Part two: MICROECONOMICS

3.1. The Theory of Demand

There are two main forces that determine the price of a commodity in a market: demand and
supply. The actual price of the commodity is determined by the intensity with which potential
buyers and potential sellers operate in the market.
The theory of demand is concerned with the influence that potential buyers exert on price. The
behavior of potential buyers in a market is called demand and the amount of a commodity that
buyers are willing and able to purchase at a certain price in a given period of time, keeping all
other influences constant, is called quantity demanded. Demand exists only if someone is willing
and able to pay for a good-that is, exchange dollars for a good or service in the marketplace. Note
that demand is an expression of consumer buying intentions not a statement of actual
purchases.
In defining the demand for a commodity, it would be of paramount importance to distinguish
between such core elements as the willingness to buy and the ability to pay for a certain product.
The willingness to buy, which is not backed by the necessary birr (dollar) is called nominal
demand. If the willingness to buy is backed by the ability to pay (purchasing power), it is called
effective demand.
Thus, demand shows the expression of consumer buying intentions, quantity demanded is the
various quantities of the commodity consumers (buyers) are willing and able to buy at each
specific price, over a given period of time. Thus, unlike quantity demanded, demand is not a fixed
number. Quantity demanded is a flow concept and does not refer only to the quantity of a
commodity consumers buy. The quantity demanded of a commodity must, therefore, be
understood with respect to a time period (day, week, month, year, etc). Hence, the quantity
demanded of a commodity is the various quantities of the commodity, which buyers are willing
and able to purchase at each specific price, over a given period of time.
Ceteris Paribus Factors
Since it is difficult to measure the effects of simultaneous changes in all variables affecting
demand, for purposes of controlled analysis, it is necessary to keep the other factors constant and
study the effect of change in the price of cars only on the number of cars. This condition is
referred to as ceteris paribus meaning other things being equal. The phrase ceteris paribus
actually means that all other variables except the one under consideration are assumed to be held
constant.
Two fundamental assumptions we will make in learning the theory of demand are
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i.

Rational Behaviour:- Individuals are assumed to be rational: they know what is best for
them and pursue what is in their best self-interest.
ii.
Consumer Sovereignty: Individuals make their decisions freely and that there is no coercion.
They know what is at stake. This rule out the Enlightened Ruler Principle of Governance-the
government can make better decisions for the populace than the populace themselves.
A democratic society, operating under the assumptions of rational behavior and consumer
sovereignty does not need the government to assume the role of a noble/enlightened ruler.

Determinants of demand
The most important factors, which influence an individual consumers demand for a commodity
(dA) are:
a The price of own commodity (PA)
If the price of a commodity rises, ceteris paribus, the quantity demanded of that commodity falls;
if the price of a commodity declines, all other factors being kept constant, the quantity demanded
of that commodity increases.
b The price of substitutes (PS)
Any two or more commodities that satisfy similar needs or desires are known as substitute
commodities or substitutes. When two commodities are substitutes, an increase in the price of
one good causes an increase in the demand for another good. For example, chicken and beef,
white teff and red teff, coffee and tea and coca-cola and Pepsi-cola are substitute goods. If the
price of white teff falls, with constant price of red teff, demand for red teff falls and the viceversa. Similarly, if the price of coffee declines, the price of tea being the same, the demand for tea
decreases, and the vice-versa.
In general, there exists a positive relationship between the price of a good and the demand for its
substitute or the price of substitute good and the demand for a commodity under consideration. It
is also essential to note that substitute goods need not be identical since identical products are
called perfect substitutes.
c The Price of Complements (PC)
Complementary goods (complements) are any two or more goods, which go together and are
used in tandem. This means that the use of one commodity immediately necessitates the use of
the other. When commodities are complements, a decrease in the price of one commodity causes
an increase in the demand for another good and an increase in the price of a commodity results in
a decrease in the demand for the other.
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Example: Film and camera, tea-leaves and sugar, gasoline and automobiles are good examples of
complements.

Therefore, whether a particular change in the price of one good increases or decreases the
demand for another good depends on whether they are substitutes or complements. The prices of
complements and substitutes are generally called the prices of related goods.
d Change in household income and Wealth (I)
For most ordinary people, income and wealth seem to be synonymous, but they are not. Income
refers to the sum of all household wages, salaries, profits, rent, interest payments and other forms
of earnings in a given period of time. But, wealth (net worth) implies the total value of what a
household owns less what it owes. Thus, while income is a flow variable (measured at a specified
time period), wealth is a stock variable (measured at a given moment).
More generally, an increase in consumers money income increases the demand for most goods
whereas a fall in consumers income tends to reduce the demand for these goods. In some
instances, however, an increase in consumers money income may decrease the demand for some
commodities. Commodities whose demand goes up when income is higher and whose demand
goes down when income is lower are called superior goods (normal goods). On the other hand,
commodities whose demand declines when income rises and whose demand goes up as income
decreases are called inferior goods (example; used clothes or second-hand products).
e Consumer's tastes and Preferences (T)
A change in consumers tastes and preferences is more likely prompted by advertising or fashion
changes. For instance, the demand for fashioned goods increases, but with the passage of time,
such goods would be less preferred. In a nutshell, if the change in consumers tastes or
preferences is favorable to a product, the demand for the product at each price increases, ceteris
paribus. On the other hand, if the change in tastes is unfavorable to (away from) the product, the
demand for the product decreases.
f Consumers expectation about future price change (E)
People may have expectation about future price changes and these may affect their decisions at
present. For instance, if they anticipate price for a given product to increase in the future, they
buy more of the product now to avert higher prices in the future.
In general, expectation of future price rise increases current demand for a commodity and
expectation of future price fall reduces current demand for it.

Therefore, the aforementioned determinants of demand can be expressed in a demand function

using mathematical form (* a function is a relationship between two or more variables) as
follows:
dA = f(PA, PS, PC, I, T,E)
This demand function states that an individual consumers demand for a commodity is a function
of (depends on) all the factors in the parenthesis. All the factors in parenthesis are generally
called determinants of demand because they determine an individual consumers demand for a
commodity. These determinants of demand can be classified into price-determinant and non-price
determinants of demand (demand shifters).
Assuming that all factors except the price of own commodity (P A) are kept constant, the
individual consumers demand for a commodity depends upon its price. By varying the price of
the commodity under consideration, we get an individual consumers demand schedule for the
commodity.
A demand schedule is a table, which presents the quantities demanded at alternative prices in a
given period of time. In other words, a demand schedule is a table, which presents a negative
relationship between the price of a commodity and the quantity demanded of the commodity,
during a specified time period, ceteris paribus.
Table 2.1. An individual consumers demand schedule for commodity A
Price of commodity A (PA)
(Birr per unit)
10
9
8
7
6
5
4

Quantity demanded of commodity A

(QA)
(Units Per Year)
40
50
60
70
80
90
100

Demand schedule can be represented most conveniently by a graph. The graphic representation or
depiction of the demand schedule is called an individual consumers demand curve. From the
above demand schedule, it is possible to draw the following demand curve of the commodity for
an individual consumer.

Price of commodity A (PA)

d
9
8
7
6
5
4
0

40

50

60

70

80

90

d
100

Quantity demanded of commodity A (QA)

Fig. 2.1. An individual consumers demand curve

The demand curve in Fig. 2.1 has only two dimensions: quantity demanded (on the horizontal
axis) and price (on the vertical axis). The demand curve slopes downwards from left to right
exhibiting the negative or inverse relationship between the price of commodity A and the quantity
of demanded of commodity A. This important property is called the law of demand. Thus, the
law of demand states that the higher the price, ceteris paribus, the lower the quantity demanded
and the vice-versa.
The functional relationship between quantity demanded and price can be represented in the
equation form, i.e Qd=a-bP where Qd is quantity demanded, a and b are constants and a is the
intercept, b is the slope and P is the price of the product.
There are four plausible explanations as to why a consumer buys more of a commodity when its
price falls and less of the commodity when its price rises. In other words, the rationale behind the
downward sloping demand curve is fourfold:
a

Common Sense: From a common sense or simple observation, price acts as an obstacle,
which deters buyers from purchasing more and more of a commodity?
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The higher this price obstacle, the less the product consumers buy and the lower the price
obstacle, the more the product people buy as low price encourages them to purchase more and
more. By lowering prices, business firms reduce their inventories than by raising them.
b

Diminishing Marginal Utility: We consume a basket of goods and services because they
give us utility a measure of happiness or pleasure.
But, consuming successive units of a particular product yields less and less extra utility and hence
consumers will only buy additional units if prices are lowered.
c

Income effect: A reduction in the price of a commodity would increase the purchasing
power of a consumers money income.
In other words, at a lower price, the purchasing power of a consumers money income grows
enabling him/her to buy more of the commodity without sacrificing other goods. For example, a
decline in the price of edible oil generally increases the purchasing power of a consumer's money
income enabling the consumer to buy more edible oil without giving up other goods. Hence, the
increase in quantity demanded of a commodity on account of the increase in the purchasing
power of the consumers money income resulting from a price fall is known as the income effect.
An increase in the price of the commodity would have the opposite effect.
d Substitution effect: if the price of a commodity falls while the price of its substitute is
constant, the commodity becomes relatively cheaper than the substitute.
Stated differently, at a lower price a consumer tends to substitute cheap products for similar and
relatively more expensive ones reducing his/her purchase of the expensive goods. This
explanation is known as the substitution effect.
The income and substitution effects combine to encourage consumers to be willing and able to
buy more of a commodity at lower prices than at higher prices. That is why the demand curve is
downward sloping.
Despite the fact that in almost all cases demand curve slopes downwards from left to right, there
are exceptional cases when the law of demand is violated. In a few instances, consumers may buy
more of a commodity just because price has increased. This is true for Giffen goods after
English economist Robert Giffen. Giffen goods are bulky and basic food items for which
quantity demanded increases as price increases and quantity demanded doesnt decrease as price
rises. These are goods necessary for subsistence like teff, maize, Potato and other necessities.
Even though the rise in the price of Gifffen goods affects the purchasing power of the consumers
money income, they buy more of these Giffen goods. This is because although the Giffen goods
have become expensive they are still cheaper than the nutritious goods such as meat, fish, eggs,
etc. Therefore, the demand curve for Giffen goods is upward sloping from left to right. This
6

implies that as the price of Giffen goods increases, the quantity demanded increases and as the
price decreases, the quantity demanded for these goods doesnt necessarily increase.
Change in Quantity Demanded and Change in Demand
d"
Price
d
d
Price
P1

d'

e
f

P2
0

d
q1

d"

d
d

q2
Quantity demanded

Fig. 2.2. Movement along a demand curve

Quantity

Fig. 2.3. Shifts of a demand curve

If only the price of the commodity itself changes and the other determinants of demand (demand
shifters) are constant, there is movement along the same demand curve. This means that at P 1 the
quantity demanded is q1 (point e) and if price falls to P 2, quantity demanded increases to q 2 (point
f). Both points lie on the same demand curve. This movement along the same demand curve
caused by the change in the price of the commodity itself is called change in quantity demanded.
Fig.3.3.depicts that the change in quantity demanded (q 2-q1) is triggered by the change in the
price of the commodity itself (p2-p1).
On the contrary, if the price of own commodity remains intact and other determinants of demand
(demand shifters) change, the entire demand curve shifts its position (either to the right or to the
left). Quantity demanded also changes in this case. However, this change in quantity demanded is
brought about not by the change in the price of own commodity but by a shift in the demand
curve caused by the demand shifters (Fig. 2.3.). This kind of shift in the entire position of the
demand curve because of the change in demand shifters is called change in demand. If demand
curve shifts to the right (dd), demand increases, and if it shifts to the left (dd), demand
decreases.
In short, movement along a demand curve is a response to changes in price of own commodity
whereas shifts of the demand curve occur when the determinants of demand change (change in
the price of substitutes, change in the price of complements, change in consumers income,
change in consumers tastes and consumers anticipation about future price).

Market Demand
The market demand for a commodity is the sum total of all individual consumers demand for
that commodity. The market demand curve is derived by lateral summation of individual demand
curves in the market at alternative prices, during a given period of time. Market demand is
determined by the number of potential buyers and their respective tastes, incomes, related goods
n

di
i 1

and expectations. Mathematically, DM=

where n= number of individual consumers
Thus, it is crucial to note that a change in the number of consumers (population size) in a market
also affects the market demand for a commodity. To state it differently, higher population
increases purchase and hence demand. That is, an increase in population size (number of
consumers) in a market causes an increase in demand and rightward shift of the demand curve,
but a decrease in the number of consumers in the market brings about a decrease in demand and
hence leftward shift of the demand curve. The individual demand curves and the total market
demand curve in the above numerical example can be portrayed as follows:
Price

Price

d1

Price
d2

4
3

d1

2
d2

1
0

4
Quantity
Demanded

Fig. 2.4. First consumers

demand curve
Price
4

Fig. 2.5 Second consumers

demand curve

3
2

d3

d3

0 1
Quantity
Demanded

5
Quantity
Demanded

Fig. 2.6. Third consumers

demand curve

1
0

10 12
Quantity Demanded

Fig.
Market
Curve
From
the2.7.
above
marketDemand
demand, it
is crucial to note that the market demand for a commodity is also
influenced by the number of buyers in addition to the other determinants of market demand.

2.2 The Theory of Supply

Economic theory also deals with the behaviour of sellers (business firms) that supply output in
the market. In the theory of supply, supply is the relationship between the price of an item and the
quantity supplied by sellers, given all other influences whereas quantity supplied (the amount of a
commodity sold in the market) refers to the quantity of a particular commodity that a firm (seller)
is willing and able to offer for sale at alternative prices, during a given period of time. Thus, like
demand, supply is a relationship but not a fixed quantity.
a

The most decisive factors which affect an individual sellers supply of a commodity (sA) are:
The price of the commodity itself (PA)
If the price of a commodity goes up, ceteris paribus, the quantity supplied of the commodity
increases, and if the price of the commodity falls, all other factors being held constant, the
quantity supplied of the commodity declines.
The Price of Substitutes (PS)
An increase in the price of a product reduces the supply of its substitutes and an increase in the
price of substitutes reduces the supply of a commodity under consideration, keeping all other
factors constant. In a similar manner, a fall in the price of a commodity raises the supply of its
substitutes and a decrease in the price of substitutes increases the supply of a commodity in
question, ceteris paribus.
For example, an increase in the price of coca-cola, with constant price of Pepsi-cola would lead
to a decrease in the supply of Pepsi-cola, and a fall in the price of Coca-cola, the price of Pepsicola remaining the same, would bring about an increase in the supply of the latter.
On the whole, there exists an inverse relationship between the price of a commodity and the
supply of its substitutes or the price of a substitute commodity and the supply of the commodity
under consideration.
c

The price of Complements (Pc)

A rise in the price of complements increases the supply of an alternative good and a fall in the
price of complements reduces the supply of the alternative good, keeping other factors constant.
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For instance, when the price of car rises, the price of petrol being unaltered, the supply of petrol
rises and a fall in the price of car, the price of petrol being the same, would cause the supply of
petrol to decline.
In general, there lies a positive correlation between the price of a commodity and the supply of its
complements or the price of complements and the supply of an alternative product, holding other
factors constant.
d The cost of production (C)
A producers willingness to supply a commodity depends on two considerations: the price of the
commodity and the cost of production. The price of the commodity is determined by the
interaction between potential buyers and potential sellers in the market. But, the cost of
production is determined and conditioned by the prices of relevant resources and technological
relationship.
If resource prices change, the supply of goods produced changes, too. For instance, a reduction in
the price of land and fertilizer will tend to increase the supply of corn. Similarly, if technology
(the knowledge that people have about how different things can be produced) improves, more
goods can be produced from the same resources. Thus, the supply of a commodity for an
individual seller mainly depends on the cost of production, which, in turn, depends on the prices
of inputs and technological use. If input prices are low and/ or the state of technology is
advanced, the supply of a product increases. If factor prices are high and/ or the state of
technology is deteriorating, however, the supply of the commodity falls.
e

Sellers expectation about future price change (E)

What motivate business people for production are not only the current prices but also the
anticipated future prices. Businesses plan their production on what they expect prices to be. For
instance, oil producers might withhold some of their current oil to have more available for the
future if they anticipate oil price rise in the future. In general, expectation of future price rise
induces business firms to produce more and hence future supply will increase. But, if business
people anticipate the price of a commodity to fall, future supply will decline.

Taxes and Subsidies (TS)

Since most taxes are treated as costs by business firms, an increase in property or sales taxes will
increase the cost of production and reduce supply. Conversely, subsidies are taxes in reverse. If
government subsidizes the production of a product, it in effect lowers costs and increases supply.
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The foregoing determinants of supply can be expressed in supply function using a mathematical
form as:
SA= f(PA, PS, PC, C, E, TS)
Price of oil
(Birr/ litre)
10
9
8
7
6
5

Quantity supplied of oil

(litre/Month)
60
50
40
30
20
10

This states that an individual sellers supply of a commodity is a function of all factors in the
parenthesis.
Assuming that all factors except the price of the commodity itself are held constant, an individual
sellers supply of a commodity depends on its price. By varying the price of the commodity in
question, we get an individual sellers supply schedule for the commodity. A supply schedule is a
table, which presents a positive relationship between the price of the commodity and the quantity
supplied of the commodity, during a specified period of time. In other words, a supply schedule is
a tabular expression of price-quantity supplied relationship.
The price-quantity information of the supply schedule can also be conveniently represented by
means of a graph. Thus, the graphic representation of the supply schedule is called a supply curve
for an individual seller. Supply curves are upward sloping to the right whereas demand curves
are downward sloping to the right. Note that supply curve is the graphical counterpart of supply
schedule.

9
8
7
6

Price per liter

10

s
0 10 20 30 40 50 60
Quantity Supplied (Units/month)

Fig. 2.10 An individual sellers supply curve for oil

The supply curve slopes upwards from left to right reflecting a positive correlation between the
price of a commodity and the quantity supplied of that commodity. This important property is
called the law of supply. The law of supply that parallels the law of demand, states that larger
11

quantities will be offered for sale at higher prices and lower quantities will be sold at lower
prices, ceteris paribus.

S'

s
e

P5

P4

P3

P2

S
S'

P1

a
s

Price of commodity X (Px)

Price of commodity X (Px)

Change in Quantity Supplied and Change in Supply

S"

S
0

Q1

Q2

Q3

Q4

Q5

Quantity supplied of X

Fig. 2.11 Movement along a supply curve

Quantity

Fig. 2.12. Shifts of a supply curve

When only the price of the commodity itself changes and other determinants of supply (supply
shifters) remain intact, quantity supplied also changes. But the movement is along the same
supply curve. Such a movement along the same supply curve, which is triggered by the
change in the price of the commodity itself, is called change in quantity supplied (Fig. 2.11).
On the contrary, if non-price determinants of supply except the price of the commodity itself
change, the supply curve shifts its position either to the left or to the right (Fig. 2.12.). If the
supply curve shifts to the right (s s), supply increases; if it shifts to the left (s s), supply
decreases. This kind of shift in the position of the supply curve due to changes in other
determinants of supply (except the price of own commodity) is called change in supply. Thus,
while movement along the supply curve is the result of change in own price, shifts of a supply
curve are brought about by changes in non-price factors (supply shifters).

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Market Supply
The market supply of a commodity is the sum total of all individual sellers supply for that
commodity. A market supply curve is derived by a lateral summation of all individual sellers
supply curves for each commodity at each specific price, during a given period of time
n

Si
i 1

Mathematically, SM=
.Thus, the market supply of a commodity depends on the number of
sellers. For instance, because of high profits or in anticipation of high profits, more sellers enter
the production of a particular good and hence the supply of the good will increase. But, with
expectation of low profits or because of low profits, a small number of sellers engage in the
production of a particular product and hence supply will decline.

2.3.

Market Equilibrium

A market, in plain language, is an arrangement wherein buyers and sellers of a commodity

interact to determine its price and quantity. Put differently, a market is an institution in which
buyers and sellers are brought into close contact for purposes of engaging in exchange. A market
exists whenever and wherever an exchange takes place in the market place. Every market
transaction involves an exchange of dollars for goods (in products market) or for resources (in
resources market).Money is thus critical in facilitating market exchange. Being an institution or
mechanism, a market provides information on the goods and services sellers want to sell and
buyers want to buy. Grain market, super-market, gas station, oil market, soft drink market, etc are
all markets.
In a market system, every good and every service has a price. Businesses receive incomes for
what they sell and use the proceeds to buy what they want. Usually, what consumers demand at a
given price is not in balance with what suppliers willingly supply at a given price. Moreover, the
quantity demanded of a commodity is inversely related to its price, ceteris paribus, and the
quantity supplied of the commodity is directly correlated with its price, holding all other factors
unaltered.
The market price of the commodity, thus, tends to bring these two conflicting forces, market
demand and market supply into balance. This means that unless the quantity supplied by
producers (sellers) is equal to the quantity demanded by consumers (buyers), there will be a
tendency for the market price to change until a balance is reached. The market condition where
13

the quantity demanded by demanders (buyers) exactly equals the quantity supplied by sellers
(suppliers) is called equilibrium. Once a market equilibrium condition is achieved, it tends to
persist because economic agents have no economic incentive to change their behavior.
Geometrically, equilibrium occurs at the point of intersection between the commoditys market
supply curve and market demand curve. The price and quantity at which market equilibrium
exists are respectively called equilibrium price and equilibrium quantity. It is crucial to make a
note that equilibrium does not imply that everyone is happy with the prevailing price or quantity.
But, the equilibrium price and quantity reflect a compromise between buyers and sellers. No
other compromise yields a quantity demanded that is exactly equal to the quantity supplied. At
any price other than the equilibrium price, however, there will be either excess demand or excess
supply in the market and that is a situation of disequilibrium. Thus, whenever the market price
is set below or above the equilibrium price, either a market surplus or a market shortage will
emerge.
Excess demand (shortage) is the condition that occurs when the price of the commodity is below
the equilibrium price as a result of which the quantity demanded surpasses the quantity supplied
(QD>QS), during a given period of time. On the other hand, excess supply (surplus) is the
condition that takes place when the price of the commodity is above the market clearing price as
the outcome of which the quantity supplied exceeds the quantity demanded (Q S>QD) during a
given period of time. Thus, the prevalence of surplus or shortage of a commodity in the market is
a characteristic of disequilibrium condition.
A clear distinction has to be made between shortage and scarcity though the two notions imply
lack of abundance. Shortage is a situation in which the quantity demanded outweighs the
quantity supplied at a price below the market-clearing price. But, scarcity is more
comprehensive that refers to a situation in which inputs or factors of production are not
adequate to produce goods and services to satisfy peoples material wants. Even though we live
in a world of scarcity, we do not necessarily live in a world of shortage. Thus, shortage is not
synonymous with scarcity.

ILLUSTRATION ON MARKET EQUILIBRIUM

Suppose that there are 250 identical individual consumers in the market for commodity X, each
with a demand function given by dx = 6-Px and 50 identical producers of commodity X, each with
a supply function given by sx =5Px. Then,
a

Derive the market demand function and the market supply function for commodity X.

Compute the market equilibrium price and equilibrium quantity mathematically.

Tabulate the market demand schedule and the market supply schedule for commodity X.
14

Plot on the same set of axes, the market demand curve and the market supply curve for
commodity X and indicate the equilibrium point.

show whether surplus or shortage occurs at

i
P=2
ii
P=5

SOLUTIONS FOR THE ILLUSTRATION

a
b

market demand function = Dx = 250 (6-Px) = 1500 250 Px

market supply function = Sx = 50 (5Px) = 250 Px
At equilibrium,
Dx = 1500 - 250 Px
Dx = Sx
= 1500-250 (3)
1500 250 Px = 250 Px
= 1500 750
1500 = 250 Px + 250Px
= 750 (Equilibrium quantity)
1500 = 500Px
Sx = 250Px
Px = 1500
500
Px = 3.00 (Equilibrium Price)

= 250 (3)
= 750 (Equilibrium quantity)

Table 3.13 Market demand schedule and market supply schedule for commodity X

Price of commodity

Quantity demanded

Quantity supplied

X (Birr/ unit)

of commodity X

of commodity X

Condition in

pressure on price

(unit/week)
0

(unit/week)
1500

the market
Excess supply

Downward

250

1250

Excess supply

Downward

500

1000

Excess supply

Downward

750

750

Balance

Equilibrium

1000

500

Excess demand

Upward

1250

250

Excess demand

Upward

1500

Excess demand

Upward

15

Direction of

[[

Price of commodity X

Market demand curve and Market supply curve

D
6
S
5

________Surplus _________

4
Equilibrium point
E

3
2

_______ Shortage ________

1
S
0

D
250

500

750

1000

1250
1500
Quantity of X

Fig. 3.14 Market demand curve and market supply curve

d

i) At P= 2,
Dx = 1500 250 (2)
Sx = 250 (2)
= 1500- 500
= 500
= 1000
Since Dx > Sx, shortage occurs with excess demand of 500 (i.e. 1,000 - 500 = 500).
ii) At P = 4,
Dx = 1,500 - 250(4)
= 1,500 - 1000
= 500

Sx = 250(4)
= 1000

Since Sx > Dx, surplus occurs with excess supply of 500 (i.e. 1,000 - 500 = 500).
From Fig. 3.14 above, when the market price is below the equilibrium price, there will be excess
demand and shortage of supply and consequently, competition among consumers (buyers) will
bid prices up and the market price rises. An increase in the price reduces the quantity demanded
and increases the quantity supplied. The upward movement of price continues until the entire
excess demand is eliminated. This results in the attainment of the equilibrium at point E.
16

On the contrary, when the market price is above the equilibrium price, there is excess supply over
demand. The excess supply of the commodity compels producers to sell the goods at a reduced
price. In other words, competition among producers (sellers) will bid prices down and the market
price falls. This reduction in price leads to an increase in quantity demanded and reduces
quantity supplied and this continues until the entire excess supply is removed.

Hence,

equilibrium will again be restored at point E.

[

In summary, equilibrium exists in the market when there is neither excess demand nor excess
supply. If price deviates from its equilibrium level, however, competitive forces will bring it
back to the equilibrium position.
Effect of shifts in demand and supply on Equilibrium
Previously, it was brought to the kind attention of the learners that demand and supply may
change in response to the non-price determinants (shifting factors). In other words, demand and
supply curves shift only when their underlying determinants change, i.e. when ceteris paribus is
violated. When either demand or supply or both change owing to changes in any one of their
determinants, the market equilibrium price and quantity in different ways. The effect of shifts in
demand and supply on equilibrium can be portrayed as follows:
D2

Price of commodity X (Px)

So
Do
P1

E2

Po D1

E0
D2

P1

E1
S0
Do
D1
0

Q1

Q0

Q2

Quantity of Commodity X

Fig. 2.15 Effect of shifts in demand on Equilibrium

17

In Fig. 2.15, if demand curve shifts outwards to the right (from D o Do to D2 D2), both equilibrium
price and equilibrium quantity increase.

Equilibrium price increases from Po to P 2 and

equilibrium quantity rises from Qo to Q2. Equilibrium point changes from Eo to E2. On the
contrary, if demand curve shifts inwards to the left (from Do Do to D1 D1), both equilibrium price
and equilibrium quantity decline. Equilibrium price falls from Po to P 1 whereas equilibrium
quantity drops from Qo to Q1. Equilibrium point declines from Eo to E1.
In a nutshell, other things being equal, an increase in demand has a price-increasing and quantity
increasing effect whereas a decrease in demand will have a price-decreasing and quantitydecreasing effect.
Thus, there exists a positive correlation between change in demand and the resulting change in
equilibrium price and equilibrium quantity.
a

Effect of shifts in supply (assuming demand is constant)

S1
So

P1

E1
S2

Po

Eo
E2

P2
S1

So
Q1

Qo

S2
Q2

Quantity of commodity X

In Fig. 2.16, if supply curve shifts outwards to the right (from So So to S2 S2), equilibrium price
decreases from Po to P2, but equilibrium quantity increases from Qo to Q2. On the other hand, if
supply curve shifts to the left (from So So to S 1 S1) equilibrium price increases from Po to P1, but
equilibrium quantity deceases from Qo to Q1.
By and large, there is an inverse relationship between change in supply and the resulting change
in equilibrium price. However, the relationship between change in supply and the resulting
change in equilibrium quantity is direct.
18

Effect of Government Economic Policies on Equilibrium

True enough, government economic policies exert an influence on both equilibrium price and
equilibrium quantity. The effect of government economic polices can be brought out hereunder:
A Price floors: A price floor is a legal minimum price, which is set up above the equilibrium
price leading to surplus of a commodity. Price floors fixed above the equilibrium price
would have the following consequences:
a
Price floors bring about excess supply (surplus) because sellers cannot easily find
enough buyers to clear the market.
b

The surplus, because of minimum price fixation by law, will create storage and income
problems to the producers.

B Price ceilings: A price ceiling is a legal maximum price, which is

established below the equilibrium price resulting in the shortage of a
commodity. If government imposes price ceilings, price is not legally
permissible to increase above the fixed price.
Price ceilings would have the following consequences:
i

There are usually persistent shortage of goods and services whose prices
are controlled as a result of price ceilings.
Moreover, prices do not perform the market system since shortage causes a problem of allocating
the limited goods and services among buyers.
ii
Price ceilings would bring about illegal or black market operations in the
supply of goods and services.
Since there would be some individuals who are willing and able to pay prices above the
controlled price and in response to such a potential market, illegal (black) markets will develop.
Definitely, the prices charged on black markets are higher than those found in a free market.
iii
Investment in industries generally dries up because price ceiling rescues
the potential returns that investors earn from their economic activities.
This means that less capital will be invested in industries due to the price control.
In summary, price ceilings have three predictable effects; they
increase the quantity demanded.
decrease the quantity supplied.
create a market shortage.
C Subsidy: A subsidy is a direct or an indirect payment by a government to its country's firms
to make selling or investment cheaper and more profitable for them. If a government grants
a per unit cash subsidy to producers of goods and services, the outcome would be:
19

supply will increase over and above the market equilibrium quantity (i.e the supply
curve shifts outwards to the right);

ii

price will fall below the equilibrium price.

D Taxation: tax is a compulsory levy imposed by government on the people inhabiting a

country for the support of government services. By collecting taxes, the government raises
income to finance its budget. If the government collects taxes per unit of output, the supply
curve shifts inwards to the left triggering
i
an increase in the price above the equilibrium price (a leftward shift of the supply
curve)
ii
a decline in supply below the market equilibrium quantity (a leftward shift of the
supply curve).
ILLUSTRATION ON GOVERNMENT POLICES
Consider the following demand and supply functions:
Dx = 400 25Px
Sx = 100 + 50Px
i
ii

Compute the market equilibrium price and equilibrium quantity.

What will happen if government imposes a price floor of 5 birr from the market
equilibrium price?
iii
What will happen if government imposes a price ceiling of 2 birr from the market
equilibrium price?
iv
Supposing the government from the above equilibrium position decides to grant a
subsidy of 2.40 birr on each unit of commodity X to each producer, what is the market
demand assuming that there is equal benefit sharing between producers and consumers?
v
With the assumption in (iv), if government collects a per unit sales tax of 2 birr from
all producers instead of providing them with a subsidy;
a calculate the market demand (consumers consumption).
b compute the total amount of taxes, which accrues to government.
SOLUTION FOR THE ILLUSTRATION
i

At equilibrium,
Dx = Sx
400 25Px = 100+50Px
400 100 = 50 Px + 25Px
300 = 75Px
75 Px = 300
Px = 300
75

Dx = Sx
400 25 (4) = 100+50(4)
400 100 = 100 + 200
300 = 300
:. Equilibrium Price = 4.00 birr
Equilibrium quantity = 300 units
20

= 4.00 Birr

ii

A price floor results in surplus in which Sx>Dx. Therefore,

(100 + 50 x) (400 25Px) = Surplus
(100 + 50 (5) (400 25(5)) = Surplus
(100 + 250) (400 125) = Surplus
350 275 = Surplus
75 = Surplus
Therefore, a price floor of 5 birr results in a surplus of 75 units.
iii

A price ceiling brings about shortage of a commodity by the amount of Dx Sx.

400 - 25Px (100 + 50 Px) = Shortage
400 2(2) (100 + 50(2) = Shortage
400 - 50 - (100+100) = shortage
350 - (200) = shortage
150 = shortage

Therefore, a price ceiling of 2 birr causes a shortage of 150 units.

iv
Recall the old equilibrium Price = 4 birr
The new equilibrium price = 4.00 1.20 = 2.80 birr(This is because subside has the effect
of price reduction and the price advantage is equal for producers and consumers).
Dx = 400 25(Px)
= 400 25(2.80)
= 400 70
Dx = 330 units
Therefore, consumers pay 2.80 birr per unit of commodity X instead of 3 birr previously paid and
they consume 330 units of commodity X rather than 300 units before the subsidy.
v
a

The old equilibrium price = 4 birr

The new equilibrium price = 4+1 = 5
(because taxation has the effect of price rise)
Thus, Dx = 400 25Px
= 400 25 (5)
= 400 125
= 275 units
21

Therefore, consumers pay 5 birr per unit of commodity X and consume 275 units instead of 300
because of the tax levy.
b) The total amount of taxes accruing to governments on the
new equilibrium quantity = 275 units X 2 birr/unit = 550birr
2.3. ELASTICITY MEASURE OF RESPONSIVENESS

Generally speaking, whenever the price of a certain commodity goes up, the quantity demanded
of the commodity goes down, keeping all other determinants of demand intact. This is what we
call the law of demand. But, the law of demand does not tell the extent or degree to which the
increase in the price of a commodity would cause the quantity demanded of the commodity to
decline.
The owner of a business may not be able to find the influence of the variables that affect the
demand for his/her product by using only the demand function. Moreover, it is insufficient for
businesses to know only the negative relationship that exists between the price of a commodity
and the quantity demanded of the commodity. Businesses also need to predict the effect of price
changes on their revenues and the sensitiveness of buyers to price changes.
The degree of responsiveness or sensitiveness of quantities exchanged (quantities bought and
sold) to the change in various variables is called elasticity. In general, elasticity measures the
responsiveness or sensitiveness of consumers and sellers to changes in various variables such as
price and income and time. The greater the degree of responsiveness, the larger the size of
elasticity; and the smaller the degree of sensitiveness; the smaller the size of elasticity.
There are four (4) different elasticities:
[[

Price elasticity of demand (Ed)

The price elasticity of demand (Ed) measures the responsiveness of quantity demanded of a
commodity to changes in its price, other things being equal. The price elasticity of demand (E d) at
any point on the demand curve is defined as the percentage change in quantity demanded as a
result of the percentage change in own price.
Mathematically,
Price elasticity of = Percentage change in quantity demanded of X
Demand (Ed)
Percentage change in price of X
Ed = % change in Qx
% change in Px
= Q2 Q1 X 100
Q1
P2 P1 X 100
22

P1
= rQ rP
Q1
P1
= r Q X P1
Q1

rP

Where:
rQ = Change in quantity demanded
rP = Change in Price
Q1 = Original quantity demanded
P1 = Original price

Ed = -rQ x P1
rP Q1

The above formula is known as the point elasticity of demand. This is because it measures the
price elasticity of demand at a given point on the demand curve.
Elasticity can also be measured between two points on the demand curve. The measure of
elasticity of demand between any two finite points on the demand curve is known as arc
elasticity of demand (average elasticity of demand).
Arc elasticity of demand can be mathematically expressed as:
Arc = -rQ x (P1 + P2)
Ed
rP
2
(Q1 + Q2)
2
Arc Ed = rQ x P1+ P2
rP
Q1 +Q2

Where:
P1 and Q1 represent the original price and quantity respectively and P2 and Q2 represent the new
price and quantity respectively.
The coefficients of elasticity (numerical value) of demand which refer to the proportionate
change in the dependent variable divided by the proportionate change in the independent variable
can range from zero to infinity which can be categorized and illustrated as follows:
i

When the price elasticity of demand is greater than unity, demand is elastic (E d > 1).
To state it differently, demand is said to be elastic if a given percentage change in
price results in a larger percentage change in quantity demanded.

23

Example:- a)

If a two percent change in price causes a three percent change in quantity

demanded of a commodity, demand is elastic (Ed =

3%
2%

= 1.5)

b) If a 5% decline in price results in (is accompanied by) a 6% increase in quantity

demanded, demand is elastic (Ed = 6% = 1.2)
5%
The demand curve for elastic demand is flatter.

P
d

d
0

Note that most luxury goods are demand elastic because a change in the price of luxury goods
would cause the demand to respond more highly to the change in the price of these goods.
ii) When the price elasticity of demand is less than one, demand is inelastic (E d< 1). This means
a given percent change in price is accompanied by a relatively smaller percentage change in
quantity demanded.
Example a) If a 3% change in price brings about a 2% change in quantity demanded, demand is

2%
3%

inelastic (Ed =
= 0.67)
b) If a 4 increase in price causes a 2% decrease in quantity demanded, demand is
inelastic (Ed = 2% = 0.50).
4%
[

24

Most essential commodities or necessities are demand inelastic and their demand curve is usually
steeper because the quantity demanded of necessities doesnt respond significantly to the change
in the prices of same. Hence, the coefficient of elasticity for necessities can be expressed as o< E d <1.

d
Price
P

d
0
Q
Quantity
iii) When the price elasticity of demand is equal to unity, demand is unitary elastic (E d = 1). This
means quantity demanded changes by exactly the same percent as price does.
Example: a) If a 4% change in price leads to a 4% change in quantity demanded, demand is
unitary elastic ( i.e. Ed = 4% = 1).
4%
b) When a 10% drop in price leads to a 10% increase in quantity demanded, demand is
10%
10%
said to be unitary elastic (Ed =
= 1).
The rectangular hyperbola reflects the shape of the unitary elastic demand curve and its price
elasticity of demand is equal to one. That is,
d
Px

d
0

Q
iii

Qx

When the price elasticity of demand is equal to zero, demand is perfectly

inelastic ( Ed = 0).
25

This is a situation in which the quantity demanded of a certain product is invariable relative to a
change in price. The demand curve for perfectly inelastic demand is a vertical line drawn parallel
to the price axis. This shows that quantity demanded does not respond to price change.
Px

d(Ed = 0)

rQ = 0

Qx

Typical examples of a perfectly inelastic demand are an acute diabetic patients demand for
insulin or an addicted persons demand for heroin.
V When the price elasticity of demand is equal to infinity, demand is perfectly elastic (E d =

).
This indicates that a one-percentage change in price results in infinite change in quantity
demanded. A demand curve of infinite elasticity means that a small price reduction would
embolden consumers to buy any desired quantities of the commodity at this price, while at an
even slightly higher prices they would buy none. The demand curve for a perfectly elastic
demand is a horizontal line drawn parallel to the quantity axis.
Px

d(Ed=

0
Qx

Practical Applications of Price Elasticity of Demand

26

The main objective of business firms in producing goods and services is to maximize profits from
the revenues they earn. A businessman aspiring to enhance his total sales revenue would like to
know whether raising or reducing the price of a product will increase the revenue. How a change
in price affects total revenue (Price X quantity) depends upon elasticity of demand.
In light of this, therefore, the price elasticity of demand has many practical applications. If the
seller of a certain product reduces the price of his product and the demand for the commodity
turns out to be price elastic, total revenue increases. This is so because even though the price cut
reduces total revenue the rise in quantity demanded, caused by the price reduction, increases total
revenue. In other words, demand is price elastic means that when price is reduced by a given
percent, quantity demanded increases by more than the decrease in price and as a consequence,
total revenue increases.
On the other hand, if the price of a commodity falls when the demand of the commodity is price
inelastic, then total revenue declines. This is because since the increase in quantity demanded is
less than the fall in price (when demand is inelastic), total revenue falls. Hence, when demand is
inelastic it is advisable for the profit-maximizing firm to increase price rather that reducing it.
Alternatively, if demand for a commodity is unitary elastic, then a fall in the price of the
commodity does not change total revenue. This is because if price falls by a given percent,
quantity demanded increases by the same percent and as a result, total revenue remains unaltered.
An increase in the price of a commodity would have the opposite effect on total revenue when
price elasticity of demand coefficient changes. That is, when Ed > 1, total revenue decreases when
price increases; when Ed <1, total revenue increases when price increases and if E d = 1, total
revenue doesnt change when price increases.
Apart from total revenue, the price elasticity of demand is also related to marginal revenue (MR
= rTR). When total revenue is increasing, marginal revenue is positive and elasticity of demand is greater than one.
rQ
When total revenue is decreasing, marginal revenue is negative (E d<1) and when total revenue is
maximum and constant, marginal revenue is zero and demand is unitary elastic (Ed = 1).
In summary, we can establish the following relationship between various elasticity coefficients
and total revenue when price changes:
i

When demand is price elastic, a reduction in price increases total revenue and an increase
in price reduces total revenue.

ii) When demand is price inelastic, a cut in price lowers total revenue and an increase in price
raises total revenue.
27

iii) When demand is unitary elastic, a reduction in price does not change total revenue and a
rise in price does not affect total revenue, either.

ILLUSTRATION
Price of a commodity (Birr/ unit)
7
6
5
4
3
2
1

Quantity demanded of a commodity

(unit/week)
1
2
3
4
5
6
7

Total sales revenue of a firm (Birr/

week)
7
12
15
16
15
12
7

A Compute the price elasticity of demand when the price of the commodity equals 4.
B Compute the price elasticity of demand in the price range from 5 to 6.
C Sketch the elasticity of demand on a liner demand curve.
Solution
a Ed = rQ x P1
rP Q1
The slope of a linear equation = (rP) = 1 - 7 = -6 = -1
rQ
7-1
6
Thus, Ed, = -rQ x P1
rP
Q1
The reciprocal of the slope
(rP) = rQ = 1 = -1
rQ rP
-1
4
4
= - (-1) x
Ed = 1
Therefore, demand is unitary elastic.
Ed = - rQ x P1 + P2
b
rP
Q1 + Q2
= -(-1) x 5 + 6
3+2
= 1 x 11
5
Ed = 2.2 Therefore, demand is price elastic.
c)

P
d
6
5

Ed > 1
28

Ed = 1

Ed < 1

d
Q

Fig. 2.19 Elasticity of demand on a linear demand curve

From Fig. 2.19 it is easy to expound that if price decreases up to 4, total sales revenue increases
because demand is price elastic. At the price of 4, total revenue is at its maximum (demand is
unitary elastic). Finally, if price decreases below 4 (where demand is inelastic) total revenue
declines.

DETERMINANTS OF PRICE ELASTICITY OF DEMAND

The most important determinants of the price elasticity of demand can be summarized as
follows:

i) The availability of close substitutes

Whether demand is price elastic or price inelastic depends on the degree of substitutability of a
commodity. The more and the better substitutes that exist for a commodity, the more elastic its
demand will be. This means whenever there is a slight increase or decrease in the price of one
commodity, it will be substituted by other close substitutes.
For example, it is more likely that consumers demand for Coca-cola is price elastic because
Coca cola has many close substitutes. Thus, when the price of coca-cola goes up, consumers
readily switch to close substitutes such as Pepsi-cola, Mirinda, Fanta, Spirite; etc. But, if a
commodity has few or no close substitutes (eg. salt), its elasticity is likely to be very low-that is,
demand is price inelastic.

ii) Nature of the commodity (luxuries versus necessities)

The demand for necessities (necessary goods) tends to be price inelastic. Bread, clothes and
electricity are generally regarded as necessities because we cannot get along without them. A
price rise does not reduce considerably the amount of bread consumed or the amount of power
and electricity consumed in a household. Nor does a price reduction increase significantly the
consumption of these necessities.
29

On the other hand, the demand for luxuries (luxury goods) such as Television Set, Tape-recorder,
video cassette, CD player and car tends to be price elastic. This is because the consumption of
luxuries can be postponed. Thus, the demand for luxuries is more price elastic than that of
necessities.
iii) The proportion of income spent on a commodity
For those goods on which a consumer spends a very small proportion of his/her income, demand
will be price inelastic (example; salt, pencil, razor, etc). In contrast, demand is price elastic for
goods on which the proportion of income spent is high (example: Television Set, car, etc).

iv) Time lag (time period)

When the price of a commodity changes, a consumer does not immediately respond to the price
change. Over a long period of time, however, the consumer can have more time to adjust his/her
consumption pattern to the price change. Besides, the consumer needs time to seek more
substitutes for a commodity when price changes. Thus, demand is relatively inelastic in the shortrun but more elastic in the long run.
V) The price level of a commodity
Assuming a linear demand curve for a product, demand tends to be more elastic at higher prices
than at lower prices. Even if a linear demand curve has constant slope, its elasticity varies from
point to point.
As shown in Fig 2.19, along the downward-sloping demand curve, demand is elastic at higher
prices, unitary elastic at the mid-point but it becomes inelastic as price declines towards the lower
end.
2) Price Elasticity of Supply (Es)
The price elasticity of supply measures the responsiveness of quantity supplied of a commodity
to changes in the price of the commodity, other things being constant. More specifically, the price
elasticity of supply (Es) at any given point on the supply curve can be expressed as a given
percentage change in the quantity supplied of a commodity as a result of a given percentage
change in the price of the commodity, ceteris paribus.
Mathematically,
Price elasticity of = Percentage change in quantity supplied of X
Supply (Es)
Percentage change in price of x
= %change in Qx
%change in Px
30

Q2 Q1
100
Q
1
Es

P2 P1
P1

X 100

Es = rQ rP
Q1
P1
Es = rQ X P1
rP Q1
The coefficient of the price elasticity of supply may vary from zero to infinity, which can be
categorized and interpreted as follows:
i) If the price elasticity of supply is greater than one, supply is price elastic (E s>1). This means
that for any price change, there will be a more than proportionate change in quantity supplied
of a commodity.
Example: a) If a 3% change in the price of a commodity brings about a 4% change in quantity
supplied of the commodity, supply is price elastic
4%
3%
(Es =
= 1.33).
b) If a 2% increase in the price of a certain product triggers a 3% increase in the
quantity supplied of the commodity, ceteris paribus, supply is price elastic (E s =
3%/2% = 1.2).
ii) If the price elasticity of supply is less than unity, supply is price inelastic (E s<1). This implies
that for any price change, there will be a less than proportionate change in the quantity
supplied of the commodity, everything being equal.
Example: a) If a 4% change in the price of a commodity causes a 3% change in the quantity
supplied of the commodity, supply is price inelastic
3%
4%
(Es =
= 0.75).

31

b) If a 5% decline in the price of a commodity is accompanied by a 4% decrease in

the quantity supplied of the commodity, supply is price inelastic (Es =

0.80)

4%
5%

iii) If the price elasticity of supply is exactly unity, supply is unitary elastic (E s = 1). This means
a given percentage change in the price of a commodity would cause a proportionate change
in the quantity supplied of the commodity. Any straight-line supply curve passing through
the origin has unitary elasticity throughout its length, regardless of its slope. Thus, for a
unitary elastic supply curve, Es = 1.
Px
S

Qx

0
Example:
a If a 3% change in the price of a commodity is accompanied by a 3% change in the
quantity supplied of the commodity, supply is unitary elastic.
b If a 6% drop in the price of a commodity causes a 6% decline in the quantity supplied
of the commodity, supply is unitary elastic.
iV) If the price elasticity of supply is exactly zero, supply is perfectly inelastic (E s = 0). This
means quantity supplied does not respond to price change and the supply curve will be
vertical drawn parallel to the price axis.
[

Px
Es =

rQx = 0

Qx

v) If the price elasticity of supply is infinity, supply is perfectly elastic (E s = ). This means an
infinite quantity of a commodity is supplied at the prevailing price and nothing will be

32

supplied at an even slightly lower prices than the ruling price. For a perfectly elastic supply,
the supply curve is a horizontal line drawn parallel to the quantity axis.
Px

S (Es =

Qx
Applications of Price Elasticity of Supply

The price elasticity of supply has many practical and useful applications in the
introduction of prices, in determining salaries and wages, in the introduction of new technology,
in the implementation of government polices on levying taxes and tariffs and in identifying the
incidence of taxes.

DETERMINANTS OF PRICE ELASTICITY OF SUPPLY

The price elasticity of supply is affected by a number of important factors, interalia, are:
i) Length of production period
The price elasticity of supply is influenced by the length of time which is required to
adjust supply to price change. The time period can be momentary, short-run or long run.
In the momentary time, supply is perfectly inelastic. This means that quantity supplied is
limited to the quantities already available in the market and it cannot be increased whatever price
is offered.
In the short-run, there is no enough time to vary all factors of production and only a
limited change in quantity supplied to the change in the price of a commodity may be possible by
hiring more variable inputs. Thus, supply is relatively more elastic in the short-run than in the
monetary time.
In the long-run, however, because there is sufficient time to vary all factors of production thereby
intensifying the scale of production, supply is much more elastic than in the short-run.
ii) Availability of factors of production

33

If factors of production such as labour, land, capital etc are available in large and desired
quantities, supply is relatively elastic. But, if factors of production are limited, supply is inelastic.
iii) Factor substitution
If there are more substitutes of factors of production (example, tractors for farming oxen), then
supply is more elastic. This means whenever there is a slight change in the price of a factor input,
it can be substituted for others making supply quite elastic. If there are less or no substitutes of
factor of production, however, supply is price inelastic.
iv) Number of sellers in the market
The market supply will be more elastic when there are a large number of firms (sellers) in the
market. However, with a small number of sellers in the market, supply is price inelastic.
V) Accumulation of stock
If warehouses exist to accumulate stock, supply is more elastic whereas in the absence of
warehouses, supply is price inelastic.
3) Cross (price) elasticity of demand (Exy)
The cross elasticity of demand (Exy) measures the responsiveness of quantity demanded of
commodity X as a result of change in the price of commodity Y. Mathematically,
Cross elasticity of = Percentage change in quantity demanded of X
Demand (Exy)
Percentage change in price of Y
= % change in Qx
% change in Py
Q x2 Q x1

Q x1

PY2 PY1
PY1

E xY

Q x PY1

PY Q x1

The numerical value of the cross elasticity of demand (E xy) can be negative, positive or zero
depending on the degree of substitutability or complementarity between two goods which can be
categorized and interpreted as follows:
a) Substitute Commodities: If the cross elasticity of demand (Exy) is positive that is, if the
quantity demanded of commodity X varies directly with the change in the price of commodity Y,
34

then X and Y are substitute commodities. The larger the positive coefficient, the greater the
degree of substitutability between X and Y.
For instance, an increase in the price of butter (Y) would encourage consumers to purchase more
of oil (X). Likewise, a rise in the price of white teff (Y) would embolden consumers to raise their
purchases of red teff (X). Thus, Exy = +ve.
b) Complementary Commodities: Because complementary goods go together that is, the
consumption of one good necessitates the consumption of the other good, the cross elasticity of
demand for these goods turns out to be negative. The larger the negative coefficient, the greater
the degree of complementarity between X and Y.
For example, an increase in the price of camera (Y) would reduce the quantity of film purchased
(X). Thus, Exy = -ve.
c) Independent (unrelated) Commodities:
If the cross elasticity of demand for two commodities X and Y (E xy) is zero, the commodities are
independent or unrelated.
For example, a change in the price of sugar (Y) would have no impact on the quantity
demanded of coca-cola (X). Thus, Exy = 0
In summary, substitute commodities have positive cross elasticities (E xy>0) and
complementary commodities have negative cross elacticities
(E xy<0). But, independent
(unrelated) commodities have zero cross elasticity (Exy = 0 ).
4) Income Elasticity of Demand (E1)
Income elasticity of demand measures the responsiveness of quantity demanded of a commodity
for an individual consumer to the change in the income of the consumer. The income elasticity of
demand (E1) is expressed as a percentage change in quantity demanded of a commodity divided
by a percentage change in income, ceteris paribus.
Mathematically,
Income elasticity = Percentage change in quantity demanded
Of demand (EI)
Percentage change in income
EI = % change in Q
% change in I
For most goods a rise in income leads to increase in demand and the income elasticity of
demand for these goods will be positive. These types of goods are said to be normal goods. For
inferior goods, demand (consumption) decreases in response to an increase in income. Thus, the

35

income elasticity of demand for inferior goods is negative. This is so because when the income of
the consumer increases, he/she substitutes the superior goods for the inferior ones.
On the whole, the income elasticity of demand for most commodities varies as income changes
depending on the nature of the commodity. If the income elasticity of demand (EI) is negative, the
commodity is inferior. If the income elasticity of demand (E I) is positive, the commodity is
normal (either luxury or necessity). A normal good is usually a luxury if E I > 1, and a necessity if
0<EI<1.
Depending on the level of income, the income elasticity of demand (E I) for a commodity is likely
to vary considerably. Thus, a commodity may be a luxury at low level of income; a necessity at
intermediate level of income; and inferior at high level of income.

2.4.

Theory of production

Technically defined, production is the process of transforming factors of production (inputs)

into output. Inputs are the physical, human, material, financial, and information resources
that enter the transformation process. Transformation process comprises the technologies
used to convert inputs into output.
If we take a university as a production process, transformation process includes technologies
such as lectures, reading assignments, laboratory experiments, term papers and tests/
examinations. Inputs at the university comprise students, faculty, building, etc. Graduating
students from universities are regarded as output.
Inputs are classified into fixed inputs, the supply (quantity) of which cannot be changed over
a short period of time and variable inputs, the quantity of which can be varied in the shortrun. The most important fixed inputs in the short-run are land and capital whereas labour and
raw materials are instances of variable inputs in the short-run. Output is defined as any final
good or service that comes out of the production process.
Thus, the description of the technical relationship between inputs and output is called
production function. Stated differently, production function describes the combination of
inputs and the maximum attainable output that can be produced using that combination of
inputs.

Production function is defined for a given technology because as technology

improves the maximum attainable output for a given cost increases and a new production
function is formed.
The distinction between the momentary-run, short-run and the long-run period is based on the
difference between fixed inputs and variable inputs. The momentary - run is the period of
36

time so short that no change in production an take place. The short-run is the period of time
in which the quantity of some factors of production cannot be varied. The long run is the
period of time in which it would be possible to increase the quantity of all factors.
Consequently, therefore, all inputs are variable in the long-run.
The time period varies from firm to firm and from industry to industry. The short-run may be
a matter of eight or ten months for some firms while for others it may extend to years.
Production in the short-run
The short-run is the period of time in which variable inputs such as labour and raw materials
can be adjusted while fixed factors such as plant and equipment cannot be fully modified or
adjusted.
At any point in time, for instance, the production of teff requires inputs of labour, land,
fertilizer and available technical knowledge, which can be portrayed in the form of the
production function as follows:
Qt = f (L, Ld, F, T,) Where:
QT = Quantity of teff produced
L = labour input
Ld = land input
F = fertilizer
T = technical knowledge
The above production function states that the output of teff depends on the inputs listed in the
parenthesis.

A real production function is very complex.

However, economists have

simplified it by reducing the number of variable inputs used in the production function to a
manageable number.
Thus, given land input, fertilizer and available technical knowledge, the output of teff in the
above production function depends on the labour input (L) in the short-run. Hence, the
production function boils down to:
QT = f (L, Ld*, F*, T)
QT = f (L)
Note that all other inputs in the bracket with the asterisk are assumed to be constant in the shortrun.
Production function can be portrayed with the help of mathematical equations, tables and graphs.
Mathematically, QT = f(L, Ld* K*,M*)
37

It can be stated as
Q = f(L1, L2 - - - Ln, Ld1 Ld2 - - - Ldn, K1, K2, - - - Kn, m1, m2 - - - mn)
Where: Q = Maximum attainable output
L = Labour service
Ld = Land input
K = Capital services
M = Materials
Table 2.2. Relations between Total , Average and marginal products of labour
Labour
(No. Of workers)

Total Product of
Labour (TPP)

Average Product of
Labour (APL)

Marginal Product of
Labour (MPL)

Stages of
Production

0
1

0
10

10

10

First stage of
Production (increasing

2
3
4
5

30
66
88
105

15
22
22
21

20
36
22
17

Returns to labour

6
7
8

114
119
119

19
17
15

9
5
0

9
10

110
70

72
7

Second stage of
Production (diminishing
Returns to labour)
Third stage of production
(Negative returns
to labour)

-9
-40

Table 2.2. displays the various levels of teff output associated with different number of workers. Here, the
following important production concepts need to be defined:

i.

Total physical product (TPP) refers to the total quantity of teff output produced and
measured in physical units by the labour input, during a given period of time, holding
other inputs constant.

ii.

Average physical product (APL) is total physical product divided by the unit of the

variable input. That is, APL =

iii.

TPP
L

Marginal physical product (MPL) is the change in total physical product as a result of a
unit change in the usage of the variable input. That is, MPL = TPL .
L
Where: TPL = change in total product
L = change in labour input
38

The relations between total, average and marginal products of labour in Table 4.1 help
define three stages of production, which can be depicted graphically hereunder:

Fig. 2. 20. Stages of Production and the Law of Variable Proportions

As shown in Fig. 2.20, a business firm encounters three stages of production in the course of
producing different levels of teff output using labour input, keeping all other inputs constant.
Stage I: It goes from the origin where TPL is zero to the point where APL is maximum and
APL=MPL. In this stage of production when additional units of labour are employed, total
product (TPP) increases at an increasing rate. This is the stage of increasing returns to the
variable input (labour)
Stage II. It originates from the point where the APL is maximum (APL=MPL) to the point where
MPL= zero. In this stage of production, total product (TPL) increases at a diminishing rate. This
means that the rate of increase of TP L (which is the MPL) falls. This is the stage of diminishing
returns to the variable input.

39

Stage III. It covers the range over which the marginal product of labour (MP L) is negative. In
stage III of production, total product (TPL) declines and this makes MPL negative. This is the
stage of negative returns to the variable input.
A rational producer would not produce in stage I of production because there is very limited
variable input (labour) for the fixed inputs (land and capital). In this stage, labour is
underemployed in relation to the fixed inputs, which are underutilized. Thus, by increasing the
usage of the variable input (labour), total product (TPP) can be increased.
In stage III, there is excess labour when compared to the given fixed inputs. Hence, labour is
over-employed in relation to the fixed inputs, which are over-utilized. Therefore, a rational
producer would not produce in this stage, either.
Thus, from the firm's point of view, setting an output target in stage I and III is irrational. This
leaves stage II the only stage of production for the rational producer, whose objective is to
produce the maximum attainable output.
In Summary, if increasing units of labour are added to fixed quantities of land and capital, the rate
of total product increase rises in the first stage of production. In the second stage of production,
the rate of increase in total product declines. Finally, there is an actual decline in the volume of
production as more and more units of labour are added to the fixed factor of production in the
third stage.
Relations between TPL and MPL
The following relations can be developed between TPP and MPL from table 4.1 and Fig.4.2
above:
I.

When TPP is increasing at an increasing rate, MPL is rising.

II.

When TPP is increasing at a decreasing rate, MPL is falling.

III.

When TPP is maximum and constant, MPL becomes zero.

IV.

When TPP itself is declining, MPL becomes negative (MPL < 0).

Relations between APL and MPL

i.

When MPL is above APL (MPL> APL), the latter is rising.

ii.

When MPL =APL, the latter is at maximum level.

40

iii.

When MPL is below APL (MPL < APL), both MPL and APL are falling.

Law of Diminishing Marginal Returns

The law of diminishing returns can be classified into the law of diminishing average returns and
the law of diminishing marginal returns. The points at which average product (AP L) and marginal
product (MPL) attain their maximum points are respectively called the points of average returns
and marginal returns.
The Law of diminishing average returns states that the average product of the variable input
(APL) tends to decline as the amount of that input increases, keeping all other resources intact.
On the other hand, the law of diminishing marginal returns holds that the marginal product of the
variable input eventually declines as the physical quantity of that input increases, holding all
other inputs constant. Put differently, the law of diminishing marginal product (the law of
variable proportions) states that when increasing quantities of a variable factor are applied to
fixed quantities of other factors, the marginal product of the variable factor begins to decline
continuously beyond a certain point.
The law of diminishing marginal returns is based on numerous empirical studies. For instance,
take the diminishing returns to water. The first units of water are essential for plant life; the next
units of water keep the plant healthy; but as more and more water gets added, the soil becomes
water - logged and most crops actually die.
Since in the short-run one or more inputs are fixed, the law of diminishing marginal returns is a
short-run phenomenon.

Theory of Costs
Production and costs are highly interrelated concepts. Production is hardly possible without costs.
When goods and services are produced, various expenses are incurred. These expenses are
generally called costs. Costs of production embody the sum of all payments made to the suppliers
of inputs. Inputs can be supplied either by the owners of inputs or owner of the business. Thus,
the payment for inputs can be made either explicitly or implicitly.
The money payments which a business firm makes to the outside suppliers of inputs in the course
of producing a variety of goods and services are called explicit (accounting) costs. Explicit costs
include payments made for labour services, raw materials, transport service, fuel, power, etc---.
By contrast, implicit costs are costs of self-owned and self-employed inputs, which do not involve out of

41

pocket payments. The value of these owned inputs can be inputted or estimated from what they could earn
in their best alternative use-opportunity cost. Implicit costs may include salary of the owner of the plant,
the estimated rent of building belonging to the owner, etc.

Economic cost is the sum total of implicit cost and explicit cost. (EC = IC + EC)
Accounting Profit versus Economic Profit
Accountants and economists define profit in quite different ways. Accounting profit is equal to
total revenue less explicit costs whereas economic (pure) profit is the difference between total
revenue and total costs (explicit + implicit). Normal profit = Accounting profit- Economic Profit.
When economic profits are negative, firms leave an industry in the long run but when long run
economic profits are positive, firms enter the industry and when economic profits are zero, firms
stay in the industry with expectation of making profits.
Short-Run Costs
Corresponding to the fixed and variable inputs, short-run costs can be divided into fixed costs and
variable costs. Fixed costs are those unavoidable overhead costs which the firm must incur
before production can get under way-fixed costs are the same whether the output is large or
small. Fixed costs are sometimes called indirect costs or sunk costs. These costs include such
things as rents on leased property, interest on borrowed funds, insurance and administrative
expenses maintenance and equipment costs, and the like.
Those costs which vary with the level of output are said to be variable costs. Variable costs are
the costs of those inputs for which supply could be altered in the short- run. Examples of variable
costs are cash outlays on intermediate goods, raw materials, wages, advertising, power and
transport.
Short-Run Total Costs
Three short-run total costs can be identified:
1) Total fixed Cost (TFC): is part of total cost that does not vary with the level of the
firms output. It is unaffected by any variation in the quantity of output.
2) Total variable cost (TVC): is a component of total cost which varies directly with the
level of output produced.
By the virtue of the fact that total variable cost depends on the level of output when output is
zero, total variable cost is zero and as output expands the total variable cost increases.
3) Total cost (TC): is the sum of total fixed cost (TFC) and total variable cost (TVC). That
is, TC=TFC+TVC.
42

Short-Run Per unit costs

The other important concept in cost analysis is per unit (average cost) analysis.
1) Average Fixed Cost (AFC): is the total fixed cost divided by the units of output. That is,
AFC=TFC/Q. Even if total fixed cost (TFC) is independent of output, the average fixed
cost (AFC) depends on output level.
2) Average variable cost (AVC): is the total variable cost divided by the units of output.
That is, AVC=TVC/Q. As TVC depends on level of output, so does the AVC.
3) Average total cost (AC): is total cost divided by the units of output. That is,
AC = TC
Q
= TFC+ TVC
Q
= TFC + TVC
Q
Q
AC= AFC+AVC
Average cost is often called per unit cost.
Short-Run Marginal Cost (SMC)
Short-run marginal cost (SMC) is the extra or additional cost of producing one extra unit of
output. That is,
SMC = TC
Q
= (TFC + TVC)
Q
= TFC + TVC
Q
Q
= TVC (since TFC =0)
Q
TVC
Q

SMC =

Hence, marginal cost (MC) is not influenced by fixed costs.

Table 2.5 Cost-output relations

Units of Total Fixed
Output (Q)
Cost
Q

(TFC)

Total
TotalAverageAverage Average Short-run
variable cost
fixed cost
variable total cost marginal cost
cost
TVC)
(TC)
(AFC)
(AVC)
(AC)
(SMC)

43

0
1

10
10

0
4

10
14

10

10
10
10
10
10
10
10
10

6
10
17
26
37
51
68
87

16
20
27
36
47
61
78
97

5
3.3
2.5
2
1.7
1.4
1.2
1.1

14

8
6.6
6.7
7.2
7.8
8.7
9.6
10.8

2
5
7
9
11
14
17
19

4
2
3
4
5
6
7
8
9

2.5
3.3
4.2
5.2
6.1
7.3
8.4
9.6

Cost in dollar
90

TC

80

TVC

70
60
50
40
30
20
10

TFC
0

Units of Output

Cost Per Unit output

Fig. 4.10 Short-run Total Costs ( TC and TVC are

Inversed S- shape curves not straight line)

ATC

16
SMC
14

AVC

12
10
44

8
6
4
AFC
2
0

Units of output

Fig. 2.21 Short-Run Marginal and per unit Cost

From Table 2.4 and Fig. 2.21, the following important points need to be noticed:

1) Total fixed cost (TFC) is $ 10 regardless of the level of output. This implies that TFC is
not affected by the level of output produced.
2) Total variable cost (TVC) is zero when output is zero and rises as output rises. Initially,
TVC increases at a decreasing rate and then increases at an increasing rate.
3) Total cost (TC) equals TFC plus TVC at each and every level of output. Since TFC does
not change with the level of production, the TC curve has similar shape as the TVC curve.
From Fig. 2.21, the following crucial points need to be borne in mind:
1) Since total fixed cost is a constant amount, dividing it by the increasing total output gives a steadily
falling AFC. In other words, the AFC curve falls continuously as output expands, imparting it a shape
of rectangular hyperbola. Nevertheless, AFC can never be zero or negative.
2) As total variable cost rises with expansion of output, the average variable cost (AVC) also rises.
3) Since average cost (AC) equals average fixed cost (AFC) plus average variable cost (AVC), the vertical
distance between the AVC and AC curves gives AFC. As output expands, the vertical distance
between AVC and AC (AFC) falls.

4) When AFC falls but AVC increases, AC changes as follows:

iii)

i)

If the fall in AFC is greater than the increase in AVC, then AC decreases.

ii)

If the fall in AFC is less than the increase in AVC, then AC increases.
If the fall in AFC equals the increase in AVC, AC remains unchanged.

45

5) The MC curve intersects both AVC and AC at their respective lowest points. Stated differently, both
AVC and AC curves are always pierced at their minimum points by the rising MC curve. But, the
minimum point of AVC curve comes before the minimum point of the AC curve.

6) When the MC curve is below the AVC and AC curves, both AVC and AC are falling because
so long as MC is below AVC and AC curves, it pulls both AVC and AC down through the
effects of TVC and TC.
7) When the MC curve is above the AVC and AC curves, both AVC and AC are rising because
when MC is above AVC and AC curves, it pulls AVC and AC up.
8) Cost curves and product curves are the inverted (mirror) images of each other. This means that
marginal product and average product curves initially rise, reach maximum and begin to fall. As a
result, MC, AVC and AC curves fall at first, subsequently reach their respective minimum points
and ultimately commence to rise. This implies that so long as the MP and AP curves are shaped, the MC, AVC and AC curves are U-shaped because of the operation of the law of
diminishing returns (the law of variable proportions) resulting from the existence of fixed inputs
in the short-run.

46