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ChapterTwo:Microeconomics

2.1.SupplyandDemand 2.1.1.PerfectlyCompetitiveMarkets/PureCompetition Market structures are classified into: Pure competition, pure monopoly, Monopolistic competitionandOligopoly Thisdivisionofmarketisbasedon: 1)Thenumberoffirmsintheindustry; 2)Productdifferentiation/standardization; 3)Easeofenteringandexitintothemarket. Definitionsofthedifferentmarketstructures: a) Pure competition: it involves large number of small firms producing standardized product.Entryandexitarefree b) Puremonopoly:iswhereasingleselleristhesolesupplierofgoodsandservices(G&S). Entryisblockedandtherenoproductdifferentiation. c) Monopolistic competition: is characterized by a relatively large number of sellers producing differentiated products. There is large nonprice competition via product differentiation.Entryandexitisquiteeasy. d) Oligopoly: involves only few sellers of the same or similar product and hence there is interdependenceindecisionmaking. Pure/perfectcompetition Thistypeofmarketstructureisfurtherdiscussedindetailfromsections2.1to2.3. Thecharacteristicsofthismarketinclude: 1. Verylargenumbers:Thedistinguishingfeatureofthismarketisthatthereexistsa large number of independently acting sellers selling at national or international markets.AgoodexamplecanberetailcigarettesellersinEthiopia. 2. Standardized product: The firms produce standardized/identical/homogenous products.Consumerswillbeindifferenttobuyfromanysellers,aslongastheprice is the same. The firms dont try to differentiate their products no nonprice competition,onlypricecompetitionexists.(e.g.Photocopyservices,theygivemore orlessthesameservice)

ECON101:PrinciplesofEconomicsLectureNotes

3. Price Takers: In pure competition individual firms dont exert any control over pricebecauseeachfirmproducesonlyasmallfractionoftotalsupplytothemarket. Hence,everyfirmispricetakeri.e.itcannotchangemarketpricebutsimplyadjust toit.Ifoneofthefirmsincreasepricegreaterthanthemarket,consumerswillnot buyfromit.Conversely,itcansellasmuchasitwantsatmarketprice.Therefore, thereisnoreasontochargelowerthanmarketprice. 4. Free entry and exit: new firms can freely enter and incompetent firms can exit freely. No significant legal, technological, financial or other obstacles prohibit new firmsfromsellingtheirproductinthemarket. NB:Althoughpurecompetitionisrareintherealworld,thismarketmodelishighly relevantbecause: Purecompetitionisameaningfulstartingpointforanydiscussionofprice andoutputdetermination Purecompetitionisastandardagainstwhichefficiencyisevaluated.

Table1belowsummarizesthedifferentmarketstructuresbycomparingthemusingtheir importantfeatures. Table1:Summaryofdifferentmarketstructures Description Numberof firms/sellers Typesof products Pure/perfectly competitive Many Standardized Puremonopoly One No differentiation andsubstitute Blocked Yes Monopolistic Competition Large Differentiated Oligopoly Few Similar

Easeofentry Free Quiteeasy Price No Yes discrimination 2.1.2Demandandsupplyfunctions,scheduleandcurve.

Difficult Yes

In economics, a desire for goods and services backed by the ability and willingness to buy those goods and services in a given period of time is generally referred to as Demand. Definition:Demandindicatesthedifferentquantitiesofaproductthatbuyersarewilling and able to buy at various prices in a given period of time, other things remaining unchanged(CeterisParibus).Thedefinitionstressesthat: 1) Theconsumeriswillingtohavethatproduct 2) Theconsumershouldhavetheabilitytobuytheproductand
ECON101:PrinciplesofEconomicsLectureNotes 2

3) Demandistimespecific Note that quantity demanded and demand are two different concepts. Quantity demandedreferstoaspecificquantitythataconsumeriswillingandabletobuyata specificprice.Butdemandreferstotherelationshipbetweenvariouspossiblepricesof a product and the corresponding quantities demanded for the product, other things remainunchanged. A. Demandschedule,curveandfunction Thedemandscheduleisatable,whichrepresentstherelationshipbetweenthevarious prices of a product and the corresponding quantities demanded, other factors remainingconstant.SeeTable2below. Fromthetablebelow,wenoticethataspricecontinuestofall,therespectivequantity demandedincreases,andviceversa.Thisinverseornegativerelationshipbetweenprice andquantitydemanded,holdingotherthingsconstant,iscalledthelawofdemand. Table2:Anindividualhouseholdsweeklydemandoforange. Priceper Kg 6 5 4 3 2 1 Quantity demandedper week 2 3 4 5 6 7

A B C D E F

Thelawofdemand:statesthat,allotherthingsremainunchanged,aspriceofaproduct increases, quantity demanded decreases, and as price decreases quantity demanded increases. Whenthedatapresentedinthedemandscheduleisdepictedgraphically,itiscalleda demandcurve.Itshowshowthequantityofaproductvariesasthepriceoftheproduct changes. Byagreement,priceisontheyaxisandquantityisontheXaxis.Thenegativeslopeof thedemandcurvereflectsthelawofdemand.

ECON101:PrinciplesofEconomicsLectureNotes

The individual households demand for orange can also be expressed in the form of mathematicalequation,whichiscalledthedemandfunction.

Oras P = f

(Qd ) P,whichisknownasinversedemandfunction

Forexample,
or P = 8 Qd

B. Individualandmarketdemand Themarketdemandisthetotaldemandofallbuyersforaproduct.Themarketdemand scheduleorcurveforaproductisderivedbyhorizontallyaddingthequantitydemanded fortheproductbyallbuyersateachprice.


P

15

Consumer1

Consumer2

Consumer3

ECON101:PrinciplesofEconomicsLectureNotes 4

C. DeterminantsofDemand Thedemandforaproductisdeterminedby i) Priceoftheproduct ii) Tasteorpreferenceofconsumers iii) Incomeoftheconsumers iv) Priceofrelatedgoods(substitutesandcomplements) v) Consumersexpectationofincomeandprice vi) Numberofbuyersinthemarket Thefirstdeterminant,priceoftheproduct,isknownasownpricedeterminantofdemand.The remaining determinants (ii) (iv), are known as nonown price determinants or demand shifters. Changeinquantitydemandedandchangeindemand Foreachpriceofaproduct,thereisacorrespondingquantitydemanded.Whenthepriceofthe product changes, the corresponding quantity demanded also changes hence a change in quantity demanded as a result of change in the price of the product is represented as a movementalongafixeddemandcurve. Achangeindemand,ontheotherhand,referstoachangeinthedemandscheduleorashiftof theentiredemandcurvetoanewlocation.Thishappensduetochangesinoneormoreofthe nonownpricedeterminantsofdemandlikechangesinincome,taste,etc. Effectsofnonownpricedeterminantsofdemand 1. Effectsofchangesintasteorpreference:afavorablechangeinconsumerstastecauses anincreaseindemand,whichisrepresentedbyarightwardshiftofthedemandcurve. The favorable change can be a result of fashion change, or intensive advertisement. Unfavorable changes in taste, such as scientific report about the negative impact of a product on health, on the other hand will reduce the demand for that product and causethedemandcurvefortheproducttoshifttotheleft.(e.g.QueenBurger;lostits marketbecausepeoplegotsickaftereatingtheburgers) 2. Effectsofchangeinincome: Howchangesinincomeaffectdemanddependsonthenatureoftheproduct.Formost products,ariseinincomecausesanincreaseindemandandviceversa.Productswhose demandvariesdirectlywithincomearecalledsuperiorgoodsornormalgoods.Onthe otherhand,therearesomeproductswhosedemanddecreasesasconsumersincome

ECON101:PrinciplesofEconomicsLectureNotes

increases and vice versa. Such goods whose demand varies inversely with income are calledinferiorgoods.Forexample,cabbage,secondhandshoes,etc 3. Pricesofrelatedgoods Achangeinthepriceofarelatedgoodmayeitherincreaseordecreasethedemandfor aproductdependingonwhethertherelatedgoodisasubstituteoracompliment. Asubstitutegoodis onethatcanbeusedinplaceofanothergood.IfXandYare substitutes,anincreaseinpriceofXleadstoanincreaseindemandforY,andvice versa,otherthingsconstant(e.g.CokeandPepsi). Acomplementarygoodisonethatisusedtogetherwithanothergoodlikesugarand tea. If X and Y are complements, then an increase in the price of X leads to a decreaseinthedemandforYandviceversa,otherthingsconstant.Forexample,a caranditstire, Unrelated goods are goods that are neither substitutes nor complements e.g. automobilesandbananas.

4. Effectsofchangeinconsumersexpectationofpriceandincome When consumers expect higher future price of a product, for example due to poor harvest in the past rainy season, they would buy more today to avoid unnecessary expenditure in the future. This causes an increase in current demand for the product andshiftsthedemandcurvetotheright. Achangeintheexpectationsconcerningfutureincomemayalsopromptconsumersto change their current spending, but its impact would depend on the nature of the product.Expectationofhigherincomewillinduceconsumerstobuymoreofanormal goodbutlessofaninferiorgood. 5. Effectsofchangeinnumberofbuyers When number of buyers increase in a market, then the demand will increases. For example,improvementsincommunicationshaveincreasedthedemandforstocksand bonds due to an increase in the number of participants internationally. Population growthinacountryalsoincreasedthedemandforfoodstuffs. D. Supplyschedule,curveandfunction Supplyindicatesthevariousquantitiesofaproductthatsellers(producers)arewilling andabletoprovideateachofaseriesofpossiblepricesinagivenperiodoftime,other thingsremainunchanged.Likedemand,supplycanberepresentedbyaschedule,curve orafunction.

ECON101:PrinciplesofEconomicsLectureNotes

Asopposedtodemand,aspricerises,therespectivequantitysuppliedalsorisesandvice versa. This direct (positive) relationship between the price of a product and quantity supplied,ceterisparibus,iscalledthelawofsupply.

The law of supply: states that, other things constant, as price of a product increase, quantitysuppliedoftheproductincreaseandaspricedecreases,quantitysuppliedalso decreases. Price is an obstacle from the standpoint of the consumer, who is on the payingend.Thehigherthepricethelesstheconsumerwillbuy.Butthesupplierison thereceivingendoftheproductsprice.Toasupplier,pricerepresentsrevenuewhich servesasanincentivetoproduceandsellaproduct.Thehighertheprice,thegreater thisincentiveandthegreaterthequantitysupplied. E. Individualandmarketsupply Themarketsupplyscheduleorcurveindicatesthetotalmarketsupplyofaproduct thatallsellersinthemarketarewillingandabletoprovideinagivenperiodoftime. Itisderivedbyhorizontallyaddingthequantitysuppliedoftheproductbyallsellers ateachprice. F. Determinantsofsupply Thesupplycurveisdrawnontheassumptionthatallfactorsexceptownpriceare fixedanddonotchange.Ifoneofthemdoeschange,achangeinsupplywilloccur andsotheentiresupplycurvewillshift. Basicnonownpricedeterminantsofsupplyareorsupplyshiftersare: 1. Pricesofinputs(resources) 2. Technology

ECON101:PrinciplesofEconomicsLectureNotes

3. Taxesandsubsidies 4. Pricesofrelatedgoods 5. Priceexpectationsofsellers 6. Numberofsellersinthemarket 7. Weather 1) Resourceprices Higherresourcepriceswillraisesproductioncosts,andassumingafixedproduct price,highproductioncostsqueezeprofits.Thisreductioninprofitsreducesthe incentiveforfirmstosupplyoutputateachproductpricesothatresourceprices andsupplyareinverselyrelated. 2) Technology Improvementsintechnologyenablefirmstoproducemoreunitsofoutputwith fewerresources.Becauseresourcesarecostly,usingfewerofthemwilllowers productioncostsandincreasessupply,thus,iftherehappenstobetechnological progress,sellerswouldbewillingandabletoproduceandprovidemoreoftheir productateachpricethanbefore.Therefore,technologicaladvancementshifts thesupplycurveoutwards(totheright). 3) Taxesandsubsidies Businessestreatmosttaxesascosts.Anincreaseinsalesorpropertytaxeswill increase production costs, hence will reduce supply. In contrast, subsidies are taxes in reverse. If the government subsidizes the production of a good, it in effectlowerstheproducerscostsandincreasessupply. 4) Pricesofrelatedgoods Firmsthatproduceaparticularproduct,say,leatherjackets,cansometimesuse theirplantandequipmenttoproducealternativegoodslikeleathershoes.The higher prices of these alternative goods like leather shoes may induce leather jacket producers to switch production in order to increase profits. This substitutioninproductionresultsinadeclineinthesupplyofleatherjackets. 5) Priceexpectationsofsellers(expectedsellingprice) Changes in expectations about the future price of a product may affect the producerscurrentwillingnesstosupplyoftheproduct.Itisdifficult,however,to generalize about how a new expectation of higher prices affects the present supply of a product. Farmers expecting a higher teff price in the future might withholdsomeoftheircurrentteffharvestfromthemarket,therebycausinga
ECON101:PrinciplesofEconomicsLectureNotes 8

decrease in the current supply of teff. In contrast, in many types of manufacturingindustries,newlyformedexpectationthatpricewillincreasemay induce firms to add another shift of workers to expand their production capabilities,causingcurrentsupplytoincrease. 6) Numberofsellers Other things equal, the larger the number of suppliers, the greater the market supply,asmorefirmsenteranindustry,thesupplycurveshiftstotherightand viceversa. 7) Weatherconditions Achangeinweatherconditionwillhaveanimpactonthesupplyofanumberof products, especially agricultural products. Other things equal, good weather conditionwillincreasethesupplyofmaizeandsothecurveshiftsoutward.That is,ateachprice,sellersarewillingandabletoprovidemoremaizethanbefore. Badweatherwillhavetheoppositeimpact. 2.1.3Marketequilibrium Marketbringssupplyanddemandtogethertodecidehowthebuyingdecisions ofhouseholdsandthesellingdecisionsofbusinessesinteracttodeterminethe price of a product and the quantity actually bought and sold. We assume a competitivemarketneitherbuyersnorsellerscansettheprice. Themarketdemandandsupplyofmaizeperweek Marketdemand (inquintal) 400 600 800 1000 1200 Price (perquintal) 120 100 80 60 40 Marketsupply (inquintal) 1200 1000 800 600 400 Surplus(+), shortage() (+)800 (+)400 0 ()400 ()800

Surpluses(+)or(Qs>Qd):Buyerscanbuywhateveramounttheywanttobuybut sellers cannot sell all they want to. For example, at the price of Birr 120 per quintal,sellersarewillingandabletosupply1,200quintalsperweekbutbuyers are willing to purchase only 400 quintals leading to a surplus of 800 quintals. Surplus is the excess of supply over demand. Surplus or unsold output in the handsofthesellersincreasesthecompetitionamongsellersandthispushesthe pricedown.

ECON101:PrinciplesofEconomicsLectureNotes

Shortages()or(Qd>Qs):Buyerscannotbuywhattheywanttobuy,butsellers sellalltheywanttosell.Hencebuyersaredissatisfied,butsellersaresatisfied. LetsjumptoBirr40perquintal.Thislowerpriceencouragesbuyerstobuymore but discourages sellers of maize. Buyers are willing and able to purchase 1200 quintals while sellers are ready to sale only 400 quintals only. This results in a shortage of 800 quintals. Shortage is the result of excess demand over supply. Theexistinglevelofshortagecreatescompetitionamongbuyersandthispushes thepriceup. Equilibriumpriceandquantity(Qs=Qd):competitionbetweenbuyersandsellers drivepricetoequalatbirr80,totalquantitydemandedisequaltototalquantity supplied i.e. the total market demand equals the total market supply. At this price,thereisneithershortagenorsupply.Economistscallthispricethemarket clearingorequilibriumprice,equilibriummeaninginbalanceoratrest.At birr 80, quantity supplied and quantity demanded are in balance at the equilibriumquantityof800.Equilibriumquantityisthequantitywhichisactually boughtandsoldattheequilibriumprice. Theequilibriumpriceandequilibriumquantitycanalsobeshowngraphically.
80 60 40 20 Shortage D 100 S Surplus

600

800 1000

Graphically, the intersection of the supply curve and the demand curve indicates the market equilibriumforthatproduct. Mathematically: Considerthatthereare200identicalbuyersofwheatinamarketwithanindividualdemand function of Qdw = 8 Pw , ceteris paribus, where Qdw is quantity demanded for wheat by individualbuyerand Pw ispriceofwheat.Therearealso100identicalsellersofwheatwithan

ECON101:PrinciplesofEconomicsLectureNotes

10

individualsupplyfunctionof Qsw = 2 Pw ,otherthingsconstant( Qsw isquantitysuppliedofwheat byindividualsellerand Pw ispriceofwheat). Question: Formulate the market demand and supply functions and calculate the equilibrium priceandquantity. ChangesinSupply,DemandandEquilibrium i. Whendemandchangeswilesupplyremainingunchanged a. Whendemandincreases
Demandshiftstotheright Equilibriumpriceincreases Equilibriumquantityincreases

b. Whendemanddecreases ii.

Demandshiftstotheleft Equilibriumpricedecreases Equilibriumquantitydecreases

WhenSupplychangeswhiledemandremainingconstant a. Whensupplyincreases
Supplyshiftstotheright Equilibriumpricedecrease Equilibriumquantityincreases

b. Whensupplydecreases iii.

Supplyshiftstotheleft Equilibriumpriceincreases Equilibriumquantitydecrease

Whenbothdemandandsupplychange a. WhenDemandincreasesandsupplydecreases

ECON101:PrinciplesofEconomicsLectureNotes 11

In all cases, equilibrium price increases. But the impact on equilibrium quantity is indeterminate.I.e.itisdeterminedbytheextentofchanges(shifts)indemandandsupply. b. Whendemanddecreasesandsupplyincreases Inthiscaseequilibriumpricewilldecreaseandthatofquantityremainsindeterminate.(Show) c. Whenbothsupplyanddemandincrease Equilibriumpricewillbeindeterminatewhileequilibriumquantityincreases.(Show) d. Whenbothdemandandsupplydecreases Equilibriumpricewillbeindeterminatewhileequilibriumquantitydecreases.(Show) Summaryoftheanalysis: Supply Increase Nochange Decrease 2.1.4.ElasticityofDemandandSupply Priceelasticityofdemand(ed): Thelawofdemandsimplystatesthatquantitydemandeddecrease(increase)aspriceofgoods andservicesincreases(decreases).It,however,saysnothingaboutthemagnitudeofchangein quantity demanded. Extent of change in quantity demanded is embedded in the concept of elasticity. Elasticity is a measure of responsiveness of quantity demanded to changes in the price of a good.Itissimplythepercentagechangeinquantitydemandedforaonepercentchangeinthe priceofagood.
ECON101:PrinciplesofEconomicsLectureNotes 12

Increase P?Q P Q P Q?

Demand Nochange P Q P Q P Q

Decrease P Q? P Q P?Q

Mathematically,

WhereQandPareoriginalquantitydemandedandpricerespectively. When elasticity is computed, changes in quantity and prices are expressed as percentages. Hence,theelasticitynumberisunitfree,i.e.,itdoesntdependonunitofmeasurement. Example: When price of wheat falls from 4 birr to 2 birr, the quantity demanded raised to 8 from6quintals.Findelasticity. Ans:

N.B.Priceelasticityofdemandisnegativebecauseofthelawofdemand. Conventionally,weignorethesignbytakinginabsoluteterms

Classificationofpriceelasticityofdemand Priceelasticityofdemandcanbeclassifiedintoelastic,inelasticandunitaryelastic. 1. Elasticdemand( demandissaidtobepriceelasticifthepriceelasticity

of demand is greater than unity (one). That is, the percentage change in quantity demanded exceeds the percentage change in prices. In other words, if the price elasticityofagoodisgreaterthanone,thendemandistermedaspriceelastic,

ECON101:PrinciplesofEconomicsLectureNotes

13

Thisimpliesthatchangeinpricesofagoodhasgreatereffectonquantitydemanded.Quantity issensitivetochangesinprices. E.g.luxuriousgoodshaveelasticdemand Thedemandforaproductmaybeperfectlyelastic.Thismeansthataminutechangeinpriceof a good will result in an infinitely large change in quantity demanded. The demand curve for suchgoodsishorizontalimplyingthatasmallchangeinpriceswillleadtoaninfinitechangein quantity.

Asmallchangeinpricewillleadtolarger(infinite)changesinquantitydemanded 2. Inelastic demand ( : If the price elasticity of demand has been zero and

one(zeroincluded),thendemandissaidtobepriceinelastic. Formally, When demand is inelastic, a change in price has little impact on quantity demanded. That is, demandisweaklyresponsivetochangesinprices. Priceelasticityofdemandmaybeperfectlyinelastic.Undersuchsituation,thedemandcurve wouldbevertical.Demandiscompletelynonsensitivetochangesinprice.

Theverticaldemandcurveindicatesthatifpricechanges,therewillbenochangeinquantity demanded.Thatisnomatterwhatthechangeinprice,demandedremainsthesame.
ECON101:PrinciplesofEconomicsLectureNotes 14

Example:demandforinsulin

3. Unitarily elastic demand ( ): If the price elasticity of demand is equal to

one,thendemandforagoodissaidtobeunitaryelastic. Formally, In other words, the percentage change in quantity demanded equals the percentage changeinprice. Example:If200%increaseinpriceofagooddecreasethequantitydemandedby200%, elasticitywillbeunitelastic. Summary Elasticity Classification Inelastic Unitaryelastic Elastic Interpretation ( (

DeterminantsofPriceElasticityofDemand Whatdeterminesthepriceelasticityofdemandforaproduct? a) Availabilityofsubstitutes: In general, the more and better substitutes exist for an item, the more elastic its demand will be. A perfectly elastic demand has many perfect substitutes. On the contrary,aperfectlyinelasticdemandhasvirtuallynosubstitutes. Example,demandfortaxiservice(ofonedriver). b) Proportionofincomeconsumersspendonacommodity: If consumers spend a large proportion of their income on a given item, then that itemhaspriceelasticdemand. E.g.Foodinlargefamily(withsomanychildren),ipod,etc. On the other hand, if consumers spend less of their income on a particular item, thenthedemandforthatitemisinelastic. Example,Matches
ECON101:PrinciplesofEconomicsLectureNotes 15

c) Adjustmenttime Demandtendstobemoreelasticwithlongertimeoverlongperiods;consumerswill havemoretimetoadjusttheirconsumptionpatternsinresponsetopricechanges, that,is,findsubstitutes. Example, A permanent increase in price of gasoline leads to development of substitutes(solar,thermal,etc.)energysources.Butinshorterperiod,itisdifficult todevelopsubstitutes. d) GeneralVsSpecified Themorenarrowlydefinedtheproduct,thegreaterthenumberofsubstitutesand the higher the elasticity of demand. Example, Pepsi Vs soft drinks, Chevrolets Vs automobile,taxiVstransportservice,etc CalculatingPriceElasticityofDemand Priceelasticityofdemandcanbemeasuredatapointorbetweentwopoints. a) Point elasticity: is elasticity measured at a single point or for arbitrarily small changes.

Withbothdistancesmeasuredalongthedemandcurve. Example P A C E = O B Q F Q P d = . P Q Q EC OF but = = P AE AE P OE = Q OF


OF OE OE CF . = = AE OF AE AE Butthetriangles AEC and CFB aresimilar
=

d =

ECON101:PrinciplesofEconomicsLectureNotes

16

CF CB = AE AC CB ThisisapplicableifyouhavethedemandfunctionforsomegoodXor d = AC at least the demand curve for some given level of price and quantity, i.e.

d =

1 P . Slope Q

b) Arc elasticity: It is an elasticity measured between two points on a demand curve. Elasticityisdefinedas:

The quantities

are easy to define (as

and

.ButthequestionarisesastowhatvaluesofQandPweuse.Are wesupposedtotakethebeginningorfinalvaluesorsomeaverage? Themostconvenientwayistousetheaverageoftheinitialandfinalvalues. Example1:Lettheinitialpointbe( andfinalpoint( ,then Thisistheformulatofindarcelasticityofdemandbetween2points. Geometrically:


P2 A B P

P1

Arc _ d =

Q2 Q1 P1 + P2 . P2 P2 Q1 + Q2

Q2 Q1

N.B.AsthegapbetweenpointAandBapproacheszero,arcelasticitybecomesclosertopoint elasticity.

ECON101:PrinciplesofEconomicsLectureNotes

17

Example2:Supposethatthepriceofaquintalofwheatrisesfrom200Birrto300Birrandasa resultthequantityofwheatdemandeddeclinedfrom100to90quintals. Given:(Q1,P1)=(100,200)and(Q2,P2)=(90,300) Arc d =

Q P 90 100 200 + 300 10 500 5 = = = (show for what would be if we 9 P Q 300 200 100 + 90 100 190 useinitialorfinalpriceandquantity).
PriceElasticityofDemandandSlop The slop of the linear demand curve is constant from point to point, with Slop = P
Q

However,since Q isnotconstant,thedemandelasticitywillbedifferentatdifferentpoints P onthenonlineardemandcurve. Example:Thequantitydemandedisrelatedtopricebythefollowingequation: Q d = a bP Forallb>0 Slop = P

Q P

1 = b

d =

1 P P bP = b = Slop Q a bP a bP

Example: Q d = 10 2 P Calculatepriceelasticityofdemandatpricesof2and4,andshowthat theaboveformulaholds. PriceElasticityofDemandalongtheDemandCurve Priceelasticityofdemandvariescontinuouslyalongalineardemandcurve.Itwillbehigherat higher price (lower output), equal to one at the mid point of a demand curve and it will be loweratlowerprice(higheroutput)levels. Graphically:
E

N.BElasticityistheratio ofthedistance frompointFtoQc(pointonthedemand curve)tothedistancebetweenEandthe pointonthecurve.

d >1
M

d =1 d <1

F 18

ECON101:PrinciplesofEconomicsLectureNotes

PriceElasticityofDemandandTotalRevenueandExpenditure Totalexpenditure(TE):istheproductoftheamountofgoodsandservicespurchasedandtheir priceduringtheperiod.i.e.

TE = P Q
Totalrevenue(TR):istheamountsoldmultipliedbythepriceoveragiventimeperiod

TR = P Q
Note:Expenditurebybuyersrepresentsrevenueforsellers. Example: A B C D E TheEffectofPriceChangeonTotalExpenditureandTotalRevenue WhatwillhappentoTR/TEwhenpricechanges?Theincreaseinpriceincreasestotalconsumer expenditure by increasing the P component of PQ. But the law of demand indicates that as price increase, quantity demanded will decrease, i.e. the Q component of PQ declines as P increases.Hence,wehavetwoopposingforcesactingonTR/TE(=PQ)aspriceincreases.The neteffectofpriceincreasesonPQdependsonpriceelasticityofdemand,whichtellsusabout therelativemagnitudeofthetwoeffects. a) InelasticDemand:Whendemandispriceinelastic,thepercentagereductioninquantity demandedloweredbythepriceincreasewouldbesmallerthanpercentageincreasein price (%Q < %P). This shows that the upward influence of price increase on total expenditure is stronger than the downward pressure of the reduction in quantity demandedonrevenue/expenditure. Price Quantity 12 10 8 6 4 1 2 3 4 5 TE=TR ChangeinTR (=MR) 12 20 8 24 4 24 0 20 4

P TR/TE(=PQ) P TR/TE(=PQ)
I.e.theneteffectofpriceincreaseonTR/TEisincreaseandtheneteffectofprice decreaseonTR/TEisadecline.

ECON101:PrinciplesofEconomicsLectureNotes

19

b) UnitElasticityofDemand:Whendemandisunitaryelastic,anygivenpercentageincome in price will result in exactly an equal percentage reduction in quantity demanded. In otherwords,theupwardforceequalsthedownwardforceandtheneteffectwouldbe nochangeintotalrevenue/totalexpenditure(as%Q=%P)

P orP nochange/effectonTR/TE
c) Elastic Demand: When demand is price elastic, the percentage reduction in quantity demandedcausedbypriceincreasewouldbegreaterthanthepercentageincreasein price (%Q > %P). This implies that the upward pressures on total revenue/total expenditure caused by price increase would be more than offset by the downward pressure on total revenue/total expenditure resulting from the reduction in quantity demanded.

P TR/TE(=PQ) P TR/TE(=PQ)
Insummary,theneteffectofpriceincreaseanddecreaseis: Priceelasticity ofdemand Elastic Unitaryelastic Inelastic MarginalRevenue(MR)isachangeintotalrevenuewhenthequantitysoldchangebyasmall amount.Thatis: MR = %Q>%P %Q=%P %Q<%P Implication EffectsonTR/TE Priceincrease () (0) (+) PriceDecrease (+) (0) ()

TR Q

dTR d ( P.Q) = dQ dQ QdP PdQ = dQ dP = p+Q dQ =

ECON101:PrinciplesofEconomicsLectureNotes 20

Butweknowthat =

dQ Q Q dQ dP P . = = dP P P dP dQ .Q

Usingthisresultintheaboveanalysiswillgiveus:

P MR = P + Q .Q
1 MR = P1 +

Wecanestablishtherelationshiptotalrevenueandelasticityofdemandas: 1. If d >1(elastic),MR>0andtotalrevenuewillbeincreasing 2. If d <1(inelastic),MR<0andtotalrevenuewillbedecreasing 3. If d =1(unitaryelastic),MR=0andtotalrevenuewillnotchange. OtherElasticityConcepts Elasticity can be defined with respect to any two related variables. There are two more importantelasticitiesofdemand,namely,incomeelasticityofdemandandcrosspriceelasticity ofdemand. a) Incomeelasticityofdemand( y ):Itmeasuresthesensitivityofconsumerpurchasesfor agivenpercentagechangeinincome,ceterisparibus.Itcanbedefinedas:

y =

Q Y ,whereY=incomeandQ=quantitydemanded. Y Q

y Measuresthepercentagechangeinthenumberofunitsofagooddemanded,when incomechangesbyonepercent,ceterisparibus.
Example: y =2.3implythata1%increaseinincomeleadstoa2.3%increaseinquantity demanded,ceterisparibus. Whencomputing y ,wedonttakeitinabsolutetermsinceitssignisofinterest. Incomeelasticityofdemandcouldbepositiveornegative. i. Positive income elasticity: such income elasticity indicates that increases in income are associated with increase in the quantity of goods purchased. Such goodswith y >0arenormal/superiorgoods.
21

ECON101:PrinciplesofEconomicsLectureNotes

Normalgoodsarealsofurtherclassifiedintonecessitiesandluxuries.Agoodissaidto benecessityifitsincomeelasticityispositiveandlessthanone,i.e. 0< y <1 E.g.thedemandforinjera Thismeansthatthequantitydemandedforaproductincreaseswhenincomeincreases, but less than proportionately. People will spend a similar fraction of their additional incomeonsuchgoods. Ifincomeelasticityofdemandexceedsone,thenthegoodiscalledluxurygood,i.e.if y >1, then this means people will spend a larger fraction of their income on luxury items. ii. Negative income elasticity: A negative income elasticity of demand implies an inverse relationship between income and the amount of the good purchased. Goodsthathavenegativeincomeelasticityofdemandarecalledinferiorgoods.

b) CrossPriceElasticityofDemand( y. PX ): Itisusedtomeasurethesensitivityofconsumerpurchaseofonegoodtochangesinthe priceofanothergood. Example: TheelasticityofdemandforgoodYwithrespecttothepricesofgoodX measuresresponsivenessofdemandforYtoachangeinthepricesofX andisdefinedas:

y.P =
X

QY PX PX Q y
Acrosspriceelasticityof y. PX =1.4meansthata1%increaseinthe priceofgoodXleadstoa1.4%reductioninthedemandforgoodY.

Example:

Againthesignoftheelasticityisimportant.Apositivecrosspriceelasticityofdemandmeans thatanincreaseinPXleadstoanincreaseinthedemandofgoodY(ordecreaseinquantity demandedofgoodX),ceterisparibus.Hence,thetwogoodsaresubstitutes. Negative crossprice elasticity on the other hand implies that an increase in PX causes a reductioninquantitydemandedofgoodY.Hence,thetwoproductsarecomplements.(e.g.tea andsugar,shoeandsocks,etc.) Note:Twogoods(XandY)havetwocrosspriceelasticities; i)

y. P elasticityofdemandforYwithrespecttoPX
X

ECON101:PrinciplesofEconomicsLectureNotes

22

y.P =
X

QY PX PX Q y

ii) x. Py elasticityofdemandforXwithrespecttoPY

x. Py =

Q X PY PY Q X

These two elasticities need not be equal. If crossprice elasticities are zero ( y. PX = x. Py =0),thenthetwogoodsareindependent/unrelated. PriceElasticityofSupply( S ) Thelawofsupplysimplytellsusthataspriceincreaseordecrease,thequantitysuppliedwill increaseordecrease,respectively.Butthelawdoesnttellusanythingabouthowmuchdoes quantitysuppliedincreaseordecreaseaspriceincreaseordecreasebyagivenamount.Supply elasticitytellsusaboutthemagnitudechangeinquantitysuppliedaspricechange. Definition:Thepriceelasticityofsupplyisanumberusedtomeasurethesensitivityofchange inquantitysuppliedtoagivenpercentagechangeinthepriceofagood.Alternatively,itcanbe defined as the percentage change in quantity supplied resulting from a 1% change in price, ceterisparibus.Thatis:

s =

%Q s Q s P = %P P Q s

s isalwayspositive noneedforabsolutevaluesign.
ClassificationofPriceElasticityofSupply:itcanbeclassifiedintoelastic,inelasticorunitary elastic. i) Elasticsupply:if s isgreaterthanone,thensupplyofanitemissaidtobeelastic(i.e. s >1). Supplyofanitemmaybeperfectlyelastic.Theshapeofelasticsupplycurveis horizontal.

s =i.e.asmallchangeinpricewillleadtoaninfinitechangeofquantitysuppliedby
firms.
Q 23 P

ECON101:PrinciplesofEconomicsLectureNotes

ii) Inelastic supply: if the price elasticity of supply is equal or greater than zero but less thanone,thensupplyissaidtobepriceinelastic. Mathematically; 0 s <1 Priceelasticityofsupplymaybeperfectlyinelastic,i.e. s =0,whichiscompletely unresponsivetopricechange.
Q P

iii) UnitaryElasticityofSupply:ifthepriceelasticityofsupplyisequaltoone( s =1),then supplyissaidtobeunitaryelastic. DeterminantsofElasticityofSupply: i. ii. iii. Time Availabilityoffactorsofproduction(resources) Possibilityofswitchingproductiontootherproducts

2.2. UtilityandConsumerEquilibrium* 2.2.1. UtilityandEquilibriuminConsumption Aconsumerbuysgoodsandservicebecauseithasutilitytohim/her.Utilityistheamountof satisfactiontobeobtainedfromagoodorserviceataparticulartime.Utilityhasnothingtodo with usefulness nor does it have any ethical connotation. Moreover, utility of a good varies frompersontoperson. According to the cardinal approach, utility can be measured and its unit of measurement is util. In the ordinal approach, on the other hand, utility cannot be measured but it can be compared. Following the cardinal approach and assuming that the consumer consumes n differentgoodsandservices,thentotalutiity(U)isthesumofutilitiesobtainedbyconsuming thevariousunitsofgoodandservices.i.e.

U = U 1 + U 2 + ... + U n = f 1 (q1 ) + f 2 (q 2 ) + ... + f n (q n )

whereqisquantitypurchased.

* Ayele K. (2006), Basic Economics, first edition, Addis Ababa, Ethiopia.

ECON101:PrinciplesofEconomicsLectureNotes

24

Theadditionalsatisfactionreceivedoveragivenperiodbyconsumingonemoreunitofagood isknownasmarginalutility(MU). A rational and utility maximizing consumer consumes goods and services in order of their utilities.Consumerequilibriumisestablishedwhenthemarginalutilitiespermoneyspentare equal on each good purchased and his/her money income available for the purchase of the goodshasbeenusedupcompletely.Thatis:

MU A MU B = = ... PA PB
Providedthat:

PA Q A + PB QB + ... = Y
Where UAmarginalutilityofgoodAandMUBmarginalutilityofgoodB M PApriceofAandPBpriceofB QAquantityofAandQBquantityofB YConsumerincome. 2.2.2. LawofDiminishingMarginalUtility The law of diminishing marginal utility states that the marginal utility of a good declines as moreofitisconsumed,overanygivenperiod.Forexample,ifaconsumerdrinksfivebottlesof cock, the amount of utility obtained from drinking the second bottle is less than that of the first;the3rdislessthanthatofthe2ndandsoon. TotalUtility 2.2.3. ConsumerSurplus Consumer surplus is the difference between what a consumer pays for some good or service andwhats/hewouldhavebeenwillingtopay.Thepriceaconsumerpaysforagoodmeasures onlytheMUbutnotthetotalutility.Onlyforthemarginalunitwhichaconsumerisjustready tobuypriceisexactlyequaltothesatisfactionthats/heexpectstogetforthatunit. Q MU Q TU Marginalutility

ECON101:PrinciplesofEconomicsLectureNotes

25

2.2.4. IndifferenceCurve Intheindifferencecurveanalysistheemphasisisoncomparingdifferentutilitylevelsinsteadof measuringthemthroughcardinalscale.Anindifferencecurveisalocusofpointseachshowing a differentcombination of two goods which yield the same satisfaction to the consumer. For examplethetablebelowshowscombinationoftwogoods,goodAandgoodB,betweenwhich aconsumerisindifferent. Combination a b c d e UnitsofgoodA 24 12 8 6 5 UnitsofgoodB 4 8 12 16 20

Movingfromonecombinationtoanother,theconsumerissubstitutingonegoodfortheother butmaintainingaconstantlevelofutilityderivedfromthem.Therageatwhichtheconsumer substitutes one good for the other so as to remain equally satisfied is the slop of the indifferencecurve.Itisknownasthemarginalrateofsubstitution:

MRS BA =

Q A ,MarginalrateofsubstitutionofBforA. QB

Characteristicsofindifferencecurve a. Anindifferencecurveslopsdownwardfromlefttoright b. Anindifferencecurveisconvextotheorigin c. Indifferencecurvesdonotintersectnortheyaretangenttooneanother I2 I1 QA I3 QB

Indifferencecurvesbythemselvescannottelluswhichcombinationistobechosen.Inaddition tohis/herdesire,theconsumermusthavethecapacitytopayforthegoods.Theconsumers
ECON101:PrinciplesofEconomicsLectureNotes 26

capacitywhichisindicatedbythebudgetlineisdeterminedbyhis/herincomeandthepricesof thegoods. Budget line: Y = PA Q A + PB QB . The budget line divides the area between quantity of A and quantityofBaxesintofeasibilityareaandnonfeasibilityarea.
E Budgetline

QB

Theutilitymaximizationrule

I QA

Consumerequilibriumisestablishedonthehighestattainableindifferencecurve.Forexample, inthefigureaboveconsumerutilityisatpointE.Atthispoint,theslopofthehighestattainable indifferencecurveisequaltotheslopofthebudgetline.Thisissobecausethetwoatetangent toeachother.

MU B PB = MU A PA
2.3. TheoryofProductionandCosts 2.3.1. TheoryofProduction

Theoryofproductionshowshoweconomicresourcesarecombinedtoproducecommodities. Ineconomics,theprocessbywhichinputsorfactorsofproduction(suchaslabour,equipment, etc.)arecombined,transformedandturnedintooutputsiscalledProduction. An input is any good or service, such as labour, capital, land and entrepreneurial ability that contributetotheproductionofaproduct.Theproducedproductiscalledoutput. Outputcanbeproducedindifferentways: i) Labour intensive technology: a technology that relies heavily on human labor rather than capital. E.g. large number of farmers using small shovels and their hand to cultivatefivehectaresofland. ii) Capital intensive technology: a technology that heavily relies on capital than human labor.E.g.threefarmerscultivatingfivehectaresoflandusingdifferentmachines. Inproductionactivitythereisacertainkindofrelationshipbetweeninputsandoutputs.And therelationshipbetweenanycombinationofinputsandthemaximumoutputobtainablefrom
ECON101:PrinciplesofEconomicsLectureNotes 27

that combination, expressed numerically, is called a Production Function. It is a technical relationshipthatsummarizesthelandoftechnologyforproducinganoutput. Mathematically: y = f ( L, K ) wherey=output,L=labourandK=capital. Tabularproductionfunction: Labourunits 0 1 2 3 4 5 6 Totalproduct 0 10 25 35 40 42 42 10 12.5 11.67 10 8.4 7 Average product

TheShortRunandtheLongRun A firm usesvarious inputs (factors of production) in a production process. And depending on thedurationofthetimeconsidered,inputsarecategorizedasfixedandvariableinputs.

FixedInputs:arethosefactorsofproductionforwhichthesupplycannotbechanged overashortperiod.Thus,fixedinputsareinputswhichdonotchangeinquantitywhen outputchangesinagivenshortperiod.(e.g.Buildings,machineries,etc.) VariableInputs:areinputsforwhichthesupplycanchangeinresponsetothedesired change in output in a short time. These inputs change in quantity to effect change in output.(e.g.labour)

Thedistinctionbetweenthetwoinputsisthetimethatisunderconsideration.Wehavetwo differentperiods: Short Run: is a period of time for which the firm is operating under a fixed factor of production. Under this period, at least one input is fixed. In the short run, production can be changed by changing variable inputs, but not fixed inputs. The firms plant capacityisfixedintheshortrun,butoutputcanbevariedbyapplyinglargerorsmaller amountsofvariableinputs.Intheshortrun,thereisalimittoproductionbecausethere isonlylimitedplantcapacityavailable. Long Run: is a period extensive enough for firms to change the quantities of all resourcesorinputsemployed,includingplantcapacity.Itisaperiodoftimeforwhich therearenofixedfactorsofproduction.
ECON101:PrinciplesofEconomicsLectureNotes 28

Note:theshortrunandthelongrunareconceptualratherthanspecificcalendartimeperiods. Theactualperiodoftimeencompassingthelongrunislikelytovaryfromindustrytoindustry. E.g.someproducersmightbeabletoincreasealloftheirinputsina monthand somemight takeyearstoincreasethecapitalinputsrequiredtoproducemoreoutput. 2.3.2. ProductionintheSortRun Productionintheshortrunischaracterizedbytheuseofsomevariableinputsandsomefixed inputs.Basedontheassumptionthatsomeinputs,likecapital,arefixedintheshortrun,the relationshipbetweeninputslikelabourandtotaloutputcaneasilybeestablished. Totalproduct(TP):isdefinedasthetotalquantityofproductproducedduringsomeperiodof timebyallfactorsofproductionemployedoverthatperiodoftime. Total product curve describes the relationship between the variable input and output, with fixedamountoftheotherinputsandundercurrenttechnology.

AverageProduct(AP)is theaverageamountof outputproducedbyeachunit ofthevariable input.

APL =

Total _ Pr oduct TP = Total _ Labor L

Average product curve shows the relationship between theaverage product and the variable input.

It indicates the productivity of labour (workers). APLinitially increases, reaches maximum and then decreases but it neverreacheszero.
ECON101:PrinciplesofEconomicsLectureNotes 29

Marginal Product (MP) is the increase in total output resulting from employment of small amountofthevariableinput.

MPL =

Change _ in _ total _ product TP = Change _ in _ amount _ of _ labor L

Marginalproductcurve:

MPL initially increasing, reaches a maximumanddeclinestozero,evento negativevalues.

Considertheinformationinthetablebelow. Totalproductincreasesatanincreasingrateuptothreeunitsoflabour(StageI),inStageII(i.e. forlaborunits4to9)totalproductincreasesatadecreasingrateandfinallyoutputdeclinesin Stage III. When the 9th labor is employed, the rate of increase in output is zero and total productisatitsmaximum. Unitof labour 0 1 2 3 4 5 6 7 8 9 10 TPL 0 8 20 39 52 60 66 69 71 71 68 APL 8 10 13 13 12 11 9.9 8.9 7.9 6.8
ECON101:PrinciplesofEconomicsLectureNotes 30

MPL 8 12 19 13 8 6 3 2 0 3

Stagesof production StageI StageIII StageII

RelationshipbetweenTotalProductandMarginalProduct MPisthechangeinTPdividedbychangeinlabor.ThismeansthatMPistheslopofTPcurve. TheTPfirstincreases,reachesmaximumandthendeclines.Thisiscalledthelawofdiminishing returns or the law of diminishing marginal productivity. (This law starts to effect from the maximumpointofMP,i.e.thelawappliesforthedecreasingportionoftheMPcurve) Thislawstatesthat,holdingotherinputsconstant,asvariableinputisinincreasedwithequal amount,eventually,theadditiontototalproductwilldecline. Additionalworkerswillhavelessoftheotherinputs,likemachines,thanearlierworkerswho hadaccesstoamplequantitiesoftheotherinputs. TherelationshipbetweenTPandMPis: If MP>0, TP will be rising as labor rises. The additional worker adds something to the totaloutput. If MP=0, TP will be constant as labor increases. The additional worker does not affect output. If MP<0, TP will be falling as labor increases. The additional worker actually reduces totaloutput. The point where MP stops increasing and starts decreasing is called inflection point, because thecurvatureoftheTPcurvechangesatthispoint.Itisherethatdiminishingreturnsstart. APcurveanditsrelationtoMPandTPcurve

APL =

Total _ Pr oduct TP = Total _ Labor L

Averageproductofavariableinputisrepresentedbytheslopofaraydrawnfromtheoriginto apointonthetotalproductcurve,correspondingtothegivenamountofthevariableinput.

Asweincreaselaborusefrom0unitstoa,tobandtocunits,thelinesfromtheorigintothe corresponding points on the TP curve first become steeper, i.e. AP increases, and eventually
ECON101:PrinciplesofEconomicsLectureNotes 31

flatter,meaningAPwillbedecreasing.ThemaximumpointontheAPcurvecorrespondstothe slopoftherayfromtheoriginwhichistangenttotheTPcurve. Rememberthatmarginalproductofavariableinputismeasuredbytheslopofthetangentline to the total product curve corresponding to the given amount of the variable input. This is because;bydefinitionthemarginalproductofagivenamountofinputisthechangeinoutput asthevariableinputchangesbyasmallamount. So,whenAPismaximum,thenitisequaltotheMP.ThentheAPdeclinesasweemploymore andmorevariableinputsbeyondthistangencypoint(MP=AP). StagesofProduction BasedonthebehaviorsofMPandAP,productioncanbeclassifiedintothreestages: StageI:MP>0,APisrising.ThusMP>AP StageII:MP>0butAPisfalling.MP<APbutstillTPisincreasingduetoMP>0. StageIII:MP<0,TPisfalling. NoprofitmaximizingproducerwouldproduceinstagesIandIII.InstageI,byaddingmoreunits oflabor,theproducercanincreasetheaverageproductivityofalltheunits.Thusitwouldbe unwiseonthepartoftheproducerstostopproductionatthisstage.

Point A is inflection point whereMPismaximized

Point B is where AP is maximized,henceAP=MP

At point C, TP is maximum andMP=0

ECON101:PrinciplesofEconomicsLectureNotes 32

InstageIII,itdoesnotpayfortheproducerstobeinthisregionbecausebyreducingthelabour unit, a producer can increase total output and save the cost of production. Hence, the economicallymeaningfulrangeisStageII. 2.2.3 AnalysisofCostsintheShortRun,Fixed,Variable,Total,AverageandMarginal Costs EconomicCostisthemonetaryvalueofallinputsusedinaparticularactivityorenterpriseover agivenperiodtomakegoodsorservicesavailabletousers. Theideabehindeconomiccostofanyresourceinproducingagoodisthatitmustreflectthe valueofthoseresourcesintheirbestalternativeusesi.e.opportunitycost. Economiccostcanbeeitherexplicitorimplicit. Economiccost=Explicitcost+Implicitcost Implicitcostsarethevaluesofinputswhichareownedbythebusinessmen. Explicitcostsarethemonetarypaymentsorcashexpendituresthatafirmmakestooutsiders whosupplyinputs. Accounting Costs are the explicit costs of operating a business (theactual payments that are made). Due to the different explanation of costs, economists and accountants use the term profit differently. Accountingprofit=Totalrevenueexplicitcost =TotalrevenueAccountingcost

Economic/pureProfit=TotalrevenueEconomiccost =TotalrevenueOpportunitycostofallinputs(implicitandexplicit) Costs in Short-run Intheshortrunsomeresourcesarefixedandothersarevariable.Thisimpliesthatintheshort run,costscanbeclassifiedaseitherfixedorvariable. Fixedcostsarecoststhatdonotvarywithchangesinoutput. Supposeyouareearning22,000birrayearasasalerepresentativeforaTshirtmanufacturing. AtsomepointyoudecidedtoopenaretailstoretosellTshirtsonyourown.Youmustinvest 20,000 birr of your saving that have been earning an interest of 1000 birr per year. And you decidedthattopay18,000birrforaclerk. Ayearafteryouopenthestore,youtotalupyouraccountandfindthefollowing. Totalsellrevenue120000
ECON101:PrinciplesofEconomicsLectureNotes 33

CostofTshirt40000 Clerkssalary18000 Utilities5000 Total(explicit)cost63000 Accountingprofit57000 Question: calculate the economic profit assuming that your entrepreneurial talent is worth 5,000birr. Normal Profit Vs Economic Profit (Pure Profit) The 5,000 birr is implicit cost of your entrepreneurial talent in the above example, called a normal profit. The payment you could otherwise receive for performing entrepreneurial functioniscalledanormalprofitandisanimplicitcost.Totheaccountant,profitisthefirms totalrevenuelessitsexplicitcosts. To the economist, economic profit is total revenue less economic costs including the normal profit. If a firms total revenue exceeds all its economic costs, any residual goes to the entrepreneur.Theresidualiscalledeconomicprofitorpureprofit. Totalfixedcostisthesamebothatzerolevelofoutputandallotherlevelofoutput. E.g.building Fixedcostscannotbeavoidedorchangedintheshortrun. Firmshavenocontroloverfixedcostsintheshortrunandhencetheyaresometimescalled sunkcosts. Variablecostsarecoststhatchangewiththelevelofoutputintheshortrun. The total variable cost is the market value of the minimum quantity of the variable inputs consistent with the prevailing technology and factor prices required to produce the various quantitiesofoutput. Variouscostscanbecontrolledoralteredintheshortrunbychangingproductionlevels. Therefore,intheshortrunfixedcostsandvariablecoststogethermakeuptotalcosts. TC=TFC+TVC

Thetotalcostfunction:TC=TFC+V(Q) Costfunctionexpressestherelationshipbetweencostandthecorrespondingoutput.

ECON101:PrinciplesofEconomicsLectureNotes

34

Total Fixed, Total Variable and Total Cost Curves Totalfixedcostcurves:isagraphthatshowstherelationshipbetweentotalfixedcostandthe firmsoutput. Sincetotalfixedcostsisconstantinshortrun,itisalwaysahorizontal,straightline. Totalvariablecostcurve:agraphwhichshowstherelationshipbetweentotalvariablecostand thelevelofafirmsoutput. Sincemoreoutputcostsmoreintotalthanlessoutput,totalvariablecostcurvehasapositive slope. TotalVariableCostalwaysstartsattheoriginandrisestotherightfirstatadecreasingrateand thenatanincreasingrate.Thisisduetothelawofdiminishingreturnsintheshortrun,asthe firm increases production larger and larger amounts of variable input are needed to produce eachsuccessiveunitsofoutput. Totalcostcurve:itisagraphthatshowstherelationshipbetweentotalcostandthelevelofa firmsoutput.

Atzerounitsofoutputtotalcostisequaltothefirmsfixedcost.Andthenforeachunitof outputtotalcostvariesbythesameamountasvariablecost.Asaresultthetotalcostcurve beginsfromthelevelofthefixedcostandmovesparallelwiththetotalvariablecostcurve. TC Cost TVC Output FC 0 1 2 3 4 5 TFC 6 7 Output 8 200 208 408 200 200 200 200 200 200 200 200 VC 0 50 90 120 140 150 156 175 TC 200 250 290 320 340 350 356 375

ECON101:PrinciplesofEconomicsLectureNotes 35

Averagecosts Average costs are important as we may make comparisons with product price, which is alwaysstatedonperunitbasis. Averagefixedcosts(AFC):isfoundbydividingtotalfixedcostbyoutput.

AFC =

TFC Q

Since total fixed costs are constant or independent of output, average fixed cost will continuouslydeclineaslongasoutputincreases. Average variable cost (AVC): Is obtained by dividing total variable cost by output. TVC AVC = Q Sincetotalvariablecostreflectsthelawofdiminishingreturns,somusttheaveragevariable costbecauseaveragevariablecostisderivedfromtotalvariablecost. Due to increasing returns, initially takes fewer and fewer additional variable resources to produceeachofthefirstfewunitsofoutput. AfterAVChitsminimumitwillstarttoriseasdiminishingreturnsrequiremoreandmore variableresourcestoproduceeachadditionalunitofoutput.

AVCisUshaped.
Averagetotalcost(ATC):istotalcostdividedbytotaloutput.

ATC =

TC Q

Average cost

ATC

AVC

ATC=AVC+AFC

TC TVC TFC = + Q Q Q

ATC Unitof output

ECON101:PrinciplesofEconomicsLectureNotes

36

Diminishingreturns The reason behind the shape of AVC and AVC lies in the shape of the marginal product curve. At first, marginal product is increasing, i.e. smaller and smaller increase in the amountsofvariableresourcesisneededtoproducesuccessiveunitsofoutput.Hence,the variablecostofsuccessiveunitsofoutputdecreases. But when as diminishing returns are encountered, marginal product begins to decline, larger and larger additional amounts of variable resources are needed to produce successiveunitsofoutput.Totalvariablecostincreasesbyincreasingamounts. TheshapeofATC,AFCandAVC Output(Q) AFC 1 2 3 4 5 6 7 8 AsAFC=TFC/QandTFCisfixed,AFCdeclinescontinuouslyasoutputexpands. ATCalwaysexceedsAVCduetothefactthatATC=AVC+AFCandAFCisalwayspositive. However,sinceAFCfallsasoutputincreases,AVCandATCgetcloserasoutputrises. - AVCfirstdeclines,reachesaminimumandthenstartsincreasing. TheRelationshipofMC,AVCandATC 200 100 66.7 50 40 33.3 28.6 25 AVC 50 45 40 35 30 26 25 26 ATC 250 145 106.7 85 70 59.5 36 51
ATC
Unitofoutput

Average cost

ATC

AVC

MCistheextracostofproducingonemoreunitofoutput. ThemarginalcostcurveintersectsboththeAVCandATCcurvesattheirminimum points. Thisrelationshipisamathematicalnecessity.Ifthemarginalcostisbelowaveragetotalcost, averagetotalcostwilldeclinetowardsmarginalcost.

If marginal cost is above average total cost, average total cost will increase, i.e. ATC, always movestowardsMC.Asaresult,marginalcostintersectsaveragetotalcostatATCsminimum

ECON101:PrinciplesofEconomicsLectureNotes

37

point. By the same reasons marginal cost intersects average variable cost at AVCS minimum point. No such relationship exists for the MC curves and the AFC curve because the two are not related. MC includes only those costs which change with output, and FC and output are independent. The average variable cost reaches its minimum before the average total cost becauseoftheinclusionofaveragefixedcost. MC ATC Average AVC TC MC = cost Q

NotethatTC=TFC+TVC TC=TFC+TVC

MC = MC =

TC TFC TVC + = Q Q Q TVC becauseTFC/Q=0,SinceTFC=0 Q

ATC
Unitofoutput

- IfMC<ATC,thenATCisfalling - IfMC>ATC,thenATCisrising,i.e.ATC=MCatminimumATC IfMC<AVC,thenAVCisfalling IfMC>AVC,thenAVCisrising,i.e.AVC=MCatminimumAVC


ThisimpliesthatMCintersectsATCandAVCattheirminimumpoint. Relationshipbetweencostandproduction

AveragetotalcostandmarginalcostcurvesareUshaped. AverageproductandmarginalproductcurvesareinvertedUshape. Theadditionalcostofproductionofagoodislowestattheoutputlevelwhere theadditionalproductofthevariableinputismaximum, MPmax MCmin Similarly,theaveragevariablecostisminimumwhentheaverageproductofthe variableinputismaximum, APmax AVCmin Thus, MC and AVC curves are mirror images of the MP and AP curves respectively.

ECON101:PrinciplesofEconomicsLectureNotes

38

TP Q Considerasinglevariablefactor;labor(L)andallotherfactorsarefixed.Thewage rateisgivenbywanditisconstant. TVC=w.L AVC=TVC/QbutTVC=w =w.L/Q AVC=w(L/Q) MP C MC AC AP L

ThisshowsthatAVCandAPLareinverselyrelated.AsAPincreases(decreases),AVC decreases(increases). RememberthatAPL=Q/LandL/Q=1/AP AVC=w/APL

Againnotethat;TC=TVC,sinceTFC=0 TC=(w.L) TC=w.L

MC =

TC TVC w.L = = Q Q Q

ECON101:PrinciplesofEconomicsLectureNotes

39

But

Q L 1 = MPL = L Q MP
w MPL

MC =

ThisalsoimpliesthatMCandMParenegativelyrelated.AsMPincreases (decreases)MCdecreases(increases). 2.3TheProfitMaximizingCompetitiveFirm A competitive firm is one which sells its products in a perfectly competitive market. The priceofaproductisuniformthroughoutthemarketandeachsellerissmallinreactionto thetotalmarketsale,andhencecannotaffectthepriceofaproduct. Thuseachsellerisa"pricetaker".Eachsellerseesthemarketdemandcurveforitsdemand asperfectlyelastic,i.e.thedemandcurvefacingaperfectlycompetitivefirmishorizontal. P* S Q Q P Firmssupply P MarketDemand

The demand curve facing a perfectly competitive firm is similarly a horizontal line at a marketequilibriumprice. P P Firmsdemand S Q
*

P* D

P* Q

D Q

Total,AverageandMarginalRevenue Total Revenue (TR)isthetotalamountthatafirmtakesinaformofrevenueofitsproduct. Totalrevenueisthen,thepriceperunittimesthequantityofoutputthatthefirmsold. TotalRevenue=priceXquality TR=PxQ

ECON101:PrinciplesofEconomicsLectureNotes

40

AverageRevenue(AR)isthequotientoftotalrevenueandquantitythatissoldinthemarket. Averagerevenue=

Total.revenue TR P Q = = = P Quantity.sold Q Q

MarginalRevenue(MR)istheadditionalrevenuethatafirmtakesin,whenitincreasesoutput byasmallchange(byoneadditionalunitforpracticalpurpose)

MR =

TR ( P.Q) P.Q = = = P Q Q Q

Thus,MRcurvefacingaCompetitivefirmisupwardslopingstraightlinewhichstartsformthe originandrisesbyafixedamountforeachadditionalunitoftheproductsold. Example Price 15 15 15 15 15 15 15 ProfitMaximizationofaperfectlycompetitivefirm Therearetwowaystodeterminethelevelofoutputatwhichacompetitivefirmwillrealize maximumprofit.


ECON101:PrinciplesofEconomicsLectureNotes 41

Revenu TR

MR=AR=P

Quality 0 1 2 3 4 5 6

TotalRevenue 0 15 30 45 60 75 90

AR 15 15 15 15 15 15

MR 15 15 15 15 15 15

TC 10 5 25 30 40 60 90

ComparingTRandTC(TC&TRApproach) ComparingMRandMC(MR&MCApproach) 1. TRandTCApproach Afirmsshortrunprofitismaximizedwhenthedifferencebetweentotalrevenueandtotal costisthehighest TC TR TC>TR>TVC,thefirmwillproducebycoveringTVCandpartofitstotalfixedcost,because thefixedcostisthecostthatthefirmusedtopayevenatzerolevelofoutput. Caseofclosedown WhenTR<TVC,thefirmhastostopproduce. 2. a Q P=MR P MRMCApproach Q Q TC Breakevenpoint TRTCismaximum TR

ItseemsseasonabletopickoutputatwhichMCisatitsminimumpoint. At a the difference between MR and MC is maximum. But at this point the MR>MC, indicatingthatprofitisnotbeingmaximized.Thatistheadditionalrevenuethattheseller hasgotisgreaterthantheadditionalcosthehasincurred.

Theprofitmaximizingperfectlycompetitivefirmwillproduceuptothepointwherethe price,orthemarginalrevenue,ofitsoutputisjustequaltotheshortrunmarginalcost.
42

ECON101:PrinciplesofEconomicsLectureNotes

When ismaximized,theslopeof curveequalszero. AtMaximumprofit,slope=0=

d dQ

d dTR dTC = = 0 dQ dQ
MRMC=0 MR=MC soatthemaximumprofit(minimumloss),MRequalsMC Note: Although output level where MC = P* is a profit maximizing level of output for the competitive firm, it may or may not result in a positive economic profit i.e it may take positive, zero, or negative economic profits for a given cost function. The level of profit actuallydependsuponthemarketprice.

WhenP*>ACatanoutputlevelwhereMC=P*,thefirmearnspositiveprofit ThefirmprovidespositiveoutputandcontinueproductionatonoutputlevelwhereMC =P*ifP*>minAVCbecause,atthislevelthefirmwillcoverallitsvariableandpartof itsfixedcost. When P* = minimum of AC at an out put level where MC = P*, the firm earns zero economicprofit(itearnsonlynormalprofit).Then,thefirminthiscaseissaidtobreak even. Inthiscasethefirmwillbeindifferentaswhetherornottoproduceatanoutputlevel whereP*=MCifP*=minAVC.BecauseatthislevelitcoversitsTVCandfacesalossof TFC,whichcouldhavebeenincurredevenatzerooutput. When P<minimum of AC at an output level where MC=P*, the firm incurs loss since TC<TR.

ECON101:PrinciplesofEconomicsLectureNotes

43

Profit MC AC

Indifferen

MC AC

Loss

MC AC MR

P*

Q Q Q

P*<minAVCattheprofitmaximizinglevelofoutputresultinalossofthevariablecost, whichthefirmcanavoidbyceasingproduction. Hence,theminimumAVCiscalledtheshutdownpoint. Derivationofthesupplycurveofafirm InthefigurebelowatpointB,P2=MC=ATCwhichmeansthatthefirmwillbemakingonly normalprofit.PointBisthebreakevenpoint.IfpricedecreasesbelowP2,thefirmwillbe makinglossbecausepricewillbelessthanAC.Intheshortrun,thefirmmaycontinueto supply even when price is less than AC provided it is above AVC (at point A). Point A is known as the shutdown point. Therefore, the shortrun supply curve of the perfectly competitivefiristhatpartoftheMCcurewhichliesaboveAVC.
P4 P3 B A ATC AVC MC Supply

P2 P1

Q1 Q2 Q3 Q4

2.4 ReviewofMarketImperfection Summery Numbers Product Firmshaveprice Free firms differentiation settingpower entry Homogeneous Differentiated No Yesbutlimited Yes Yes Distinguishers Price computation Price & quality

Many Perfect Computation Monopolistic Many

ECON101:PrinciplesofEconomicsLectureNotes

44

Computation Oligopoly Monopoly Monopsony Few one Either Singleproduct Yes Yes Limited No

computation Strategic behaviour Still constant marketdemand

- Isamarketwithonlyonebuyercalled'monopsonist'facingmanysellers, Marketissaidtobeimperfectwhenoneormoreoftheassumptionsofaperfectlycompetitive marketarenotsatisfied.


Pure monopoly Amarketissaidtobemonopolywhenthereexistsonlyonesupplierofaproductforwhich thereisnoclosesubstitute.

Featuresofpuremonopoly i. Singleseller ii. Theproductshavenoclosesubstitutese.g.publicsectormonopolyinwatersupply iii. Pricemaker:Amonopolistcanset/controlthepriceatwhichitsellstheoutput.In essencethemonopolististhepricemaker.(e.g.ETCsmobilesubscriptionandair timetariffs) iv. Huge barrier to entry: Legal, financial and/or technological barriers makes it difficult. The following entry barriers have been associated with the existence of monopoly; - Controlofinput:Afirmmayownthetotalsupplyofrawmaterial,which isessentialintheproductionoftheproduct. - Patent: this is an exclusive right to produce the product granted to the inventor of the product. Monopolist may also have unique access to a techniquethatisusefulintheproductionofsomegoodorcouldhavethe solerighttoproducethegood(patent). - Economies of scale: because of the level of technology used by the monopoly,thecostmaybelowerthanthesmallfirmssharingor(trying toshare)themarket.Thisblocksentry. - License:governmentsometimesblocksentryintoaparticularmarketby requiring firms to have governmentally provided license as a condition foroperatinginsuchmarket. - Entry lag: entry to some market takes time. This gives the firms temporarymonopolytime. o Monopoly market is characterized by absence of competition. Hence, it is the most inefficientmarketstructure.
ECON101:PrinciplesofEconomicsLectureNotes 45

o Monopolists also practice price discrimination i.e. the same good is sold at different pricestodifferentbuyersand/orindifferentmarkets. Monopolists Demand, Marginal Revenue and Total Revenue Curve Since the monopoly is the only seller of the product, its demand curve is the same as the market(industry)demandcurve.Assuch,themonopolistdemandcurveisdownwardsloping. Amonopolistispricemaker.Sinceamonopolistfaceanegativeslopeddemandcurve,asprice increasesthequantitydemandeddecreases. D Q Thisnegativelyslopeddemandcurveshowsthatthemonopolistmustdecreasepriceinorder tosellmoreoutput. o Monopoliststotalrevenue(R)is: R=P.QThisisnomorelinearbecausePisnotconstant. o Marginalrevenue(MR):istheadditionalrevenueattributedtothesellofonemoreunit ofoutput. dP TR dR d ( P.Q) becausebothPandQarevariable MR = = = = P + Q. Q dQ dQ dQ MRisafixedamountbutvariedwiththequantitiessold.
Q.dP = MR = P1 + P.dQ 1 MR=0orTRismaximumat d =1andMR<P. P 1 d

DandMRstartatthesamepointontheverticalaxisbecausetheMRofthefirstunitsold equalsthepriceofthegood.

Showthisusingtheinversedemandfunction:P=a+bQ AlsoshowthatRismaximumatoutputwhereMR=0ord=1 Atmidpointofthedemandcurve,MRiszero(|Ed|=1),MRiszero;Rismaximum 1 = 0 at|Ed|=1 MR = P1 d

- Whendemandisinelastic(|Ed|<1),MR<0;Risdecreasingwithoutputincrease. - Whendemandiselastic(|Ed|>1),MR>0;Risincreasingwithoutput.

ECON101:PrinciplesofEconomicsLectureNotes

46

Tabularexample: MR TR Q P

d > 1 d = 1 d < 1
D Q

P 11 10 9 8 7 6 5 4 3

Q 0 1 2 3 4 5 6 7 8

R 0 10 18 24 28 30 30 28 24

MR 10 8 6 4 2 0 2 4

AR=P 10 9 8 7 6 5 4 3

d < 1 d < 1
AR=R/Q=P.Q/Q=P

NB.MR=P=10forthefirstoutput,butforallotheroutputsold,MRislessthanP (MR<P) Rismaximum(30)whenMR=0

Profit Maximizing under Monopoly The objective of a monopolist is to maximize profit. There are two approaches to profit maximizationundermonopoly; a. TCTRApproach InthisapproachmonopolistsprofitissaidtobemaximizedwhenthedifferencebetweenTR andTCishighest i.e.=TRTCishighest =Q(PATC)

Graphically,profitismaximizedwhentheverticaldistancebetweenRandTCishighest. Q*isthemonopolistsprofitmaximizinglevelofoutput.

ECON101:PrinciplesofEconomicsLectureNotes

47

TC Q Q* b. MarginalApproach Inthisapproach,profitismaximizedwhenMR=MC
1 Rememberthat MR = P1 d 1 =MC Henceprofitismaximizedwhen MR = P1 d

TR

Graphically,theprofitmaximizationlevelofoutputoccurswhenMRintersectsMC(whileit isrising): TheprofitmaximizinglevelofoutputoccurswhenMC=MR<P

SincecompetitivefirmsproducewhenMC=P,amonopolizedindustrychargeshigher priceandproducesmalleroutputthanwouldcompetitiveindustry.

P P*

MC ATC

D Q* Q

MR Supposethedemandfunctionforamonopolistisgivenby:P=108Q Andthecostfunctionis C(Q)=Q2+Q+3

Findprofitmaximizinglevelsofoutputandpriceusing:TotalapproachandMarginal approach
ECON101:PrinciplesofEconomicsLectureNotes 48

Taxonomy of Imperfect Market Models Inadditiontopuremonopoly,thereareothertypesofimperfectmarketssuchas;oligopolyand monopolisticcompetition. Oligopoly: is a market structure characterized by a few firms selling either uniform or differentiatedproducts.Asaresult,thereismutualinterdependenceamongthefewfirms,i.e. theactionofonefirmwillhavesignificanteffectontheother.(Readthedetail) Monopolistic Competition: is a market structure where many small firms sell differentiated products.(Readthedetail) SummaryofImperfectmarket Description No.offirms Typesofproduct Pricediscrimination Entryintothe industry Puremonopoly One Nosubstitute Blocked Difficult Easy Oligopoly few Differentiatedor homogenous Monopolistic competition Largeno.butsmall seller differentiated

ECON101:PrinciplesofEconomicsLectureNotes

49

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