Intro to Econ Material

CHAPTER FIVE: PERFECT COMPETITION

Economic theory has described four market structures at which the world is operating. Despite the variation in
the intensity of these market structures across geographic zones (be it global, national, regional, local) and along
markets (such as commodity market, labor market, financial market etc) all the four market structures are good
models of any economy. Employment opportunities for citizens, quantity and quality of products supplied by
producers, price of the product consumers pay, quality of life of the people, economic growth etc, are largely
determined by the market that governs an economy. Any government is therefore responsible to establish a
fertile environment for the good of the society by launching polices and regulating the economy so that the
market would supply the required good/service for the needy citizens at best.

One of the classic market structures is the perfect competitive market that you are going to budget some of your
scarce time from now on. Think over competition is a fierce business here in Ethiopia in some of the business
sectors over the past few years (consider for example the agriculture products, boutiques, hotels and restaurants,
formal sector employment etc). How do firms operate when they face the fiercest competition? Does
competition bring efficiency? Why do firms sometimes shut down temporarily and lay-off their workers? Why
do firms enter and leave an industry? You will find out all these important concepts in this and the next chapter
and try to reconcile what you understand here with your local and national context.

5.1 What is Perfect Competition?
Let us formally introduce ourselves to the basic characteristics of the perfectly competitive market structure to
properly defend these questions.

Perfect completion is industry in which:
• Many firms sell identical products to money buyers
• There are no restrictions on entry into and exit from the industry
• Sellers and buyers are well informed about prices

Farming, shopping, grocery retailing etc are examples of highly competitive industries. These characteristics of
the market imply that each firm is relativity small to the market and has no power to influence the market price
by regulating its supply. Perfect competition arises if the firm’s minimum efficient scale is small relative to the
demand. A firm’s minimum efficient scale is the small quantity of output long-run average cost (LAC) reaches
its lowest level. If the firm’s minimum efficient scale is small relative to the demand, there is room to new firm
to join the industry. Perfect competition also arises if each firm is perceived to produce a good or service that
has no unique characteristics so that consumers do not care which firm they buy from.

From the characteristics of the industry we have outlined above one can imply that the firm in a competitive
industry is a price taker but not a price maker. Why? Again think over a couple of minutes why a teff growing
farmer in your district is considered to be a price taker.

A price taker is a firm that can’t influence the market price and that sets its own price at the market price. This is
because:

• The market share of each firm in the industry is small. The firm produces only a tiny fraction of the total
output of a particular good. Thus, if a single firm is entered into or exits from the industry neither
significant volume of the total supply nor the price of the product is to be affected.

• The products of all firms are homogenous (identical) in any case. In effect each firm is impotent to set a
separate price to its produces. Instead the firm is enforced to charge its customers the price set by the
market.

• Buyers and sellers posses perfect information about the market such as price, product quality etc. As a
result there is no market distortion (price variation) among firms resulting from asymmetry of
information.

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Imagine your parents or one of your kin growing a teff/wheat with pessimistically ten hectares of land under
cultivation. This sounds quite a lot in your woreda (even in Ethiopia) context. But when compared to hundred
thousands of hectares of land in the woreda, the ten hectares of land owned by your kin is a drop in the ocean.
Nothing makes your kin’s teff/wheat any better than any other farmer’s teff/wheat and all the local buyers of
teff/wheat know the price at which they can do transaction. If the price of a quintal of teff is Birr 100 and if your
families ask Birr 1100, no one will buy from your families instead the buyer will visit the next farmer who is
ready to sell at the market price of Birr 1000.

If your families set the price of a quintal of teff at Birr 900, they will have lots of buyers but they can sell their
entire quintal of teff at Birr 1000. So, there is no economic reason to cut price down. In sum, your parents/kin
can do no better than sell a quintal of teff at the prevailing market price. Thus, they are price takers.

Habitually, the term competition is understood as a market where firms(sellers) are engaged in very tough
rivalry among themselves. People usually expect that there is unlimited price war among market players so that
one can sell more and defeat its competitors too. In general competitive market condition is believed to be a war
front that businessmen battle each other. However, technically the concept of perfect competition is different
from such type of misconception. Note that the equilibrium market clearing price is determined by the forces of
summed-up demand and supply. Each firm in the market has no role to set price and influence the market
clearing price as it is little relative to the market. The firm can clear sell its entire product at the market clearing
price. The combined effect of all these market forces entirely avoids unnecessary price war among the
competing firms. We can, therefore, confidently emphasize that perfect competition is a market structure where
there is no any form of rivalry among the competing firms.

5.2 Total Revenue, Marginal Revenue and Demand Curves of a Competitive firm

In the previous chapters you have learned that a firm aims to generate the highest possible profit. And profit is
nothing more than the difference between revenue and costs. Total revenue (TR) of the firm is the product of
price (P) and the quantity (Q) of the good sold. That is

TR = P.Q

The following data reflects the performance of a competitive rice growing farmer in Fogera woreda. The total
revenue of the rice grower is increasing with increasing sales volume and market price.

Quantity of Rice Price/Quintal Revenue Marginal Revenue
sold(Q)in quintal 1000
1000 TR = P.Q MR = ∆TR ∆Q
10 1000
15 10,000 1,000
18 15,000 1,000
18,000

Figure 5.1 The Total Revenue curve

Total
Revenue

TR = PxQ

Quantity of Rice sold (Q) in quintal

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Marginal revenue a firm, which you are familiar too, reflects the additional revenue that the rice grower collects
from the sale of one more quintal of rice at Birr 1000. In simple mathematical notation we can express is as:

MR = ∂TR Which is equivalent to MR = ∆TR
∂Q ∆Q

From the table above please note that when the sale of rice grows from 10 quintals to 15 quintals and from 15 to

18 quintals the marginal revenue of the farmer is Birr 1000 and is constant.

Have you noticed that the Marginal Revenue, Price and Demand of a competitive firm are equal? I think you did

it so. The price of the product is exactly the same as the marginal revenue of and thereby the demands curve of a

competitive firm. Because the price remains constant when the quantity sold changes, the change in TR that

results from a one unit increase in the quantity sold equals price-in perfect competition, marginal revenue equals

price. A competitive firm therefore faces a perfectly elastic demand curve.

− Mathematically, we can express it as to what follows.
Since price is constant, the change in total revenue emanates from
TR = P XQ

∂TR − ∂Q − the change in quantity only.

MR = ∂Q = P X ∂Q = P

Thus, the marginal revenue and demand of a firm are the same as the constant price (the bar over p reflects that
price is kept constant). We can present the framework in the following graph

5.3 The Firm’s Decision

The perfectly competitive firm faces two constraints while optimizing its decisions. The first constraint is the
constant price set by the market and is reflected by the marginal revenue curve of a firm and the second one is
the technological constraint. The technological constraint is described by the product curves you have studied in
the previous chapters of this course. The technology available to the firm determines its costs. On the other
hand, the goal of the competitive firm is to harvest the highest attainable profit given the aforementioned
constraints. To achieve this objective, a firm must make four decisions, two in the short-run and two in the long-
run.

Short-run decisions: In the short run the number of firms is fixed and a given firm has a fixed plant size. Under
such circumstances how does the firm react if there is some market shock for example fluctuation of the price of
rice in Fogera and around its vicinity? Thus the firm must react to these fluctuations and decide:

♥ Whether to produce or temporary shut down

♥ If the decision is to produce, what quantity to produce

Long-run decision: In the long run the firm has the time to determine its plant size and can decide whether to
leave the industry or enter into the industry. Here you can easily note that both the number firms and the scale of
the plant are subject to change. In the long-run the technology is also dynamic. Firms react to these long-run
changes and decide:

♥ Whether to increase or decrease their plant size

♥ Whether to remain in an industry or leave it

5.4 Profit Maximizing Output
A perfectly competitive firm maximizes economic profit by choosing its level of output. There are two
approaches to find the optimal level of output. These are the total revenue-total cost approach and the marginal
analysis. We will see some detailed version of these two approaches here below.

The Total Revenue-Total Cost Approach

One way of maximizing the profit maximizing output is to study a firm’s total revenue and total cost curves and
to find the output level at which total revenue exceeds total cost by the larger amount.

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Figure 5.2 Total Revenue and Total Cost curves

TC

TR

Total B
Revenue,
Total Cost

A

4 9 12 Quantity of Rice sold (Q) in quintal

The figure above shows how to find the profit maximizing output for the Fogera rice grower. The graph is
generated using a hypothetical data in the table below. The following table lists the rice farmer’s total revenue
and total cost (TC) at different output. The total revenue curve is linear and upward sloping. This is because
total revenue is proportional to the level of output while price is determined by the market. The slope of the total
revenue curve is the constant price. The total revenue and total cost curves are graphed using the data in the first
three columns of the table. Note that the price is fixed at Birr 1000.

Quantity of Rice Total Revenue in Total Cost(TC) of Economic Profit
sold per day in Birr Production (π = TR-TC)
0 22 -22
quintal 1000 1020 -20
0 2000 2016 -16
1 3000 3010 -10
2 4000 4000 0
3 5000 4989 11
4 6000 5976 24
5 7000 6966 34
6 8000 7960 40
7 9000 8958 42
8 9960 40
9 10,000 10970 30
10 11,000 12,000 0
11 12,000 13,035 -35
12 13,000
13

The forth column of the table shows the farmers economic profit. The TR and TC curve is a graphical
representation of the tabulated data. The farmer makes an economic profit at outputs between 4 and 12 levels of
output. At output fewer than 4 quintals a day the farmer incurs a loss. It also incurs a loss if it produces more
than 12 quintals of rice a day. At 9 level of output the farmer earns the highest level of positive profit. Economic
profit is zero if the farmer produces either 4 or 12 quintals of rice per day. At these points both TR and TC are
equal. This point is break-even point. At breakeven point the firm makes normal profit where the firm obtains an
income equal to the best alternative return forgone.

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The Marginal Analysis

One can compare the marginal revenue (MR) and marginal cost (MC) of a firm to find the level of output that
ensures the highest profit.

Figure 5.3 The Marginal Revenue-Marginal cost curves

Price MC
25 A P = MR

9 Quantity

As the level of output rises MR remains constant but MC changes. At lower level of MC decreases when output
expands but eventually MC increases. So where the MC curve intersects the MR curve from below (at point A
of the graph), MC is rising-the marginal cost curve is upward sloping. This is illustrated in the above graph too.
Essential elements of the marginal approach could be summarized in the following three ways.

♥ If marginal revenue exceeds marginal cost, then the extra revenue from selling one more unit exceeds
the extra cost incurred to produce it. The firm makes an economic profit and expansion of output is
recommended.

♥ If marginal revenue is less than marginal cost, then the extra revenue from selling one more unit is less
than the extra cost incurred to produce it. The firm incurs an economic loss and contraction of output is
recommended.

♥ If marginal revenue is equal to marginal cost, then the extra revenue from selling one more unit is the
same as the extra cost incurred to produce it. The firm makes the maximum economic profit and neither
expansion nor contraction of output is recommended.

You can also determine the profit maximizing output of a firm simply busing the revenue and cost schedule of
the firm. For example each day, Domain bakery distributes a dozen of bread (a set of 12) to its customers at a
price of Birr 25. Look at the following table to understand how the marginal rule is applied to determine the
optimal production of bread for Domain bakery.

Quantity of Total Revenue Marginal Total Cost(TC) Marginal Economic Profit
Bread(set of 12) in Birr (TR) Revenue(MR) 141 Cost(MC) (π = TR-TC)
161
7 175 25 185 20 34
8 200 25 212 25 39
9 225 25 245 27 40
10 250 25 33 38
11 275 30

Focus on the highlighted row of the above table. If output rises from 8 to 9 dozen of bread marginal revenue and

marginal cost are equal at Birr 25.The economic profit in the last column also increases from Birr 39 into Birr

40.If Domain Bakery increases its output beyond 9, not that the MR is kept at Birr 25 whereas MC is 27 and 33
for the 10th and 11th units of bread. These marginal costs are above the marginal revenue and the bakery is

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making a loss at the margin. This in turn shrinks the volume of economic profit from Birr 40 into Birr 38 and
then to Birr 30.

5.5 Demand for a Firm’s Product and Market Demand

A horizontal demand curve is perfectly elastic. So the firm faces a perfectly elastic demand for its output
(denoted by dd curve). But the market demand (DD) for bread in Bahir Dar, in figure 5.4(a) is not perfectly
elastic. The market demand curve is downward sloping.

Figure 5.4 Demand, Price and Revenue in Perfect Competition

Price

SS TR

25 25 25
DD DD=MR

9 Q9 Q
Fig 5.4(a) Fig 5.4(b) Fig 5.4(c)

In part (a) market demand (DD) and supply (SS) determine the market price (and quantity). Part (b) shows
Domain’s total revenue curve which corresponds to third row of the above table. Part(c) shows the marginal
revenue curve. The curve is the demand curve for Domain bakery which faces a perfectly elastic demand curve
at the market price of Birr 25.

How can the demand for Domain bakery be perfectly elastic while the market demand for bread is not perfectly
elastic? The answer is that the elasticity of demand depends on the closeness of substitutes for a good. Domain
bread is close substitute for Gojjam bread or any other bakery in Bahir Dar and vice versa. But bread in general
is not close substitutes for other goods and services.

5.6 Profits and Losses in the Short-run
In the short-run, although the firm produces the profit maximizing output, it does not necessarily end up making
an economic profit. It might do so, or it might alternatively breakeven (earn normal or zero profit) or incur an
economic loss. Economic profit (loss) per unit is price minus average total cost, ATC. So total economic profit
(loss) is:

Pr ofit(loss) = (P − ATC)Q

There are three possibilities:

A. If price and ATC are equal the firm is at its breakeven point. This condition is illustrated in Figure
5.5(a).

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Figure 5.5 The possible profit outcomes in the short-run MC
Price ATC

P* A P = MR

Q* Quantity
(a)
At point A, the price of the commodity/service (P*) is exactly the same as the average cost of production which
make the difference between price and average total cost zero. The firm is earning normal economic profit
B. If price exceeds ATC, the difference between price and ATC is positive which induces the firm to
collect positive (super normal) profit. This is illustrated in figure (b).

MC

ATC

Price and Costs

P* B MR

DA

Q* Quantity
(b)

At the level at which equilibrium price P* is the same as the MR, ATC is below the price (P*) the firm charges
its customers. For each unit of sale the firm maintains AB amount of profit and the total profit from the sale of
Q* level of output is denoted by area ABP*D, which is nothing but Pr ofit = (P * − ATC)Q *

C. If price of the product (P*) is below the average cost of production (ATC), the firm is making an
economic loss because the selling price is not sufficient to cover the production cost of each unit of
good/service. This possibility is shown in fig (c).

Note that the ATC of production, at the point where profit is maximized, is over and above the price of
the product (P*). The firm is making an economic loss per unit of output quantified by the difference
between market price and the ATC. The total loss of the firm is, therefore, area ABDP* or it is the same
as:

loss = (P * − ATC)Q *

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Price, Costs MC B ATC
A MR
D
P*

Q* Quantity
(c)

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CHAPTER SIX: IMPERFECT COMPETITION

In chapter five, we have seen some of the important features of perfect market structures where large number of
buyers and sellers make an exchange. The number of market players coupled with the homogeneity of the
product makes each firm powerless to control over price-the so called price taking firm. In effect, a perfectly
competitive firm earns normal (zero) economic profit in the long-run and its demand curve is perfectly elastic.
However, real market conditions are far from perfect. For instance,

♥ Certain goods and services are produces and/or sold by one or few or relatively large number of
suppliers.

♥ It is evident that the products supplied to the market are heterogeneous. This implies that unlike the
perfectly competitive firm, an imperfect competitive firm may have at least some degree of price setting
power. Suppose a cup of macchiato at Azewa Hotel is not identical to a cup of macchiato at Millennium
café or anywhere else though there is relatively large number of sellers.

♥ The domestic flight is owned by Ethiopian Airlines which is a sole supplier of the service. Thus a
passenger who wants to visit Lalibela by plane has no other alternative other than using the Ethiopian
Airlines.

♥ There are also cases where large size of the market is served by only little number of sellers. Consider
the soft drink market of Ethiopia. Moha Plc and Coca-Cola fully controlled the entire market of the
nation.

Thus, from now on you will be more acquainted to the pricing and output decisions of these market structures in
some detail. There are three market structures under the imperfect market structure. These are:

• Monopoly
• Oligopoly
• Monopolistic Competitive
6.1 Monopoly
Benchmarking: Ethio telecom is the sole player in the telecom industry of Ethiopia. How do firms like this
behave? How does it choose the quantity of telecom service to supply and the price to charge? Does it charge
too much and produce too little? Would more competition among suppliers in the telecom industry of Ethiopia
bring greater efficiency? Find out in this chapter.

Market Power: Market power and competition are the two forces that operate in markets. Market power is the
ability to influence the market, and in particular the market price, by influencing the total quantity offered for
sale.

Firms in perfect competition have no market power. They face the force of raw competition and are price takers.
A monopoly firm exercises raw market power. A monopoly is a firm that produces a good or service for which
no close substitute exists and which is protected by a barrier that prevents other firms from selling that good or
service. In monopoly, the firm is the industry. In Ethiopia, the following are typical examples of monopoly.

• The Ethiopian Electric Power Corporation
• The Ethiopian Telecom
• Ethiopian Airlines (Domestic flight)
• Urban water supply service
• The Ethiopian Tobacco monopole
• The Ethiopian postal service

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6.1.1 How Monopoly Arises
Monopoly has two key features

• The products have no close substitutes

If a good has a close substitute, even though only one firm produces it, that firm effectively faces competition
from the producers of substitutes. Mobile service supplied by Ethiopian telecom is an example of a service that
doesn’t have close substitute. Monopolies are constantly under attack from new products and ideas that
substitute for products produced by monopolies.

• There is a barrier to entry

Legal or natural constraints that protect a firm from potential competitors are called barriers to entry. A firm can
sometimes create its own barrier to entry by acquiring a significant portion of key resources such as controlling
strategic resources. Most monopolies arise from two other types of barriers: legal barriers and natural barriers.

Legal barriers to entry: Legal barriers to entry create legal monopoly. A legal monopoly is a market in which
competition and entry is restricted through ownership of a resource by:

A granting of monopoly franchise: An example is the exclusive right to carry out postal services given to the
Ethiopian Postal Agency.

A government license: A government license controls entry into particular occupations, professions and
industries. Examples of this type of barrier to entry occur in medicine, law and many other professional services.
A government license doesn’t always create a monopoly but it does restrict competition.

A patent or a copy right: A patent is an exclusive right granted to the inventor of a product or service. A copy
right is an exclusive right granted to the author. Patents and copy rights are valid for limited period that varies
from country to country.

Natural barriers to entry: These would create natural monopoly, an industry in which one firm can supply the
entire market at a lower price than two or more firms can. Example the Ethiopian Electric Power Corporation is
a natural monopoly in the distribution of electric power at lower prices.

6.1.2 Monopoly Price Setting Strategies
All monopolies face a trade-off between price and the quantity sold. To sell a larger quantity, the monopolist
must charge a lower price. But there are two broad monopoly situations that create different trade-offs. They
are:

Price discrimination: It is the practice of selling different units of a god or service for different prices. Different
customers might pay different prices for the same item. For example, Ethiopian Airlines offer a dizzying array
of different prices for the same trip so different passengers on the same flight end up paying different prices.
When a firm price discriminates, it looks as though it is doing its customers a favor by offering low prices to
some of them. However, the firm is doing the opposite. It is charging the highest possible price for each unit that
it sells and making the largest possible profit.

Not all monopolies can discriminate price. The main obstacle to price discrimination is resale by customers who
buy for a low price. Because of resale possibilities, price discrimination is limited to monopolies that sell
services which cannot be resold.

Single Price: A single price monopoly is a monopoly that must sell each unit of output for the same price to all
its customers.

6.1.3 Price and Output Decision of a Single Price Monopolist
To understand how a single price monopoly makes its output and price decision, we must first study the link
between price and marginal revenue.

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Price and Marginal Revenue

Because in a monopoly there is only one firm, the demand curve facing the firm is the market demand curve. Let
us look at Papyrus hotel’s swimming pool, the only swimming pool at the downtown of Bahir Dar. The table in
figure 6.1 shows the market demand schedule. At a price of Birr 20, the hotel sells no swimming service, the
lower the price, the more service per hour Papyrus can sell. For example, at Birr 12, consumers demand 4
swimming sessions per hour.

Price per Quantity Total Revenue Marginal Revenue
session demanded
TR = PXQ MR = ∆TR ∆Q
A 20 0
B 18 1 0 18
C 16 2 18 14
D 14 3 32 10
E 12 4 42 6
F 10 5 48 2
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The table shows the demand schedule. Total revenue is price multiplied by quantity sold. Marginal revenue is
the change in total revenue that results from a one unit increase in the quantity sold. For example when the price
falls from Birr 16 to Birr 14 per session the quantity of service sold increases by one and total revenue increases
by 10. Marginal revenue is 10. Figure 6.1 shows the market demand curve and marginal revenue (MR) curve
and illustrates the calculation we have just made. Notice that at each level of output, marginal revenue is less
than price-the MR curve lies below the demand curve except on the level of the y-intercept. Why?

Marginal revenue less than price because when the price is lowered to sell one more unit, two opposing forces
affect total revenue. These are:

• The lower price results in a revenue loss and

• The increased quantity sold results in a revenue gain

For example, at a price of Birr 16 papyrus hotel sells two swimming services. If the hotel lowers the price to
Birr 14 it sells 3 swimming services and has a revenue gain of Birr 14 on the third swimming service. But the
hotel now receives only Birr 14 on the first two -2 Birr less than before.

Fig 6.1 Demand and Marginal Revenue

Price
16
14

10 Demand

MR

02 3 Quantity of service

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The hotel loses Birr 4 of revenue on the first 2 swimming services. To calculate marginal revenue, the hotel
must deduct this amount from the revenue gain of Birr 14. So its marginal revenue is Birr 10 which is less than
price. In sum, in monopoly demand is always elastic.

A monopolist sets its price and output at the levels that maximize economic profit. To determine this price and
output levels, we need to study the behavior of both cost and revenue as output varies. A monopoly faces the
same type of technology and cost constraints as a competitive firm. So, the shape of its costs (total cost, average
costs and marginal costs) behave just like those of a firm in perfect competition. And its revenues (total revenue,
price and marginal revenue) behave in the way that we behave described just now.

In the table below, you can see that the total cost (TC) and total revenue(TR) both rise as output expands, but
TC rises at an increasing rate and TR rises at a decreasing rate.

Price Quantity TR = PXQ MR = ∆TR ∆Q TC MC = ∆TC ∆Q π = TR − TC
demanded

20 0 0 20 -20
18 1 18 -3
16 2 32 18 21 1 8
14 3 42 12
12 4 48 14 24 3 8
10 5 50 -5
10 30 6

6 40 10

2 55 15

Economic profit which equals TR minus TC, increases at small output level, reaches a maximum and then
decreases. The maximum profit (Birr 12) occurs when Papyrus sell 3 swimming services for Birr 14 each. If it
sells 2 swimming services for Birr 16 each or 4 swimming services for Birr 12 each, its economic profit will be
only Birr 8.

Economic profit is maximized when marginal revenue equals marginal cost. Therefore, the profit maximizing
output is 3 session of swimming services an hour. The price is determined by the demand curve and is Birr 14
per session. The average total cost (ATC) Birr 10 per session, so economic profit, area ABCD is Birr 12- the
profit per session (Birr 4) multiplied by 3 swimming sessions per hour.

Figure 6.2 Demand , Marginal Revenue and Cost curves
MC

16 Price ATC
14 D Demand
10 C A
B

MR

02 3 Quantity of service

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All firms maximize profit by producing the output at which MR equals MC. For a competitive firm, price equals
MR, so price also equals MC. For a monopoly, price exceeds MR, so price also exceeds MC. A monopoly
charges price that exceeds marginal cost but does it always make an economic profit? In the swimming pool
case when the hotel produces 3 swimming sessions an hour, the ATC is Birr 10 and the price is Birr 14. The
swimming pool is therefore profitable.

If a firm in a perfectly competitive industry is making positive economic profit, new firms enter. This doesn’t
happen in monopoly. Barriers to entry prevent new firms from entering and industry in which there is a
monopoly. Thus a monopoly can make positive economic profit and might continue to do so indefinitely.

6.2 Monopolistic Competition

6.2.1 What is Monopolistic Competition?
You have studied two types of market structure: Perfect competition and monopoly. In perfect competition a
large number of firms produce identical goods, there are no barriers to entry and each firm is a price taker. In
monopoly, a single firm is protected from competition by barriers to entry and can make an economic profit
even in the long run.

Most real world markets are competitive but not perfectly competitive because firms in these markets possess
some market power to set their prices as monopolies do. We call this type of market monopolistic competition.
Monopolistic competition is a market structure in which:

• A large number of firms compete

In monopolistic competition, as in perfect competition, the industry consists of large number of firms. The
presence of large number of firms has three implications.

 Each firm has small market share. Consequently each firm has only limited market power to influence the
price of its product. Each firm’s price can deviate from the average price of other firms by a relatively a small
amount.

 A firm in a monopolistic competition must be sensitive to the average market price of the product. But each
firm does not pay attention to any one individual competitor. Because all firms are relatively small, no one
firm can dictate market condition and so one firm’s action directly affect the action of the other firm.

 Firms in monopolistic competition would like to be able to conspire to fix a higher price-called collusion. But
because there are many firms, collusion is not possible.

• Each firm produces differentiated product

A firm practices product differentiation if it makes a product that is slightly different from the products of
competing firms. A differentiated product is one that is a close substitute but not a perfect substitute for the
products of other firms. Some people will pay more for one variety of the product, so when its price rises, the
quantity demanded falls but it does not necessarily fall to zero.

• Firms compete on product quality, price, marketing and branding firms

Product differentiation enables a firm to compare with other firms in four areas: quality, price, marketing and
branding.

• Firms are free to enter and exit

In monopolistic competition, there is free entry and free exit. Consequently, a firm can not make an economic
profit in the long-run. When firms make an economic profit, new firms enter the industry. This entry lowers
prices and eventually eliminates economic profit. When firms incur economic losses, some firms leave the
industry. This exit raises prices and profits and eventually eliminates the economic loss. In long-run equilibrium,
firms neither enter nor leave the industry and the firms in the industry make zero economic profit.

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Some examples of monopolistic competition are:

Audio and video equipments
 Computers
 Book printing
 Clothing
 Hotels and restaurants
 Haircuts and beauty salons etc

6.2.2 Price and Output in Monopolistic Competition

Suppose you have been employed by one of the hotels in Bahir Dar to manage the production and marketing of
meal products and services of the hotel. Think about the decisions that you must make at the hotel. First, you
must decide on the quality and type of meal product/ service to produce and the price at which to sell more.

We will suppose that the hotel has already made its decisions about the type and quality of products you planned
above and now we will concentrate on the output and pricing decisions for the time being. For a given type of
quality and marketing activity, the hotel faces given costs and market conditions. How, given costs and demand
for its meal services does the hotel decide the quantity of meal services to produce and the price at which to sell
them?

A. The firm’s short-run price and output decision

In the short-run, a firm in monopolistic competition makes its output and price decision juts like a monopoly
firm does. Figure 6.3 illustrates this decision for the hotel you are assigned to manage.

Figure 6.3 Economic profit in the short-run

Price, Costs MC

100 Profit

MR=MC

75 B

ATC D

25 A MR

Profit

maximizing quantity

0 125 Quantity

The demand curve for the meal service is D. This demand curve tells us the quantity of hotel’s meal services
demanded at each price.MR shows the marginal revenue curve associated with the demand curve for meal
service. It is derived just like the MR curve of a single price monopoly that you studied before. The ATC curve
and MC curve show average total cost and marginal cost of producing services of the hotel.

The goal of the hotel is to maximize profit. To do so, it will produce the output at which marginal revenue
equals marginal cost. In the figure above, the output is 125 meals an hour. The hotel charges the price that
buyers are willing to pay for the quantity, which is determined by the demand curve. This price is Birr 75 per
meal. The average total cost for the supply of a unit of meal is Birr 25 and it makes an economic profit Birr 6250
per hour( 50 per meal multiplied by 125 meals).

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B. Long-run Zero Economic Profit

If firms in a monopolistic industry are making an economic profit, other firms have the incentive to enter the
industry. As other similar hotels are opened in the city of Bahir Dar and offer similar meal services, the demand
for your hotel decreases. The demand and marginal revenue curves of the hotel therefore shifts leftward. The
firm (hotel) produces 75 meals an hour and sells at Birr 50. The average total cost and price are equal and
hence long-run profit is becoming zero. See the following figure for graphical illustration.

Figure 6.4 Output and price in the long-run

Price, Costs MC

Zero profit

80 ATC

50

D

20

MR Profit
maximizing quantity

0 75 Quantity

6.2.3 Monopolistic Competition and Perfect Competition
Figure 6.5 compares monopolistic competition and perfect competition and highlights two key differences
between:

• Excess capacity

A firm has excess capacity if it produces below its efficient scale, which is the quantity at which ATC is a
minimum.-the quantity at the bottom of the U-shaped ATC curve. In figure 6.5 the efficient scale is 100 meals
an hour. Your hotel(fig a) produces 75 meals per hour and has excess capacity of 25 meals an hour. But if all the meals
are a like and are produced by firms in perfect competition (fig b) each hotel hourly produces 100 meals, which is the
efficient scale.

Average total cost is the lowest possible in perfect competition. You can see excess capacity in monopolistic
competition all around you. Family hotels (except for the truly outstanding ones) almost always have some
empty tables. You can always get a dish delivered in 10 minutes or so. Another illustration is that it is rare that
every pump at a petrol station is in use with customers queuing up to be served. There is always an abundance of
estate agents ready to help find or sell a home. These industries are examples of monopolistic competition. The
firms have excess capacity. They could sell more by cutting their prices, but they would then incur losses.

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Figure 6.5 Efficiency comparison between monopolistic competition and perfect competition

Price, Costs MC

40 ATC
25
D
Mark up
10 Excess

0 Capacity Quantity
75 100

(a) Monopolistic competition
MC

Price ATC
25 P = MR

100 Quantity
Efficient scale

(b) Perfect competition

• Mark-up

A firm mark-up is the amount by which price exceeds marginal cost. In perfect competition price always equals
marginal cost and there is no mark up. In monopolist competition buyers pay a higher price than in perfect
competition and also pay a higher price than in perfect competition and also pay more than marginal cost.

6.3 Oligopoly
How did you find the critical features of the three market structures we have discussed so far? Have you
observed a kind of these market structures in your district? Now we are left with the forth type of market
structure to complete our discussion- that is Oligopoly.

Oligopoly, like monopolistic competition, lies between perfect competition and monopoly. The firms in
oligopoly might produce an identical product and might compete only on price, or they might produce a
differentiated product and compete on price, product quality and marketing. The distinguishing features of
oligopoly are that:

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• Natural or legal barriers prevent the entry of new firms
Either natural or legal barriers to entry can create oligopoly. You are a little bit familiar about natural monopoly.
The same factor can create a natural Oligopoly. On the other hand, the market (demand) may not be sufficient
(large enough) so that more firms would join the market. For example, in some woredas there are only two or
three Bajaj taxi riding daily, Hotels that serve the community, Haircuts, etc.

A legal Oligopoly arises when a legal barrier to entry protects the small number of firms in a market. Your local
license provider might license only few suppliers of Baja though the demand leaves a room for more than little
number of firms. For example, at this moment because of traffic congestion, the Bahr Dar city administration
doesn’t allow extra Bajaj to enter into the market

• Only a small number of firms compete
Because barriers to entry exist, Oligopoly consists of a small number of firms each of which has a large share of
the market. Such firms are interdependent and they face a temptation to cooperate to increase their joint
economic profit.

Interdependence

With a small number of firms in a market, each firm’s actions, influences the profit of the other firms. For example if your
firm cuts price, your market share increases, and your profit might increase too. But the market share and profit of other
firms will fall down. The reverse holds true if other firms other than yours cut price. In sum, your profit depends on the
action of the other firms and their profit depends on your action. You are interdependent.

Temptation to cooperate

When a small number of firms share a market, they can increase their profits by forming a cartel and acting like
a monopoly. A cartel is a group of firms acting together-colluding-to limit output raise price and increase
economic profit. Cartels are hard to maintain and even formal cartels tend to breakdown. Thus cartels are
unstable.

6.3.1 The Traditional Model of Oligopoly: The Kinked Demand Curve Model
Have you properly defended all the above questions? I think you did it successfully. Wonderful!

To understand Oligopoly markets in some detail, we are now on the way to discuss the traditional model of
oligopoly. The modern theory of Oligopoly is beyond the scope of this course.

The kinked demand curve of oligopoly is based on the assumption that each firm believes that if it raises its
price, others will not follow; but if it cuts its price other firms will cut theirs.

Figure 6.6 The kinked demand curve

Price and Cost MC1
P MC2

A
BD

MR

Q Quantity
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Figure 6.6 shows the demand curve (D) that a firm believes it faces. The demand curve has a kink at the current
price P and quantity Q. At price above P a small price rise brings a big decrease in the quantity sold. The other
firms hold their current price and the firm has the highest price for the good., so it losses market share., At price
below P, even a large price cut brings only a small increase in the quantity sold., in this case, other firms match
the price cut so the firm gets no price advantage over its competitors.
The kink in the demand curve creates a break in the marginal revenue(MR) curve. To maximize profit the firm
produces the quantity at which marginal cost(MC) equals marginal revenue(MR). The quantity, Q, is where the
marginal cost curve passes through the gap AB in the marginal revenue curve. If marginal cost fluctuates
between A and B, like the marginal cost curves MC1 and MC2, the firm does change neither its price nor its
output. Only if marginal cost fluctuates outside the range AB does the firm changes its price and output. So the
kinked demand curve model predicts that price and quantity are insensitive to small cost changes

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CHAPTER SEVEN: MACROECONOMICS

As you remember, economics is broadly divided into two main branches – microeconomics and
macroeconomics. You already covered microeconomics in the first part of this module. In this second part,
macroeconomics will be discussed. Here, problems of the macro economy are identified and examined in a
reasonable detail. Moreover, national income accounting of the macro economy is introduced and the basic
concepts associated to this are clarified, and methods of income accounting are described. Furthermore, among
the most pressing macroeconomic problems, unemployment and inflation are separately treated and analyzed.
Likewise, this chapter tries to handle issues related to aggregate demand and aggregate supply of the economy to
understand how aggregates in the economy can affect the country. Eventually, this chapter tries to deal with the
policy instruments of the macro economy that are essential to stabilize the economy.

7.1 Problems of Macroeconomics
To understand, the above issues of the macro economy, let’s first define what macroeconomics is about.
Macroeconomics (from Greek prefix macr(o) - meaning large + economics) is the branch of economics dealing
with the structure, performance, behavior and decision making of the entire economy. This includes a national,
regional or global economy. With this very nature of macroeconomics, macroeconomists develop models that
explain the relationship between such factors as national income, output, consumption, unemployment, inflation,
savings, investment, international trade and international finance. In contrast, microeconomics is primarily
focused on the actions of individual agents, such as firms and consumers, and how their behavior determines
prices and quantities in specific markets. An important question, however, is why macroeconomics was created
as a separate discipline and how it evolved from time immemorial?

Until 1930’s there was little need to distinguish between the two branches of economics, namely
microeconomics and macroeconomics. Prior to the Great Depression (Great Economic Crisis) of 1930’s
classical economists (Economists during 18th century) believed that markets would adjust quickly and direct the
economy toward full employment. There was nearly complete unanimity among economists that Even if
cyclical problems would happen in the economy they are only temporary or short-lived. They can adjust
themselves to equilibrium situation through automatic actions of economic forces. This was the common belief
before Great Depression. However, the huge decline in output, prolonged unemployment, and lengthy duration
of the Great Depression undermined the classical view and provided the foundation for Keynesian economics.
During this period, Keynes started questioning that “in the long run we all are dead why should we wait until the
economy collapses”. Hence, Keynes successfully challenged classical economists and came up with
macroeconomics in 1936. Thus, Great Depression was the very reason for the appearance of the book of Keynes
and the rise of interest for macroeconomics.

Having understood why and when macroeconomics was created, what are the main macroeconomic problems
countries face with which are supposed to be addressed by macroeconomics? Any economy faces
macroeconomic problems such as undesirable situations that exist in the macro economy, largely because one or
more of the macroeconomic goals are not satisfactorily attained. The primary macroeconomic problems are
unemployment, inflation, maintaining balance of payment and stagnant growth. Macroeconomic theories are,
then, designed to explain why these problems emerge and to recommend corrective policies.

Macroeconomic problems arise when the macro economy does not satisfactorily achieve the goals of full
employment, price stability, balance of payment and economic growth. Unemployment results when the goal of
full employment is not achieved. Inflation exists when the economy falls short of the goal of price stability.
These problems are caused by too little or too much demand for gross production. Unemployment results from
too little demand and inflation emerges with too much demand. Problem of balance of payment happens when
payments to foreigners is more than receipts from foreigners. Stagnant growth means the economy is not
adequately attaining the goal of economic growth. Each of these situations is problematic because society is less
well off than it would be by reaching the goals.

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Issues of growth are generally considered in a long-run framework, which focuses on supply. Business cycles
are generally considered in the short-run framework, which focuses on demand. Unemployment and inflation
fall within both frameworks

(A) Unemployment

Unemployment, as defined by the International Labor Organization, occurs when people are without jobs and
they have actively looked for work within the past four weeks. In other words, unemployment is a phase where
people who are fit and willing to work do not get work at the prevailing rate of wages after due efforts. The
unemployment rate is a measure of the prevalence of unemployment and it is calculated as a percentage by
dividing the number of unemployed individuals by all individuals currently in the labor force.

Unemployment arises when factors of production that are willing and able to produce goods and services are not
actively engaged in production. Unemployment means the economy is not attaining the macroeconomic goal of
full employment.

The problem of unemployment is a world-wide reality. The developed countries like the U.S., England, France,
Germany, Italy, etc. also suffer from this problem, but it is more pronounced in developing countries. With the
passage of time it has become worse. It has become a threat to developing countries’ economic well-being and
social development. It is one of the major causes of our poverty, backwardness, crimes and frustration among
the people. But because of large scale unemployment there is no suitable employment for these people. They are
forced to remain idle.

There are millions of young men and women waiting and waiting for job opportunities. This chronic problem of
unemployment is not confirmed to any particular class, segment or society. It affects all aspects of society.
There is massive unemployment among educated, well-trained and skilled people, and it is also there among
semi-skilled and unskilled laborers, small and marginal farmers and workers in developing countries. Then there
is underemployment. The jobs being created have miserably failed to keep pace with the ever increasing number
of job-seekers. It is a problem which presents a great challenge to leaders, thinkers, planners, economists,
industrialists and educationists.

While attention is usually focused on the unemployment of labor, any of the four factors of production (labor,
capital, land and entrepreneurial ability) can suffer unemployment. For example, a textile company with two or
more factories might be operating one of its factories at half capacity or a commercial farmer might leave a
section of his farmland uncultivated.

Unemployment is a problem because:
• Less output is produced and thus the economy is less able to address the problem scarcity.
• The owners of unemployed resources receive less income and thus have lower living standards.

There are three main types of unemployment. These are: Frictional unemployment, cyclical unemployment and
structural unemployment. Frictional unemployment takes place when people look for jobs and jobs look for
people and the two do not meet. Discussions of frictional unemployment focus on voluntary decisions to work
based on each individual’s valuation of ones own work and how that compares to current wage rates plus the
time and effort required to find a job. Cyclical unemployment is the type of unemployment when persons look
for jobs but there are no jobs, which can absorb them. Structural unemployment occurs due to mismatch
between supply and demand for workers. Structural arguments emphasize causes and solutions related to
disruptive technologies and globalization.

(B) Inflation

Do you imagine what price instability is? Price instability is a situation in which prices change frequently. It is a
situation in which the prices of goods alter daily or even hourly. Price instability is not desirable for the health of
any economy. Hence, one of a government’s macroeconomic goals is maintaining price stability. Another way

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to express this is to say that governments desire a low and stable rate of inflation. Then, what is inflation? Is a
onetime increase in price considered as inflation? Can we say that inflation is taking place when there is an
increase in the price of a particular good or service? In economics, inflation is an upward movement in the
average level of prices. Its opposite is deflation, a downward movement in the average level of prices. The
boundary between inflation and deflation is price stability.

Inflation arises when the average price level in the economy consistently and persistently increases. In other
words, prices generally rise from month to month and year to year. With inflation the economy is not attaining
the stability goal. Inflation is an average increase in prices, with some prices rising more than the average, some
rising less, and some even declining. As such, not every member of society is likely to experience exactly the
same inflation.

To put it differently, inflation is a persistent increase in the average price level in the economy, usually
measured through the calculation of a Consumer Price Index (CPI). What is, then, consumer price index? CPI is
the type of price index that is commonly used to measure inflation. CPI weighs each price of the commodity
according to their importance to the economy.

The word “persistent” is of great importance in your understanding of the concept of inflation. A single increase
in prices is not called inflation. When inflation occurs, there is a sustained increase in the price level. It is also
very important not to confuse inflation with an increase in the price of a particular good or service. When the
general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also
reflects erosion in the purchasing power of money – a loss of real value in the internal medium of exchange and
unit of account in the economy. A chief measure of price inflation is the inflation rate, the annualized percentage
change in a general price index (normally the Consumer Price Index) over time.

Inflation's effects on an economy are various and can be simultaneously positive and negative. Negative effects
of inflation include a decrease in the real value of money and other monetary items over time, uncertainty over
future inflation may discourage investment and savings, and high inflation may lead to shortages of goods if
consumers begin hoarding out of concern that prices will increase in the future. Positive effects include ensuring
central banks can adjust nominal interest rates and encouraging investment in non-monetary capital projects.

To put it differently, inflation is a problem because:
• The purchasing power of financial assets such as money declines, which reduces financial wealth and
lowers living standards.
• Greater uncertainty surrounds long-run planning, especially the purchase of durable goods and capital
goods.
• Income and wealth can be haphazardly redistributed among sectors of the economy and among resource
owners

(C) Stagnant Growth

The third problem of macro economy that is stagnant growth arises because the supply of aggregate production
is not increasing at a desired level or is even declining. An increase in the total production of goods and services
is generally needed to keep pace with an increase in the population of society and expectations of a rising living
standard. Stagnant growth exists if total production does not keep pace with population growth. This means the
macroeconomic goal of economic growth is not attained.

Reasons for stagnant growth can be identified with a closer look at the quantity and quality of the resources used
for production.

• Quantity: The available quantities of the four factors of production--labor, capital, land, and
entrepreneurship--can restrict the growth of production.
The quantity of labor is based on both the overall population and the portion of the population willing
and able to work. If one of these decline, then growth is not likely to keep pace with expectations. If, for

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example, Abebe decides to quit his job and spend his time doing nothing but vegetating on his parents’
living room sofa, then the total quantity of labor declines.

• Quality: The quality of the four resources can also lead to stagnant growth. The two most noted resource
quality influences are technology and education. The lack of technological progress, which could result
from allocating fewer resources to scientific research can limit increases in the quantity of resources.
Along a similar line of reasoning, allocating fewer resources to education can also limit resource
quality.

(D) Problem of Balance of Payment

What does Balance Of Payments - BOP mean? A BOP is a record of all transactions made between one
particular country and all other countries during a specified period of time. BOP compares the dollar difference
of the amount of exports and imports, including all financial exports and imports. A negative balance of
payments means that more money is flowing out of the country than coming in, and vice versa.

Balance of payments may be used as an indicator of economic and political stability. For example, if a country
has a consistently positive BOP, this could mean that there is significant foreign investment within that country.
It may also mean that the country does not export much of its currency. This is just another economic indicator
of a country's relative value and, along with all other indicators, should be used with caution. The BOP includes
the trade balance, foreign investments and investments by foreigners.

To sum up, the balance of payments (BOP) records all of the many financial transactions that are made between
consumers, businesses and the government in the country (for Example Ethiopia) with people across the rest of
the World. The BOP figures tell us about how much is being spent by Ethiopian consumers and firms on
imported goods and services, and how successful Ethiopian firms have been in exporting to other countries and
markets. It is an important measure of the relative performance of Ethiopia in the global economy.

The balance of payments (BOP) is the method countries use to monitor all international monetary transactions at
a specific period of time. Usually, the BOP is calculated every quarter and every calendar year. All trades
conducted by both the private and public sectors are accounted for in the BOP in order to determine how much
money is going in and out of a country. If a country has received money, this is known as a credit, and, if a
country has paid or given money, the transaction is counted as a debit. Theoretically, the BOP should be zero,
meaning that assets (credits) and liabilities (debits) should balance. But in practice this is rarely the case and,
thus, the BOP can tell the observer if a country has a deficit or a surplus and from which part of the economy the
discrepancies are stemming.

When we see BOP of our country, Ethiopia's balance of payments has been significantly affected by weather
conditions, terms of trade, and emergency drought relief efforts provided by the international community. The
US Central Intelligence Agency (CIA) reports that in 2000 the purchasing power parity of Ethiopia's exports
was $442 million while imports totaled $1.54 billion resulting in a trade deficit of $1.098 billion.

The International Monetary Fund (IMF) reports that in 2001 Ethiopia had exports of goods totaling $433 million
and imports totaling $1.63 billion. The services credit totaled $523 million and debit $526 million.

7.2 National Income Accounting
In ordinary business accounting a firm’s performance can be determined by measuring its profits or loss over a
specific period of time. By the same principle, National Income Accounting summarizes a country’s economic
performance by measuring its aggregate income and output over a given period of time. What is National
Income Accounting? National Income Accounting is a systematic recording of the economic performance of a
nation (country).

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National income accounts (NIAs) are fundamental aggregate statistics in macroeconomic analysis. The ground-
breaking development of national income and systems of NIAs was one of the most far-reaching innovations in
applied economics in the early twentieth century. NIAs provide a quantitative basis for choosing and assessing
economic policies as well as making possible quantitative macroeconomic modeling and analysis. NIAs cannot
substitute for policymakers’ judgment or allow them to evade policy decisions, but they do provide a basis for
the objective statement and assessment of economic policies.

Without national income accounting economic policy would be based on guess work. To avoid the guess work
and to assess the health of the economy and to formulate possible policies that can maintain the country, we
need National Income Accounting.

7.2.1 Basic Concepts in NIA
A variety of measures of national income and output are used in economics to estimate total economic activity
in a country or region, including gross domestic product (GDP), gross national product (GNP), and net national
income (NNI). All are especially concerned with counting the total amount of goods and services produced
within some "boundary". The boundary is usually defined by geography or citizenship, and may also restrict the
goods and services that are counted. For instance, some measures count only goods and services that are
exchanged for money, excluding bartered goods (exchange of goods for goods), while other measures may
attempt to include bartered goods by imputing monetary values to them.

National income accounting refers to a set of rules and techniques that are used to measure the national income
of a country. Countries follow the concepts and methodology recommended in the United Nations Publication
“A system of National Accounts, in 1968” for the compilation of national figures. This is to ensure that
Ethiopia’s national statistics will be consistent and compared with other countries.

National Income
National income is a measure of the value of goods and services produced by the residents of an economy in a
given period of time, usually a quarter or a year. National income can be real or nominal. Nominal national
income refers to the current year production of goods and services valued at current year prices. Real national
income refers to the current year production of goods and services valued at base year prices (the normal year
where there is no inflation or deflation).

In estimating national income, only productive activities are included in the computation of national income. In
addition, only the values of goods and services produced in the current year are included in the computation of
national income. Hence, gains from resale are excluded but the services provided by the agents are counted.
Similarly, transfer payments are excluded as there is income received but no good or service produced in return.
However, not all goods and services from productive activities enter into market transactions. Hence,
imputations are made for these non-marketed but productive activities. Imputed rental for owner-occupied
housing is a typical example. Thus, national income refers to the market value or imputed value of additional
goods and services produced and services performed in the current period.

GDP, GNP, NDP and NNP.
National incomes in many countries are either in Gross Domestic Product (GDP) or Gross National Product
(GNP). Gross Domestic Product (GDP) refers to the total value of goods and services produced within the
geographical boundary of a country before the deduction of capital consumption. Net Domestic Product (NPD)
refers to the total value of goods and services produced within the geographical boundary of a country after the
deduction of capital consumption (depreciation of capital goods).

Gross National Product (GNP) refers to the total value of goods and services produced by productive factors
owned by residents of the country both inside and outside of the country before the deduction of capital
consumption. Net National Product (NNP) refers to the total value of goods and services produced by
productive factors owned by residents of the country both inside and outside of the country after the deduction
of capital consumption (depreciation of capital goods).

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Relationship between GDP and GNP
GNP = GDP + NPIFA (Net Property Income from Abroad)
Net Property Income from abroad refers to the difference between income that comes from abroad and income
that goes to abroad.

7.2.2 Approaches to Measuring GNP: Product, Expenditure and Income

There are 3 approaches to measure national income i.e. output approach, income approach and expenditure
approach. Theoretically, the national income calculated from the 3 approaches is the same, i.e.,
Expenditure Approach = Output Approach = Income Approach Or
Expenditure on goods = Value of goods and services produced = Income Earned by services of factor owners

Output Approach
Output approach measures national income by adding the total value of the final goods and services produced in
the year or by adding the value added by each sector of the economy.

Value Added
Value added refers to the difference between the value of gross output of all goods and services produced in a
given period and the value of intermediate inputs used in the production process during the same period. In the
value added approach, national income is calculated as the value of sales of goods - purchase of intermediate
goods to produce the goods sold.

Double counting or multiple counting of the value of wheat, for example, at each production stage is avoided
when the value added or final value is used in the computation as the value of wheat is counted only once in the
value added method or the final value method. In the value added approach, national income is difference
between the value of sales of goods - purchase of intermediate goods to produce the goods sold.

Income Approach
Income approach measures national income by adding the income earned by the factor owners that are residents
of the country, undistributed company profits and government income from economic participation. It excludes
transfer payments and stock appreciation because transfer payments and stock appreciation are not due to goods
and services performed.
Computation of National Income by Income Approach includes:
Income from Employment
Income from Self-employment
Gross trading profits of companies
Gross trading surplus of public corporations
Gross trading surplus of general government enterprises
Rent, Interest and Dividend, etc

In other words, using the Income Approach, GDP is calculated by adding up the factor incomes of the factors of
production in the society. These include

National Income (NY) + Indirect Business Taxes (IBT) + Capital Consumption Allowance and Depreciation
(CCA) + Net Factor Payments to the rest of the world (NFP)

In this approach,

NY (National Income) = Employee compensation + Corporate profits + Proprietor's Income + Rental income +
Net Interest

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NFP = Payments of factor income to the rest of the world minus the receipt of factor income from the rest of the
world.

Thus,

GDP - NFP = GNP （GROSS NATIONAL PRODUCT)

GNP - CCA = NNP (NET NATIONAL PRODUCT)

NNP - IBT = NY (NATIONAL INCOME)

Expenditure Approach
Expenditure Approach measures national income by adding the private consumption expenditure, government
consumption expenditure, gross fixed capital formation i.e. investment expenditure, increase in physical stocks
and net exports of goods and services i.e. the difference between exports and imports.

It only includes expenditure on goods and services to satisfy the needs of final buyers. It excludes expenditure
on intermediate goods and services. Moreover, resale of consumer and capital goods are excluded because the
expenditures are on these resale goods, not goods produced in the current period and hence expenditures on
resale goods are not counted.

Private Consumption Expenditure (consumption)
Private consumption expenditure refers to the final purchases of goods and services by households. It includes
expenditure on single use consumption or non-durable goods e.g. food, durable goods such as TV, household
utensils, and services including hairdressing services and medical services.

Household purchases of new houses are treated as investment expenditure and hence residential investments are
not included in private consumption expenditure. Instead residential investments are included in investment
expenditure. Resale of consumer durables e.g. second hand TV are excluded as the expenditures are on second
hand TV, not TV produced in the current year and hence expenditures on second hand TV are not included in
the private consumption expenditure.

Government Consumption Expenditure / Government Expenditure
Government consumption expenditure refers to the cost of running the various government departments and
public non-profit organizations to provide goods and services for the public. It excludes the expenditure by
government on grants, interest subsidies, transfer payments, loans and repayments.

Gross Domestic Fixed Capital Formation / Investment Expenditure
Investment expenditure refers to the expenditure on equipments and machinery, residential and non-residential
construction, and changes in inventories. An increase in inventories is treated as an investment and a fall in
inventories is treated as dis-investment. Resales of capital goods are excluded from investment expenditure.
Gross Investment = Net Investment + Replacement Investment
Gross investment refers to the new capital goods produced that can be used to the capital stock or to replace the
existing worn-out capital goods. Net Investment refers to the new capital goods that are added to the capital
stock. Replacement investment refers to the new capital goods that are used to replace the existing worn-out
capital goods.

Net Exports of Goods and Services
Net exports of goods and services refer to the difference between the exports of goods and services and imports
of goods and services. Exports of goods and services refer to goods and services that are produced in the country
but they are sold to foreigners for their consumption. Imports of goods and services refer to goods and services
that are produced by other countries but they are consumed within the country.

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Computation of National Income by Expenditure Approach
National Income =Private Consumption Expenditure + Government Consumption Expenditure + Gross
Domestic Fixed Capital Formation / Investment Expenditure+ Exports of Goods and Services
In other words, GDP is the total spending on all final goods and services (Consumption goods and services (C)
+ Gross Investments (I) + Government Purchases (G) + (Exports (X) - Imports (M))
GDP = C + I + G + (X-M)

7.2.3 Nominal and Real GDP

Nominal GDP measures the value of output during a given year using the prices prevailing during that year.
Over time, the general level of prices rises due to inflation, leading to an increase in nominal GDP even if the
volume of goods and services produced is unchanged.

Real GDP measures the value of output in two or more different years by valuing the goods and services
adjusted for inflation. For example, if both the "nominal GDP" and price level doubled between 1995 and 2005,
the "real GDP” would remain the same. For year over year GDP growth, "real GDP" is usually used as it gives a
more accurate view of the economy.

Relation between Real GDP and Nominal GDP

Real GDP is calculated using constant prices (base year prices) whereas nominal GDP uses current prices. The
difference between the nominal GDP and real GDP is due to the inflation rate in market.

Example: Assume our simplistic economy only produces teff and maize. The price for teff is 800 Birr in 2000,
whereas the price for maize is 500 Birr. Same year we produce 100 tons of teff and 50 tones of maize. In 2003,
because of the inflation the price for teff goes up to 1000 Birr, whereas the price for maize is 600 Birr at the
same production levels.

The nominal GDP in 2000 is 105000 and the nominal GDP in 2003 is 130000. However, real GDP did not
change, because real GDP only changes with the changing production level and therefore is a better size
measure for an economy.

7.2.4 National Product and the Informal Economy
Do know about informal sector? Do you think all economic activities run with formal registration? The informal
sector or informal economy as defined by governments, scholars, banks, etc. is the part of an economy that is
not taxed, monitored by any form of government, or included in any gross national product (GNP), unlike the
formal economy. In developing countries, some 70% of the potential working populations earn their living in the
informal sector. They would define this economy or sector in other words: not in what it is not, but what it is:
the only way to earn a living for people who are self-employed outside the formal economy and not on anyone's
payroll. Most of them live and work in this sector not because it is their wish or choice, but because they have
no chance to be hired by an employer from the formal sector except for a few hours or days, with no legal right
to be hired again.

In describing this sector, one should bear in mind that the informal economy is not a deviation of the formal
economy, if only because all economic activities started informal and formed the basis from which the formal
economy sprang, with firms and annual accounts, taxes, chambers of commerce, etc. Although the informal
economy is often associated with developing countries, where up to 60% of the labor force work and 40% of
GDP is contributed, all economic systems contain an informal economy in some proportion. The term informal
sector was used in many earlier studies, and has been mostly replaced in more recent studies which use the
newer term. The English idioms under the table and off the books typically refer to this type of economy. The
term black market refers to a specific subset of the informal economy in which contraband is traded, where
contraband may be strictly or informally defined.

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7.2.5 GNP and Economic Welfare

Gross National Product (GNP)
Why does anyone bother to estimate the GNP or GDP? For the same reasons statistical data is also gathered on
unemployment rates, consumer price levels, the international trade balance and so on -- to facilitate economic
policy making by government, to assist in planning by decision-makers in private business, and to test economic
theories. If government policy makers include among their goals the promotion of economic growth and
material prosperity in the national economy as a whole by means of monetary and fiscal policy, they need to
have some reasonably precise way of telling how the economy is doing so as to decide what action to take.
Businessmen responsible for planning new investments in plant and equipment or the introduction of new
products can use macroeconomic data and economic theory to forecast the likely levels of demand for their
products and the probable trends in their various costs of production. Finally, a historical record of such
statistics provides economists with the necessary data to test and refine their theories about how the economy
actually works (and, in the process, perhaps to improve the policy makers' understanding of the likely
consequences of their policies).

GNP and GDP are among the most comprehensive measures of the overall amount of economic production
taking place in a national economy. Is GDP a true measure of economic welfare?

We have said that GDP or Gross Domestic Product is defined as the total market value of all final good and
service produced in a given year. It is a simple formula that adds together personal consumption expenditures,
gross private domestic investment, government purchases, and Net Exports, otherwise expressed as GDP= C+
I+G+X-M. However, GDP is being used for a purpose other than what it was designed for. It was not to be an
indicator of economic welfare but that is how it is used today in all countries around the globe. At first glance it
may seem like a good way to sum up the economic welfare of a country, but upon digging a little deeper some
problems are uncovered.

One of the biggest problems of using GDP as an economic welfare indicator is that every expenditure is factored
in as a good expenditure. A good example would be the building up of police in the country. This would
bolster GDP. Nevertheless, the available statistics produced by government agencies are always far from perfect
estimates of what they try to measure. They are measured in money value terms to get around the problem of
adding up total output of many different goods and services that are normally expressed in many different kinds
of incomparable physical units. Microeconomic theory gives us lots of reasons for believing that the relative
prices at which products trade on a free market represent reasonably unbiased estimates of the relative values
consumers put upon the various kinds of goods and services traded -- at least where there are no large problems
with externalities or public goods. But not all the final goods and services produced in a society are traded on
the free market, and the relative contributions of these untraded goods and services to the consumers' material
living standards are therefore terribly difficult to estimate very well. Most of the services produced by
government, to take the largest example, cannot be valued at a free market price because they are not offered for
voluntary purchase on a free market -- instead, the presumed beneficiaries of these services (the citizens) are
forced to pay for them through taxes, whether they think the benefits are "worth it" or not. In compiling the
national accounts, the government statistical offices simply make assumptions that all the goods and services
provided by government are "worth" at least what was spent to produce them, however outrageous the costs
might have been and however worthless (or harmful) the output might have been in the eyes of the citizens.

A very large category of privately produced goods and services whose production does not register at all in the
official GNP or GDP statistics (because they do not trade for money on the market) consists of householders'
home production for their own use -- things like backyard vegetable gardening, do-it-yourself home and auto
repairs, and the innumerable productive service activities of homemakers in cooking, cleaning, sewing,
childcare and so on. Another major omission from the national accounts consists of goods and services that
actually are traded for money on markets -- black markets -- but the transactions are deliberately concealed from
government information collectors, either to avoid prosecution for trading in illegal demerit goods (for example,
drugs and prostitution) or simply to avoid paying taxes or submitting to costly regulations on otherwise

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potentially legal business transactions (working off the books, unauthorized import/export trade, "moonshine"
production of liquor, etc.). For example, Economists' unofficial estimates of the size of the American
"underground economy" in recent years range from no less than 5% to as much as 30% of official GDP! Even it
may be more in developing countries.

If one wants to use GNP (or GDP) to measure changes in overall levels of economic production from one year
to the next, then using money prices as a "common denominator" for adding up all the disparate kinds of goods
and services introduces another problem for the accuracy of the estimates -- inflation. Using money valuations
to measure output at several points in time is a little like using a rubber tape-measure to measure several
different distances. Part of the increase in GNP (or GDP) from one year to the next really is the result of
increased output, but part is also likely to be due merely to change in the value of the currency unit used to
measure it. Government statistical compilers try to deal with this problem by producing estimates of "real" or
"constant Birr" GNP (and GDP), dividing their original ("current Birr") estimates by one or another of many
possible "price indexes" constructed to account for and remove the effects of general price inflation -- but the
problems of choosing and constructing appropriate price indexes for this purpose are themselves numerous and
admit of no single unambiguous "best" answer to the problem.

It is also important to keep in mind that GNP and GDP (even when divided by the size of the population to
produce "per capita GNP") were never intended even theoretically to be good measures of overall economic
welfare: they are at best only measures of recent levels or rates of productive activity. Overall societal welfare
is a broader concept than just economic welfare, and GNP (or GDP) is at best only a very incomplete measure
even of economic welfare, since levels of current production do not necessarily reflect the levels of
accumulated wealth actually at the disposal of the citizens. Moreover, the greater availability of leisure time
made possible by today's higher levels of productivity is pretty clearly an improvement in our economic
welfare over the days of the early 19th century 14-hour workday. But this improvement does not show up at all
in our long-term GNP growth rates -- except possibly in a backwards way, since our official GNP would no
doubt be much higher than it is today if everyone still worked a 14-hour workday using our modern technology
instead of "wasting" all those potential labor hours on "nonproductive" recreation, relaxation, contemplation
and socializing. And of course aggregate GNP and GDP do not give any indication as to who gets to consume
how much of the goods and services produced, nor do their compilers exercise any "judgment" about what
these goods and services are or ought to be (as the advocates of the "equitable distribution" and merit goods
and demerit goods concepts would want to insist upon as crucial determinants of societal welfare).

7.3 Fluctuations in Economic Activities: Unemployment and Inflation
The Business Cycle
Unemployment and inflation tend to vary with business-cycle instability. At some times, unemployment is less
of a problem and inflation is more. At other times, unemployment is more of a problem and inflation is less.
Consider how these two problems connect to the two primary phases of the business cycle.

• Contraction: The contraction phase of a business cycle is characterized by a general decline in economic
activity. Aggregate demand is less, meaning less output is produced, and thus fewer resources are
employed. For this reason, unemployment tends to be a key problem. However, because markets are
more likely to have surpluses than shortages, inflation tends to be less of a problem.

• Expansion: The expansion phase of a business cycle is characterized by a general rise in economic
activity. Aggregate demand is higher, production is greater, and more resources are employed. Demand
for production often outpaces the ability to supply the production. Under these circumstances, because
markets are more likely to have shortages than surpluses, inflation tends to be the primary problem.
However, with robust production and jobs are plenty, unemployment tends to be less of a problem.

All countries experience business cycles (sometimes known as trade cycles) where the rate of growth of
production, incomes and spending fluctuates over a period of time. The length and volatility of each of these
cycles tends to change over time partly because the structure of an economy evolves. Often, as economists, we
find that previously observed theoretical relationships between different variables, for example between

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unemployment and inflation, appear to have changed. This can make life difficult for policy-makers when they
are trying to manage the economy and meet their objectives. We will tend to focus on what has been happening
to the Ethiopian economy over recent years. But bear in mind that many of the ideas here can be applied and
tested with other countries many of whom will be at different stages of their economic development.

Unemployment is a serious problem of many countries, especially, of developing countries. There remains
considerable theoretical debate regarding the causes, consequences and solutions for unemployment. Classical
and Neoclassical (economic thinking following the line of classical economists in 19th century with some
modifications) economics focus on market mechanisms and rely on the invisible hand of the market to resolve
unemployment. These theories argue against government interventions on the labor market such as unionization,
minimum wage laws, taxes, and other regulations that, according to them, discourage the hiring of workers.
Keynesian economics emphasizes the cyclical nature of unemployment and potential interventions to reduce
unemployment during recessions.

Most of the people who become unemployed remain without work for very short periods. However, there is also
a hard core of unemployed who remain without work for long periods of time. The adverse consequences of
unemployment are much more acute for this group of people.

Unemployment has obvious and well-documented links to economic disadvantage and has also been connected
in some discussion to higher crime rates especially among the young, suicide, and homicide. Unemployment
broaden the consequences of unemployment, relating it to increases in the incidences of alcoholism, child abuse,
family breakdown, psychiatric hospitalization, and a variety of physical complaints and illnesses. Some
researchers have emphasized the importance of preventing youth from falling into unemployment traps. Some
researches suggest that unemployment among youth not only causes current hardship, but may also hinder future
economic success. This is because unemployed youths are not able to gain experience and on-the-job training
and because a history of joblessness signals that the individual may not have the qualities that are valued in the
labor market.

Unemployment may impair the functioning of families by affecting the parents' interactions with their children
and the interactions between partners. Although it has been shown that unemployed parents spend more time
with their children, the quality of these interactions suffers in comparison with those of employed parents.
Unemployment, particularly among male partners, is also likely to lead to major role changes in the home.

When economists look at inflation and unemployment in the short term, they see a rough inverse correlation
between the two. When unemployment is high, inflation is low and when inflation is high, unemployment is
low. Inflation is inversely related to unemployment.

In the classical view of inflation, the only thing that causes inflation is, in reality, changes in the money supply.
The classical economists believe that there is a natural rate of unemployment, the equilibrium level of
unemployment of the economy. Unemployment, therefore, will just be at a given level, no matter at what point
inflation is. Basically, unemployment below natural unemployment leads to inflation higher than expected and
unemployment higher than natural unemployment leads to inflation lower than expected.

7.4 Aggregate Demand and Supply Equilibrium
Can you envisage the difference between individual demand, market demand and aggregate demand? You have
already studied what individual demand and market demand are. Here, we will learn aggregate demand. In
macroeconomics, aggregate demand (AD) is the total demand for final goods and services in the economy (Y) at
a given time and price level. It is the total amount of goods and services demanded in the economy at a given
overall price level and in a given time period. This is the demand for the gross domestic product of a country
when inventory levels are static. It is often called effective demand. It is represented by the aggregate-demand
curve, which describes the relationship between price levels and the quantity of output that firms are willing to
provide. Normally there is a negative relationship between aggregate demand and the price level. Aggregate
demand is also known as "total spending".

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It is often cited that the aggregate demand curve is downward sloping because at lower price levels a greater
quantity is demanded. While this is correct at the microeconomic, single good level, at the aggregate level this is
incorrect. The aggregate demand curve is in fact downward sloping due to other factors.

An aggregate demand curve is the sum of individual demand curves for different sectors of the economy. The
aggregate demand is usually described as a linear sum of four separable demand sources.

Where

• is consumption (may also be known as consumer spending.
• is Investment,
• is Government spending,
• is Net export,

o is total exports, and
o is total imports.

These four major parts, which can be stated in either 'nominal' or 'real' terms, are:

• Personal consumption expenditures or Consumers' expenditure on goods and services (C) or
"consumption," demand by households and unattached individuals; its determination is described by the
consumption function. This includes demand for consumer durables (e.g. washing machines, audio-
visual equipment and motor vehicles & non-durable goods such as food and drinks which are
“consumed” and must be re-purchased). Household spending accounts for over sixty five per cent of
aggregate demand in Ethiopia.

• Gross private domestic investment (I), such as spending by business firms on factory construction. This
includes all private sector spending aimed at the production of some future consumable.

• In Keynesian economics, not all of gross private domestic investment counts as part of aggregate
demand. Much or most of the investment in inventories can be due to a short-fall in demand (unplanned
inventory accumulation or "general over-production"). The Keynesian model forecasts a decrease in
national output and income when there is unplanned investment. (Inventory accumulation would
correspond to an excess supply of products; in the National Income and Product Accounts, it is treated
as a purchase by its producer.) Thus, only the planned or intended or desired part of investment (Ip) is
counted as part of aggregate demand. (So, I do not include the 'investment' in running up or depleting
inventory levels.)

Investment is affected by the output and the interest rate (i). Investment has positive relationship with the output
and negative relationship with the interest rate. For example, an increase in the interest rate will cause aggregate
demand to decline. Interest costs are part of the cost of borrowing and as they rise, both firms and households
will cut back on spending. This shifts the aggregate demand curve to the left. This lowers equilibrium GDP
below potential GDP. As production falls for many firms, they begin to lay off workers, and unemployment
rises. The declining demand also lowers the price level. The economy is in recession. This is investment
spending by companies on capital goods such as new plant and equipment and buildings. Investment also
includes spending on working capital such as stocks of finished goods and work in progress.

Gross government investment and consumption expenditures (G). This is government spending on state-
provided goods and services including public and merit goods. Decisions on how much the government will
spend each year are affected by developments in the economy and also the changing political priorities of the
government. In a normal year, government purchases of goods and services accounts for around twenty per cent
of aggregate demand. We will return to this again when we look at how the government runs its fiscal policy.

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Transfer payments in the form of welfare benefits (e.g. state pensions and the job-seekers allowance) are not
included in general government spending because they are not a payment to a factor of production for any
output produced. They are simply a transfer from one group within the economy (i.e. people in work paying
income taxes) to another group (i.e. pensioners drawing their state pension having retired from the labor force,
or families on low incomes).

The next two components of aggregate demand relate to international trade in goods and services between the
UK economy and the rest of the world.

Net exports (NX and sometimes (X-M)), i.e., net demand by the rest of the world for the country's output.
Exports sold overseas are an inflow of demand (an injection) into our circular flow of income and therefore add
to the demand for UK produced output.

M: Imports of goods and services. Imports are a withdrawal of demand (a leakage) from the circular flow of
income and spending. Goods and services come into the economy for us to consume and enjoy - but there is a
flow of money out of the economy to pay for them.

Net exports (X-M) reflect the net effect of international trade on the level of aggregate demand. When net
exports are positive, there is a trade surplus (adding to AD); when net exports are negative, there is a trade
deficit (reducing AD). The UK economy has been running a large trade deficit for several years now as has the
United States.

In sum, for a single country at a given time, aggregate demand (D or AD) = C + Ip + G + (X-M).

These macro-variables are constructed from varying types of micro variables from the price of each, so these
variables are denominated in (real or nominal) currency terms.

Aggregate demand (AD) and aggregate supply (AS) analysis provides a way of illustrating macroeconomic
relationships and the effects of government policy changes.

X: Exports of goods and services -

Aggregate demand curves

Understanding of the aggregate demand curve depends on whether it is examined based on changes in demand
as income changes, or as price changes.

In economics, aggregate supply is the total supply of goods and services that firms in a national economy plan
on selling during a specific time period. It is the total amount of goods and services that firms are willing to sell
at a given price level in an economy.

The aggregate supply (AS) curve is usually drawn as upward-sloping in the short run, since the quantity of
aggregate production supplied (Qs) rises as the average price level (P) rises.

There are two main reasons why Qs might rise as P rises, i.e., why the AS curve is upward sloping:

• Higher prices motivate profit-seeking firms to increase output. This is because of diminishing returns and
thus rising marginal costs that arise because one or more of the factors of production does not change in the
short run and is assumed to be fully employed at all times.

• An alternative model starts with the notion that any economy involves a large number of heterogeneous
types of inputs, including both fixed capital equipment and labor. Both main types of inputs can be
unemployed in the short run.
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There are generally three forms of aggregate supply (AS). They are:

1. Short run aggregate supply (SRAS) — Within the time frame during which firms can change the
amount of labor used but not capital (such as building new factories). This form demonstrates what
happens to the economy under the most slack, when resources are underused. Upward shifts in SRAS
generally increase output (y) but don't increase price (P). The SRAS curve is nearly perfectly horizontal.
The concept is that wages (price of labor) don't change over the short run.

2. Long run aggregate supply (LRAS) — Over the long run, only capital, labor, and technology affect the
LRAS in the macroeconomic model because at this point everything in the economy is assumed to be
used optimally. In most situations, the LRAS is viewed as static because it shifts the slowest of the
three. The LRAS is shown as perfectly vertical, reflecting economists' belief that changes in aggregate
demand (AD) have an only temporary change on the economy's total output.

3. Medium run aggregate supply (MRAS) — As an interim between SRAS and LRAS, the MRAS form
slopes upward and reflects when capital as well as labor can change. More specifically, the Medium run
aggregate supply is like this for three theoretical reasons, namely the Sticky-Wage Theory, the Sticky-
Price Theory and the Misperception Theory. When graphing an aggregate supply and demand model,
the MRAS is generally graphed after aggregate demand (AD), SRAS, and LRAS have been graphed,
and then placed so that the equilibria occur at the same point. The MRAS curve is affected by capital,
labor, technology, and wage rate.

Aggregate demand-aggregate supply model
Sometimes, especially in textbooks, "aggregate demand" refers to an entire demand curve that looks like that in
a typical Marshallian supply and demand diagram.

Figure 7.1 Aggregate supply and aggregate demand curves

Thus, that we could refer to an "aggregate quantity demanded" (Yd = C + Ip + G + NX in real or inflation-
corrected terms) at any given aggregate average price level (such as the GDP deflator), P.

In these diagrams, typically the Yd rises as the average price level (P) falls, as with the AD line in the diagram.
The main theoretical reason for this is that if the nominal money supply is constant, a falling P implies that the
real money rises, encouraging lower interest rates and higher spending. This is often called the "Keynes effect."

Carefully using ideas from the theory of supply and demand, aggregate supply can help determine the extent to
which increases in aggregate demand lead to increases in real output or instead to increases in prices (inflation).
In the diagram, an increase in any of the components of AD (at any given P) shifts the AD curve to the right.
This increases both the level of real production (Y) and the average price level (P).

But, different levels of economic activity imply different mixtures of output and price increases. As shown,
with very low levels of real gross domestic product and thus large amounts of unemployed resources, most

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economists of the Keynesian school suggest that most of the change would be in the form of output and
employment increases. As the economy gets close to potential output (Y*), we would see more and more price
increases rather than output increases as AD increases.

Beyond Y*, this gets more intense, so that price increases dominate. Worse, output levels greater than Y*
cannot be sustained for long. The AS is a short-term relationship here. If the economy persists in operating
above potential, the AS curve will shift to the left, making the increases in real output transitory.

At low levels of Y, the world is more complicated. First, most modern industrial economies experience few if
any falls in prices. So the AS curve is unlikely to shift down or to the right. Second, when they do suffer price
cuts it can lead to disastrous deflation.

In a standard aggregate supply demand model, the output (y) is the x axis and price (P) is the y axis. An increase
in aggregate demand shifts the AD curve rightward, bringing the equilibrium point horizontally along the SRAS
until it reaches the new AD. This point is the short run equilibrium.

7.5 Economic Policy Instruments: Monetary, Fiscal and Income policies
Macroeconomic policy instruments: refer to macroeconomic quantities that can be directly controlled by an
economic policy maker. Instruments can be divided into two subsets:

- Monetary policy instruments- policy is conducted by the national (central) bank of a country.
- Fiscal policy instruments- Fiscal policy is conducted by the executive and legislative branches of the

Government and deals with managing a nation’s budget.

Monetary Policy
Monetary policy instruments consists in managing short-term rates (interest and discount rates), and changing
reserve requirements for commercial banks. Monetary policy can be either expansive for the economy (short-
term rates low relative to inflation rate) or restrictive for the economy (short-term rates high relative to inflation
rate). Historically, the major objective of monetary policy had been to manage or curb domestic inflation. More
recently, central bankers have often focused on a second objective: managing economic growth as both inflation
and economic growth are highly interrelated.

In other words, monetary policy is the process by which the monetary authority of a country controls the supply
of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The
official goals usually include relatively stable prices and low unemployment. Monetary theory provides insight
into how to craft optimal monetary policy. It is referred to as either being expansionary or contractionary,
where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and
contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy
is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that
easy credit will entice businesses into expanding. Contractionary policy is intended to slow inflation in hopes of
avoiding the resulting distortions and deterioration of asset values.

Monetary policy differs from fiscal policy, which refers to taxation, government spending, and associated. There
are different methods to exercise monetary policy.

i. Open Market Operations
There are two types of open market operations:
Open market purchases government buys securities to increase the monetary base.
Open market sales = government sells securities to decrease the monetary base.
Thus, the government conducts open market operations by buying and selling Ethiopian government securities–
especially treasury bills.

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ii. Discount Loans
When the government or national bank can affect the volume of loans by setting the discount rate it is
discounting. A higher discount rate makes discount borrowing less attractive to banks and will therefore reduce
the volume of loans. A lower discount rate makes discount borrowing more attractive to banks and will therefore
increase the volume of loans.

iii. Changes in Reserve Requirements
By affecting the money multiplier, changes in the required reserve ratio can lead to changes in the money
supply.
Changes in reserve requirements can cause problems for banks by making liquidity management more difficult.
Fiscal Policy
Fiscal policy consists in managing the national Budget and its financing so as to influence economic activity. It
operated on managing government expenditure and taxation. There are two types of fiscal policies. This entails
the expansion or contraction of government expenditures related to specific government programs.

a. Expansionary fiscal policy – it is used when the government wants to raise total output and employment.
It is usually taken during recession (low total output) period. To achieve this objective the government
increases its expenditure or/and reduce taxes. This increase AD thereby total output and employment
level increases.

b. Contractionary fiscal policy - it is used when the government want to control high inflation. To achieve
this objective the government decreases its expenditure or/ and raises taxes. This decrease AD there by
the general price level of goods and services decreases.

Income Policy
Income policy is another instrument by which government achieves its predefined goals and objectives. It refers
to a set of rules and regulation designed by a government to control wage and price rise.

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