Intro to Econ Material

BAHIR DAR UNIVERSITY
COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ECONOMICS

INTRODUCTION TO ECONOMICS

COURSE MATERIAL

Prepared by:

YONATHAN M. (CHAPS. 1-2)
GETACHEW Y. (CHAPS. 3-4)
SURAFEL M. (CHAPS. 5-6)

MOLLA W. (CHAP. 7)

Edited by:

NATNAEL S.
GETACHEW Y.

JAN 2012
BAHIR DAR

TABLE OF CONTENTS
CHAPTER ONE: BASIC CONCEPTS IN ECONOMICS ................................................................................ 1
1.1 Definition of Economics ........................................................................................................... 1
1.2 Types of Economic Resources................................................................................................... 3
1.3 Rationale for Studying Economics............................................................................................ 3
1.4 Scarcity , Choice and Opportunity Cost.................................................................................... 3
1.5 The Methodology of Studying Economics ................................................................................. 4
1.6 Classifications in Economics.................................................................................................... 5
1.7 Production Possibility Frontier (PPF) ..................................................................................... 6
1.8 Basic Economic Problems ........................................................................................................ 9
1.9 Alternative Economic Systems ................................................................................................ 10
1.10 Decision Making Units and the Circular-flow of Economic Activities..................................... 11
CHAPTER TWO: THE THEORIES OF DEMAND AND SUPPLY .................................................................. 13
2.1 The Theory of Demand........................................................................................................... 13

2.1.1 Determinants of Demand.................................................................................................. 14
2.1.2 A Shift in Demand ............................................................................................................ 15
2.1.3 Elasticity of Demand........................................................................................................ 16
2.2 The Theory of Supply.............................................................................................................. 21
2.2.1 Determinants of Supply .................................................................................................... 22
2.2.2 A shift in Supply ............................................................................................................... 22
2.3 Market Equilibrium................................................................................................................ 23
CHAPTER THREE: THE THEORY OF PRODUCTION .............................................................................. 28
3.1 The Production Function........................................................................................................ 28
3.2 The Period of Production ....................................................................................................... 29
3.2.1 The Short-run Production Function.................................................................................. 29

3.2.1.1 Total, Average and Marginal Products ..................................................................... 30
3.2.1.2 Stages of Production ................................................................................................. 33
3.2.1.3 The Law of Diminishing Marginal Product (LDMP) ................................................. 34
3.2.2 The Long-run Production Function .................................................................................. 34
3.2.2.1 Isoquants and Isocosts .............................................................................................. 35
3.2.2.2 Optimum of the Producer in the Long-run................................................................. 38
3.2.2.3 Returns to Scale ........................................................................................................ 41
CHAPTER FOUR: THE THEORY OF COSTS........................................................................................... 42
4.1 Analysis of Costs in the Short-run........................................................................................... 42
4.1.1 Total, Average and Marginal Costs.................................................................................. 42
4.1.2 Comparing Production and Cost Curves in the Short-run................................................. 46

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CHAPTER FIVE: PERFECT COMPETITION ........................................................................................... 48
5.1 What is Perfect Competition?................................................................................................. 48
5.2 Total Revenue, Marginal Revenue and Demand Curves of a Competitive firm........................ 49
5.3 The Firm’s Decision............................................................................................................... 50
5.4 Profit Maximizing Output....................................................................................................... 50
5.5 Demand for a Firm’s Product and Market Demand................................................................ 53
5.6 Profits and Losses in the Short-run......................................................................................... 53
CHAPTER SIX: IMPERFECT COMPETITION.......................................................................................... 56
6.1 Monopoly............................................................................................................................... 56

6.1.1 How Monopoly Arises ...................................................................................................... 57
6.1.2 Monopoly Price Setting Strategies.................................................................................... 57
6.1.3 Price and Output Decision of a Single Price Monopolist .................................................. 57
6.2 Monopolistic Competition ...................................................................................................... 60
6.2.1 What is Monopolistic Competition?.................................................................................. 60
6.2.2 Price and Output in Monopolistic Competition................................................................. 61
6.2.3 Monopolistic Competition and Perfect Competition ......................................................... 62
6.3 Oligopoly ............................................................................................................................... 63
6.3.1 The Traditional Model of Oligopoly: The Kinked Demand Curve Model .......................... 64
CHAPTER SEVEN: MACROECONOMICS ................................................................................................ 66
7.1 Problems of Macroeconomics ................................................................................................ 66
7.2 National Income Accounting .................................................................................................. 69
7.2.1 Basic Concepts in NIA...................................................................................................... 70
7.2.2 Approaches to Measuring GNP: Product, Expenditure and Income ................................. 71
7.2.3 Nominal and Real GDP.................................................................................................... 73
7.2.4 National Product and the Informal Economy.................................................................... 73
7.2.5 GNP and Economic Welfare............................................................................................. 74
7.3 Fluctuations in Economic Activities: Unemployment and Inflation ......................................... 75
7.4 Aggregate Demand and Supply Equilibrium........................................................................... 76
7.5 Economic Policy Instruments: Monetary, Fiscal and Income policies..................................... 80

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CHAPTER ONE: BASIC CONCEPTS IN ECONOMICS

1.1 Definition of Economics

Have you ever heard of the term economics? If yes, how have you understood it? If no, what do you expect the

discipline of economics to deal with?

Just consider the following terms, and judge the level of your knowledge on them.

− Inflation − Consumption of goods and services

− Unemployment − Exchange of goods and services

− Interest rate − Price of goods and services

− Exchange rate − Cost and profit of doing a business

− Saving − Import and export of goods and services

− Investment − Making a choice among various options

− Production of goods and services

Each of the above variables falls under the domain of economics. Of course, these are only very few of the many
issues that the discipline of economics encompasses.

You may think this is a good example. Unfortunately, this is not the case. You can’t have a vivid example which
can fall out of the domain of economics. Therefore, economics a powerful and dominant science, its analysis is
applied throughout society, in business, finance and government, but also in education, health, law, politics,
religion, culture, crime, war, etc. Because of this, in the today’s modern world the expanding domain of
economics in science thinking has been described as economic imperialism.

You can also understand the growing influence of economic philosophy from your own experience. You may
have mentioned so many reasons in this regard. However, despite the number of reasons you mentioned, we can
easily associate all of them with economics. Since everybody knowingly or unknowingly lives in an
economically defined life, it is pertinent to introduce you with the science of economics so that you would be
familiar with all or some of the aforementioned economic variables and you would able to think logically and
decide rationally in your day to day life. Just take your time to think of the following issues.

• Have you ever experienced an increase in living expense from time to time?
• How many of your friends or people living in your locality managed to secure a job?
• What percent of your income do you reserve for future use?
• Have you ever deposit money in a bank and lent to somebody else? Or, Have you ever borrowed money

from a bank or somebody else? What have return have you got or what cost have you incurred?
• Have you ever bought and used a commodity bought from China? Or, have you, or any people, or

organization sold good to a foreigner?
• Have you ever engaged in buying and selling of commodities? And, have you ever negotiate on price of

the commodities?
• Have you ever considered your choice for watching a movie in the cinema over studying this course in

the library?
These are the very few economic aspects which you experience in your day-to-day life. Therefore, to better
understand these and other similar issues in your personal and professional career, you need to acquaint yourself
to the basics of economic science.

Hence, regardless of the various ways people understand economics, and the many ways scholars define
economics, one can easily understand the concept in one of the following ways.

i) Economics is a branch of social science that deals with the production, distribution and consumption of
goods and services and their management.

ii) Economics is the management of scarce resources such as land, labor, and capital to produce, distribute,
and sell tangible objects or to provide services in order to satisfy apparently unlimited human wants.

iii) Economics is the study of choice making by individuals, institutions, societies, nations and the world,
under conditions of scarcity and surplus, towards maximizing benefits and satisfying the unlimited
present and future needs. The subject economics is defined as the study of choices by all in maximizing
production and consumption benefits with the given resources of scarce and surplus, for present and
future needs.

Given the above three different, but closely related, definitions, one can easily understand economics in a very
simple and concise language, as a science dealing with the efficient allocation and wise use of scarce
resources to satisfy unlimited wants.

The terms in this definition need additional explanation.
Efficiency – refers to doing things right. It does mean also producing the same level of output with the required
quality with a less cost (effort) than alternative ways.
Example: assume two farmers, A and B. Suppose that farmer has harvested 10 quintal of teff after incurring a
cost of Birr 200 to purchase fertilizer, pesticides, seeds and the like. On the other hand, farmer B has incurred
Birr 300 to harvest the same quintals of teff having the same quality as the teff of farmer A. Which one of the
two farmers do you think has used efficient teff harvesting mechanism? As per the definition, efficient
production system has been used by farmer A; because he/she has managed to produce the same amount of
output with smaller cost of harvest.

Allocation – refers to distribution of resources for alternative activities.

Scarcity- refers to the limited availability of economic resources in a way less than what people actually want. a
resource is said to be scarce if the total demand for it exceeds its total supply at zero price level (without
payment) and its supply can be affected by price. Scarcity limits us both as individuals and as a society. As
individuals, limited income (also time and ability) keep us from doing and having all that we might like. As a
society, limited resources (such as manpower, machinery, and natural resources) fix a maximum on the amount
of goods and services that can be produced.
Example: Lets us assume you need to perform three types of activities in a day, namely reading this course,
visiting your relatives/friend and sleeping. Let us also assume that you need 9 hours to read and fully understand
this course; 8 hours to visit your friends and relatives; 8 hours to sleep comfortably. In other words, you need a
total of 25 hours for the three activities to be performed in one day. Do you think can you perform them as per
required time?
The answer is no. This is because of the naturally limited availability of time within a day. A day has only 24
hours. Therefore, time is one of the scarce resources.

Unlimited Human Wants - this refers to the ever increasing and escalating interest of human beings to have a
command over resources and various opportunities over its life cycle.
Example: Do you remember what made you happy when you were a kid? Do you remember your wishes in your
childhood? Have you realized these wishes? Are you satisfied with them? Or still wishing for more wealth,
fame, social recognition, power? Just ask yourself. I wonder who is ever satisfied or have stopped wishing for a
better life?

The above concepts clearly indicate that there are two fundamental facts, which are the foundation for the field
of economics. The first fact is: human wants (needs) are unlimited. The second is: economic resources-the
means of producing goods and services and satisfying human wants-are limited in supply or they are scarce.
With human wants being unlimited and resources being scarce, it is impossible, therefore, to satisfy all our
wants and desires by producing and consuming everything we want. Thus, a society has to decide to efficiently
use its scarce resources and to obtain the maximum possible satisfaction from them. This is the central concern
of the subject matter of economics. Because of this fact, some believe that economics as a science wouldn’t have
existed had it been the case that resources were not scarce.

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1.2 Types of Economic Resources

Since the birth of economic science and its philosophy is highly linked with efficient utilization of resources, it
would be rational to discuss here about the various types of resources. Resources in economics are
conventionally classified into the following four broad categories:
a) Land (Natural Resource) – to economists, land refers to all resources that are freely gifted by nature.

Natural resources are also classified in to three broad categories.
• Renewable natural resources:-these are resources whose quantity and /or quality can be degraded by

unwise use but whose quantity and /or quality can be maintained when used wisely. E.g. forest, fertile
land ,wild animals etc
• Exhaustible natural resources:-natural resources which may get exhausted (end-up) some times in the
future if used uneconomically. E.g. petroleum, gold, diamond etc.
• Non-exhaustible natural resources: - Natural resources which do not get exhausted (end up) by the
action of human beings. E.g. gravitational energy, solar energy etc this resources are available free of
charge. But, the reward (payment) of renewable and exhaustible resources is rent.
b) Labor - this refers to all the physical and mental talents of human beings in the production and distribution
of goods and services. Labor could be skilled or unskilled (manual worker). The payment of labor is wage.
c) Capital - these are finished and semi-finished manufactured goods that are used for the production of other
goods and services. The reward for the service of capital is interest. Examples: machineries, buildings,
equipments, trucks, ware houses etc.
d) Entrepreneurial Skill - entrepreneurial resource refers to a special set of talents that enables an individual to
start, organize, run and manage a business. Some of the functions of an entrepreneur are: produce new
products, start new techniques of production, takes risk and make business decisions. The payments to
entrepreneurs are profits.

As we discussed while defining economics, only scarce resources are the central concern of the subject matter of
economics.

NOTE: While a resource is said to be scarce if the total demand for it exceeds its total supply at zero price level
(without payment) and its supply can be affected by price, it would be considered as non-scarce if the total
demand for it doesn’t exceed its total supply for free. Its supply cannot be affected by price.

1.3 Rationale for Studying Economics

Although you have been introduced about the importance of economic science and philosophy for our daily
today activity, here are the most important reasons for studying economics. The knowledge of economics is
important to:

 Wisely allocating scarce resources to satisfy the unlimited human wants;
 Efficiently managing your business, since it deals about price, cost, profit, market, production, saving,

investment, etc;
 Better understand the economic problems of societies, such as rising unemployment, inflation, budget

deficit, external debt, poverty, food security, rampant corruption, etc;
 Formulate different policies to solve social, economic and political problems in a nation. In so doing,

presidents and prime ministers seek the help of economists during the formulation of economic
policies.

1.4 Scarcity , Choice and Opportunity Cost

Please refer back to the above example given under scarcity. In the example, as you cannot perform the three
activities within the required time resource for each activity, you have to perform them within a maximum of 24
hours. That means you have to reduce 1 hour from the required time resource. But, the problem is: from which
one of the three activities should you reduce 1 hour? Sleeping? reading? visiting? This sends an important
message that scarcity poses choice, implying that you need to choose one of the activities to be performed with

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less time than initially required. Thus, choice is made in economic decision making to balance unlimited
resource need with limited resource availability.
Let us consider one more example to clarify the relationship between scarcity, choice and hence opportunity
cost.
Assume that there is a farmer facing scarcity of resources (limited labor, capital and land) in harvesting two
types of crops, say teff and wheat. Suppose that this year, the farmer has harvested 50 quintals of teff and 30
quintals of wheat after efficiently utilizing his/her resources. Now let us assume that price of both crops is
expected to rise next year and the farmer is a rational decision maker so that he/she has to increase production of
the crops.
Do you think the farmer can increase the volume of production for the two crops? The answer is no. He/she can
increase the volume of production only for one of the crops. If that is the case, can he/she increase the
production of one of the crops by keeping the volume of production of the other constant? The answer is again
no. Why? This is because, if the farmer is faced with scarce resources and he/she efficiently utilized the
available resource, he/she can increase the production of say wheat only by shifting resources from the
production of teff. That means he/she has to take some of his/her labor, land and capital which formerly
employed to produce teff, and devote them to the production of wheat.

The reverse would happen if he/she decides to increase the production of teff. This would, therefore, cost the
farmer. Based on the example above, suppose the farmer decided to reduce teff production to 45 quintals to
increase wheat production to 40 quintals. This implies that, so as to gain additional 10 quintals of wheat, the
farmer has lost 5 quintals of wheat. In economics, we call this opportunity cost.

Opportunity cost is a key concept in economics, and has been described as expressing "the basic relationship
between scarcity and choice. The notion of opportunity cost plays a crucial part in ensuring that scarce resources
are used efficiently. Opportunity cost is the cost of any activity measured in terms of the best alternative
forgone. It is the sacrifice related to the second best choice available to someone who has picked among several
mutually exclusive choices. In economics, unlike in accounting, costs are not restricted to only monetary or
financial costs: the real cost of output forgone, lost time, pleasure or any other benefit that provides utility
should also be considered opportunity costs. Accordingly, the opportunity cost of producing a quintal of
additional wheat is 0.5 quintals of teff (=5 quintals teff /10 quintals of wheat).

In sum, Scarcity Choice Opportunity Cost

1.5 The Methodology of Studying Economics

While you are studying economic science, you need to acquaint yourself with the following basic concepts and
methods of analysis. The methodology of economics refers to the procedure economists employ to derive
hypothesis, theories, generalizations, principles, and laws that explain the behavior of economic phenomena.

a) Some Basic Concepts
The following terms are some of the basic concepts related the methodology of economics.

• Hypothesis- It is an ``if…then`` statement usually obtained from a causal observation of the real world.
it represents a tentative and yet untested explanation of the event.

• Model- is a simplified representation of a real situation.
• Theory- is a hypothesis that has been successfully verified and accepted. That is a hypothesis that passed

the entire test.
• Principle- it is a basic general truth about the cause and effect relation about variables.
• Law- It is a theory, which is always true under the same set of conditions. Unlike a principle, a law

implies a high degree of exactness and universal applicability. E.g. the law of demand.
• Policy- is an instrument designed directly or indirectly by a government to solve a given economic

problem –e.g. ADLI

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• Scientific method- It is a technique where by one gathers a systematically arranged real facts (events) to
generalize up on facts (called induction). And the development of hypothesis which is to be tested
(verified), against facts is called deduction.

b) Logical Reasoning
To derive economic generalizations, theories, principles and laws, economists employ logical reasoning namely
inductive and deductive methods.

• Inductive method: It is a logical approach where raw data are collected with regard to a certain
economic phenomenon and effort is then made to arrive at certain generalization, which follow from the
observations collected. It moves from particular to general.
Example: Assume you are a researcher interested to identify the very reason for recurrent food
insecurity problem in Eastern Ethiopia. However, as the area and the population living in it are vast, you
may not have sufficient resource to collect data from the entire population. Rather you may decide to
take samples of kebeles, woredas or households which could represent the whole population. And let us
assume that the information from the sample signifies that the real cause of the recurrent food insecurity
problem experienced by the sample is drought. Hence, you can infer from this that the main cause of
food insecurity in Eastern Ethiopia is drought. You may be faced with resource limitation. This is
inductive reasoning.

• Deductive method: It is a logical approach (method) where the analyst or researcher starts his task at the
level of theory and proceeds to verification of his theory by an appeal to facts in the real world. It moves
from the general to the particular; from the theory to the facts and from the abstract to the concrete.
Example: Suppose you have learnt from your research that the main cause of poverty in Ethiopia is
rapid growth of population. From this, you can tell that poverty in and around Gojjam is caused by high
population growth rate in the area.

1.6 Classifications in Economics

a) Normative Vs. Positive Economics
An important distinction in economics can made between positive economics and normative economics based
on how arguments are made in explaining economic problems. These two are very important types of economic
theory.

i) Positive Economics - it is that part of economics science which deals with specific statements that are
capable of verification by reference to the facts about economic behavior, i.e. it is concerned with
describing and analyzing the economy as it is.
• In other words, positive economics deals with objective explanation of how the economy works. It is
the science of economics, and concerns the analysis of facts.
• Positive analysis tries to answer the questions what is, what was or what will be.
• The theory of positive economics provides a "good enough" explanation of economic phenomena i.e.
the theory is verifiable empirically.

ii) Normative Economics - A normative statement expresses a judgment about whether a situation is
desirable or undesirable.
• It deals with how the economic problem should be solved.
• It attempts to produce answers to the questions " what ought to be."
• Normative economics, in contrast to positive economics, it involves some one's value judgments
about what the economy should be like or what particular policy action should be recommended to
solve economic problems based on a given economic relationship.

"The world would be a better place if the moon were made of green cheese" is a normative statement because it
expresses a judgment about what ought to be. Notice that there is no way of disproving this statement. If you
disagree with it, you have no sure way of convincing someone who believes the statement that he is wrong.
Economists have found the positive-normative distinction useful because it helps people with very different

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views about what is desirable to communicate with each other. If their disagreement is on normative grounds,
they know that their disagreement lies outside the realm of economics, so economic theory and evidence will not
bring them together. However, if their disagreement is on positive grounds, then further discussion, study, and
testing may bring them closer together.

Examples:
- Increasing the money supply will lead to higher prices. (Positive aspect)
- The inflation rate in Ethiopia is not greater than three percent. (positive aspect)
- The inflation rate in Ethiopia should not be greater than three percent. (Normative aspect)
- The government should raise the minimum wage in order to help low income workers. (Normative aspect)

Most statements are not easily categorized as purely positive or purely normative. Rather, they are like tips of an
iceberg, with many invisible assumptions hiding below the surface. Suppose, for example, someone says, "The
minimum wage is a bad law." Behind that simple statement are assumptions about how to judge whether a law
is good or bad (or normative statements) and also beliefs about what the actual effects of the minimum wage law
are (or positive statements).

b) Microeconomics Vs. Macroeconomics
The distinction in economics is made as microeconomics and macroeconomics based on the scope on which
economic problem is discussed and analyzed.

i) Microeconomics:
It studies the economic decision making behavior and interaction of individual economic units.
Individual economic units are households, firms and the government. Microeconomics deals with:
• The behavior of consumers in maximizing their satisfaction
• How businesses make decisions so as to obtain the maximum possible profit
• How prices of products and factors of production are determined in product and factor market.
• The different types markets and their respective impact on the efficiency of producers and welfare
of consumers etc

Some examples of microeconomic issues:
- The demand and supply of a commodity in market
- The mechanism under which price is determined in a market
- The issue of profit maximization and (or)cost minimization by a firm.
- The issue of resource allocation in satisfying the needs of members of a family (household).
- The issue of market functions and failures.
- Market regulation by the government(tax and subsidy).

ii) Macroeconomics:
It deals with the functioning of the economy as a whole. The study of macroeconomic variables is
indispensable for understanding the working of the whole economy. It focuses on how the aggregations
of individual micro units affect the economy. It emphasizes on magnitudes such as unemployment, total
national output, total income, inflation, total investment, economic growth, fiscal and monetary policy
etc.

Some examples of macroeconomic problems:
- The issue of import and export of commodities
- The problem of inflation and unemployment in Ethiopia
- The issues of economic growth and development
- Interest rate and exchange rate policies
- Issues of investment and saving in Ethiopia

1.7 Production Possibility Frontier (PPF)

Consider the case of the farmer producing teff and wheat under scarcity of resources. In the example, we looked
that there is an opportunity cost to be incurred by the farmer when he/she decides to increase the production of

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wheat. As the production of wheat increases a by a certain volume, the production of teff will fall by a certain

amount. This can best be represented graphically using a line called PPF. In economics a production-possibility
frontier (PPF), sometimes called a production-possibility curve or product transformation curve, is a graph that

compares the production rates of two commodities that share the same factors of production. The PPF curve

shows the specified production level of one commodity that results given the production level of the other.

To better understand how PPF is drawn and how economic analysis can be made regarding opportunity costs
under the condition of scarcity, consider an economy producing only two commodities, butter and gun. These

commodities are produced under the following assumptions.

i. Efficiency-The economy is operating at full employment and is achieving full production.
 Full employment means no idle resource /all the available resources have been utilized/
 Full production means resources are used to produce the highest possible output level.
 It assumes the maximum possible efficient use of the resources for a maximum possible production
of both commodities.

ii. Fixed resources –The quality and quantity of resources available in the economy remain fixed or constant.

iii. Fixed technology-the level of technology does not change .but the society uses the best technology it has.

iv. Two products-for simplicity, say, the economy is producing only the two products i.e. Gun and Butter.

Table 1.1 Production possibility schedule

Type of product Production a alternatives D
Coordinates BC 150
Butter 50 100 75
Guns 300 200

Figure 1.1 Production Possibility Frontier of an economy producing two Commodities

As can be seen from the above graph, PPF shows all possible combinations of two goods that can be produced
simultaneously during a given period of time, other things being constant. Commonly, it takes the form of the
curve on the right. For an economy to increase the quantity of one good produced, production of the other good
must be sacrificed. Here, butter production must be sacrificed in order to produce more guns. PPFs represent
how much of the latter must be sacrificed for a given increase in production of the former. Such a two-good
world is a theoretical simplification, due to the difficulty of graphical analysis of multiple goods. If we are
interested in one good, a composite score of the other goods can be generated using different techniques. For
example, assume that the supply of the economy's factors production does not change over time, in order to
produce more butter, producing "guns" needs to be sacrificed. If production is efficient, the economy can choose
between combinations (i.e. points) on the PPF: B if guns are of interest, C if more butter is needed, D if an equal
mix of butter and guns is required.

In the PPF, all points on the curve are points of maximum productive efficiency (i.e., no more output can be
achieved from the given inputs); all points inside the frontier (such as A) can be produced but productively

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inefficient; all points outside the curve (such as X) cannot be produced with the given, existing resources.
Therefore, they are unattainable
As can be seen from Table 1.1, as one goes from B to C, production of Gun decreases but production of Butter
increases. This implies that a fall in gun’s production represents the opportunity cost of increasing Butter
production. If there is no increase in productive resources, increasing production of a first good entails
decreasing production of a second, because resources must be transferred to the first and away from the second.
Points along the curve describe the trade-off between the goods.
In the context of a PPF, opportunity cost is directly related to the shape of the curve (see above). If the shape of
the PPF curve is straight-line, the opportunity cost is constant as production of different goods is changing. But,
opportunity cost usually will vary depending on the start and end point. In the table, producing 50 more packets
of butter, at a low level of butter production, costs the opportunity of 100 guns (as with a movement from B to
D). At point C, the economy is already close to its maximum potential butter output. To produce 50 more
packets of butter, 125 guns must be sacrificed (as with a movement from D to C).
The slope of the PPF is equivalent to the opportunity cost of producing butter. In addition, although there is a
possibility of having a straight line PPF, what usually used to represent a number of economic factors is the
concave line to the origin. This shape is assumed to exist because of increasing opportunity cost. As you go
from the left to the right along the line, opportunity cost increases. Hence, the slope of PPF gets steeper.
The two main determinants of the position of the PPF at any given time are the state of technology and
management expertise and the available quantities and productivity of factors of production (Efficiency). Only
points on or within a PPF are actually possible to achieve in the short run. In the long-run, if technology
improves or if the productivity or supply of factors of production increases, the economy's capacity to produce
both goods increases, i.e., economic growth occurs. This increase is shown by a shift of the production-
possibility frontier to the right. Conversely, a natural, military or ecological disaster might move the PPF to the
left, in response to a reduction in an economy's productivity.
Figure 1.2 Outward shift in PPF due to technology improvement

If there is improvement in technology, if there is additional efficient utilization of resources, if either quantity or
quantity of factor inputs improved, the curve will shift to the right. Otherwise, it will shift to the left.

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1.8 Basic Economic Problems

As it has been discussed earlier, human wants are practically unlimited, but the resources available to produce

goods and services to satisfy human wants are limited. Accordingly, the subject matter of economics deals with

problems associated with the production and distribution of economic goods. Economists, therefore, have

identified six basic economic problems that are faced by all societies. Economists try to find out how decisions

on such core problems are made by various economic agents. The basic economic problems faced by societies

are:

a) What to produce d) Full utilization of resources

b) How to produce e) Attainment of efficiency

c) For whom to produce f) Growth of the economy

a) What to produce
The problem "what to produce" is the problem of choice between commodities. This problem arises mainly for
two reasons. Firstly, scarcity of resources does not permit production of all the goods and services that people
would like to consume. Secondly, all the goods and services are not equally valued in terms of their utility by
the consumers. Some commodities yield higher utility than others. Since all the goods and services cannot be
produced for lack of resources, and all that is produced may not be bought by the consumers, the problems of
choice between the commodities arise.

Example: Consider a potential businessperson planning to start a business around Main Campus of BDU. Given
his initial capital, he may have a number of alternative business ideas in his mind, like running a cafeteria, a
photocopy shop, a barber, internet café, grocery etc. Because of resource limitations, however, he can run only
one or two types of businesses. Thus, he has to decide which business to run. Thus, he has to identify the most
attractive business sectors and start producing commodities (goods or services).

b) How to produce
The problem "how to produce" refers to the methods or techniques of production to be adopted; i.e. the choice
of technology. Here, the problem is how to determine an optimum combination of inputs. Labor and capital to
be used in the production of goods and services. This problem mainly arises mainly because of scarcity of
resources. If labor and capital were available in unlimited quantities, any amount of labor and capital could be
combined to produce a commodity. But, since resources are not available in unlimited quantity, it becomes
imperative to choose a technology which uses resources most economically. A basic distinction is between
capital-intensive production and labor-intensive production technology. Capital-intensive technology uses large
amounts of capital relative to labor in a production process. While labor-intensive technology uses large amount
of labor resource relative to capital to produce a commodity.

Example: Assume two road construction projects in Bahir Dar city. Project A is construction of a ‘cobblestone’
road, while project B is construction of ‘asphalt’ road. In which one of the two projects do you think the
technology is labor-intensive? Why?
Based on the definitions, the cobblestone project is labor-intensive, as it absorbs many labor input relative to
capital. And Project B is capital intensive as it employs huge capital relative to labor. Therefore, a society
which decides to construct a road has to decide also how to construct the road, in other words, which of the
available technologies to use.

c) For whom to Produce
For whom to produce is the problem related to the distribution of products, i.e. identifying the market or the
users of the commodity what you produce using a certain technical means. In other words, this problem the
problem of synchronizing the supply pattern with demand pattern so that those who have the ability and
willingness to pay the price get the commodity and there is no surplus production.

Identifying the users of a commodity to be produced would help whether to produce that commodity or not,
where to use a capital-intensive or labor-intensive technology, and what amount of the commodity to produce.

9

Example: In the case of the road construction projects, if the users of the road are mainly pedestrians and
lightweight cars, the road can be constructed using cobblestone. Otherwise, it should be constructed using
asphalt. Similarly, if the community around the Main Campus has a demand for photocopy and cafeteria
services, the businessperson can start these businesses. Otherwise, he should think of a better business idea.

d) The problem of resource utilization
Full utilization of resources is the most desirable way of optimization of production and consumption in the
economy. Production of goods and services is always constrained by the scarcity of relevant resources. When
resources are scarce, one would expect that they are utilized fully but there are examples in different societies of
under utilization of resources in spite of demand for goods and services in whose production the resources can
be used. What are the reasons for such unemployment or underutilization of productive resources is a big
question that economists try to respond.

e) The problem of efficiency
Production is said to be inefficient if it would be possible to reallocate resources and to produce more of at least
one good without simultaneously producing less of any other good. The goods (including services) that are
produced are said to be inefficiently distributed if it would be possible to redistribute them among the
individuals in the society and make at least one person better off without simultaneously making any one worse
off. Inefficiencies in both, production and consumption are to be reduced. That is the same thing as saying that
production and consumption in the society have to be efficient.

f) Problem of Growth of Economy
The problem of growth of economy is quite serious in most of the countries particularly under-developed and
developing ones. By "growth" we mean increase in productive capacity and actual production of goods and
services from year to year. More goods and services are required by a country over time because of necessity to
meet the demands of growing population. A part from this, the standard of living of people improves over time
due to the impact of education and development of science & technology. Thus, they need varieties of goods and
services which meet their requirements. An economy has to make necessary arrangements for production of
greater amount as well as greater varieties of goods of services. It is, however, not very easy to achieve the
objective of growth of the economy. There will be several constraints to this which are to be removed. What is
to be the rate of growth, what is the appropriate way to achieve growth and development of the economy? These
are vital questions for which a society must find the answers. The six problems as discussed above are
fundamental and common to all economics.

The first three problems i.e. what to produce, how to produce and for whom to produce are normally considered
more fundamental than the other three but all of them are of equal importance in the context of contemporary
economic complexities The different economic systems try to solve these problems in different ways. In a free market
economy, these problems are solved by a system of prices. In mixed economy, they are solved partly by a system of prices
of and partly by government. In centralized socialist economy, these problems are solved by a set of public norms or
directions by the government. In brief, we can say that the basic economic problems of different societies are solved in
different ways.

1.9 Alternative Economic Systems

Societies have developed the following different economic systems, or institutions or mechanisms, in order to
resolve the three fundamentals economic problems.

a) Pure Market Economy
In this system, the three basic economic questions are answered as follows. Firms address the ‘what to produce’
question by producing those goods and services that could give them the maximum possible profit. The ‘how to
produce’ question is answered by choosing the techniques of production which are least costly. The ‘for whom
to produce and distribute’ question is addressed depending on peoples decision as to how to spend their income.
Economic activities are coordinated and directed through market mechanism (or demand and supply). There is

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no government intervention in the economy. Rather the private sector, through the forces of demand and supply,
is expected to solve the problems.

You should be aware of the fact that no economy in the real world has a characteristic of pure market economic
system, even that of the economy of USA. This is because, although very rarely, the government of USA
intervenes in the economy. However, as compared to many economies in the world, many of the characteristics
of the economy of USA are much closer to the pure market economic system.

b) Command Economy
It is an economic system where the questions of what, how, and for whom to produce is resolved by the
government through a central planning board. The central planning board studies the needs and preferences of
the society and decides on what, how and for whom to produce. Resources are owned by the public sector.
Example: North Korea and Cuba.

c) Mixed Economy
It is a type of economic system in which decisions of what, how and for whom to produce is provided by profit
making firms via the market system(through the forces of demand and supply) and the government. It is a
midway system between pure market system and strict planned economy. All real world economies, including
that of our economy, are examples of this economic system.

1.10 Decision Making Units and the Circular-flow of Economic Activities

i. Decision Making Units
Households, business organizations also called firms and government make important economic decisions such
as consumption, production, exchange and distribution. In short, they make economic decisions to resolve the
basic economic problems.

a) Households:- they are the owner of scarce resources, they are mostly considered as consumers.
Households, as decision making units, decide on:
 The sale of their scarce resources (labor, land, capital and entrepreneur) to firms and the
government.
 What and how much of the goods and services to buy.
 Paying tax to the government.

b) Firms:- they are economic agents who transform scarce resources in to final goods and services, mostly
referred as producers. They make economic decision on:
 What, how and for whom to produce?
 The level of resources they will purchase from the households
 Paying tax to the government

c) Government:- Government is an organization that has legal and political power to exert control over
individuals, firms and market. Sometimes, markets fail to work properly (as required) and hence fail to
allocate scarce resources efficiently. This calls for the intervention of the government in the economy.

ii. The circular flow of economic activities
It shows the interaction of decision-making units.

 Resource market:- are markets where inputs that are used in the production of goods and services are
sold.

 Product market:- are markets where goods and services are traded.
 Real flow: - the flow of goods, services and resources.
 Financial or money flow: - the flow of money (income and expenditure).
Look at the following two-sector circular flow model and critically observe the diagram. The diagram shows
how the decision-making units (households and firms) interact each other in a given economy.

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Figure 1.3 Two sector circular flow of economic activities

In the diagram above, firms and households are the two decisions making units. Households supply resources in
the resource market. In return, they receive money income and they spend all the income to purchase goods and
services from firms (i.e. they do not save). Firms buy resources from households. Then, they combine these
inputs and produce goods and services. Finally, they sell these goods and services to households in the product
market and generate income (revenue).

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CHAPTER TWO: THE THEORIES OF DEMAND AND SUPPLY

This chapter opens the discussion on the concept of microeconomics. Here, we will discuss about the theory of
demand, theory of supply and the way market equilibrium would be set.

2.1 The Theory of Demand

In economics, demand is defined as willingness and ability of buyers to buy and use a commodity in a specific
time. Thus, demand for a particular commodity does not mean only interest or want of individuals to use a
commodity. Rather, it implicates also the purchasing power to command on the commodity.

Example: Assume you are interested to have a laptop which would be sold for Birr 5000. But, unfortunately you
have only Birr 3000. In this case, even if you are willing to buy the laptop, you do not have the ability to buy it
as you run short of Birr 2000. Thus, you do not have demand for that specific laptop, but you have the interest
for it.

The amount of a good that consumers will be willing and able to buy in any one time will be influenced by
many variables. But, perhaps the most important variable that will have an effect on the quantity demanded of a
good is its price. When the price of a good increases, the quantity demanded will fall. Conversely, if the price
falls, then the quantity demanded will rise. Therefore, there is an inverse or indirect relationship between price
and quantity demanded. This inverse relationship between price and quantity demanded is called the law of
demand.

The law of demand can be demonstrated by the following instruments:

a. Demand schedule – It is a tabular presentation of the relationship between price and quantity a commodity

that consumers are able and willing to buy at each specific price.

Quantity Q1 Q2

Price P1 P2

b. Demand curve – it is a graph that shows the inverse relationship between price and quantity demanded, and
is plotted from the demand schedule.

Figure 2.1 Demand curve

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c. Demand equation – It is a mathematical equation that shows the relationship between price and quantity

demanded of a commodity; Qd= a − bP where Qd is quantity demanded, P is price, ‘a’ is

the reciprocal intercept, and ‘b’ is the reciprocal of the slope of the line.

Numerical Illustration:
Assume that your demand for orange decreases from 5 kg to 3 kg when the price of a Kilogram of orange rises
from Birr 8 to Birr 12. Derive your demand equation for orange.

Solution:
Step 1: Calculate ‘b’, the change in quantity demand divided by the change in price. Change in Quantity
Demand = Q2-Q1= 3Kg -5Kg= -2 Kg; and change in price is =P2-P1= Birr 12- Birr 8= Birr 4. Thus, b = -2/4= -
0.5
b measures by how much Qd changes as a result of a unit change in P. The negative sign shows the inverse
relationship between the two variables.
Thus , Qd= a-0.5P

Step 2: Calculate ‘a’. To find the value of ‘a’, just substitute the values for Qd and P From the coordinates.
Thus, 5= a-(0.5*8)= a-4; a = 5+4=9
Therefore, your demand equation for orange can be written as Qd = 9-0.5 P.

The above demand equation represents the demand of a single individual. But, in the orange market there could
be more than one buyer who buy orange. In this case, you can derive a demand curve for each buyer like what
we have done in the example.
The sum of the quantity demand by each individual for orange will give the total quantity demand in the market.
We call this market Demand. And market demand is simply the horizontal summation of individual demand.

Numerical Illustration:
Assume the following three equations represent the demand for individual A, B and C respectively, who are the
only buyers of orange in the market.
QdA = 40-2P ; QdB= 10-0.4P ; QdC= 20-2P;
Suppose now that the market price of a kilogram of orange is Birr 10.

a) Calculate the Qd of each individual.
b) Calculate the market demand for orange.

Solution:
a) QdA = 40-2*10= 20 Kg ; QdB= 10-0.4*10= 6Kg ; and QdC = 20-2*10= 0Kg.
b) The market demand for orange is the sum of the quantity demand by A, B and C. Therefore, QdM =
20Kg+6 Kg+ 0Kg= 26 Kg.

You can also alternatively calculate the market demand after deriving the market demand equation. The market
demand equation can be derived simply by taking the horizontal summation of the three equation as follows;
Qd M= QdA +QdB+QdC= (40-2P) + (10-0.4P) + (20-2P)
By taking similar terms together; QdM= (40+10+20)-(2P+0.4P+2P)= 70-4.4P
Now you can calculate the market demand for orange by just substituting the price in the equation . Thus ,
QdM= 70- 4.4(10) = 70- 44= 26 Kg.

2.1.1 Determinants of Demand

Although quantity demand for a commodity is highly determined by price of the commodity itself, there are still
other factors which would influence the demand for a commodity, even if price remains the same. Generally, the
factors affecting demand level are the following.

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i. Price of the good - as we have already seen, as the price of a good change, so the quantity of the good
demanded changes when prices change, there is a movement along the demand curve.

ii. Income - an increase in income raises consumers’ ability to purchase an item. If the quantity demanded
of a good increase as in come increases, the good is said to be normal, if the quantity demanded of a
good decreases as income increases the good is said to be inferior.

iii. The prices of related goods – the change in the price of some goods may affect the demand of some
other goods. If the fall in the price of one good cause a fall in the quantity demanded of another good,
then the goods is substitutes, if the falls in the price of one good cause arise in the quantity demanded of
the other good, then the two goods are called complements.
Example of substitutes are ; coca-cola and Pepsi ; sprite and 7UP; Coffee and Tea
Examples of Complements are; Sugar and Tea; Enjera and Doro-wot; Driving a car and Gasoil etc.

iv. Tastes – a change in tastes in favor of a good, such as if the good becomes fashionable, will cause an
increase in demand. Unfavorable change in the testes of the good will cause a decrease in it.

v. Expectation of future price of goods: when consumers expect higher price of goods and service in the
future, current demand for goods and services will go up.
Example ; if you expect the price of Teff will increases next year you will buy more of it this year. The
reverse will be true if you expect a fall in its price.

vi. The number of buyers: when the numbers of buyers are large, the demand for goods becomes higher and
the converse is also true.

vii. Season: demand for a commodity would fall and rise as per seasonal variation in human walks of life.
The demand for stationery would be high during academic periods, and falls during school vacation.
Similarly demand for overcoats falls during hot and dry season and increases during rainy and cold
seasons.

2.1.2 A Shift in Demand

A change in any factor, except a change in the price of the commodity itself, affecting demand will cause a shift
in demand curve of a commodity.

As you can see in the graph below, the shift of a demand curve takes place when there is a change in any non-
price determinant of demand, resulting in a new demand curve. Non-price determinants of demand are those
things that will cause demand to change even if prices remain the same—in other words, the things whose
changes might cause a consumer to buy more or less of a good even if the good's own price remained
unchanged. Some of the more important factors are the prices of related goods (both substitutes and
complements), income, population, and expectations. However, demand is the willingness and ability of a
consumer to purchase a good under the prevailing circumstances; so, any circumstance that affects the
consumer's willingness or ability to buy the good or service in question can be a non-price determinant of
demand. As an example, weather could be a factor in the demand for beer at a baseball game.

Figure 2.2 A shift in demand curve

D2 D0 D1

When income rises, the demand curve for normal shifts outward as more will be demanded at all prices, while
the demand curve for inferior goods shifts inward due to the increased attainability of superior substitutes. With
respect to related goods, when the price of a good (e.g. tea) rises, the demand curve for substitute goods (e.g.

15

coffee) shifts out, while the demand curve for complementary goods (e.g. sugar) shifts in (i.e. there is more
demand for substitute goods as they become more attractive in terms of value for money, while demand for
complementary goods contracts in response to the contraction of quantity demanded of the underlying good.

Demand Shifters
• Changes in income
• Changes in tastes and preferences
• Changes in expectations
• Changes in the prices of related goods (substitutes and complements)
• Population size and composition

Changes that increase demand
Some circumstances which can cause the demand curve to shift outwards (a shift from D0 to D1) include:

• increase in price of a substitute
• decrease in price of complements
• increase in income if good is a normal good
• decrease in income if good is an inferior good

Changes that decrease demand
Some circumstances which can cause the demand curve to shift inwards (from D0 to D2) include:

• decrease in price of a substitute
• increase in price of a complement
• decrease in income if good is normal good
• increase in income if good is inferior good

Factors affecting market demand
Market or aggregate demand is the summation of individual demand curves. In addition to the factors which can
affect individual demand, there are three factors that can affect market demand (cause the market demand curve
to shift):

• a change in the number of consumers,
• a change in the distribution of tastes among consumers,
• a change in the distribution of income among consumers with different tastes.

2.1.3 Elasticity of Demand

Elasticity in physics is a term used to explain how big or small a deformation in the shape of an object when
external force is exerted on it. You can just take the case of a plastic string and a metal object with equal length.
If you hang a 10Kg stone of each of the objects, and measure the new length of the objects, you may see that the
plastic string is longer than the metal object. This shows that for a change in an external force the plastic is
highly responsive (more elastic) than the metal object.

Similarly, in economics the concept of elasticity can be applied to measure a change in (responsiveness of)
demand for a particular commodity as one of the factors affecting demand, which we discussed above, is
changed.

In this course, we will discuss about three types of elasticity.

A. Price Elasticity of Demand
As name implies, price elasticity of demand is a measure of the responsiveness of quantity demand of a good to
the change in its price.
Let Ed stand for price elasticity of demand. Then mathematically the formula for calculating the price elasticity
of demand can be written as:

16

Ed = Percentage Change in Quantity Demanded = ∆X X 100 ∆X ∆P ∆X . Pi = Ed = ∆X . Pi
Percentage Change in Price = Xi Pi ∆P ∆P Xi
Xi =
∆P X 100
Xi
Pi

Where, Xi and Pi are initial quantity demand and price level respectively and ∆ (Delta) is the is symbol

meaning “a change in”.

Thus, ∆X ∆P
is a relative change in quantity, and is a relative change in price generally, a negative sign is
Xi Pi

put before the term ∆X . Pi , which simply indicates the quantity demanded and price are inversely related. The
∆P Xi

sign of Ed is always negative. It is a pure number, that is, it stands by itself being independent to units of

measurement. The value of the coefficient Ed will lie between 0 and ∞ (infinity) or very large number;
including both 0 and ∞ .

 If the absolute vale of Ed equals 1, demands has unit elasticity (unitary elastic).

 If the absolute vale of Ed is greater than 1, demands is elastic.

 If the absolute vale of Ed is nearly ∞ , demands is perfectly elastic.

 If the absolute vale of Ed is less than 1, demands is inelastic.

 If Ed is 0, demand is said to be perfectly inelastic.

Numerical Illustration:
Assume your daily demand for coffee increases from 4 cups to 5 cups as the price of a cup of coffee falls from
Birr 4 to Birr 2.

i) Calculate the Ed
ii) Interpret the size of Ed
iii) Calculate Ed if your demand coffee remains 4 cups despite the change in its price. And interpret your

results.

Solution:

i) Ed = ∆X . Pi ; where ∆X= 5 cups - 4 cups = 1 Cup; and ∆P= Birr 2-Birr 4= -2. The negative sign is
∆P Xi

just only to show that price has fallen by 2 Birr. Accordingly, Ed = 1 * 4 = -0.5
−2 4

ii) Since the absolute value of Ed is less than 1, demand is inelastic.

iii) Ed= 0 * 4 = 0
−2 4

Since the value of Ed= 0, demand is perfectly inelastic; although coffee gets cheaper, your demand for

coffee remains the same.

Although generally, the demand curve is understood as being downward sloping, it might have different
directions (hence slopes) based on the size price elasticity of elasticity of the demand.

i. Perfectly Elastic demand – (Ed = ∞ ). It refers to that the situation where small rise in price will cause

the quantity demanded to be zero. This demand curve mostly represents the demand for luxury
commodities.

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Figure 2.3 Perfectly elastic demand d
Price perfectly elastic dd curve

ab

P Ed= ∞

0 Quantities
X1 X2

In such a situation, price of commodity remains constant.

Ed = ∆X Pi =∞ because ∆P=0
.
∆P Xi

The above graph indicates that the situation where the price is fixed and at this fixed price any quantity of the

commodity can be sold. In other words, perfectly elastic demand for a commodity refers to those cases in which

the quantity demanded is independent of price.

ii. Elastic demand (1<Ed< ∞ ) – It reflects to that situation where the proportionate change in quantity

demanded is much greater than the proportionate change in price. For example, a 5 percent change in

price will lead to a 10 percent change in quantity demanded, then

Ed = 10 percent = 2 This is shown by Fig 2.4 where ∆X > ∆Pi
5 percent Xi Pi

Figure 2.4 Elastic demand
Price

d

P1 a Ed>1

∆P

P2 b

∆X

d

0 X1 X2 Quantity

iii. Unitary Elasticity of demand (Ed=1) - It refers to that situation where the proportionate change in quantity

demanded is equal to the proportionate change in price.

Figure 2.5 Unitary elastic demand

P1 a Here, ∆X = ∆P
∆P Ed=1 Xi Pi

P2 b
∆X d

0
X1 X2 Quantity

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iv. Inelastic demand – (0<Ed<1) = It refers to that situation where the proportionate change in quantity
demanded is less than the proportionate change in price. In such a case the numerical value of the
coefficient Ed will take the limit, 0<Ed<1

Figure 2.6 Inelastic demand Here, ∆X < ∆P
Price XP

P1 a b For instance, a 20% change in
∆P Ed<1 price will lead to a 10% change
d in quantity demanded.
P2 ∆X
Ed= 10% = 1 < 1
0 20% 2

X1 X2 quantity

v. Perfectly inelastic demand: (Ed=0) – It refers to that situation where quantity demanded is perfectly
independent of price changes. In such a case, the demand is non-responsive. Commodities with such type
of demand elasticity are regarded as absolutely necessity goods. Example - the demand for insulin by

diabetic patients. Ed = ∆X . P = 0 , because, ∆X = 0
∆P X

Figure 2.7 Perfectly inelastic demand

Price d
Perfectly inelastic demand curve

P1 a d
∆P Ed=0

P2 b

0 X quantity

In the figure, if price increases or decreases, it will be unable to make any change in quantity demanded, which
is fixed at OX. This case is rarely found in real life.

Determinants of Price Elasticity of Demand
Since price-elasticity of demand measures the degree of responsiveness of demand for a change in demand
determinant factors, the degree at which demand respond to a change in those factors depends again on various
factors. As a result, while it could sometimes be highly elastic, it might be totally inelastic or averagely elastic
some other time.
Some of the determinant factors are:

• Availability so substitutes: – The closer the substitute, the greater the elasticity of demand for a
commodity.

• Nature of the commodity: – Commodities can be grouped as luxuries, comforts and necessities, on the
basis of their nature. Demand for luxury goods (eg. Air conditions, costly TV set, Cars etc) is more
elastic than the demand for necessity goods (e.g. Sugar, clothes, etc).

• Proportion of Income spent: If proposition of income spent on a commodity is very small; its demand
will be less elastic and vice versa.

• Time factor: price elasticity of demand also depends on the time consumers take to adjust to a new
price: the longer the time taken, the greater the elasticity.

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B. Income Elasticity of Demand
Income elasticity of demand, as the name implies measures the responsiveness of demand for a change in
income of buyers. Income elasticity of demand may be defined as the ratio of the proportionate change in the
quantity purchased of a good to the proportionate change in income. The mathematical formula is derived in a
similar fashion like that of price elasticity of demand.

Income elasticity = Proportionate change in the quantity demanded
Proportionate change in income

As can be seen, one difference between the previously discussed elasticity and this is the variable in the

denominator.

∆X

Symbolically, EY = Xi ∆Y = EY = ∆X . Yi ; where EY is income elasticity of demand; X is Quantity
∆Y Xi

Yi

demand, and Y is income. The subscript ‘i’ shows that the variable shows initial value.

Another major difference between Ed and EY is that, unlike the former, the latter may not necessarily have

negative sign; it can be positive, negative or zero.

 If EY<0, the commodity is inferior.
 If EY>0, the commodity is normal.

However like Ed, EY has also the following values:

 If the absolute vale of EY equals 1, demands has unit elasticity (Unitary elastic)
 If the absolute vale of EY is greater than 1, demands is elastic

 If the absolute vale of EY is nearly ∞ , demands is perfectly elastic

 If the absolute vale of EY is less than 1, demands are inelastic.
 If EY is 0, demand is said to be perfectly inelastic

Numerical Illustration:
i. Assume a 5% increase in income leads to a 2% increase in quantity demanded of a good, calculate the
income elasticity of the good.
ii. When the income of a household rises from Birr 1000 to Birr 1200, the monthly consumption of maize
falls from 50Kg to 30Kg. Calculate income elasticity.

Solution:
i. EY = 2 % /5 % = 0.4 ; implies EY is inelastic, the sign shows that the commodity is normal and
inelastic.

ii. EY = −10 * 1000 = -10/8= -1.25; implies EY is elastic, the sign shows that the commodity is inferior.
200 40

C. Cross Elasticity of Demand
Do you remember how a change in the price of coffee affects the demand for tea? Good! Cross elasticity of
demand is a measure of responsiveness of demand for a change in the price of related commodities. Very often
demands for two gods are so related to each other that when the price of any of changes, the demand for the
other goods also change, given its own price remains the same. Therefore, the change in the demand for one
good in response to the change in price of another good represents the cross elasticity of demand of one good for
the other.

Cross elasticity can be also defined as the proportionate change in the quantity demanded of A resulting from a

proportionate change in the price of B. Therefore,

Eab = Proportionate Change in the quantity demand of A
proportionate change in the price of goods B

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Eab = ∆Qa . Pb
∆Pb Qa

Where Eab = cross elasticity of demand of A for B
Qa = initial quantity demanded of A ; ∆Qa = change in quantity demanded of A
Pb = initial price of good B; ∆Pb = Change in the price of B
Cross elasticity may take positive or negative numbers.

 If Eab > 0 ; A and B are substitutes
 If Eab < 0; A and B are substitutes

Numerical Illustration:
i. Assume an increase in the price of commodity A by 5% causes a fall in demand for B by 3%. Calculate

Eab.
ii. If a rise in the price of commodity B from Birr 5 to Birr 6 causes a fall in demand for B from 6Kg to 10 Kg ,

calculate Eab.

Solution:

i. Eab = − 3% = −0.6 ; Eab is inelastic ; and A and B are complement goods.
5%

ii. Eab = (10 − 6) * 5 = 2
(6 − 5) 10

2.2 The Theory of Supply

In economics, supply represents the other major component in a market. It is defined as the ability and
willingness of sellers to sell their commodity for a given market price. Therefore, supply is a relationship
between the price of an item and the quantity supplied.

The relationship between price and quantity supply can be presented by one of the following ways:
a) Supply schedule - It is a table that shows the various amounts of a product which a producer is willing
and able to produce and make available for sale in the market at each price.

Qs of orange 5 20 35 50 60

Price of orange 1 2 3 4 5

b) Supply curve - It is a graph that shows the relationship between price and quantity supplied. In this
curve, the price variable is plotted on the vertical axis and quantity supplied on the horizontal axis.
Let’s draw the graph of the above supply schedule:

As we can be seen from the supply schedule and curve, there is a direct/positive relationship between price
and quantity supplied. This is called the law of supply. The law states that, other things being equal, the
quantity supply of a commodity increases as the price of that commodity increases.

Figure 2.8 Supply curve Supply curve
5
4

Price of 3
Orange 2

1

5 20 35 50 60 Qs of orange
21

c) Supply Equation - It is a mathematical relationship between the price of a commodity and the quantity
supplied of a commodity. It can be written as ;

Qss= a + bP ; Where Qss is quantity supply; P is price; ‘a’ is the reciprocal of intercept of the

line and; ‘b’ is the reciprocal of the slope of the line.

Numerical Illustration;

Consider the following schedule

Qss of orange 10 35 60

Price of orange 2 4 6

Derive the supply equation using the above schedule.

Solution:
Step 1: calculate ‘b’. b = change in Qss /Change in P = (35-10)/(4-2)= 25/2= 12.5
Step 2: calculate ‘a’. Just take any one of the coordinates form the table and substitute for Qss and P. Hence,
10= a+(12.5*2)= a-25⇒ a= 10-25= -15
Therefore, the supply equation can be written as: Qss = 12.5P- 15

2.2.1 Determinants of Supply

The amount of a product that seller is willing and able to provide in the market will be influenced by the
following factors:

a) Price of the good: - this is the major factor to influence the quantity supplied of a commodity. When
there is a change in the price of a good, there will be a movement along the supply curve

b) Costs of production /price of resources- if the price of an input/resource rises, then the costs of
production will rise. Since there will be a reduction in profit, the producer will be forced to reduce its
supply. However, a fall in the price of an input causes an increase in supply.

c) Prices of other goods: - if the price of one good increase relative to another, there will be an increase in
supply of the relatively more expensive good. This is because producers obtain greater profits when they
sell at higher prices. Conversely, a fall in the price of a good relative to another will cause its supply to
decrease.
Example: If the price of bread is higher relative to chocolate, then chocolate producer will reduce their
production of chocolate and shift to produce bread. This will have an impact to reduce the supply of
chocolate and increase the supply of bread. The opposite is also true.

d) Tax and subsidy: Both taxes and subsidy affect the supply of goods and services. An increase in tax
reduces the supply of a commodity and an increase in subsidy increase the supply of goods and
services. The opposite also holds true.

e) Technology: technological acceleration leads to an increase in supply and the opposite also is valid.

2.2.2 A shift in Supply

Similar with the case of demand, a change in the determinants of supply except a change in the price of the
commodity itself cause a shift in supply curve.
Some of the factors that shift the supply curve to the right (S1 to S2) are :

- a fall in the price of inputs
- an improvement in technology
- a fall in the price of an alternative product
The following conditions might also reduce supply and shift the supply curve to the left: (i.e. from S1 to S3)
- A rise in price of inputs
- A declaration in technological growth
- A rise in the price of relative good.

22

Figure 2.9 A shift in supply curve

Price of good A S3

S1
S2

Qss of good A

2.3 Market Equilibrium

A market has been defined as any institutional arrangement in which buyers and sellers communicate with each
other to buy and sell a good. On the demand side of the market we have consumers (households) who wish to
buy the good and maximize their utility. On the supply side, we have producers (firms) who offer goods for sale
and maximize profit.

Market equilibrium – is a condition where the quantity of a commodity that consumers are willing to purchase
exactly equals to the quantity producers are willing to supply. In other words, at equilibrium, quantity
demanded is equal with quantity supplied. The price and quantity at which equilibrium exists are known
respectively as equilibrium price and equilibrium quantity.

Graphically, equilibrium occurs at the intersection of the commodities market demand and market supply
curves.

Figure 2.10 Market Equilibrium

P

Surplus ss

P* = equilibrium price

P* E Q* = equilibrium quantity

Shortage dd

0 Q* Q

− Surplus (excess supply) – occurs when quantity supplied exceeds the quantity demanded, i.e. when market
price is greater than P*.

− Shortage (excess demand) - occurs when quantity supplied is lower than quantity demanded, i.e. when the
market price is less than P*.

Mathematically, market equilibrium condition can be presented as follows:
Qdd = a − bP = Qss = a + bP ⇒ Qdd = Qss

23

Numerical Illustration;
Suppose the market demand and supply of a sugar market are given as follows ;
Qdd= 30-2P ; and Qss= 10+0.5P

a) Calculate the equilibrium price and quantity.
b) What will be if the market condition if P=9.
c) What will be the market condition if P=7.
Solution:
a) To maintain equilibrium condition ; Qss = Qdd ; implying that: 30-2P = 10+0.5P ; putting similar

terms together, 20=2.5P; therefore, P*=8 Given P =8; Qdd= 30-(2*8) = 14 ; and Qss= 10+(0.5*8)=14;
Therefore, Q*=14.
b) If P=9; Qdd= 30-(2*9)=12; Qss= 10+(0.5*9) =14.5 ; therefore as price rises above the equilibrium price,
market demand will fall but market supply will increase. Thus, the market is with excess supply
(shortage of demand) of Q= 2.5 units. This conforms to the laws of demand and supply.
c) If P=7; Qdd=30-(2*7)=16 ; Qdd=10+(0.5*7)=13.5; therefore as price falls below the equilibrium price
level , market demand will increase but market supply will decrease. Thus the market is with excess
demand (shortage of supply) of Q= 2.5. This conforms as well to the laws of demand and supply.

Assuming that the market is free and there is no government regulation, the forces of demand and supply
gravitate all the prices towards the equilibrium position.

A shift in market equilibrium
Like the case of a shift in demand and supply curves, there is also a possibility that new market equilibrium
would be established because of a change in some determinant factors.

In fact, the factors which induce a change in the equilibrium position of a market are all the shifting factors of
demand and supply which we discussed before. It does not always mean that a shift in market equilibrium
condition will be followed by a new equilibrium price and quantity. This depends on the direction of the shift in
the demand and supply curves and the magnitude at which they shifted.

Look at the following different cases.

Case 1: A shift in demand curve, keeping supply constant

Figure 2.11 A shift in demand curve with constant supply curve

Panel (a) Panel (b)
24

As can be seen from the two graphs, there is a shift in the equilibrium condition. In a leftward shift in the
demand curve from D1 to D2 causes a new equilibrium at the intersection of the supply curve and the D2 line.
Therefore, the equilibrium price and quantity shift from P1 and Q1 to P2 and Q2 respectively; i.e. a fall in
equilibrium price and quantity. On the other hand, a rightward shift in the demand curve from D1 to D3 causes a
new equilibrium condition at the intersection of the supply curve and the D3 Line. Therefore, the equilibrium
price and quantity shift from P1 and Q1 to P3 and Q3 respectively; i.e. a rise in equilibrium price and quantity.

Case 2: A shift in supply curve, keeping demand constant

Figure 2.12 A shift in supply curve with constant demand curve

Panel (a) Panel (b)

Like the case of a shift in a demand curve, a shift in the supply curve causes a shift in market equilibrium. In

panel (a) a rightward shift in the supply curve (from S1 and to S2) has created a new equilibrium point at the

intersection point of the demand curve and S2 line. Therefore, the equilibrium price and quantity shift from P1

and Q1 to P2 and Q2 respectively; i.e. a fall in equilibrium price and quantity. On the other hand, a leftward

shift in the supply curve from S1 to S2 causes a new equilibrium condition at the intersection of the demand

curve and the S2 Line. Therefore, the equilibrium price and quantity shift from P1 and Q1 to P2 and Q2

respectively; i.e. a rise in equilibrium price and quantity.

Case 3: A rightward shift in both the supply and demand curves

Figure 2.13 A simultaneous shift in demand and supply curves to the right

A rightward shift in the supply curve induces price to fall and but the increase in demand would raise the price.
The net price effect is; rise in price if ∆DD> ∆SS; fall in price if ∆DD<∆ SS; constant price if ∆DD=∆ SS.
Hence, price is indeterminate. But, in all the cases, the new equilibrium quantity will be higher than the original
(i.e. Q2>Q1).

25

Case 4: A leftward shift both in the supply and demand curves
Figure 2.14 A simultaneous shift in demand and supply curves to the left

A leftward shift in the supply curve induces
price to rise, but the leftward shift in demand
would reduce the price. The net price effect is;
rise in price if ∆DD< ∆SS; fall in price if
∆DD>∆ SS; constant price if ∆DD=∆ SS.
Hence, price is indeterminate
But in all the cases the new equilibrium quantity
will be lower than the original (i.e. Q2<Q1).

Case 5: A leftward shift in the supply curve and a rightward shift in the demand curve
A leftward shift in the supply curve induces price to rise, and also the rightward shift in demand would raise the
price. In both cases price will rise. However, the leftward shift in supply will reduce the quantity while the
rightward shift in demand increases it. The net Quantity effect is; a fall in Q if ∆DD< ∆SS; rise in Q if ∆DD>∆
SS; constant Q if ∆DD=∆ SS. Thus, Q is indeterminate.
But in all the cases, the new equilibrium quantity will be lower than the original (i.e. Q2<Q1).
Figure 2.15 A shift in demand to the right and supply curve to the left

26

Case 6: a leftward shift in the demand curve and a rightward shift in the supply curve
Figure 2.16 A shift in demand to the left and supply curve to the right

A leftward shift in the demand curve
induces price to fall, and also the
rightward shift in supply would reduce
price. In both cases price will fall.
However, the leftward shift in demand
will reduce the quantity while the
rightward shift in supply increases it.
The net Quantity effect is; a fall in Q if
∆DD< ∆SS; rise in Q if ∆DD>∆ SS;
constant Q if ∆DD=∆ SS. Thus, Q is
indeterminate.

27

CHAPTER THREE: THE THEORY OF PRODUCTION

3.1 The Production Function

In simple words, production refers to the process of transferring inputs into outputs. An input (factor of
production) is a good or service that goes into the production of another good or service. In other words, an
input is simply anything which the firm buys for use in its production process. Inputs include labor, land, capital
and entrepreneurial talent. The end products of the production process are outputs which could be tangible
(goods) or intangible (services).

Simple examples of production:
- A furniture-producing firm combines workers labor time, machineries, his organizational skills and various

raw materials like wood, metal, etc to produce sofas for sale to its customers.
- A high school uses teachers, books, educational materials (aids), class rooms, the available technology (like

plasma tv), etc to provide educational services to students.

The theory of production explains and formalizes the nature of relationships between factors (inputs) used and

output. As you might have noticed, the production process does not necessarily involve physical conversion of
raw materials into tangible goods. Besides teachers, lawyers, doctors, social workers, consultants, hair-dressers,

etc are all engaged in producing intangible goods.

Production function is a technical relationship between inputs and outputs. It shows the maximum output that
can be produced with a fixed amount of inputs and the existing technology. A production function may take the
form of an algebraic equation, table or graph.

A general equation for production function could for instance be described as: (3.1)

Q = f(X1 , X 2 , X3 ,..., X n )

where Q is the maximum output produced; and
X1, X2, X3,…, Xn are different types of inputs.

To illustrate, suppose a wheat-producing firm uses labor (L), capital (K), land (S) and entrepreneurship (E).
Other inputs such as seeds, fertilizers, insecticides, and the like may e included in one of these large groups of
factors of production. The production function for wheat may then be expressed as:

Quantity of Wheat = f(L, K, S, E) (3.2)

Note that we must assume that the production of Q tons of wheat is realized in the most efficient way possible.
If it, for instance, is possible to produce 20 tons of wheat using a certain combination of L, K, S and E, it is also
possible to produce only 19 tons with the same combination. So, the second technology has to be abandoned as
it is not efficient (it is wasting resources that could be used for the production of one more ton).

Normally, firms employ inputs whose amount does not change for some time and others whose quantity varies
according to the amount of production (output). One can hence categorize inputs as fixed and variable.

Fixed Inputs are inputs whose quantity remains Variable Inputs are inputs whose quantity can be
fixed for a given period of time. increased or decreased during a given period of time.

Example: Capital (e.g. machineries), plot of land, Example: Labor, raw materials, etc.
etc.

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3.2 The Period of Production

Depending on the nature of economic adjustment in a firm to changing economic environment, the production
period is divided into short-run and long-run.

Short-run Production Period Long-run Production Period

• Refers to a period of time in which at least one • Refers to a period of time in which all inputs are
input is fixed while others are variable. variable and there is no fixed input.

• Is a period in which a firm can alter its level of • Is a period long enough to allow changes in the
output by increasing or decreasing the use of levels of all inputs.
variable inputs.

Note that the supply of fixed inputs in the short-run is inelastic while the supply of variable inputs in the short-
run is elastic.

If you attempt to put figures, that is wrong. Sorry, there is no precise answer for the question. In short, it differs
from industry to industry and more specifically from firm to firm. In some industries, such as groceries, short-
run may be a few weeks or while in some other industries like electricity and telecommunications, short-run
may mean 4 or more years. Similarly, long-run may be 2 or 3 years while in other industries it might be 10 or
more years. Therefore, long-run and short-run do not refer to any fixed period of time. There is no hard and fast
rule that specifies how short is short-run or how long is long-run.

Based on these classifications and concepts, we can see the short-run and the long-run production functions in
the sub-sections that follow.

3.2.1 The Short-run Production Function

The algebraic production functions expressed in equations (3.1) and (3.2) above are better understood as long-
run production functions. By definition, in the long-run all inputs are variable which implies that the change in
the quantity of total output is attributed to the change in quantities of all of the inputs. We, in other words, are
interested in the impact of the size (scale) of the firm on the output it intends to produce. However, we have to
retain the details of the discussion on that for the next sub-section.

The majority of production decisions of firms are made in the short-run in which the quantity of at least one
factor of production changes with output. Hence, the short-run production function shows the relationship
between the maximum product and the level of the variable input. In more general expression, a short-run
production could take the following form, for Q output and X1 variable input quantities:

Q = f(X1 ) (3.3)

As an illustration, consider a sheets-producing textile firm. The factory of course uses such inputs as laborers,

land, machineries, cotton and chemicals to produce sheets. We may simplify our analysis by assuming grouping

of these factors of production into capital and labor. Capital is used to capture all inputs that are fixed for a

certain period of time – the short-run and labor represents other inputs which are variable – always vary with

output. Therefore, the short-run production function of sheets could be expressed as:

Quantity of Sheets = f(Labor) (3.4)

Here, the short-run level of sheets produced is supposed to depend on labor, the only variable input. Since other

factors are assumed to be fixed in the short-term, we do not include them in the production function. This,

however, does not mean that they are not used in the production process. The function merely means this: to

increase/decrease the amount of sheets produced, increasing/decreasing laborers or their hours is enough, for

fixed amount of other factors of production. But, as we will see shortly, this positive relationship between

quantity of output and the variable input does not hold indefinitely.

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3.2.1.1 Total, Average and Marginal Products

For easy analysis and understanding of the theory of production, economists distinguish between the various
types of output realized by use of inputs. Beginning from total product, we will discuss average and marginal
products of an input (such as average and marginal product of labor).

Total Product (TP)

It refers to the total output (say wheat or sheets) produced by a given amount of a variable input (say labor)
keeping the quantity of other inputs fixed (say capital and land). In almost all real world production processes,
TP in the short-run follows a certain trend: it initially increases at an increasing rate, then increases at a
decreasing rate, reaches a maximum point but eventually falls with a rise in the quantity of the variable input.
This trend could better be analyzed using tabular and/or graphical approaches.

Table 3.1 contains the total product (TP) and other product types for various amounts of labor units (e.g. number
of workers) and a constant amount of capital (e.g. 5 machineries). The values in column 3 of the table show total
output. If you carefully have a look at the values of the TP, they initially increase at an increasing rate as labor
units rise from 0 to 4. TP still increases but at a decreasing rate when labor units are between 4 and 8. The
maximum total output of 119 units is realized by combining 8 units of labor and 5 units of capital at the cheaply
available technology. This could be interpreted as the total output maximizing level of labor employment is 8.
Finally, the total product begins to decline when the amount of the variable input exceeds 8 units. (For easy and
visual observation of this trend, just have a look at Figure 3.1 where you of course find similar results.)

Average Product (AP)

Average product of an input is the level of output that each unit of input produces, on the average. It tells us the mean
contribution of each variable input in the total product. Mathematically, AP is total product divided by the amount of
variable input used to produce that product. The average product of labor (APL), for instance, is given by:

Total Product TP (3.5)
APL = Total Labor = L

Table 3.1 Production with One Variable Input

Amount of Amount of Total Product Average Product Marginal Product Stage of
Labor, L Capital, K TP (Q) AP(=TP/L) MP(=ΔTP/ΔL) Production
Stage I
0 5 0 - -
1 5 10 10 10 Stage II
2 5 32 16 22
3 5 63 21 31 Stage III
4 5 84 21 21
5 5 100 20 16
6 5 111 18.5 11
7 5 119 17 8
8 5 119 14.9 0
9 5 117 13 -2
10 5 110 11 -7

30

Now, copy the values of the 1st and 3rd columns of Table 3.1 on a separate piece of paper. Then, use equation
(3.5) to compute the corresponding values of APL (for each value of labor unit). Compare your results with those
in the 4th column. What trend have you observed for the APL?
Good. Like that of TP, APL first increases (in our case, up to 4 labor units), gets its maximum value (in our case
of 21 output units at the 4th labor unit) and eventually falls continuously afterwards. (This is better observed if
you yourself draw a graph of labor units and APL values or have a look at Figure 3.1.)

Marginal Product (MP)

We may, at times, be interested in knowing the extra output brought about by the extra employment of a
variable input. In terms of labor, we may ask “how much has the last laborer added to total product?” These
issues are explained by the marginal concept.

Marginal product is the extra or additional output obtained when one extra unit of a variable input is entered in
production while other factors remain fixed. Simply, marginal product is a change in the amount of total product
divided by a change in the amount of variable input used. For instance, marginal product of labor (MPL) is given
by:

MPL = Change in Total Product = ∆TP = ∂Q (3.6)
Change in Labor ∆L ∂L

The last term in this equation (read as the partial derivative of Q with respect to L) is applied when a continuous
production function (i.e. an algebraic equation) is given for output Q. (We will exemplify it in a while.)

Figure 3.1 Total, Average and Marginal Product Curves in Practice TP
140
Product
120

100

80 Stage II Stage III
60 Stage I

40

20 APL

0 12 34 5 6 7 8 9MPL

-20 Labor

Now also, copy the values of the 1st and 3rd columns of Table 3.1 on a separate piece of paper. Then, use
equation (3.6) to compute the corresponding values of MPL (for each value of labor unit).

Hence, MPL first rises (in our case, up to the 3rd labor unit), gets its maximum value (in our case of 31 output
units for the 3rd labor unit) and eventually falls afterwards. MPL becomes zero when total product gets its
maximum. This means that the last factor of production adds nothing to total output. Further employment of
labor beyond the zero MPL point even makes it negative implying that total production is falling from its
maximum value. In our illustration, this happens after the employment of 8 units of labor. Workers hired after
8th laborer contribute negatively. Note that geometrically, MPL curve is the slope of the total product (TP) curve.
(You capture similar ideas by observing Figure 3.1.)

31

Relationship between Average Product and Marginal Product

If you just have a close look at Table 3.1 and Figure 3.1 or Figure 3.2, particularly at APL and MPL, you easily come up
with the following:

− When MPL > APL, APL keeps on increasing. This is what you observe in the entire area labeled as stage I.
− When MPL = APL, APL is already at its maximum. One can locate this at the point where MPL and APL intersect

(end of stage I and beginning of stage II).
− When MPL < APL, APL keeps on decreasing. You see such a scenario in what we labeled as stages II and III.
A simpler way to understand the relationship between average and marginal product is to think of it in terms of grades.
Suppose you took only two courses so far and your average score for the two courses is 90 (=APL). If your score for an
additional (marginal) course is 93 (=MPL>APL), your new average will be 91. But, had your additional (marginal) score
been 87 (=MPL<APL), your new average would be 89. Thus, your marginal score pushes up or down your average product
depending on whether the marginal score is above or below the average respectively. The same relationship holds true for
APL and MPL.

As you know, in addition to tables and graphs, equations are important tools in economics to understand relationships. Let
us consider the following illustration.

Numerical Illustration:

Suppose that the short-run production function for cut-flower by a certain Ethiopian firm is given by:
Q = 4KL - 0.6K 2 - 0.1L2

where Q - represents the annual quantity of cut-flower produced.
K - annual capital input; suppose K=5.
L - annual labor input.

a) Determine the average product of labor (APL) function.
b) At what level of labor does the total output of cut-flower reach the maximum?
c) What will be the maximum achievable amount of cut-flower production?

Solution:

Q 4KL - 0.6K 2 - 0.1L2 0.6K 2 15 20L - 15 - 0.1L2
a) APL = L = = 4K - - 0.1L = 20 - - 0.1L =
L LL L

∂Q
b) We know that when total product (Q) is maximum, MP will be zero. And MPL = ∂L .

That is, partially differentiating1 Q with respect only to L and equating it to zero:

∂Q ∂(4KL - 0.6K 2 - 0.1L2 )
∂L ∂L
MPL = = = 4K - 0.2L = 0

⇒ 20 - 0.2L = 0 ⇒ L = 20 = 100
0.2

(Q – cut-flower level of output will be the maximum if the firm employs 100 units of labor.)

c) Substituting the optimal values of labor (L=100) and capital (K=5) into the original production function (Q) gives the
maximum level of cut-flower production:

Qmax = 4KL - 0.6K 2 - 0.1L2 = 4* 5* 100 - 0.6 * 52 - 0.1* 1002 = 985

1 As you may recall from your calculus, the partial derivatives of the multivariate function Z = aX b + cY d + eXY
with respect to X and Y (a-e are constants), respectively, are: ∂Z = baX b-1 + eY and ∂Z = dcY d-1 + eX

∂X ∂Y

32

3.2.1.2 Stages of Production

Based on the relationship between TP, MP and AP, economists have defined three stages of production. For
visual observation of the discussions that follow, you may refer to the following figure (Figure 3.2) for the
general case and/or Figure 3.1 for a numerical depiction.

Figure 3.2 Relationship between Total, Average and Marginal Product Curves
Product

TP

Stage I Stage II Stage III

L1 L2 APL Labor
L3

MPL

Stage I:
This stage of production includes the range of variable input levels at which the average product (APL) continues
to increase. Stage I goes from the origin to the point where the APL is maximum, which is the equality of MPL
and APL. In terms of Figure 3.2, this goes to L2 level of labor employment. At L2, the APL is at its maximum
value. A unit increase in labor initially has an impact of increasing output at an increasing rate (up to the L1 unit
of labor). That is why this stage of production also called the stage of increasing marginal returns.

Two explanations may be given for the presence of increasing marginal returns:
i. There is plenty of fixed input supply compared to the variable input. Therefore, as more and more units of
the variable input are added to the fixed input, the fixed input will be more intensively and effectively
exploited. Hence, the efficiency of capital or land will increase in proportion to the additional units of
variable input, labor for instance.
ii. Another explanation: As more and more units of the variable input is used, there will be division of labor
which will result in specialization. Specialization leads to higher productivity.

However, this will not persist indefinitely as average output begins to fall and marginal output continues falling
which mark the commencement of the second stage in production.

Stage II:
This stage of production covers that range of variable input used at which MPL is less than APL and is positive.
In this stage, both the APL and MPL of the variable input (labor) are diminishing but positive. According to
Figure 3.2, this starts from L2 and goes up to L3. In other words, stage II goes from the point where APL is at its
maximum (MPL=APL) to the point where MPL is zero. Here, as the input increases by one unit, output still
increases but at a decreasing rate, i.e., each increment on labor generates a smaller increase in output than the
last. This continues until output reaches its maximum at the L3 unit of labor. Due to this, the second stage of
production is termed the stage of diminishing marginal returns.

The reason for decreasing average and marginal products is due to the scarcity of the fixed factor. Once the
optimum capital-labor combination is achieved, employment of additional unit of the variable input will cause

33

the output to increase at a slower rate. As a result, the marginal product diminishes. The additional labor will
have less and less of the fixed input to work with. This reasoning has led to the emergence of the law of
diminishing marginal product, which will be our focus in the upcoming sub-section.

Any further additional labor unit after L3 will result in a decline in output and such a situation happens at the
third stage of production.

Stage III:
At this stage, an increase in the variable input results in the decline of the total product. Hence, the total product
curve slopes downwards and the marginal product of labor becomes negative. This happens after L3. The stage
is also known as the stage of negative marginal returns to the variable input.

The cause of negative marginal returns is the fact that the volume of the variable inputs is quite excessive to the
fixed input to the extent that they get in each others’ way – creating a problem of overcrowding. As a result, the
total product declines and results in negative marginal product. The saying "too many cooks spoil the broth”
seems to well fit this stage of production.

The second stage is the efficient stage of production. Let us begin from stage III. It implies that an increase in
the variable input (labor) results in a decrease in total product. As a result, a rational producer will never choose
to produce at this stage. Even if the producer gets labor for free, s/he cannot increase total output by engaging
more laborer. On the contrary, s/he can increase output by using less labor. On the other hand, stage I implies
the opposite. An increase in the variable input results in an increase in total product. At this stage, a rational
producer will not stop production. S/he expands his or her output further and makes use of the fixed input
efficiently. If a firm does not produce either in stage I or in III, the efficient stage of production is stage II.

3.2.1.3 The Law of Diminishing Marginal Product (LDMP)

The LDMP is the major factor behind the relationship between TP, MP, and AP. It states that as the number of
units of the variable input increases, other inputs held constant, the marginal product of the variable input
declines after a certain point. The law is sometimes called the law of variable proportions.

For instance, as you add more labor to a garden plot of fixed size, the marginal increase in vegetable may
increase. Nonetheless, a point is reached where an increase in the use of the variable input yields progressively
less and less additional (marginal) product. Each additional unit has, on average, fewer units of the fixed input
with which to work.

3.2.2 The Long-run Production Function

As we defined earlier, the long-run production function shows the maximum amount of output that could be
produced when all inputs vary. In the long-run, production of a commodity can be increased by employing more
of both variable and fixed inputs. While in the short-run a producer may be able to expand output only by
operating an existing plant for more hours per day, in the long-run it may be more economical to install
additional productive facilities to return to the normal working day.

The general expression for the long-run production function with the common four factors of production is:

Q = f(L, K, S, E) (3.7)

However, for ease of analysis especially in a bi-dimensional plane geometrically, we assume the use of only two
factors – labor and capital – so that:

Q = f(L, K) (3.8)

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3.2.2.1 Isoquants and Isocosts

For the analysis of a production function with two variables factors in the long-run, we make use of a concept
known as Isoquants. And adding the concept of isocosts to isoquants, we will be able to analyze the equilibrium
situation of a producing firm in the long-run.

(A) Isoquant

An isoquant is a curve that shows the different technically efficient combination of the two inputs that can
produce the same level of output. It is also called equal-product curve or product indifference curve.

Since an isoquant represents those combinations of two inputs which will capable of producing an equal
quantity of output the producer will be indifferent between them. The various combinations of labor and capital
could be presented, as usual, in tables called isoquant tables or schedules, graphs called isoquant curves and
equations. Due to their simplicity and visual expression, we prefer isoquant curves to others.

The following table presents 5 combinations of labor and capital. Each combination of labor and capital
produce the same level of output, say 50 tons of wheat.

Table 3.2 Isoquant Table (Schedule)

Input Labor (L) Capital Maximum
Combination (K) Output

A 1 12 50
B28 50
C35 50
D43 50
E52 50

I hope that plotting the above combination between L and K is a very simple task for you. So, your plot of the
data on the XY plane gives you following the iso-product or isoquant curve.

Figure 3.3 Isoquant Curve

14Capital
12
10
8
6
4
2
0

1 2 3 4 5 Labor

Here also, whether the form produces at point A or B or E, the same amount of output is realized. If the firm
produces less or more of that amount, it produces at another point and in another isoquant.

Collection of isoquants is known as an isoquant map, as shown in Figure 3.4. The further an isoquant is from
the origin, the larger the output level it represents as, for instance, 75 quintals of teff is greater than 25 quintals.

35

Figure 3.4 Isoquant Map
Capital

K4

K3

K2

K1 Q3=75
L1 Q2=50
Q1=25

L2 L3 L4 L5 Labor

Marginal Rate of Technical Substitution (MRTS)

It is the rate at which one input can be substituted for another given constant output. It is the absolute value of

the slope of the isoquant at the given point, i.e., marginal rate of technical substitution is the slope of an

isoquant.

Slope of an isoquant = MRTSL for K = amount of K given up = ∆K = dK = ∂K (3.9)
amount of L employed ∆L dL ∂L

The d before a variable indicates a change or total differential in the variable.

MRTS and marginal products are highly related. Recall the two-factor long-run production function in equation

(3.8).

Q = f(L, K)

The total differential of Q is given by:

dQ = ∂Q dL + ∂Q dK
∂L ∂K

= MPL (dL)+ MPk (dK)
However, along an isoquant the change in output is zero so that

dQ = MPL (dL)+ MPk (dK)= 0

⇒ dK = - MPL
dL MPK

This means that the ratio of marginal products is also similar to MRTS, i.e,

MRTSL for K = - MPL (3.10)
MPK

Note the following two things:

(i) It is also possible to arrive at the same finding using the following concept. When a producer employs
additional labor, he will get additional output given by MPL(ΔL). When the producer reduces the use of
capital input, he will face a decrease in output given by MPK(ΔK). Since along an isoquant the change in
output is zero, the increase and the decrease in output should be equal in magnitude, i.e,

36

MPL (∆L)= -MPK ( ∆K)

⇒ ∆K = - MPL ⇒ MRTSL for K = - MPL
∆L MPK MPK

(ii) Marginal rate of technical substitution of labor for capital ( MRTSL for K or MRTSL,K ) & marginal rate of

technical substitution of capital for labor ( MRTSK for L or MRTSK,L ) are not identical. Hence,

MRTS K, L = ∆L = dL = - MPK (3.11)
∆K dK MPL

The Law of Diminishing Marginal Rate of Technical Substitution (LDMRTS)

Most of the time inputs are imperfect substitutes. The LDMRTS states that as the amount of a given input
increases, given other inputs, its marginal product decreases. On the other hand when the amount of a given
input decreases, its marginal product increases. The more labor the firm has, the harder it is to replace the

remaining capital with labor. So, MRTSL,K falls as the isoquant becomes flatter.

On the way, we illustrate diminishing marginal rate of technical substitution.

Table 3.3 Marginal Rate of Technical Substitution

Input Labor Capital MRTSL, K MRTSK, L
(K)
Combination (L) - 0.25
12 4 0.33
A1 8 3 0.5
B2 5 21
C3 3 1-
D4 2
E5

MRTSL,K increases as more and more labor is employed – it falls to 1 from zero. It is that we called the law of
diminishing marginal rate of technical substitution. On the other hand, MRTSK,L increases as the employment

of capital increases. This is easily observable from the above table.

Properties of Isoquants

All isoquants share the following common properties.
(i) They are downward slopping (negatively slopped).
(ii) They are convex to the origin. This happens because of the law of diminishing marginal rate of technical
substitution.
(iii) Two isoquants never cross each other. If two isoquants cross each other, a single combination of the two
inputs (K and L) will represent two different levels of output, which is false.
(iv) Isoquants far from the origin represent higher levels of output.

(B) Isocost

As we will discuss in the upcoming chapter, production requires money at least for the acquisition of factors of
production. This money is a cost to the producer. A very interesting and simple fact is that a firm can spend an
identical total cost for various combinations of inputs. Here comes the concept of an isocost.

37

An isocost is simply a line that shows the various combinations of two inputs (in our case, labor and capital) that
can be purchased for the same amount of outlay (total cost).
Let us assume that the total cost incurred by a firm is only TC. And if the price of labor (L) and price of capital
(K) are symbolized by w and r respectively, then

TC = wL+ rK (3.12)

If we express K in terms of others, we get

K = TC - w L (3.13)
rr

This equation is known as isocost equation. It has the following implications:
 If the firm devotes its entire fund to purchase K, then it can employ TC/r amount of K, leaving no money to

hire labor (L=0).
 If the firm devotes all the funds to buy labor, then it can hire TC/w amount of L, leaving no money to

purchase K (K=0).
 All the intermediate positions on these two extreme points show any other combinations of L and K the

firm can hire at a cost of exactly TC.

Graphically, this could easily be put as follows.

Figure 3.5 Isocost Line
Capital
TC/r

TC/w Labor

Slope of an isocost line is given by the ratio of price of labor (w) and the price of capital (r), i.e., it is just the
derivative of the isocost equation given by equation (3.13) with respect to labor (L).

Slope of an isocost = dK = - w (3.14)
dL r

Note that the slope an isoquant and the slope of an isocost are both negative, implying the use or purchase of one
input disregards the other. (We have omitted it deliberately above.)

3.2.2.2 Optimum of the Producer in the Long-run

The objective of any firm is maximizing profit which could be achieved by either output maximization or cost
minimization or by both. In general, the optimum of the producer refers to the least cost combination of inputs
providing the maximum achievable output level. The optimum levels of the two inputs (K and L) can be found
by the use of isoquant curves and isocost lines.

A rational firm wants to produce more output i.e. to have isoquants far from the origin (like Q3=75 in Figure
3.6). However, that desire may be constrained by shortage of outlay for the purchase of factors of production.

38

The money may not buy enough inputs which help produce no more than 50 units of the output (Q2=50). So,
there must be a certain level of employment of inputs which maximizes output at the given cost of production.

The optimum of the producer is achieved at the point where an isocost line is tangent to an isoquant curve. This
means the point at which the slope of an isoquant is equal to the slope of an isocost line.

Figure 3.6 Equilibrium of the Producer
Capital

TC/r

A

K* E C

Q3 =75

B Q2 =50

Q1 =25 Labor
L* TC/w

 At point A, the firm uses all its money to buy L and K. But, it produces only 25 units of a product; it is very

low. The firm’s outlay is able to buy more inputs to produce further output. Point B is similar to point A in

terms of level of production.
 At point C, the firm can produce 75 units of a product. However, it cannot purchase the combination of L

and K that produces this much quantity.
 At point E, the firm produces 50 units of a product; and this is the maximum possible amount given the

cost. Therefore, the optimum combination of K and L is found at point E where the isocost line is tangent

to the second isoquant curve. At this equilibrium point, the slope of the isoquant equals with the slope of

w
the isocost, i.e. MRTSL,K = r .

 Accordingly, the firm has to purchase L* units of labor and K* units of capital to realize the maximum

possible level of output (=50 units) using the limited outlay of TC.

Numerical Illustration

Suppose a certain small enterprise allocates only 20,000 birr for the production of furniture (school armchairs).
The enterprise wants to employ workers (L) whose wage is w=1000 birr and purchase implements (K) at a price
of r=4000 birr. Suppose further that the production function for furniture is given by Q = 10L0.5 K 0.5 .
(a) Determine the marginal product functions of workers and implements.

(b) Find MRTSL,K and MRTSK,L .

(c) How many workers (L) and implements (K) must be acquired for the small enterprise to produce the
maximum possible number of armchairs.

(d) How many armchairs will be produced at the equilibrium of the enterprise?
(N.B.: Attempt them by yourself before looking at the solutions that follow.)

39

Solution:

We are given the production function as Q = 10L0.5 K 0.5 and the total cost (TC) function as

TC = wL+ rK ⇒ 1000L+ 4000K = 20,000 .

(a) Marginal product of a worker (MPL):

MPL = ∂Q = 0.5(10)L(0.5-1)K 0.5 = 5L-0.5 K 0.5
∂L

Marginal product of an implement (MPK):

MPK = ∂Q = 0.5(10)L0.5 K (0.5-1) = 5L0.5 K -0.5
∂K

(b) MRTSL, K = - MPL 5L-0.5 K 0.5 =− K and
MPK = - 5L0.5 K -0.5 L

MRTSK, L = - MPK = - 5L0.5 K -0.5 =− L
MPL 5L-0.5 K 0.5 K

(c) The optimum of the small enterprise is found at the following point:

wr
MRTSL,K = - r or MRTSK,L = - w .

If we use the first equality, we have:

w ⇔ - K = - 1000 = - 1 ⇒ L = 4K
MRTSL,K = - r L 4000 4

Substituting this last equation into the TC equation, gives:

1000L + 4000K = 20,000

⇒ 1000(4K)+ 4000K = 20,000

⇒ 8000K = 20,000

⇒ K* = 2.5

Hence, L* = 4K = 4(2.5)= 10

If the enterprise purchases 2.5 implements and employs 10 workers, it will have the least cost optimal level
of armchair production.

(d) At those levels of employments, the least cost amount of armchairs produced will be:
Qmax = 10(L* )0.5 (K* )0.5
= 10(10)0.5(2.5)0.5

= 10( 2.5 )
= 50

40

3.2.2.3 Returns to Scale
In the long-run, supply of both labor and capital becomes elastic. Firms can therefore employ more of both labor
and capital to increase their production. We now turn to determine the amount by which output changes if a firm
increases all its inputs proportionately (by the same percentage). This is what we mean by returns to scale. It
shows the percentage change in output as the firm changes all its inputs by the same proportion.

We have three types of returns to scale.

I. Increasing Returns to Scale (IRS):
If output rises more than in proportion to an equal percentage increase in all inputs the production function is
said to exhibit increasing returns to scale (IRS).
Example: A given production function exhibits IRS if doubling all inputs more than doubles the output: ƒ(aL,
aK) > aƒ(L, K) , a>1.

Reason for IRS:
Although a firm could duplicate a small factory and double its output, the firm might be able to more than
double its output by building a single large plant, allowing for greater specialization of labor or capital. In the
two smaller plants, workers have to perform many unrelated tasks such as operating, maintaining, and fixing the
machines they use. In the large plant, some workers may specialize in maintaining and fixing machines, thereby
increasing efficiency. Similarly, a firm may use specialized equipment in large plant but not in small plant.

II. Decreasing Returns to Scale (DRS):
If output rises less than in proportion to an equal percentage increase in all inputs, the production function
exhibits decreasing returns to scale (DRS).
Example: Doubling all inputs less than doubles output: ƒ(aL, aK) < aƒ(L, K), a>1.

Reasons for DRS:
− Difficulty of organizing, coordinating and integrating activities increase with firm size. An owner may be

able to manage one plant well but may have trouble of running two plants.
− Large team of workers may not function as well as small teams, in which individuals take greater personal

responsibility.

III. Constant Returns to Scale (CRS):
If output rises by the same proportion to an equal percentage increase in all inputs, the production function
exhibits constant returns to scale.
Example: When all inputs double, output also doubles: ƒ(aL, aK) = aƒ(L, K), a>1.

41

CHAPTER FOUR: THE THEORY OF COSTS

When firms produce goods and services, they have to incur various expenses. These expenses are known as cost.
In other words, cost of production is the monetary value of inputs used to produce an item over a given period of
time. Production and costs are interrelated terms. Production without cost is impossible and cost without
production is economically meaningless.

Costs (money payments) may be made either explicitly or implicitly. Explicit (accounting) costs are payments
which a firm makes to the outside suppliers of inputs to it. Payments made to raw materials, lab our service,
transport cost, etc are good examples. Implicit (imputed) costs refer to the value of non-purchased inputs owned
by the firm and used by the firm in its own production process. Wages to owner’s managerial labor time and
family labor, rent of the owner's productive assets, interest on the owner's money, etc could make few examples
of implicit costs.

Costs could be analyzed in the short-run and in the long-run. In line with the definition of the short-run, there are
costs paid to variable inputs called variable costs and to fixed inputs known as fixed costs. But, all inputs are
variable in the long-run so that we do not have fixed costs in this period. The scope of the course, however,
limits our analysis of costs only in the short-run.

4.1 Analysis of Costs in the Short-run

You may recall from the previous chapter that the short-run is the period in which at least one factor is fixed.
This helps us categorize costs broadly into fixed and variable costs. In a similar fashion as we did in the theory
of production, these fixed and variable costs could also have total, average and marginal counterparts.

4.1.1 Total, Average and Marginal Costs

Total Variable Cost (TVC)
It is the sum of all payments to variable inputs needed to produce a given level of output. TVC directly varies
with the amount of output. The monetary values of services of workers, fuel, raw materials, rent for machineries
and equipments on hourly basis, etc are examples of variable cost. To determine TVC for a given amount of
output, we simply multiply the quantity of each variable input by the price of that input and sum the result.

Total Fixed Cost (TFC)
It represents the payments made to all fixed inputs employed. Such costs remain the same regardless of the level
of output. Regardless of the amount of output chosen to be produced (even if a firm does not produce anything),
it has to incur fixed costs. Property taxes, mortgage payments, insurance, interest on borrowed money,
managers’ salary, depreciation and general overhead costs are examples of TFC.

Total Cost (TC)
It is the total cost of all inputs (both fixed and variable) used to produce a given level of output. That is, total
cost is the sum of total fixed cost and total variable cost:

TC = TFC +TVC (4.1)

While TFC is fixed at a certain value, TVC and TC have an obvious increasing trend if output increases and

vice-versa.

The analysis of costs could be simplified if one presents them either in tables, curves or equations as functions
of output. We begin from tables. In Table 4.1, we consider a firm spending some 100 thousand birr as total fixed
cost (TFC). As expected, TVC is zero at zero output (Q) level but rises continuously with the increase in output.
This increasing trend of TVC is also shared by TC although it begins at the value of TFC, not at zero like TVC.

42

Table 4.1 Total Costs

Q TFC TVC TC
0 100 0 100
1 100 46 146
2 100 78 178
3 100 102 202
4 100 124 224
5 100 150 250
6 100 186 286
7 100 238 338

Figure 4.1 Total Cost Curves
Cost

400

350 TC

300

250 TVC
200

150

100 TFC

50

0
01234567
Output

You might have noticed the following from the Figure 4.1:
− The TFC is a straight line.
− The vertical distance between the TVC and the TC is a constant. That vertical distance measures the TFC

since TC – TVC = TFC.
− TVC and TC not straight lines, they are curves.
− The shape of TC curve takes the shape of TVC.

From the total costs, we can derive other types of costs: average and marginal costs.

Average Cost (AC)
If we divide total cost by the total quantity produced, we get average cost (AC). It measures the cost of
producing a single quantity of output (AC is the unit cost of production). AC is a contribution of average fixed
cost (AFC) and average variable cost (AVC). This is due to the fixed and variable components of TC. Look at
the following expression:

43

AC = TC = TFC +TVC = TFC + TVC = AFC + AVC (4.2)
QQ QQ

Marginal Cost (MC)
Marginal cost is the extra or additional cost of producing one more unit of output. It is calculated on the basis of
an additional unit using the following formula:

MC = ∆TC = d(TC) (4.3)
∆Q dQ

However, since TFC does not change, MC could be expressed as the change in total variable cost due to the

extra unit of production. That is:

0
d(TC) d(TFC +TVC) d(TFC) d(TVC) d(TVC)
MC = = = += (4.4)
dQ dQ dQ dQ dQ

Table 4.2 Average and Marginal Costs

Q TFC TVC TC AFC AVC AC MC
- -
0 100 0 100 -- 146 46
89 32
1 100 46 146 100 46 67.33 24
56 22
2 100 78 178 50 39 50 26
47.67 36
3 100 102 202 33.33 34 48.29 52

4 100 124 224 25 31

5 100 150 250 20 30

6 100 186 286 16.67 31

7 100 238 338 14.29 34

Below is the graph of the above derived costs based on Table 4.2.
Figure 4.2 Average and Marginal Cost Curves

16C0ost

140 AC

120

100 AFC
80

60 MC
AVC
40
6 Output 7
20

0
012345

From Table 4.2 and Figure 4.2, one may get the following generalizations:
As the number of outputs produced increases,

44

− AFC continuously declines but never becomes zero - showing the spread of overhead costs over the total
quantity of output produced.

− The gap between AVC and AC gets narrower and narrower because AFC becomes smaller and smaller
with more production. Note that AC – AVC = AFC.

− AVC and AC curves first decline, then reach their minimum points and increase afterwards. N.B.: AVC
reaches a minimum before AC does.

Important Points about MC
− The marginal cost is the same as the slope of the total cost curve or the total variable cost curve.
− Since the marginal cost curve is not a straight line, its slope changes along the curve. The MC curve first

decreases, then reaches a minimum and increases afterwards. This is the mirror of the law of diminishing
returns.
− The MC curve cuts both AC and AVC at their minimum points.

Numerical Illustration

Consider a firm having the following total cost of production function:
TC = 750 + 30Q - 4.5Q2 + 1 Q3 where Q is the level of output.
3

(a) Determine the TFC and TVC functions.
(b) Find the AFC, AVC, AC and MC functions.
(c) Calculate the level of output Q at which the AVC reaches its minimum.

(N.B.: As usual, attempt them by yourself before looking at the solutions that follow.)

Solution:

(a) TVC is, by definition, a function of output level Q, i.e., the part of TC which contains Q is TVC. And that
component of TC that is free from Q is the TFC. Hence,

TFC = 750 and TVC = 30Q - 4.5Q2 + 1 Q3

3

(b) AFC = TFC = 750 , AVC = TVC = 30 - 4.5Q + 1 Q2
QQ Q3

AC = AFC + AVC = 750 + 30 - 4.5Q + 1 Q2
Q3

d(TVC) d(30Q - 4.5Q2 + 1 Q3 )
3
MC = = = 30 - 9Q + Q2
dQ dQ

(c) Remember that when AVC reaches its minimum, MC cuts it from below. This implies that at the minimum
of AVC, we have:

45

AVCmin = MC
⇒ 30 - 4.5Q + 1 Q2 = 30 - 9Q + Q2

3
⇒ 2 Q2 = 4.5Q

3
⇒ 2Q = 13.5
⇒ Q = 6.75

It is also possible to apply the optimization concept from calculus to get the same AVC minimizing level of
output Q as above. Any function at its minimum (or maximum) has its first order derivative equal to zero.
Hence, at its minimum, the derivative of AVC with respect to Q (slope of AVC) is zero. That is,

d(AVC) = 0 ⇒ - 4.5 + 2 Q = 0 ⇒ 2Q = 13.5 ⇒ Q = 6.75
dQ 3

This implies that when the firm produces 6.75 units of output, its variable cost of producing a single unit
of output will be the minimum.

4.1.2 Comparing Production and Cost Curves in the Short-run

There is a clear and interesting relationship between production functions and cost functions in the short-run. In
general, in production and cost relationships, increasing returns (stage I of production) and diminishing costs
(falling average and marginal costs) go together, and vice-versa. The graphical presentations make comparisons
visual. Short-run cost curves are the mirror images of their corresponding production curves. While AVC, AC
and MC curves are all U-shaped, AP and MP curves are inverted U-shaped.

The following precise relationships are identified between average and marginal values in production and costs.
(Refer to Figure 4.3 for clarity.)

Relationship between MP and MC:
− When MP rises, MC falls.

In the upper panel of Figure 4.3, MP curve is increasing throughout the segment CA, while MC curve is
falling all over segment C’A’ at the lower panel of the figure.
− When MP reaches maximum, MC reaches minimum.
Point A is the maximum of MP curve and at the same time, MC attains its minimum at point A’.
− When MP falls, MC rises.
In terms of Figure 4.3, MP curve falls after the maximum point of A while MC begins to rise after point
A’, the mirror of point A.

Relationship between AP and AVC:
− When AP rises, AVC falls.
− When AP reaches maximum, AVC reaches minimum.
− When AP falls, AVC rises.
− When AP is equal with MP, AP reaches maximum.
− When MC reaches minimum MP reaches maximum
− When MC declines, MP rises.
− When MC rise , MP declines
− When AVC equals with MC, AVC reaches minimum.

46

Figure 4.3 Relationship between Production and Cost Curves
Output

C A
D B

Cost AP
Variable Input
D’ B’
C’ A’ MP

MC
AVC

Output

47