Microeconomics

By: Zemach Lemecha (M.Sc, Asst. Prof.)

Semester I, 2015
 Chapter 1: Introduction to
Economics

1: Basic concept of economics

 OUTLINE
Foundation of economics
Definition of economics
Scope of economics (Branches of
economics)
Nature of economics
Efficiency and production possibility
frontier(PPF) and economic growth
Economic problems and Economic system
Types of goods
2
 1.1 Foundation of Economics
 The fundamental facts of economics
foundation consist of;
a) Unlimited human wants
• Infinite
• Insatisfiable
b) Limited Resource
 Resources are means of producing goods
and service that society wants on.
3
 Resources can be divided in two:
a) Free resource:
- Like breathing air, wind, river water, and
sunlight
  - it is gift of nature and no ask of price( at zero
price)
- No opportunity cost( no scarification)
- Qdd < Qss
b) Scarce resource: limited in supply
o Qdd >Qss
o Positive opportunity cost
o They are economic resources factors of
4 production like land, capital ,labor or human
 Scarcity:
 is the excess of human wants over what can
actually be produced.
 limited amount of resources
 It is a fundamental problem for every society
 The decision that can be solve scarcities are
- what to produce
- how to produce it
- for whom to produce  These
decisions involve opportunity costs- the value
of the next highest valued alternative use of
5
that resource.
Economic resource/ factors of production/
a) Land- all gifts of nature
 Reward of land is  rent
b) Labor: human resource
skilled labour mental labour reward for it is
salary
unskilled labour physical labour reward for it is
wages.
c) Capital: refers to all manufactured inputs usable in the
production of other goods and services(sells manufactured
input)
 E.g textile machinery: input for textile factory
 To produce textile machinery fabricate factory;
textile machinery is output. So it is capital.
6
Human capital: skill, talents and knowledge
embodied in people
Is not pure capital but only a type of labour
Financial capital: stocks, bonds, paper money
Not directly production (not directly
economic capital)
Thereward for it is interest
Real capital: various durable manufactured types
of capital capable of producing other goods and
services.
E.g machinery equipment
7
d) Entrepreneurship:
Is a special type of human expertise
with the objective of making profit
(∏) that organizes and manages
factor of production and takes risk of
making loss(risk takers)
The reward for entrepreneurship is
profit.
S/He is innovative, Risk taker and
8 Organizer.
Characteristics of entrepreneurship
Initiative
Decision makers
Risk takers  risks for effort, time, finance,
even life…
Entrepreneurship: organize factors of
production to get output for maximizing
profit
Innovators: ability to create new type of
business after creating new type of business
they may produce new product and new
9
market.
 It1.2deals
Definition of economics
with:
 How societies allocate scarce resources in the production and
distributes of goods and services to attain the maximum
fulfillment of society’s material wants i.e.  Limited resource
and unlimited human wants.
 Lets look the following ones;
Mankiw’s definition
…is the study of how society manages its scarce resources
Hedrick’s definition
…is how society chooses to allocate its scarce resources
among competing demands to improve human welfare
Alternative definitions
… what economists do.
… is the study of alternative use of resource.

10
 1.3 Scope of economics
• By scope of Economics mean:
o coverage or major areas of study
• The two main scopes or branches of
economics are:
1. Micro economics – from the
Greece prefix small
2. Macro economics- large

11
 It is the study of the economy in the small
1. Micro economics

It deals with

 Decision making of firms and individuals
 Economic activities of individual consumer and producers
 Specific economic units

 It examines "the individual trees in the forest”

2. Macro economics
It deals with the economics as a whole and its aggregates
and sub aggregates.
 E.g Ethiopia GDP, GNP.
 It study“ the forest but not the individual trees”
GDP is market value of all final goods and services
produced in a country in the a given year.
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1.4 Nature of economics
1.4.1 Goals of economics
1. Economic growth : means the production of more output to
increase the living standard of people
Economic development; broader and is social and economic
progress and seek to improve economic well-being and quality of
life for society
It has also multidimensional meaning. Eg. Norway is number one
 Quantitative: economic growth(GDP);e.g. 10%
 Qualitative: institutional set up, mass part
 e.g. – political participation of people must be developed
 Attitude of human being towards work
 Human resource activity
 Women participation in work
 Development index: income index, educational index(enrolment index, literacy
index).
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2. Economic security- welfare issue
Provision of welfare; handicapped, disabled
3. Full employment
 All resource would be efficiently utilized
 Not resource would be idle
 Not worker should be involuntary out of work
 No( idle resource, -L, L, K, E fully utilized)

4.Economic efficiency: PPF production possibility

frontiers. To measure the efficiency
5.Price stability
 They should not be fast fluctuation in price (stable)
 Two types of fluctuation
 Inflation;general price increase
 Deflation; general price decrease
15
6. Equity
 Fair distribution of national resource among the citizens of the
nation
 There should not be great poverty gap between rich and poor.
 They should not be division between people
7. Balance of Trade (BoT)
 Trade deficit: export less than import
 X<M  high need of hard currency
 Trade surplus : export greater than import
 X>M
 Trade balance: export equal to import
 X=M
 As much as possible to try illuminate trade deficit for
development

16
 Scarcity ,Nature of Choice and Opportunity Cost
What is the crucial ingredient that makes a problem in
economics?
 Scarcity:
Is the central economic problems faced by all
individuals and all societies.
At any time the world can only produce a limited
amount of goods and services because of the world
only has a limited amount of resources. It can be
product which can be;
o Good - is physical (tangible) things that satisfies
people’s wants and desires such as a car or a
17 hamburger.
 Cont…….
So, scarcity reflects the imbalance between our
wants and the means to satisfy these
want( resources).
The problem of scarcity lies in the inability of
people to produce the quantity and quality of all
goods and services (resources)that all people
want.
 Choice:
 Is the most clear implication of scarcity.
 Because of scarcity or not enough resources,
people need be choice what should be produce
18 and what should not be produced.
 Cont…….

The society must make choices about :

o what output to produce in what quantities and what output not
to produce
 involves decisions about the kinds and quantities of goods
and services to produce
o how to produce
 Requires decisions about what techniques to use and how
economic resources (or factors of production) are to be
combined in producing output.
 The economic resources used to produce goods and services
include: (the economy’s natural resources-such as land, trees,
and minerals.); labor (The mental and physical skills of
individuals in a society); capital (Goods-such as tools,
19
machines, and factories-used in production or to facilitate
production).
o for whom to produce.
 involves decisions on the distribution of output
among members of a society
 dealing with the above three economic problems
involves choice.
 By deciding which goods and services to produce,
society will choose these at the expense of others.
 In other words, choice implies cost. i.e., choice
involves sacrifice(give up).
 This means that when choice is made an alternative
opportunity is sacrificed.
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 Opportunity Cost
 Is value of the next best alternative that must be
sacrificed or missed (forgone) in order to obtain
one more unit of a product.
 Scarcity choice opportunity
cost.
This relation is known as economics equation.
 The economics equation is clearly
illustrated using the production possibilities
curve
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 1.5 Efficiency and production possibility frontier(ppf)

Economics is a science of choice and efficiency

In order to understand efficiency we have to achieve two things
1. full employment
2. full production
 Full employment; all factor of production(L,L,K,E) efficiently utilized(no
idle resource)
Ability and willingness
No labor (worker) should be involuntarily out of work (unemployed)
 Full production: the full employment of all available resource is necessary
but not sufficient condition to achieve efficiency.
It can be achieved when all the employed resources(L,L,K,E) shall be used
that they provide the maximum possible satisfaction of material wants
Is productive or efficiency in which the goods and services society desires
22 are being produced in the least costly way
Two types of full production
A. Productive efficiency
o Production of product mix in a least cost way
o Producing goods and service at least cost.
o On the PPF curve, it is impossible to produce more of one
good without producing less of another or without
sacrificing production of another good.
B. Allocative efficiency
oproduction of product mix that society wants most.
oIs an out put level where the price equals the Marginal Cost
(MC) of production .
This is because the price that consumer's are willing to pay
is equivalent to the marginal utility that they get.
oIs more concerned with the distribution and allocation of
23 resources in society.
 Cont…….
Production possibility frontier(PPF)
 is a curve or graph that shows the various combination
of goods and service that can produced in a full
employment, full production economy in which case the
available resources are fixed, and technology is constant

24
 Production possibility
curve

A
Unattainable
Efficient and attainable

Inefficient and attainable

25
 Assumptions of the PPF model:
1. Two products: economy is assumed to produce only two products.
2. Fixed resources: The quantity and quality of economic
resources(L,L,K,E) available for use during a certain period are
fixed.
3. Fixed technology: the state of technology-the methods used to
produce goods and services-does not change during specific
(given) period of time.
4. Efficiency: - The economy is operating at full employment and
achieving full production. I.e., No resource must sit idle and the
employment of these resources must provide us the maximum
possible output level.
5. Possibility of reallocation/shifting of resources: Thorough of
quality and quantity of economic resources are fixed, with in
26
limits, they can be shifted or reallocated among different uses.
 Cont…
 E.g1 land  factory site –machinery production 
farming- bread production
E.g2 Unskilled laborer can work on a farm, at a fast-
food restaurant or in a gas station.
 

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 Production possibility schedule
Commodity Production possibility
type

A B C D E

Machine 100 90 70 40 0

Bread 0 10 20 30 40

28
 Cont…….
The economy has 5 production possibilities
Production possibility :
 A and E unrealistic
 A+A  unrealistic b/c all the economy resources are devoted only to
the production of machine.
 E+E  unrealistic b/c all the economy resources are devoted only to
the production of Bread.
 B,C,D realistic because the economy production mix of
capital goods and consumer goods

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 CONT….
Production Possibilities Frontier (Curve)

A
100 n
nB
90
G
70 nC n
Units of
Machine

60
F D
n n
40
30

nE
10 20 30 40
Bread
30 (N o of Loaves)
 Cont…..…….
 A society is said to be efficient when it cannot produce more of one good
without producing less of another good.
 ON and WITHIN the PPF:
 The combination is attainable :
-The society can produce of both commodities
 The combination is efficient:
- a society must achieve both full employment and full
production

Ex. If the society wants to produce more bread, say 20 loaves Bread,
the society is forced to reduce its production of machine from 90 to 70.
Thus, we say that the society is efficient at point B (and also at points
A, C, D and E)
 Ex B(10, 90) transfer to C( 20, 70) increase the amount of bread
produce, sacrifice machine produce on PPF.
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 Cont……
 Inside the PPF
 The combination is inefficient
- There is some idle( unemployed) or unused resources.
 The combination is attainable
- The economy could produce more of both commodities
Ex: we can increase bread and machinery
We can decrease bread and machinery
 OUTSIDE the PPF
 Unattainable : we cannot attain with limited factor of
production( with limited technology and fixed resources)
 It can only be achieved by increases in resource supply and
quality, and technological advance, or in general economic
growth.
 Ex: Point G
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 Unattainable : - with fixed resources
- with constant technology

 In the long run:-

 when the factor of production increase in quantity and

quality and
 the advancement of technology
We can attain outward the PPF.

33
 Important concept embodied in the PPF or PPC
1. scarcity:- i.e. society can’t have unlimited amount of
output even if it employees all of resources and utilizes
them in the best possible way.
2. Choice:- Any movement on the curve indicates the
change in choice. Choice is indicated in the graph by the
movement along the curve either down ward or in ward.
3. Opportunity Cost:- when the economy produce on
PPF. Production of more of one goods requires
scarifying some of another good. The downward( -ve)
slope of the PPF implies the idea of opportunity cost .

34
 Cont…..

 Example, In moving from point B to point C in the above PPF, 20 units of

machine must be given up (forgone) in order to obtain 10 additional loaves of
bread. Thus, the opportunity cost is given by:
 
Opp cost = Units given up of one good
Units obtained of another good

 Numerical example of opportunity cost

Movement from B(10, 90) to C (20, 70)

Opportunity Cost: Sacrifice ( forgone) = 70-90

gain( obtain) 20-10
-20
10
=/-2/= 2

35
 The Interpretation is:
In order to obtain one additional loaf of bread two units
of machines must be sacrificed. In other words the
opportunity cost of obtaining one additional loaf of bread
is two unit of machine(1:2)
4 . Increasing opportunity cost/concavity
 The concavity of the PPF reveals increasing opportunity
cost
 The Law of Increasing Opportunity cost indicates the
shape of the PPF is concave or bowed outward.
 This reveals that the slope is increasing in either
36 direction, which means the amount of one good we have

to give up in order to obtain the other good increases

 1.6 Economic Growth and the PPF
 Economic growth :is an increase in the real output level of an
economy over time.
 Causes/ingredients of economic growth
Supply factor/ ability to grow
-quantity and quality of economic resources
-stock of real capital
-state of technology
Demand factor-in order to realize its growing productive potential, a
nation must provide for the full employment of its expanding
supplies of resources. This refers to the aggregate demand.
Allocative factor- to achieve its productive potential, a nation must
provide not only for the full employment of its resources but also for
full production from them. It refers to good and effective policy.
37
 
 Cont……
Thus, increases in total output level occurs:
o when there is an increase in the quantity and /or quality
of economic resources such as labor, natural resources,
capital, etc.
o advance (progress) in technology, i.e. when methods or
techniques of production are improved.

38
 Cont…..

39
 Cont………..
The increase in total real output (economic growth)
 Is reflected by the outward (rightward) shift of the PPF. When
economic growth is realized, the production possibility frontier
shifts outward to the right (from PPF1 to PPF2).

40
1.7 Economic problems and Economic system
1.7.1 Three fundamental economic problems
1. What to produce ?
 Sometimes called problem of choice
 such type of question in market economy( competitive market
system) answered by price system.
i.e by the interaction of dd and ss.
 This refers to the identification of what mix of good and services to
produce over a period of time.

 What collection (kind) of goods and services will mostly satisfy the
needs of its citizens and what quantities the goods and services to
produced

41
 2. How to produce?
 this problem refers to technical and organizational
problem of production.
 Choice of technique of production.

3. For whom to produce?

 Refers to distribution of outputs
 In market economy : Demand and supply determined by
the price system( profit oriented)
 In central command economy: fair distribution of output
through the country.

42
 1.6.2 Economy system
 In a set of organizational and institutional arrangements and
coordinating mechanism establishing to answer the three
basic economic question

There are three economic systems

1. Capitalism/ market economy/ sometimes laissez-faire
economy.
2. Command/ socialist/ planned economy
3. Mixed/ hybrid/ realism system.

43
 1. Capitalism

 The three basic economic question are answered by price

system( market mechanism)

 Adam smith invisible hand theory.

44
 Specific characteristics of capitalism
1. Market determination : price is the main determinant
factor of the market
2. Freedom of enterprises and consumers sovereignty ( free
entry and exit the market.
3. Private ownership of resources
4. Competition and independence
5. Specialization of goods
6. Role of self interest or individual system
7. Profit motive( profit oriented)
8. High inequality( high marginality)

45
 In capitalism system the gap b/n rich and poor is high. The
ownership of the means of production is falls in the hands
of a few wealthy persons.

2. Command system
 The 3 basic fundamental questions are answered by
central planning Authority( CPA) appointed by the
government.

46
 This is a form of economic system in which means of
production except labor are owned by the state and groups

Both resource allocation and pricing decision is

undertaken by a central planned decision.

47
 Specific characteristics of command system
1. Central planning board determination
2. Restrictive policy ( no freedom of enterprise and no
consumer sovereignty)
3. High government intervention
4. No competition ; due to price is allocated by the
government
5. Public ownership of resources
6. No specialization
7. Role of social interest ( welfare point of view)
8. Social motives
9. Highly equity .

48
 3. Mixed economic system

 “The market needs the state as much as the state needs” is

the base of mixed economy. In mixed economy, the strong
elements of both capitalism and socialism are hybridized.

 In such a system both government and the market

mechanism answer the fundamental economic questions.

49
 Market and Gov’t - distribution of income
- provision of market goods
- correcting market failures
- stabilizing the economy etc..

50
Chapter Two: Market model
Demand, Supply and Utility
Theories
 Market model
A market is an institution or an established arrangement or
place or mechanism, which brings together buyers
(demanders) and sellers (suppliers) of particular goods or
services.
 It is a place where potential buyers and sellers meet.
Or, market is an institution arrangement within which a
voluntary exchange is taking place between buyers and
sellers of goods and services in specific place with a given
period of time.

52
 Market model deals with the following theories.

 Theory of demand – deals with behavior of only consumers of

goods and services.

 Theory of supply – deals with behavior of only suppliers of goods

and services.

 Theory of equilibrium – deals with interaction between the

behavior of both sellers and consumers of goods and services.

 Theory of elasticity – deals with response/sensitive of sellers and

consumers of goods and services to policy, environmental, social,
human, and variable( such as prices, income etc) changes.

53
2. 1. Definition, law and determinants of demand of
agricultural commodities
Definition of demand (Dd) and Demand function.
 Demand in economics has different meaning as compared to our day-to-
day use ( ordinary meaning is want or desire)
 Effective demand : Fulfill the following Criteria
A. Desire (want) to use a Commodity
B. Sufficient money to purchase the commodity (ability to pay)
C. Willingness to spend money to acquire that Commodity( willingness to buy)
 Demand in economics is defined as a schedule,
 Which shows the various amounts of a product which consumers are
willing and able to purchase at each specific price in a series of possible
prices during some specified period of time in a specified market.
Or in shortly it is:
 Amount of a good or service consumers are willing & able to purchase

54 during a given period of time

 Cont……….
 Important elements from the definition of demand

Purchaser or demander for goods and services.

Seller or supplier of goods and services.
Products/ goods and services.
Time: there should be specific period of time
Prices specific price.
Willingness and ability.
Because willingness alone is not effective in the
market.
Willingness should be supported by ability
For instance, I may willing to buy a car but my ability
55 may not permit to do so. 
 Demand schedule and Curve
Demand schedule :
 Is a tabular presentation of the demand for a
commodity.
 It is simply a tabular statement of a buyer’s plans, or
intentions, with respect to the purchase of a product.
E.g. Hypothetical
Price Demand
per unit (in Birr/ unit) Schedules
Quantity for a Commodity X
Demanded/Week
(units/wk)

1 5
2 3
3 1

The above table in row 1 shows that the buyers in this market
56 demand 5 units of X per week at the price of birr 1 per unit
and so on
 It is a graphic representation of preferences for a particular good.
In other words, it is the graphic form of the demand schedule- the
quantity on the horizontal axis and the price on the vertical axis.
The demand curve : shows an inverse relationship between
product price and quantity demanded.
price

Vertical axis :Price

Horizontal axis: quantity

Quantitiy

57
 The Law of Demand
 Keeping all other factors being constant (ceteris
paribus), as price falls, the corresponding quantity
demanded rises, or as prices increases, the
corresponding quantity demanded falls.
 Qd/P must be negative
 The most important circumstance affecting the
demand for a good is the price.
 People buy more if the price of a good falls; they
will buy less if the prices rise, holding other factors
constant.
58
 Exceptions to the law of demand 
 There is situations when fall in price of a good actually cases people to
by less of it, or a rise in price causes them to buy more.
 Goods demanded for their price: the consumer may buy the
commodity because it is expensive, i.e. the price is part of the attraction
of the article and a rise in price may cause to be it more attractive ‘snob
value’.
Ex: Diamond P Qdd
 Expectation of a further change in price: on a stock exchange market,
a rise in the price of a share often attracts people to buy it and vice versa.
 Giffen Goods: If the product is inferior good and if the product takes
major portion of the household income, as the price of the commodity
declined this freed a proportion of the family income (income effect),
which was immediately spent on other goods, to vary the diet.
E.g. Beans 
59
 Individual Vs Aggregate (Market) Demand:
 Individual demand is single consumer( demanders)
 The market (aggregate) demand is driven by summing up the demand of all persons
participating in the market for that particular product.
 The market demand schedule can be constructed by adding the quantities demanded by
each consumer at the various possible prices in a given market.
Schedule
Price/kg A B C = Mkt Dd

5 0 0 0 0
4 10 10 10 30
3 15 20 20 55
2 20 30 30 80
1 30 40 40 110
P P p P

+ + =
60 Q Q Q Q
 Why do the curves slope downward
 Downward sloping demand curve means a rational consumer will
demand more of a commodity when its price falls. Some of the reasons
for the phenomenon would be:
1. Operation of law of diminishing marginal utility
U= satisfaction
 Buy something = consume it to get satisfaction.
 Any body scarifies money to get satisfaction .
If scarifies < satisfaction= everybody agree to buy
If scarifies > satisfaction= disagree to buy.

 LDMU: tells that the more a consumer consumes a commodity the

smaller the marginal utility.
Q = Mu
 Therefore negative slope.
61
 2. Income effect
 When price of a commodity falls, consumer's real income rises
that is he can now purchase more of the commodity with the
same income
Ex: allocate 120 birr income for buy milk
milk per liters Qdd
2 birr 60 liters
3 40
4 30
3. Substitution effect.
price increase/ decrease= Qdd decrease/increase
Ex= butter and edible oil are substitute good
When price of butter increase and the price of edible oil constant,
62the quantity demand for butter will decline.
Or P(butter) decrease when the price of edible oil constant , the
quantity demand for edible oil will decline.
4. New consumer creating demand.
P = Qdd
eg P( car) = Qdd for car increase
P( car) = Qdd decrease = leave the market.

63
Change in demand and change in quantity demand
Change in Qdd: This is a movement along the original demand curve due to
change in price.
 Change in quantity demanded refers to change in the quantity purchased due to increase
or decrease in the price of a product.

Quantity

Change in demand : is the total change in quantity of the demand schedule

having price constant.
 Change in dd is due to changes in various other factors such as change in
income, change in consumer’s tastes and preference, change in the price of
related goods, while Price factor is kept constant.
 Increase/decrease in demand refers to the rise/fall in demand of a product at a
64given price
 P

D2 D0 D2( increase)

Quantity

 A decrease in demand shifts a demand curve to left of the initial and

an increase to the right of the initial.
 It indicated graphically by a shift in dd curve either to the right or to
left of the initial

65
 Factors/ Determinant / Influencing Demand
Generally, there are two determinants.

1.Own-price determinant/demand mover/-the price of the product

2 . Non- Own-price determinants/demand shifters/

1. own- price

Law of demand P and Qdd= -ve slope.( inverse relation ship).

2. Non- Own-price determinants

1) The income of consumers (level of income of consumers)


The relationship between income and demand will depend upon
1. The type( nature of ) product considered and
2. The level of consumers’ income.

66
 Cont…………….
Generally , for most goods and service as increase in income(y)
(purchasing power) will cause an increase in demand, such type of
goods are normal goods.
 y and dd of normal goods= they have direct (positive relationship)
 Normal goods divide into luxury goods and necessity goods.
But as y increase some the level goods and services whose dd decrease
such type of goods are inferior goods.
ex. Bean Vs meat.
Income of some person increase beyond some level the preference
(demand) change from bean to meat so bean is inferior goods for that
person.
Dd of inferior goods and income= -ve ( inverse relationship)
Note : inferior goods at the very beginning normal goods, but the
income increase beyond some level the dd of inferior good decrease.
The
67 demand for inferior good is inversely related to income.
 2. Price of other related goods
The effect of the change in the price of other related goods is
dependent on the nature of the relationships between the
goods in consideration.
 The are two particular interrelationships of demand which
may be quantified,
1. substitutes goods : Where goods are substitutes one for
another
2. complementary goods :Where goods are complementary.
a) substitutes goods : two goods are substitutes if they
satisfy similar needs or desires.

68
 With substitutes, the demand for one rises as the price of the
other rises or the demand for one falls as the price of the other
falls,. For example, for many people butter is a substitute for
cooking oil and vice versa

ex : coca and Pepsi

tea and coffee
 If price of tea increase = demand of coffee increase

Price
Dd coffee 1
Dd coffee 0
quantity
69
 b) Complementary goods: are those goods that are jointly
consumed or demanded.
With complements, the demand for one rises when the price
of the other falls and the demand for one falls as the price of
the other rises.

 Thus if two goods are complements, the price of one good

and the demand for the other are inversely related.
 Ex1: if P of camera increase = Qdd of camera decrease
if Qdd of camera decrease= demand for films decrease
Ex2: price of car increase = Qdd of fuel decrease
price of car decrease= Qdd 0f fuel increase
70
 3.Tastes and preferences
These are usually subjective and changing.
Positive taste and preference favor the demand for a
commodity.
 A change in favor of a good shifts the demand curve
rightward.
A change in preferences away from the good shifts the
demand curve leftward.
Ex : fashion
4. Change in number of buyers
Since the market demand for a good or service is the
sum of all individual demands, an increase in the
71
number of buyers in a market increases demand.
 Increase in the number of buyers could be due to
expansion of markets which could be caused by
expansion the dd curve.
How number of buyers increase
 Expansion of trade- export to abroad
 Expansion of disorder
 Increase number of population( increase population
growth)
5. Size and composition of population
Composition Age composition
sex composition

72
 Age composition= predominance youth – e.g price of
cosmetics increase
predominance Adult- price of
normal good increase
 Sex composition= female( price of female material increase)
6. Seasonal factors( time)
The demand for many products is influenced by the season.
Example, demand for cloth during holidays; demand for
meat during fasting period.

73
 7. Expectation of consumers about future income, price
and product availability affects demand.
Current demand depends heavily on long-term
expected income.
Expectation of rise in future income may initiate
consumers to increase their current spending.
An increase in future price= current dd for goods and
service increase.
e.g Teff in December
Future product availability= current dd for goods and
services decrease .

74
8. Culture: Religious or traditional forbidden for some
products- either seasonal or permanent.
9. Government influences: prohibitions or restrictions of
some goods decrease the demand. 
10. Distribution of national income.
Equitable( socialist) = dd( necessity good) increase
dd( luxury )decrease
Inequitable (capitalist)=dd(luxury goods) increase =
dd( necessity) increase.

75
2.2 Definition, law and determinants of supply of
agricultural commodities
Definition of Supply (ss)
 Supply of a commodity can be defined as the - quantity that
producers are willing and able to offer for sale in a given time
period.
 In other words, individual producers point of view, supply is a
schedule which shows the various amount of the product which a
producer is willing and able to produce and make available for sale
in the market at each specific price in a serious of possible prices
during some specific time period
 Supply is which tells us the quantities of a product, which will be
supplied at various prices, all other factors being held constant.
 Like demand supply is a flow of goods and services. 
76
 Cont…….
 Important element in the definition of supply
Willing to produce
Able to produce
Make available for sale( product)
Purchaser of product
Time: specify period of time
Price: specific price

77
 The Supply Schedule:
Is a tabular presentation of the supply for a product.
It shows a series of alternative price-quantity supplied combinations.
In other words, it lists the quantities supplied at each different price,
when other non-price factors are held constant.
E.g. Hypothetical supply schedules for commodity X

Price per quintal (in Birr) Quantity supplied/week

1 2
2 4
3 6

This shows with an increase in price the quantity supplied also

increases.
78
 Supply curve: graphical representation of price and Qss
combination
P
ss

Qss

It
is constructed on a two-dimensional graph by assigning the price on the vertical
(Y) axis and the quantity supplied on the horizontal (X) axis.

Thesupply curve has a positive slope showing the positive or direct relationship
between price and the quantity supplied, holding everything else constant.

79
 Law of Supply
 The law of supply shows the behavior of suppliers - those
that at the receiving end in a market.
 Other things being equal, the higher the price of a good,
the greater is the quantity supplied, i.e. price and quantity
supplied is directly related.
 As price rises, the corresponding quantity supplied rises;
as price falls, the quantity supplied also falls.

80
 Why is the ss curve upward slopping( or there is
direct relationship b/n price and Qss?
A. An up-ward slopping curve reflects the fact that under certain
conditions a higher price is an incentive to producers to
produce more of a good.
B. Some producers employ additional quantities of factor of
production.(L,L,K)
C. High price attracts some producers who will, otherwise not be
interested in producing the commodity.

81
 Individual versus Aggregate (Market Supply)
An individual supply curve represents the price-quantity
combinations for a single seller (or firm).
However, in the real world markets there are many producers
or suppliers of the same product.

The market supply is simply the horizontal sum of the individual

supply curves.
The market supply curve represents the price-quantity
combinations for all sellers of a particular product.

82
 Factors Influencing Supply (Determinants of ss)
Two major determinants
1. Own-price determinant/supply mover/-the price of the product
2. Non- Own-price determinants/supply shifters/
1. Own-price determinant
 P and Qss have +ve relationship movement along the supply
curve is change in Qss
P
ss

83 Qss
2. Non- Own-price determinants
1. Price of related goods
a. Production substitutes
b. Production Complements

i. Production substitute
 Two products are substitutes in production when an increase in the price
of one product causes a reduction in the price of the supply of the other
product.
Eg: farmer use the plot of land for production of barley and wheat
W B W B
substitute

50% 50% 75% 25%

because price of wheat increase

P(wheat) increase= Quantity supply of barley decrease
84
Unlike dd, substitution of supply price of one good inversely
relationship of Qss of the other goods.
 Generally if the price of one production substitute increase,
this will decrease the supply of other substitute.
ii. Production complements:
 Are goods that are production together or jointly, or one is a by-
product of the other product.
 Their production process is inseparable.
 Generally two products are complements in the production when an
increase the price of one product causes an increase the supply of
the other product.
Eg1: p(beef) increase= ss(beef) increase
= ss skin increase
85 so P(beef) increase= ss skin increase.
2. Change in price of inputs (factors of production)
Inputs are the things that are used in the production of goods and services.
Change in the price of inputs directly affects the cost of production.
Input costs =cost of production = units of inputs used X respective prices
Therefore, there is close relationship between cost of production and
supply.  
An increase in the price of a factor will increase the cost of production of a
firm.
For a particular commodity, when the costs of production are low, relative
to market price, then it will be profitable for producers to produce a great
amount.
When production costs are varying high relative to price, producers will
produce little (or may stop producing).
This lowers supply. A decrease in supply is shown by a shift of supply
curve to the left of the original; where as an increase in supply is shown by
shift to the right.
86
3. Change in the level of technology
The state of technology affects the efficiency of production.
Usually advancement or improvement in technology allows
producers to reduce their cost of production per unit of output.
This would therefore, have the effect of shifting the supply curve to
the right. However, the effect of technology on supply tends to be a
long-term.
4. Number of Suppliers
The larger the number of suppliers the higher will be the volume
of supply, other things being constant.

87
5. Change in the level of taxes and subsidies
Taxes are deductions from the profit of producers or they are
additional costs to producers.

So their effect is similar to increase in cost of production.

Subsidies, however, are opposite of taxes.
Subsidies are expense for the government or society but
deductions from the cost of production to the individual
producer. The government, for instance subsidies on
fertilizer products.

88
 6. Nature, especially weather and pests
Bad weather, pests and disease can greatly reduce supplies
of agricultural products, while good weather and absence
of pests can greatly assist in increasing yields and hence
supply.

7. Expectation of producers with regard to future price and

other specific factors  

89
 Change in Supply versus Change in Quantity Supplied 
Change in Supply
Change in supply is a total change in the location of the
supply curve.
The change or shift in supply could be an increase or a
decrease.
It is caused by change in any of the non-price supply
shifters or determinants.
An increase is shown using supply curve, by shift to the
right of the initial.
An increase in supply happens when, due to changes in
one or more of the non-price supply shifters, the amount
supplied increases at each market price.
90
 Change in quantity supplied
This is movement from one point to another point on a
stable supply curve (the original supply curve).

 It is caused by a change in the price of the specific

product under consideration.

91
 2.3 Market Equilibrium Determination 
 Equilibrium is determined by the interaction of Demand and
supply curves.
 The actual quantity that demanders get in the market and the
actual quantity that producers offer are only determined when the
two actors meet in a market
 Therefore, we shall now combine our analysis of demand and
supply to show how a competitive market price is determined.
 The motives of consume and producers are different in that the
consumer wishes to buy cheaply while the supplier wishes to
obtain the highest price possible.

92
93
 Determination of the equilibrium condition
In any market one of the following three conditions may exist:
1. Equilibrium (balance) Point
Qss= Qdd at market price
PE= equilibrium price.
QE= equilibrium quantity
 Equilibrium price: is the price at which the wishes of buyers and
sellers coincide or the price that exists when Qdd equals Qss in a
given market, in specific time period.
 Graphically it is represented by the level of price that exists at the point
of interaction of dd and ss curves.
 It is sometimes is called market- clearing price.

94
 Equilibrium quantity: it is the quantity that corresponds
the equilibrium price. The quantity that corresponds the
equilibrium price.
The quantity at which the amount of good buyers are
willing to buy equals the amount sellers are willing to
sale, provided that both have the ability.

95
2. Excess demand (shortage): a condition in which quantity
demanded is greater than quantity supplied.
When excess demand occurs in an unregulated market, there is a
tendency for price to rise as demanders bid against each other for
the limited supply.
 There are various problems associated with shortage economy;
 Discrimination-some people will be satisfied while others will not.
 Black market or under economy activities.
There are different solutions for the problems associated
with shortage economy;
rationing or government intervention
Ex edible oil market in our case…
effective policy
96
3. Excess supply (surplus): a condition in which quantity
supplied is greater than quantity demanded at the current
price.
When there is excess supply, price tends to fall as competing
suppliers attempt to sell their product by lowering the price.
There are many problems associated with surplus
economy;
excess production problem/ lots of inventory/ products
remain unsold
removal product
discourage investor
Solution
dealers offers discounts to encourage buyers
97
government provides subsidy to sellers.
  shortage


 surpluss

Effect of change in Dd and Ss on the equilibrium State

Equilibrium price and quantity determined by SS and Dd

any time. Either Dd or SS or both may change, thus the
equilibrium price and quantity also change.

98
Case I: Change in Demand but Supply being Constant
i. Increase in demand, supply being constant

ii. Decrease in demand, supply being constant

Case II: Change in supply assuming that demand is constant
i. Increase in supply, demand being constant

ii. Decrease in supply, demand being constant

Case III: When both demand and supply change (combined effect)
a. Supply and demand change in opposite direction (in equal or unequal magnitude of
change)
i. When demand increases but supply decreases

ii. When demand decreases but supply increases

b. Supply and demand change in the same direction (in equal or unequal magnitude of
change)
I. Both demand and supply increase

ii. Both demand and supply decrease


99
 2.4 Elasticity
Elasticity is a general concept that can be used to quantify the
response in one variable when another variable changes.
 It denotes the responsiveness (sensitivity) of one variable to
changes in another.
It is a measure of the responsiveness of a market to a stimuli
(change in a variable)
Types of Elasticity
A. Elasticity of Demand
 It is important to determine how much the amount demanded will
change in response to a change in one of its determinants.
 Three types of elasticity's of demand
Own-price elasticity of demand
Income-elasticity of demand
100
Cross-price elasticity of demand
 1. Price Elasticity of Demand
Measures how sensitive or responsive consumers are to a
change in the price of the commodity under consideration other
factors held constant.
It is the percent of change in the quantity of a good demanded
that is bring on by a one percent change in price,
Edp = Percentage change in quantity demanded
Percentage change in price
Edp= Q / Qi = % Q
P /Pi %P
= 1. Pi
Slope Qi

101
 = 1 . Pi
Slope Qi
= 1 . Pi
P Qi
Q
denotes = Q . Pi
P Qi

Where, Q = Change in quantity demanded

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

102
 Arc (average) elasticity

Edp = Change in quantity . Average of prices

Change in price Average of quantity
 
Edp = Q . Pi + Pf
P Qi + Qf
 
Where, Q = Change in quantity demanded
P = Change in price
Qi = Initial quantity Qf = Quantity final
Pi = Initial price Pf = Price final

103
 Example : Assume that a price of birr 5 per kg of x , the
quantity of x demanded is 12 kgs when the price decrease to
birr 4 per kg the quantity of x demanded increase to 14 kgs.
Then calculate elasticity?
Given
Po =5 birr Qo= 12 kgs
P1= 4 birr Q1= 14 kgs
Ed= Q . Po
P Qo
= 2 .5
1 12
= 0.83

104
 Degree of price elasticity of demand
i. perfectly elastic demand( ed= ∞)
 If Qdd keeps on increasing or decreasing and price remains
constant , elasticity of demand is said to be perfectly elastic.
Consumers will purchase all they can at a particular price but
none of the product at a higher price (Edp = ).
Here a slight change in price corresponds to an infinitely large
change in quantity.
Quantity demanded is extremely responsive to even very small
changes in price .
The demand curve in this case is a horizontal line.

105
 P constant d

Qo Q1 Q2

Q . Pi =
P Qi

 This indicates one percentage change in price results in infinite

change in quantity.

106
ii. Perfectly inelastic(Edp=0)
Quantity demanded does not change as price changes.
Quantity demanded is completely unresponsive to
changes in price.
Own-price elasticity of demand (Edp) is zero.
The demand curve in this case is a vertical line.

p2
P1
p0
Qo
107
 iii. Unitary elastic: (Edp = 1).
 This is the intermediate case.

In this situation quantity changes by the same percentage

as price, i.e. both changes in the same proportion.

Ex if a 10% increase in price is accomplished by a 10%

decrease in qdd…. Price elasticity is unitary.
Q . Pi =1
P Qi

108
 iv. Elastic: (Edp > 1)
 Quantity of demand is changes by a lager percentage than
price,
i.e. it occurs when some percent change in price results in
a large percentage change in quantity.
A change in price induces a more than proportionate
change in quantity demanded.
Consumers are quite responsive to a price change.
The larger the elasticity, the larger the percentage change
in quantity for a given percentage changes in price.
Ex; if the price of a commodity increase by 10% ,then in
responses to it the qdd falls by >10%.

109
 Q . Pi =>1
P Qi
-20 = /-2/ = 2
10
Most of the time luxury goods are elastic demand
Inelastic demand: (Edp 0< ed< 1).
When a decline in prices brings a smaller percentage
increase in quantity
i.e. quantity of dd changes by a smaller percentage than
price.
 Consumers are less responsive to a price change.
Generally, a change in price causes a less than
proportionate change in quantity consumed
110
Ex : price of x commodity = 7 to 9 P = 2
Qdd of x commodity = 24 to 20.3 Q= /-3.5 /

Q . Pi =< 1
P Qi
/-3.5 /. 7= 0.6
2 20
Most of the time necessity goods inelastic demand.

Note: The demand for necessities tends to be inelastic.

It is very difficult to get along without some commodities like basic food,
water, closing and shelter, so that if the price go up, the quantity demanded
will hardly change.

111
Exercise one..
1. The price of a stick of cigarettes increased from 20 cents to
30 cents per stick. A smoker who used to smoke 30 sticks of
cigarette per day before the rice in price now decreased to
27 cigarettes. Calculate the price elasticity of demand and
degree of elasticity?

112
 2 . Income elasticity of demand
 It relates changes in the quantity demanded to changes in
income.

 It measures the degree of responsiveness of the quantity

demanded of a product to changes in income.

In other words, it measures the responsiveness of consumers to

income changes as the demand curve shifts from one position to
another.

It is the proportional change in quantity demanded divided by the

proportional change in income.
113
 Cont…….
Edy = Percentage change in quantity demanded
Percentage change in income

Edy = Q / Qi = % Q
y /yi %y
= Q . yi
y Qi
Where,
Q = Change in quantity demanded
Y = Change in income
Qi = Initial quantity Qf = Quantity final
Yi = Initial income Yf = Income final
114
 Cont…….
If demand increases when income increases, the income
elasticity is a positive number and such goods are superior or
normal goods, (Edy > 0)

If demand decreases with an increase income, the income

elasticity is negative and such goods are inferior goods, (Edy <
0).
If demand change is the same as income change, the income
elasticity is unit, (Edy =1).

115
 Type of income elasticity
1.High income elasticity
The percentage change in quantity demanded of a good is greater than the
percentage change in income.
 when % Qdd > Y
Edy = % Q >1
%y
2. Unitary income elasticity
Percentage change in quantity demanded of a good is equal to the
percentage change in income

 % Q = %  y

Edy = % Q = 1
%y

116
3. Low income elasticity
 The percentage change in quantity demanded of a good is
less than the percentage change in income
 % Q < %  y
Edy = % Q 0<edy< 1
%y
Saving is behavior show in this type of elasticity .
4. Zero income elasticity
 When change in income doesn’t lead to any change in quantity
demand( whatever the level of income….the quantity demand remains
the same.
 the graph of the elasticity is vertical graph.
 Saving is the habit of the person
117
 Edy = % Q = 0
%y
5. Negative income elasticity
It occurs when the level of income increase , the quantity demand
actually decrease

118
 Graphically

Y edy

Qdd

Generally
Normal goods= +ve income elasticity
 Luxury goods= edy> 1
 Necessity goods= 0< edy<1 …..like basic food; water, closing
and shelter,
119
 Exercise
Consider that the average monthly income of an average
Ethiopian increase from birr 120 to 150. as a result,
average monthly dd for good x increase from 20 to 30
units
a, calculate income elasticity
b, identify what type of goods.

120
 3. Cross elasticity of demand
 If two commodities X and Y are either substitute or
complement to each other, the demand for one of them will
be responsive to changes the price of the other.
 The extent of this responsiveness is called cross elasticity of
demand

 Edxy = Proportionate change in the quantity demanded of good X

Proportionate change in the price of good Y
 
Where, good X and good Y are related goods.
denotes = Qx . Pyi
Py Qxi
121
 Where
Q x = Change in quantity demanded of good X
Py = Change in price good Y
Qxi= Initial quantity of good X
Pyi = Initial price of good Y
If the cross elasticity of dd is positive the goods are
substitute.
Ex: quantity demand of Coca-Cola increase the price of
Pepsi increase.
On the other hand If the cross elasticity of dd is negative
the goods are complementary and if zero unrelated goods.

122
 Ex :quantity of film decrease when the price of camera
increase,( complementary good)
Exercise
 Suppose the price of Y rises from 8 to 10 birr per Kg and
as a result, the demand for x rises from 4 to 6 kg. what is
the relationship of the two goods? ( find the exy)

123
 B . Elasticity of supply
 Is also applicable to measure the behavioral changes of the supplier/seller/ in
response to the changes in the determinants.
 Two types of elasticity's of supply
Priceelasticity of demand
Cross-price elasticity of demand
I. Price Elasticity of Supply(PES)
 Is the measure of responsiveness of producers in terms of output to changes in
the price of their products.
Essp= Percentage change in quantity supply
Percentage change in price
Essp = Q / Qi = % Q
P /Pi %P
It denotes = Q . Pi
P Qi
Where, Q = Change in quantity supplied P = Change in pric
124
Qi = Initial quantity Pi = Initial price
 E.g. If Esp is 3, a 5% increase in price will result in a 15% increase
in quantity supplied.

 Arc (average) elasticity

Essp = Change in quantity × Average of prices
Change in price Average of quantity
 
Essp = Q . Pi + Pf
P Qi + Qf
 
Where, Q = Change in quantity supplied
P = Change in price
Qi = Initial quantity Qf = Quantity final
125
Pi = Initial price Pf = Price final
 Three types of price elasticity of supply
I Elastic-Esp >1, i.e % Qss > % P
 If the percentage rise in quantity supplied is greater than the percentage
rise in price that brought it about.
 That is, when a change in price causes a more than proportionate change
in quantity supplied.
 This means producers are relatively responsive to price changes.
II. Unitary elastic- Esp equal to one, i.e % Qss = % P
 the percentage increase (change) of quantity supplied is exactly equal to
the percentage increase (change) in price.
III. Inelastic- Esp < 1, % Qss < % P
 If the percentage rise in quantity supplied is less than the percentage rise
in price that brought it about. That is, quantity changes by a smaller
proportion than price. This means producers are relatively insensitive to
price changes. 
 
126
 Two extreme cases of elasticity of supply:
1. Perfectly elastic (Infinitely elastic)-
 Where changes in supply occur with out any large change in
price being necessary.
 Implies a small change in price changes quantity supplied by
an infinitely large amount.
 The supply curve for this case is a horizontal one
2. Perfectly inelastic-
 The Esp is equal to zero (Where supply is fixed).
 Where a change in price brings no change in quantity
supplied.
 The supply curve for this case is vertical one.
 E.g. Out of season demand, entrance ticket for some game

127
2. Cross-elasticity of supply
  The percentage change in the supply of one good in response
to a one percent change in the price of alternative product (a
product with in the production possibility of the producer).
Esx = % change in quantity supplied of a good “X”
% Change in price of good “Y”
Where ‘X’ and ‘Y’ being production alternatives.
 The value of the Esx can be negative or positive
If the value of Esx is positive, the two products are
complements in production (Complements in production
means the two goods are produced together.)
If the value of Esx is negative, the two products under
consideration are production substitutes.
128
 Exercise 1
Assume that there are 200 identical buyers of wheat in a
market with an individual dd function of Qdd= 8-P. there
are also 100 identical sellers of wheat of wheat with an
individual supply function of Qss=2p, cetrus paribus .
Calculate
A, equilibrium price.
B, equilibrium quantity

129
 Exercise 2
Consider the market dd function for computer is
represented as Qdd=20000-0.5P.

A, calculate the price elasticity of demand when the price

per unit is birr 10000.

B, is it elastic or inelastic.

130
 Solution 1
Market demand function Qdd= 200(8-p)
Market supply function Qss= 100(2p)
Qdd= Qss
200(8-p)= 100(2p)
1600-200p=200p
1600=400p
P*= 4
Q*= 200(8-p) Q*= 100(2p)
= 200 (8-4) = 100(2 x 4 )
= 200(4) = 100 x 8
= 800 = 800
131
 Solution 2
a, edd = Q . Pi
P Qi
Qdd= 20000-0.5p
derivation ∂Q = Q = -0.5
∂p p
at Po= 10000
Q0= 20000- 0.5( 10000)
= 15000
edd= /-0.5 x 10000 / = /-5 x 10 / = / -1 /
15000 10 15 3
= 0.33 inelastic demand
132
 THE THEORY OF CONSUMER BEHAVIOR
Consumer preference, Choice, and Utility
A Consumer is an individual or a household composed of
one or more individuals consuming a basket of goods and
services.
The consumer is the basic economic unit determining
which commodities to purchase and in what quantities.
Basket of goods and services refers to the various types
but in fixed quantities of commodities available for
consumption.

133
 Cont…
Preference and Utility
 Why do consumers purchase some commodities
and not others?
People have their own unique preferences for
certain commodities over others.
 A consumer’s choice to purchase more or less of a
good or service (or not purchase) depends partly
on: 
 The ‘taste’ (preference) of the individual
 The relative price (income of the consumers
indicated by the cost of each good or service) of
various commodities available for purchase.
134
 Cont…
 Preference: is the choice among commodities to satisfy
consumer wants.
Commodities (goods and services) are desired because of
their ability to satisfy wants.
Goods and services however differ in their ability to
satisfy a want.
Example: -An individual may prefer coffee to tea.
-Another person still may prefer tea to coffee.
Both consumers are still deriving some level of
satisfaction by consuming the good they choose.

135
 Cont…
 The power of a good or service that enable it to
satisfy human wants or needs is known as utility.

Utility : is the level of satisfaction that is need by

consuming a commodity or undertaking an activity.
For example: _ bread has the power to satisfy hunger
- water satisfy our thirst
- books fulfill our desire for knowledge
-a bed gives us a service for our desire to sleep
All the goods that people hold or consume possess utility.
Thus, utility is the “want satisfying power’’ of a
commodity.
136
 Cont…

However, this statement holds true only in relative

terms not in absolute term.
 It is relative to a person’s need.
In other words, whether a commodity possesses utility
or not depends on the person’s need of that commodity.
 All the persons need not derive utility form all
commodities.
For example: - Non-smokers do not derive any utility form
cigarettes
-Men do not drive utility by consuming a Modes;
- No one in Ethiopia (of course ‘Ethiopian by birth’)
derives utility from eating dog’s or donkey’s flesh, etc. 
137
 Cont…
 The utility of a thing can be different at different places
and time.
Example: during fasting the utility that we derive from
meat is not the same as any time else.
Utility is a purely subjective concept not objective i.e.,
-- we cannot get the exact measure of utility derived
from consuming a commodity.
 There are two major approaches to the analysis of
consumer behavior. 
Cardinal utility Approach-(Neo-classical approach)
Ordinal utility approach (Indifference curve analysis)

138
 The cardinal utility Theory 
The cardinal utility approach is based on early
psychological experiments and individual responses to
various incentives that led to the conclusion of
quantitative (cardinal) measurement of utility.
This theory holds that utility can be assigned
cardinal number like, 1,2,3, etc i.e.,
Utils- an util is a cardinal number like 1,2,3 etc simply
attached to utility.
Example: The first banana consumed might yield 6 utils of
satisfaction and the second banana might yield 10 utils.
 The utility that the consumer derived from consumption
of the second banana is 4 utils higher than the first
banana.
139
Assumptions: 
Cont…
1) Rationality of consumers: -A Consumer has to be rational in the
sense that his/her main objective is to maximize satisfaction.
2) Utility is Cardinally measurable: - the Cardinal approach holds that
utility of each commodity is measurable. The most convenient
measure is money.
3) Diminishing marginal utility (DMU): -this approach introduces an
important concept called Diminishing Marginal utility. the MU of a
commodity diminishes as the consumer acquires larger quantities of it.
4) Constant MU of money: - The essential feature of a standard unit of
measurement is that it must be constant.
5) Limited income: - the consumer has limited money to spend on the
goods and services he/she chooses to consume; thus, choice is
expected.
6) The total utility of a basket of goods depends on the quantities of
the individual commodities. If there are n commodities in the
bundle with quantities,
140
 Cont… )
 the total utility is
TU= f ( X , X
1 2 ...... X N )

Total and Marginal Utility 

Total Utility (TU): refers to the total amount of satisfaction or
pleasure a person derives from consuming or possessing some
specific quantities of a commodity at a particular time
Marginal Utility (MU: is the additional utility obtained from
consuming an additional unit of a commodity.
 It is the extra unit of satisfaction derived as a result of the consumption
of one more unit of a commodity.
MU = TU i.e. Marginal utility is the slope of the total utility curve.
Q
While total utility generally increases as an individual consumes more of
a commodity, his/her marginal utility declines.
 Total utility comes from all units consumed while marginal utility
comes only from the last unit consumed . 
141
Law of Diminishing Marginal Utility (LDMU)
 States that as the quantity consumed of a commodity
increases per unit of time, the utility derived from each
successive unit decreases, consumption of all other
commodities remaining the same.
The highest utility that an individual can get from
consuming a particular commodity is called the
saturation point.
This point lies at the pick of the Total utility curve
or at the zero point of Marginal utility.
 Consuming more units of a commodity past the
saturation point leads to a decline in total utility.
142
 cont…

Table 2.1 Hypothetical table showing TU and MU of

consuming Oranges ((X)
Units of
Orange s x
consumed
O 1st 2nd 3rd 4th 5th 6th

TUX 0 util 10 utils 16 utils 20 utils 22 utils 22 utils 20 utils

MUX 0 10 6 4 2 0 -2

143
144
 Cont…
As an individual consumer consumes more of a good per time
period, the total utility :
 first increase at an increasing rate when the MU is increasing
2nd increases at a decreasing rate when the MU starts to
decrease.
3rd reaches a maximum when the MU is zero; and thereafter
assumes a negative value.
Equilibrium of a consumer
The utility maximizing consumer reaches his/her equilibrium
position when allocation of his expenditure is such that the
last birr spent on each commodity yields the same utility.
In other words, a consumer, to maximize his/her utility, will
choose a market basket where his/her marginal utility of the
last birr spent on all commodities purchased is the same.
145
 Cont…

How does a consumer reach equilibrium position?

We know from our assumption that the consumer has
limited income and the utility, which he/she derives from
various commodities, is subject to diminishing returns.
We also know that the MU schedules of various
commodities may not be the same.
Some yield higher utility and others yield lower.
 A rational and utility maximizing consumer consumes
commodities in the order of their utilities by switching the
expenditure from one Commodity to the other in
accordance with their MU till he/she reaches a stage where
MU of each commodity is the same per unit of expenditure. 

146
 A case of One commodity (X) 
 Since both money income and commodity (X) generate
utility for the consumer, he/she can either spend his/her
money on commodity X or retain it.
a utility maximizing consumer exchanges money with the
commodity.
 Therefore, the utility maximizing consumer reaches
equilibrium level of satisfaction :
 when MUX=PX(MUM)
i.e: MUX/PX(MUm)=1
Because, MUx is subject to DMU while the MUM remains
constant (the constant MUM assumption).

147
 Diagrammatically,

148
 The case of two commodities (X&Y)
 If the consumer consumes two commodities (X and Y) at a
time, the equilibrium analysis takes the comparison
between money and the two commodities consumed.
By making use of similar analysis as in the above one
commodity case:
 MUx= Px(MUm), and thus, MUx/Px(MUm)=1, and
MUy=Py(MUm), and thus,MUy/Py(MUm)= 1 
It follows that, MUx/Px(MUm)=Muy/Py(MUm), but MUm
is constant and can be cancelled out from the above
relation ship, and it becomes :

149
 Many commodities case (A, B…up to Z)
It follows from the above two-commodity case that for
more than two goods, equilibrium is achieved when:

Where is the marginal utility of money. 

 This means that the consumer reaches his /her

equilibrium when the utility derived from each Birr spent
on all commodities is the same.

150
2. The ordinal utility Approach (Indifference
curve Analysis)
The ordinal utility approach holds that utility cannot be
measured absolutely; only ordering or ranking of preferences
is possible.
Assumptions:
1. Consumers are rational- they aim at maximizing their
satisfaction or utility.
2. Utility is ordinal, i.e. utility is not absolutely (cardinally)
measurable. Consumers are required only to order or rank
their preference for various bundles of commodities.
3. Preferences are complete, i.e. when consumers looked with
any two baskets of goods; a consumer can determine
whether he/she prefers basket A to basket B, B to A, or
whether he/she is indifferent between the two.
151
By “indifferent” we mean that a person is equally happy with
either basket.
 Cont…

5. Preferences are consistent or transitive, i.e. if the consumer prefers

market basket A to market basket B, and prefers B to C, then the
consumer also prefers A to C.
6. A commodity is good rather than bad in the sense that consumers
prefer more of a commodity to less.

 When we say “Good”, we mean desirable or valuable; Bad represents

things that are not desirable.
 The Ordinalist school postulated that utility is not measurable, but
is an ordinal magnitude:

 The concept of ordinal utility is based relative or subjective

measurement of utility.
 i.e consumers express their utility by weather the commodity drives
more or less or equal satisfaction when compared to others.
 It is practically possible for the consumers to rank commodities
152 in the order of their preference as 1st 2nd 3rd and so on.
 Indifference Curves
Locus of points representing different bundles of goods, each
of which yields the same level of utility (level of
satisfaction) to the consumer.
It is the locus of points representing market basket
among which the consumer is indifferent (equally happy).
is a concept used to represent an ordinal measure of the tastes
and preferences of the consumer and to show how he/she
maximizes utility in spending income.
 A higher indifference curve refers to a higher level of
satisfaction and a lower indifference curve shows lesser
satisfaction.
The entire set of indifference curves is known as an
indifference map
Negatively sloped & convex
153
 Cont…
 Indifference curves are also called iso-utility curve or Equal
utility curve.
To exemplify the indifference curve, consider a hypothetical
household consuming two commodities, X (meat) and Y
(Potatoes), which are substitutable for each other to some
extent, in consumption.
Assume this household obtains a given level of satisfaction, ,
in consuming given level (say, 1X and 10Y) of meat and
potatoes per day.
There are so many ways of combining X and Y in
consumption so as to give this same level of satisfaction.
Some four bundles or combinations are given below.

154
 Cont……

Table 2.2 Indifference Schedule

Bundle
(Combina A B C D
tion)
Meat in 1 2 4 7
kg(X)
Potatoes 10 6 3 1
in kg(Y)

155
 Cont…..

 By transforming the indifference schedule into graphical

representation, we get an indifference curve.

156
 Cont…
The number of possible locus of points - particular
combinations or bundles of goods-which yield the same
utility to a consumer indifference curve.
Characteristics of Indifference Curves:
 Indifference curves have negative slope (downward
sloping to the right).
 Indifference curves do not intersect each other
 The further away from the origin an indifferent curve
lies, the higher the level of utility it denotes
 Indifference curves are convex to the origin.
Convexity is a reflection of decreasing marginal
rate of substitution,
157
 The Marginal Rate of Substitution (MRS)
 The negative of the slope of an indifference curve at any
point is called the marginal rate of substitution of the two
commodities X and Y, and
It is given by the slope of the tangent at that point: i.e.

Slope of indifference
y / x  dy / dx  MRS
curve = XY

158
 Cont…
It refers to the amount of one commodity that an
individual is willing to give up to get an additional unit of
another good while maintaining the same level of
satisfaction or remaining on the same indifference curve.
Measures the downward vertical distance (the amount of
y that the individual is willing to give up) per unit of
horizontal distance (i.e. per additional unit of x
required) to remain on the same indifference curve.

159
 The consumer Budget Line
 The budget line is a line indicating different combinations
of two goods that a consumer can buy with a given income
at a given prices.
 It Shows all possible commodity bundles that can be
purchased at given prices with a fixed money income

160
 Cont….
By assuming that the consumer spends all his/her income on
two goods (X and Y), we can express the budget constraint as:
I =PXX+PYY
Where,
I=consumer’s money income
PX=price of good X
PY=price of good Y
X=quantity of good X Y=quantity of good Y

 In the real world, it is unrealistic to assume that there are only

two commodities in existence but the notion is to simplify the
model.
161
 Cont…
This means that the amount of money spent on X plus
the amount spent on Y equals the consumer’s income.
Suppose the situation of a household with 10 Birr per day
to spend on food items, like meat at 2 Birr each and
potatoes (good y) at 1 Birr each. That is,
Table2.3: Alternative purchase possibilities (With
income=birr 10; )
Consumpti
on
A B C D E F
Alternativ
es
Kgs of
Meat 0 1 2 3 4 5
(X)
Kgs of
Potatoe 10 8 6 4 2 0
s (Y)
162
 Effect of changes in income and price on the
budget line
A. Effects of changes in income
If the income of the consumer changes (keeping
the prices of the commodities unchanged) the
budget line also shifts (changes).
 Increase in income causes an upward (but parallel)
shift of the budget line and decreases in income cause a
downward (but parallel) shift of the budget line.
 It is important to note that the slope of the budget line
does not change when income rises or falls.
 This is because there exists a parallel shift in the
budget line as a result of change in income
163
 Cont…

164
 B. Changes in the prices
Changes in the prices of the commodities change the
position and the slope of the budget line.
But, proportional increases or decreases in the price of
the two commodities (keeping income unchanged) do
not change the slope of the budget line if it is in the
same direction.
Nevertheless, the effects of the simultaneous changes
in and in opposite direction depend on the strength of
the changes of each of them.

165
 Consumer Optimum: Utility Maximization
A rational consumer maximizes utility by trying to attain the
highest possible indifference curve, given the budget line.
This occurs where an indifference curve is tangent to the budget
line so that the slope of the indifference curve is equal to the
slope of the budget line
Thus, the condition for constrained utility maximization,
consumer optimization, or consumer equilibrium occurs
where the consumer spends all income (i.e. he/she is on the
budget line) and

MRS XY  PX / PY
166
 Graphical configuration of consumer optimum is given
by:

167
 Cont…
At point ‘e’ (which represents combination X and Y) is the
most preferred position by the consumer since he/she
attains the highest level of satisfaction within his/her
reach.
And point ’e’ is known as the point of consumer
equilibrium (or consumer optimum).
And this occurs at the point of tangency between the highest
possible indifference curve and the budget line.
In other words, equilibrium is established at the point where
the slope of the budget line is equal to the slope of the
indifference curve.

168
 Cont…
Symbolically consumer optimum is attained at
the point where:
PX MU X MU Y MU X PX
MRS XY  , But we know   .......MU X PY  MU Y PX ..., 
PY PX PY MU Y PY

169
 CHAPTER 3
THEORY OF PRODUCTION AND COST
IN RELATION TO AGRICULTURAL
FIRMS

170
3.1 CONCEPTS OF PRODUCTION BEHAVIOR
Technique of production

 How a farmer/firm combines economic resources so as to

maximize output, given the technology.

A technique :– is any feasible method by which inputs

can be converted in to outputs.
Production or production process:- is the transformation
of resources (inputs) in to outputs of goods and services.
Production technology : relates inputs to outputs- specific
quantities of inputs are required to produce any given good
or service.
171
Output :-is not only to final commodities like automobiles,
TV, bread, etc but also to intermediate products like steel,
wires, flour, etc that are used in the production of final
commodities.

 out put are classified in to two

Final commodity Intermediate commodity

Final commodity: directly use for consumption

Intermediate commodity: this are out put of one factory
and input for other factory .
ex: wheat -> flour -> Bread
172
  Output also divide goods and service
 Out put of services are like banking, legal counsel,
transportation, storage, wholesaling, medicine, etc.

 A firm (farmer, organization or enterprise) that combines

and organizes resources for the purpose of producing
goods and services) will use technologically efficient
production methods so as to maximize its profit.

In choosing the most appropriate technology, firms choose

the one that minimizes the cost of production.

173
Technique of production : how to produce economics
question answered by technique of production .
There are two types of technique of production
1. labor-intensive technique( capital saving)
 For a firm in an economy with a abundant supply of
inexpensive labor but not much capital, the optimal
method of production will be labor-intensive technique.
 Example Textile production in Ethiopia involves
larger amount of labor than capital.

 Labor-intensive techniques are also called capital

saving techniques of production.

174
2. Capital-intensive (Labor saving )
In the contrary, firms in an economy with high wage rate and
high labor cost have an incentive to substitute away from labor
and use more capital.

Production Function:
shows the relationship between various combinations of inputs
and the maximum output obtained from those combinations.

It represents the maximum output that can be obtained from

given combination of inputs, given the state of technology.

 A table, graph, or an equation showing the maximum output

of a commodity that can be produced per period of time can
175represent the production function.
The general mathematical representation of production
function showing units of total output as a function of units of
inputs is given by:
Q= f(L, L,K, N, E)
Types of inputs
Inputs are ingredient or means of production or factors of
production.
we have two types of inputs
Variable Input: - is an input whose quantity can be changed
(Increased or decreased) during a given period of time
 Example: Unskilled labor, raw materials, etc
Fixed Input: - is an input whose quantity cannot change during
a given period of time.
Example: Highly skilled labor and capital (firms plant and
176equipment) i.e. the factory, buildings, Machinery, etc
 The Short Run and the Long Run

Short Run and the Long Run are economics conceptual period.
It is the length of the period varies from one firm to another

The short run

 Is the time period in which the quantity of at least one input
remains varies.
It is the time period so short that a firm can vary the quantity of
at least one of its inputs.
The long run
 Is a time period so long that a firm can vary the quantities all of
its inputs.
 In the long run, a firm can make a complete adjustment to any
177change in its environment.
 Example
 For a firm engaged in the production of foodstuff, a
period of five years may be along run phenomenon.

 Whereas, for a firm engaged in the production of

automobiles and airplanes such as Toyota and Boeing, it
will take them 50 years to construct and install new
plant

178
 The short Run Production Function
(Production with one variable input)
 A firm’s short run production function describes how the
maximum attainable output varies as the quantity of labor
employed in a given production plant varies.
 most of the time variable input is= labour
( K, L and, E, remain constant)
The increase or decrease in total output (Q) is represented
as, a function of, depends only on, the quantity (and of
course quality) of labor (L) available on the given time
period.
Short run production function Q= f(L), Where land, capital
and technical knowledge remain fixed.
179
 Definition of TP, AP and MP

Total product (TP) –refers to the total quantity of output

that a given input can produce over a given period.
Average product (AP) –refers to output per unit of labor
input.
  AP= TP/L
Average product is also called Labor productivity. (in this
case the only variable input is labour)
Out put per unit of labor
Marginal product (MP) –The marginal product of any input
is the increase in (additional) total product resulting from
an increase of one unit of that input.
180
MP= change in total production/change in labor input
MP= ∆TP where ∆ signifies “change in”
∆L
 In order to determine which production technique, i.e. which
combination of inputs a firm/farm should use it is necessary to
consider:
 The Average product and marginal product.
This is because they imply productivity – If labor
productivity is high use labor –intensive techniques of
production. Otherwise, look for some other technology.
Both marginal product and average product of the variable
factor (i.e labor) are derived from the total product of the factor.
Thus, the three type of returns; total product, marginal product,
and average product are interrelated.
For this consider the following data in the table
181
182
 hypothetical graph

183
 Properties of and relationships between TP, AP, and
MP curves
 The Total product curve: starts from the origin, rises to
its maximum and then declines.
The TP curve rises first at an increasing rate and then at a
decreasing rate until it reaches its maximum point. 
Ex MP1= 2 TP increasing MP4= 8 TP increasing

MP2= 4 an increasing rate MP5= 5 an decreasing rate

MP3= 6 MP6= 2
MP7= 1
 The marginal product curve: first rises and reaches
its maximum point known as the point of Diminishing
Marginal Returns or Inflection point.
184
  The MP, after achieving it maximum point, declines and
assumes a zero value when the TP curve is at its maximum.
When the TP curve declines, MP becomes negative.
 The Average product curve: initially rises, attains its
maximum value, and then declines.
The point at which AP curve attains its maximum point (value)
is known as the point of diminishing average returns .

 Up to the highest point on the MP curve, if additional units

of labor are employed, total product increases at an
increasing rate, this is the stage of increasing returns to labor.
 From the highest point of the MP to its zero value, If
additional units of labor are employed, total product still
increases but at a decreasing rate, this is the stage of
diminishing returns to labor.
185
 When Marginal product is negative, total product falls,
this is the stage of negative returns to scale.

The Law of Diminishing Marginal Returns (LDRM)

State that as more and more (successive) units of a

variable input (say, labor, in our case) are added to a fixed
input (say, land or capital), after some point, the extra or
marginal product attributable to each additional unit of
the variable input (labor) gets smaller and smaller. 

In short ,if firm employ s more and more labor at given

period, the out put gets smaller and smaller.
186
 Assumption
(the Law of Diminishing Marginal Returns holds true
only if the following conditions are maintained)
When technology is assumed to remain fixed(constant)
When there is at least one fixed input.
The LDMR assumes all units of the variable input are of
equal quality
The Law of Diminishing Marginal Returns is a short run
phenomenon

187
 Stages of production
stage I : The range from the origin to the point where
AP becomes maximum is stage I of production for
the variable input.
In this case, AP is rising to its maximum while MP
rises, reaches its pick point, and then starts to decline.
In stage I of production:
The fixed input is underutilized (underemployed)
AP is rising (productivity is rising 
 As AP is the measure of productivity or efficiency and
since AP is rising in stage I, it pays the firm to employ
more and more labor to boost production …
In addition, in this stage, the fixed input (in our

188
example, land) is underutilized.
 Example more production of wheat can be made possible
by employing successive (additional) units of labor.
In this stage the MP of land is under utilized and that of
labor is positive.
Stage II of production: proceeds from the point where AP
is maximum to the point where MP is Zero.

In this stage, both AP and MP are declining but remain

positive.
This means that the productivity of all workers decline.
In addition, the extra output from each successive units of
labor declines but still adding to Total product.

189
 Resource in some extent efficiently utilized.
Mp labor +ve and MP of land +ve
Increasing the out put level. Maximum output(TP) produce.

Stage III of production: ranges over the area where MP is

negative.
In this stage, total product is declining.
Each successive units of labor brings no output but makes TP to
decline.
This is because the fixed input (Land, in our example) is over
utilized.
 The overall labor employed does not have enough
complementary (land) to work with (on).
 It means greater output (TP) can be achieved by decreasing
workers (labor). It means that MP of labor is negative while that
190 of land is positive.  
Labor is over employed and capital is over utilized this stage is
known as intensive margin

Conclusion
 Rational producer would not produce in stage I because excess
capital for the very limited variable input( labor). In stage I labor is
under employed and capital is under utilized. This stage of
production is known as extensive margin .

 Therefore, the only stage where production can take

place is the stage II where both MP labor and AP labor
are showing positive values.
 This means that the only feasible stage of production for a rational
producer is Stage II
191
 The Long Run Production Function
(Production with two variable Inputs)
In our previous discussion, we have kept every other input
fixed except labor.
The long run function, we will deal with production behavior
when we have two variable input (Labor and Capital).
Assume
2 variable inputs = capital /K/
Labor / L/

Ex: production function :

 Production function in the long run by using Isoquant

and Isocosts.
192
Isoquant: is a curve that shows the different combinations of
labor and capital inputs that yield the same output.

 In other words, an Isoquant is a graph that shows all the

possible combinations of two Inputs (Labor and Capital)
that yield the same maximum output among which the
producer is indifferent.

 An isoquant is a curve along which the maximum

achievement rate of productions attain.

193
 Example :

Capital

194
Labor
Graphically

 Isoquants are combination of different level of L and k that

give the same level of output
Mathematically ex: Q= 500√LK Q= 500 √4*1
= 500 √3*1 = 500 *2
195
= 870 = 1000
 Properties of Isoquants
1. An isoquant must be negatively sloped in the relevant range.
 In means that if the firm wants to reduce (increase) the
quantity of one input used in production, it must increase
(reduce) the quantity of the other input in order to continue
to produce the same level of output (remain on the same
isoquant).
 Specifically, use of more capital requires the use of less of
labor and vice versa to maintain or produce the same (given)
level of output.
2. An isoquant that lies further away from the origin represents a
greater output( high level of output).
3. Isoquants cannot intersect or be tangent to each
other.
This is because the point of intersection would imply two

196
different levels of output
4. Isoquantsare convex to the origin.
Convexity of isoquants implies i.e the slope decline upward or
downward in either direction.
This follows from the fact that the two inputs are not perfect
substitutes.
5. Isoquants ( production Ics) show cardinal magnitudes…. Expressing
in cardinal numbers.

Marginal Rate of Technical Substitution (MRTS) 

Is the slope of an isoquant
Is the rate at which one input can be substituted for another without
changing the given output.
When output is constant. For instance , the marginal rate of technical
substitution of capital(K) and labor( L) is the amount by which labor
(L) can be reduced per unit of increase of capital (K) for maintaining a
constant level of output.
197
 Consider the following figure on an isoquant which
define the combination of labor and capital used in
the production of Q.
K
C1 A
C2 B C

o L1 L2
 We can see from the figure the quantity of capital decreased
from OC1 to OC2 and the quantity of labor increased from OL1
to OL2. The rate at which capital substitute by labor would be
the ratio of change in quantities of these units.

198
 forgone( given up)

i.e MRTS Lk = OC2-OC1 = -AB = - ∆K = MPL

OL2-OL1 Bc ∆L MPK
gain
gain forgone MPL = ∆TP
∆L =∆
K
MP K= ∆TP ∆
L
∆K

 The absolute value of the slope of the isoquants gives us

MRTS.
MRTS KL = = - ∆L = MPK
199 ∆K MPL
 Isocosts
To determine the combination of inputs that will
minimize the firm’s costs, one can use the isocost concept.
Or it is least cost combination of input
The Isocost Line shows all the alternative quantity
combinations of two inputs that the producer is able to
buy at current market prices in a given period by fully
using a given budget.

Shows the locus of input combinations that can be

purchased with a given amount of expenditure.

200
 B= PL* L + PK. K
k=0
B= PL* L + PK. 0
B= PL* L
L= B
PL
L=0
B= PL* 0 + PK. K
B= PK* K
K= B
PK
 Point on the cost line and inside the cost line are attainable
and the cost above the Isocost line are unattainable which
201
means the producer has no capacity .
 Ex : Tc= LPL+ KPK
K 8

birr 350

B
10 L

 Suppose the unit of price of labor( PL)= 15 birr and the unit
price of capital(pk)= 25 birr, then the total cost of labor and
capital combined together would be..
(15*10)+(8*25)= 350

202
 B= PL* L + PK. K
(0 , B/PK ) ( B/PL , 0 )
X0 Yo X1 Y1
Slope = y1- y0/ x1- x0
=0-B/PK = -B/PK = -B*PL = -PL = PL
B/PL - 0 B/PL PK* B PK PK
Rate, change measured of cost from
capital to labor cost

The Producer’s optimum

 The producers optimum point is at the tangency of the
Isoquant line and Isocost line.

203
 How can a firm minimize the cost of producing any output it
wishes to produce? How can a firm maximize the quantity of
output it wishes to produce with a given budget?
Given both the isoquant and the isocost curves, one can
readily determine the input combination that will minimize
the firm’s cost.

In order to minimize the cost of production, the producer must

use the input combination that is located on the lowest isocost
line that enables a specific quantity of output to be produced.

 A producer in order to minimize his /her cost of production

must allocate his/her expenditure between the two inputs in
such a way as to equalize the marginal product per dollar of
each input.
204
 i.e MPL = MPk
PL Pk

The producer Optimum occurs at the tangency point

of an isoquant and isocost line. It means , when the
slope of the isoquant ( MRTSLk) equals to the slope of
isocost line (PL/PK).

mathematically , MRTSLk(MPL/ MPk )= PL/PK

205
  The optimal input combination as such is thus the tangency point.
 Let’s see why. The movement along the isoquant from C to A, which
leaves the output unchanged, costs the producer less (because point A is on
a lower isocost than point C).
 Again, movement from B to A costs the producer less to produce still the
same output.
 Therefore, the minimum cost that the producer has to incur so as to
produce a specified level of output occurs when the isocost is tangent to
206
the isoquant. This tangency point is said to be the point of Producer
optimum
 Shortly
A=B=C = 1120
I3> I2>I1 (Isocost)
Where the Isocost far from the origin the cost of
production increase

The Expansion Path

 The equilibrium path along which production expands as
production budget or expenditure increases is called
Expansion path.

207
 An expansion path shows the locus of the least cost input
combinations for producing various levels of output when
input prices remain constant.
208
 Returns to scale
It refer to the increase in output those results from
increasing all inputs by some proportion (percentage).
It is change of out put as the result of factor of production
(combination of input)change.
A. Constant Returns to Scale
It refers to the condition where output changes by the
same proportion as inputs.
 Ex: if input increase by 5% then the output increase by
5%.
this case, isoquants are equidistant apart.
 the size of the firm’s operation does not affect the
productivity of its inputs.
The average and marginal productivity of the firm’s inputs
209 remain constant.
 B. Increasing Returns to Scale
 It refers to the condition where output increases by a
larger proportion than inputs. is often called economies
of scale.
 Ex: if input increase by 5% then the output increase >
5%.
 Isoquants get closer together (distance between
isoquants declines).
Increasing Returns to Scale can be made possible by:
Greater division of labor and specialization, which
enhances productivity of labor.
Using more specialized and sophisticated machines or
equipment–more specialized machines are more
productive than less specialized machines.
210
 C. Decreasing Returns to Scale
It refers to the condition where output changes by
a smaller proportion than inputs.
Ex: if input increase by 5% then the output
increase < 5%.

 Isoquants become farther apart (distance between

isoquants increases).

Decreasing returns to scale occurs because as the

scale of operation increases, it becomes difficult to
manage and coordinate activities effectively.
211
 Theory of cost in Agricultural Firm

212
 As we observed in the market model, the basic factor
underlying the ability and willingness of the firm to
supply a product in the market is the cost of production.

Cost refers to the amount a firm spend on factors of

production to produce goods and services

Depending on various criteria, costs could be

classified as 
Implicit Vs Explicit costs by structure
Privates Vs social costs by agriculture firms
Economic Vs Accounting cost by analysis
Fixed Vs Variable cost by input
Short run Vs long run cost
213
Explicit costs(accounting cost): are the actual
pocket expenditures of the firm to purchases or
hire the inputs it requires in production.
Monetary payments to owners of market-supplied
resources
Payment for none owned factor of production.
Examples:
Wages & salaries of labor
Interest on borrowed capital
Rent on land & buildings
Expenditures or raw materials & semi finished
materials
214 Payments made for utilities, taxes, machines etc. 
Implicit costs: refer to the value of the inputs
owned and used by the firm in its own production
processes.
The value of thus self owned or self employed
inputs must be estimated from what thus inputs
could earn in their best alternative uses.
Examples:
 Wages of labor rendered by the owner /entrepreneur
Interest on capital supplied by the owner
Rent of land and buildings belonging the owner
Normal profit of the entrepreneur’s this refers to the
minimum payment needed to the entrepreneur in the
215
business for the entrepreneurial talent
 Short run cost
Is expenditure incurred in the short run production process.
Long run costs
Are costs incurred in the long run production process. 
Private costs
Are either explicit and implicit opportunity costs incurred by individuals and firms in the
process of producing goods and services 
Social costs
Are costs incurred by society as a whole.
Economic cost
This means opportunity cost, the cost to a firm in using any input (hired or owned) is what the
input could earn in its best alternative use.
The sum of EC and IC, (Explicit cost+ implicit cost)

Accounting cost= explicit cost
Economic Profit= TR- Economic cost and Accounting profit=Total Revenue-Explicit cost
 

216
 Opportunity cost :Is the second best benefit forgone
(scarified) or best alternative forgone.
Short run costs
 Short run costs are the costs over a period during which some
factors of production (usually capital equipment and
management/entrepreneurship) are fixed.
 At least 1 fixed cost.
These costs are also subdivided in to:
 Totals,
 Units or averages
 Marginal
1. Totals
A. Total Fixed costs (TFC):
 Are those costs do not vary with changes in output.

217
 They are payments for fixed inputs
They are independent of output
These include:
Insurance premiums
Property taxes
Interests on borrowed capital
Rental payment
A portion of depreciation (wear & tear) on equipment &
buildings
Fixed costs are associated with the very existence of the firms
plant, and therefore must be paid even the firms output is zero.
 Hence fixed costs are unavoidable costs.
TFC= quantity of fixed inputs * price of fixed inputs

Ex: machinery buy 20000 birr always 20000birr do not depend of

218 quantity or price change.
Graphically
Cost

k TFC

Quantity

B. Total variable cost (TVC)

Costs that change with the level of output.
This refers to the payment for variable inputs.
TVC are dependent on the level of outputs.
It is also called avoidable cost or direct cost
These include
 Payment to raw materials
 Payment Fuel
 Payment most labor
219 Payment power & transportation etc
These costs are direct costs of output because when output
increase, total variable cost increases, when output decreases
total variable cost decrease, and when out put is zero then
total variable cost is zero.
TVC= quantity of variable inputs * price of variable inputs

Cost TVC

Quantity

C . Total cost
It is the sum of fixed cost and variable cost at each level of
output.
At zero levels of output, total cost is equal to the firm’s fixed cost.
TC=TFC+TVC
220
The distinction between fixed and variable cost is
significant to the business manager.
Variable can be controlled or altered in the short run by
changing production levels.
Fixed costs are beyond the business executive’, present
control; they are incur in the short run and must be paid
regardless of output level
When TP= 0, TVC= 0 TC= TFC+ 0
TC= TFC……….TP=0
Cost TC
TVC

TFC
221 Quantity
 2. Units ( Average cost)
Unit costs are derived from the total costs
Producers are certainly interested in their total
costs.
In particular, average-cost data are more meaning
full for making comparisons with product price,
which is always stated on a per-unit bases.
A. Average fixed cost (AFC)
Is found by dividing TFC by the level of output.
AFC= TFC/Q Where Q is out put
Since TFC is the same regardless of output, AFC must
decline as output increases AFC graph is continuously
222
declining curve as a total output is increased.
B. Average variable cost (AVC)
Is found by dividing TVC by the level of output.
AVC= TVC/Q
As output increases by adding variable resources, AVC
declines initially, reaches minimum, and then increases
again.
AVC is a U-shaped or saucer -shaped curve.
Initially due to increasing marginal returns, variable cost
per unit (AVC) declines.
After the law of diminishing marginal returns starts to
operate, the AVC will increase.
In simpler terms, initially, at very low levels of output
production is relatively inefficient and costly.
Because the firm’s fixed plant (asset)
is understaffed or
223 underemployed, AVC is relatively high.
C. Average Total cost (ATC)
Is found by dividing total cost by output.
ATC= TC/Q = TFC +TVC/Q =AFC + AVC
3.Marginal cost (MC)
Is the additional or extra cost of producing one more unit of
output.
It measures the additional cost of inputs required to produce
each successive unit of output
MC equals the change in TC or in TVC per unit change in output.

MC= ∆ TC/ ∆Q
MC = ∆ (TFC+TVC)/ ∆Q
MC= ∆ (0+TVC)/ ∆Q
MC= ∆ TVC/ ∆Q
224
 Unit
costs
MC
AC

AVC

AF
C
OUTPUT

Summary
The AFC curve is a rectangular hyperbola, i.e. it approaches both
axes asymptotically because the TFC is constant
ATC, AVC&MC curves are U-shaped, i.e. they at first decrease
reach minimum point and then increase as output increases. This
is because they all reflect the law of diminishing returns.
The vertical distance between ATC and AVC at any level of
output is AFC.
225
AVC reaches its minimum before ATC does. This is because
the continuous decline in AFC as output increases.
The MC cuts both the AVC and ATC at their minimum
points. The reason is MC is the change in TC for producing
an extra unit of output. Assume that we start from the level
of n-units of output. If output increase by one unit, MC
the change in total cost resulting from the production of
unit

226
Activities
 Suppose Abebe runs a small potter firm, the hires one
helper at 12,000 per year, pays an annual rent of Birr
5000 for his shop, and spends 20,000 per year on
materials, Abebe has 40,000 of his own funds invested
in equipment which could earn him 4000 per year
alternatively invested. Abebe has been offered $ 15,000
per year to work as a potter for a competitor. He
estimated his entrepreneurial talents as worth $ 3000
per year. Total annual revenue from sales is $ 72,000.
 A. Calculate the accounting Cost & economic Cost for
Abebe’s pottery.
B. Calculate the accounting profit & economic profit for
Abebe’s pottery.
227 C. What is his decision?
Explicit cost =12000+5000+20000=37000
Implicit cost=4000+15000+3000=22000
Total revenue = 72000
A, I, Accounting cost= explicit cost=37000
II, Economic cost =Explicit cost + Implicit cost=59000
B, I, Accounting profit=Total Revenue-Explicit cost
=72000-37000
=35000
II, Economic profit=Total Revenue-Economic cost
=72000-59000
=13000

C. By comparing the opportunity cost and economic profit, it is

possible to decide the decision of the firm. If opportunity cost
exceeds economic profit, the firm doesn’t have to invest, otherwise.
Thus here the firm has not to invest.
228
 CHAPTER-FOUR
Theory of the Firm/ Market Structure
As discussed previous, A market is any arrangement through
which buyers & sellers exchange goods & services
 Markets reduce transaction costs
• Costs of making a transaction other than the price
of the good or service
MARKET STRUCTURES
Is market characteristics that determine the economic enviro
Based on the number of firms participating, nature of the
product and nature of entry the general types of market are:
Perfectly competitive
Monopolistic competition
Monopoly
Oligopoly.

230
 Perfect Competition
Perfect competition is a market structure characterized by a
complete absence of rivalry among the individual firms.
Assumptions of perfect competition/General characteristics
 Large numbers of sellers and buyers
Product homogeneity 
Price taker
Free entry and exit of firms
Profit maximization
Equilibrium condition, MR=MC=P
Efficient
Perfect mobility of factors of production
 Perfect knowledge
E.g Agriculture
231
 Monopolistic competition
General characteristics
Many sellers and buyers
Differentiated or heterogeneous products
Some but within rather narrow limits, price maker
Relatively easy entry
Non-price competition with considerable emphasis on
advertising, brand names, trade marks etc.
Equilibrium condition, MR=MC but P>MR
Inefficient
Imperfect/asymmetry information
E.g Retail trade, shops

232
 Pure monopoly
General characteristics
Single/ one firm
Unique with no close substitution products
Price power is considerable / price maker
Entry is blocked
No non-price competition, mostly public relation but
not others
MR=MC but P>MR
Inefficient
Imperfect/asymmetry information
E.g Local utilities

233
 Oligopoly
General characteristics
A few firms
Standardized and Differentiated products
Price power is circumscribed by mutual
interdependence/collusion Or price maker
Condition of entry present with significant obstacles such
technology and economic costs
Few none Price competition typically a great deal esp. with
product differentiation
MR=MC but P>MR
Inefficient
Imperfect/asymmetry information
E.g Automobiles, household appliances, beer

234
 CHAPTER- FIVE
The Tools of Macroeconomic
Problems and Policies
5. Macroeconomics
5.1 Definition and objectives of macroeconomics
Macroeconomics: is the is branches of economics which
study of behavior of economy as a whole(deal general or
aggregate economic issue)

It examines and concerned with the combined aggregate

effects of million's of individual choice on such variables
as national output, the overall level of employment, the
general level of price.
Both micro and macro economics are interrelated
The summation of all individual economy affect macro

236
economics
Basic issues deals in macro economics (objective)
1. Aggregate price level
 Inflation: decreasing the purchasing power of money.
 Deflation: increasing the purchasing power of money( the general price
level decrease)
2. Unemployment
 Is a situation in which there is an idle labors force that is seeking for job
and has the capacity and willingness to work.
 High employment( low unemployment): the next major objective of
economy policy is high employment, which also requires low
unemployment

3. There is recession and depreciation

Recession: increase economic growth
Depreciation: decrease economic growth

237
  The ultimate yardstick of a country economic success is its
ability to generate a high level of production of economic
goods and service for its population.
GDP and GNP increment.

4. Foreign exchange policy: To promote a proper foreign

economic policy.
whether there is deficit- trade deficit.

238
5.2 National income accounting
5.2.1 Basic
concepts of Gross domestic product (GDP) and
Gross national product (GNP)

GNP: is the total market value of all final goods and services
produced by the factor of production of a country in a given
year.

Nominal GDP and Real GDP

Nominal GDP: measures the value of output in a given period in

the price of that period (I,e GDP measures at current period).
The problem with nominal GDP is that the change nominal
GDP can be due to either a change in the production of goods
239and service, or a change in price of those goods and services.
So an increase in price will cause nominal GDP to
increase, even if production has not changed at all. This
gives a misleading picture of how well the economy is
doing.
It also makes it difficult to compare production from year
to year.
Real GDP: values of goods and services in any given year
by using the price of a set base period. By holding using
price constant, real GDP measures only the change in
production from year to year.
Is measure that attempt to isolate changes in the physical
output in the economy b/n different periods by valuing
all goods produced in the two periods at the same periods.
240
Example
1972 1980 1980 Real GDP
15 bananas @ 15 c= 2.25 20 bananas @ 30c= 6 20 bananas @ 15c= 3
50 Oranges @ 18 c= 9.00 60 Oranges @ 25c= 15 60 Oranges @ 18c=
10.90
Nominal GDP = 11. 25 Nominal GDP = 21.00 real GDP = 13.90

1972 is the base period for calculating real GDP of 1980

ÞUsed to calculate inflation ( Nominal and real GDP)
GDP deflator = Nominal GDP
Real GDP
GDP deflator = 21.00
13.90
= 1.52
Inflation is less than 10% its normal inflation

241
 3.2.2 Measuring (estimation) of national income

There are three different methods, but interrelated

A. Value added method
Intermediate goods: are goods and services that are
completely used in the process of production

Value added: is the difference between the value of

production as they leave that stage of production and
the cost of the goods as entered that stage.

242
 Firm stage of production Value of sales Value added
A sheep ranch $ 60 $ 60
B wool processor $ 100 $ 40
C suit manufacture $ 125 $ 25
D clothing whole sales $ 175 $ 50
E Retail clother $ 250 $ 75
Total sale of Value = $ 710 $ 250

value added( total income)

Use of value added in GNP to avoid double counting
B. The expenditure Approach of national income accounting
 Expenditure approach; determines aggregate demand or
gross national expenditure by summing consumption (C),
investment (I), government expenditure (G) and net export(X-
M) i.e.
243
 1. Personal consumption expenditure (C)
C- includes – expenditure goods – durable goods
- non-durable
- service: e.g payment to lawyer, doctors
etc.
2. Growth private investment (I)
Incorporate: Building – residential building
- non-residential building
Fixed investment – expenditure on machinery and
equipment
change in inventory – the difference b/n
output produce and output sold
244 Inventory change= what is produce - what is sold
 3.Government expenditure on goods and services(G)
Incorporate all expenditure by federal and regional
government on produced goods.
Government transfer payments => It could be social
security expenditure( pension).

4. Net export(NX)
The difference between value of export- value of import
(X-M)

Y= C+I+G+(NX)
Y denotes for total output( income)
245
 c. Income (allocation) Method
According to the income method, total output can be looked at in
terms of the incomes generated in the process of processing the
output . All output produced automatically generates income for
the factors that take part in the production process.

measures the total income earned by citizens and business in a

country in one year. It consists of :
 Employee compensation
 Rent ( Land and Building)
 Interest
 Profit
GNP= wage+ Rent+ Interest+ profit
Wage- for labor income generate
Rent- owner of building
Interest- for rent of machine etc
246
Profits- owner of income
 3.3 Macroeconomic policy instrument
1. Fiscal Policy
 The first instrument of macroeconomic management is
fiscal policy, which consists of setting the levels of taxation
and government expenditure to affect macroeconomic
performance.
 Expenditure :government spending for goods and services
 Government spending affects the overall levels of spending
in the economy and can thereby affect the level of GNP.
 The other half of fiscal policy is taxation. In
macroeconomics , taxation play two key roles.
 Taxes reduce people’s incomes. By cleave households
with less spending income.
 High taxes tend to reduce their consumption spending,
247 lowering aggregated demand and actual GNP.
 In addition, taxes help determine the prices that
businesses and individuals face in markets and thereby
affects incentives and behavior. One important set of
taxes are those affecting the cost of investing in capital
goods.

2. Monitory Policy: the second major tool of

macroeconomic policy which comprises the
management of a nation’ central bank. By speeding or
slowing the growth of money supply, the central bank
makes interest rates lower or higher or induces or
retards investment in houses, plant, equipment etc.

248
 Business cycle and Macroeconomic policy instruments
Concept of Business cycle
Business cycle is fluctuation of economic activities about its
long term growth trend. Inflation, growth and
unemployment are related through business cycle.
Business cycle involves features like boom, recession and
recovery.
Inflation is a general rise in price level measured against
standard level of purchasing power and it has different
methods to measure such as consumer price index and GDP
deflator.
Inflation has different causes and categorized under three
major factors (Demand pull inflation, Cost push inflation
249 and Built in inflation).
 Core problems associated with Inflation are:
 Fixed income groups will be worse off.
 Causes wage spiral
 Creates deficit on the current account.

Mitigating measures to reduce inflation

 Reduce demand pressure
 Reduce cost push pressure
 Print less money
 With draw some money from the economy

250
 THANK YOU!!!!!!!!!

251