the general or average price levels commodities. Price index
serves to measure inflation. Two points about this definition need emphasis. First, the increase
price must be a sustained one, and it is not simply once time increase in prices. Second, it must

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be the general level of prices, which is rising; increase in individual prices, which can be offset
by fall in prices of other goods is not considered as inflation.

Causes of inflation
The causes of inflation are generally classified into two major groups: demand pull and cost
push inflation.
Demand pull inflation: according to demand pull theory of inflation, inflation results from a
rapid increase in demand for goods and services than supply of goods and services. This is a
situation where too much money chases too few goods.
Cost push or supply side inflation: it arises due to continuous decline in aggregate supply. This
may be due to bad weather, increase in wage, or the prices of other inputs.

6.6 Macroeconomic policy instruments

The ultimate policy objective of any country in general is to have sustainable economic growth
and development. Policy measures are geared at achieving moderate inflation rate, keeping
unemployment rate low, balancing foreign trade, stabilizing exchange and interest rates, etc and
in general attaining stable and well-functioning macroeconomic environment.

6.6.1 Monetary policy

Monetary policy refers to the adoption of suitable policy regarding the control of money supply
and the management of credit which is important measure for adjusting aggregate demand to
control inflation. It is concerned with the money supply, lending rates and interest rates and is
often administered by a central bank.
Monetary policy is a highly flexible stabilization policy tool. For instance, during economic
recession where output falls with a fall in aggregate demand, monetary policy aims at increasing
demand and hence production as well as employment will follow the same pattern of demand. In
contrast, at the time of economic boom where demand exceeds production and treat to create
inflation, the monetary policy instruments are utilized that could offset the condition and
achieve price stability by counter cyclical action upon money supply.

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Government monetary policy regulation is under responsibilities of Central Banks. Central Bank
controls the money supply to control nominal interest rates. Investment and saving decisions are
based on the real interest rate. When government lowers interest rate, firms borrow more and
invest more. Higher interest rates mean less investment.

6.6.2 Fiscal policy

Fiscal policy involves the use of government spending, taxation and borrowing to influence both
the pattern of economic activity and also the level and growth of aggregate demand, output and
employment. It is important to realize that changes in fiscal policy affect both aggregate demand
(AD) and aggregate supply (AS). Most governments use fiscal policy to promote stable and
sustainable growth while pursuing its income redistribution effect to reduce poverty. Fiscal
policy therefore plays an important role in influencing the behaviour of the economy as
monetary policy does. The choice of the government fiscal policy can have both short and long
term influences. The most important tools of implementing the government fiscal policy are
taxes, expenditure and public debt.
Traditionally fiscal policy has been seen as an instrument of demand management. This means
that changes in government spending, direct and indirect taxation and the budget balance can be
used to help smooth out some of the volatility of real national output particularly when the
economy has experienced an external shock.
Fiscal policy decisions have a widespread effect on the everyday decisions and behaviour of
individual households and businesses. Thus, it is mainly used to achieve internal balance, by
adjusting aggregate demand to available supply. It also promotes external balance by ensuring
sustainable current account balance and by reducing risk of external crisis. In general, it helps
promote economic growth through more and better education and health care.

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