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Micro Economics 1.1. Definition and Scope of Economics • There are two fundamental facts, which constitute the economizing problems and provide foundation for the subject economics. • These are: • unlimited human wants and • limited availability of economic resources. • Material wants - the desires of consumers to obtain and use various goods and services that provide utility (satisfaction or pleasure) - cannot be completely satisfied. • This is because: • Wants are recurring in nature - even if some wants are satisfied for a while, they will reappear at some intervals. • Wants multiply endlessly over time - as soon as one want is satisfied, another want begins to be felt.
Wants are multiplicative • Human nature is accumulative. • Limited economic resources: Economic resources like various types of labor, natural resources, capital and entrepreneurial ability we use to produce goods and services are limited. • Economics is the study of how scarce resources are allocated among alternative and competing ends or uses in order to maximize the consumption of material goods and services. • It is also defined as the scientific study of the choices made by individuals and societies in regard to the alternative uses of scarce resources which are employed to satisfy wants.
Individuals engage in four essential economic activities: • resource maintenance, • production of goods and services, • distribution of goods and services, and • consumption of goods and services..
1.2. Branches of Economics a. Microeconomics : is the branch of economics that studies individual units in the economy: e.g. households, firms and industries. It studies the interrelations between these units in determining the pattern of production and distribution of goods and services. • It examines the trees not the forest. b. Macro-economics: is the branch of economics that studies the entire economy, e.g. aggregate consumption, aggregate production , aggregate investment, unemployment, inflation, business cycles and so on(grand totals). • It is concerned with the economy as a whole • It examines the whole forest not individual trees.
1.3. Basic Economic Concepts: Productive Resources, Scarcity, Choice, Opportunity Cost. • Resourceis anything that can be used to produce output. • Also called inputs or factors of production. • These factors of production are divided into four categories: • Labor is defined as the physical and intellectual efforts of human beings used in production process. • The efforts of a factory worker, teacher, etc. are all called labor. • The return for labor is called wage.
Land refers to all natural resources that can be used as inputs to production, for example, minerals, water, air, forests, oil, and even such intangibles as rainfall, temperature, and soil quality. • The return for land is called rent. • Capital is defined as all man-made aids to production. Capital includes tools, factories, warehouses, stocks of inventories, etc. The return for capital is called interest. • Entrepreneurshipis the special sort of human effort that takes on the risk of bringing labour, capital, and land together to produce goods or services in the expectation of a future reward. • When they put money into their production process, entrepreneurs are taking risks. The return for entrepreneurship is called profit.
Outputcould be goods (tangible e.g., shoes, bread), and services ( intangible e.g., education, entertainment). • People use these goods and services to satisfy their wants. • The act of making goods and services is called production and the act of using them is called consumption. • The quantity of factors of production and the goods and services they help produce is not infinite. • Wants are unlimited, because no matter how much people have, they always want more of them. …. Scarcity.
Scarcity implies that resources are insufficient to produce all goods and services desired by consumers or society as a whole. • Because all wants cannot be satisfied simultaneously, scarcity forces us to choose. • Choice refers to selecting of alternative uses of scarce resources or giving priority. Whenever we choose one alternative to another, we are making scarification. • In other words, choice implies opportunity cost.
Opportunity cost is the option foregone in making a choice of alternative A over alternative B or it is the value (amount) that must be sacrificed to obtain something else. • This definition captures the idea that the cost of something is not just its monetary cost but also the value of what you didn’t get. • The opportunity cost of spending $17 on a CD is what you would have done with the $17 instead, and perhaps the value of the time spent shopping.
1.4. Production possibility and Economic growth • Production possibility refers to the different combinations of goods and services that can be produced with a given amount of resources. • It shows the combination of outputs produced by utilizing the resources available efficiently. • Useful to demonstrate economic growth and opportunity cost
Economic growth is an increase in the total output of the economy. • It occurs when a society acquires new resources, or when it learns to produce more using existing resources. • The main sources of growth are increases in the quantity and quality of the economy's resources (land, labour, capital and entrepreneurship). • It is measured by measuring total national output in an economy in two different time periods.
1.5. Fundamental Economic Problems and Alternative Economic Systems Problems All Economies Face Limited Resources Unlimited Wants Scarcity Scarcity forces all countries to answer these 3 questions Scarcity leads to conflict 1. What to produce? 2. How to produce it? 3. For Whom to produce?
Economic system is the set of organizational arrangement and institutions established to solve the fundamental economic problems, what, how and for whom to produce. • Economic systems are different from each other on the basis of: • Ownership of economic resources and • The method by which economic activities are coordinated. • Historically, four different types of economic systems are observed. These are: • 1. Traditional Economy (Customary Economy) • 2. Pure Capitalism (Free Market Economy) • 3. Pure Socialism (Command Economy) • 4. Mixed Economy (Hybrid Economy)
1) The Planned Economy • In a command economy, all resources are collectively owned and directed by the government. • In a command economy, the government answers the three basic economic questions: • 1. What? A dictator or a central planning committee decides what products are needed. • 2. How? Since the government owns all means of production in a command economy, it decides how goods and services will be produced. • 3. For whom? The government decides who will get what is produced in a command economy.
2) The Market Economy • In a free-market, people can own their own businesses and property. People can also buy services for private use, such as healthcare. • The organizing principles, here, are the forces of demand and supply. • The determination of what to produce is made by consumers, and the force of demand causes prices to go up for certain products when consumers desire more of them. • Suppliers combine resources, determining how things are to be produced. • Assuming suppliers are self-interested and seek to maximize their profits, they tend to combine inputs to produce any good or service at the lowest possible cost. • The goods are then distributed to consumers who have the purchasing power to buy them.
3) The Mixed Economic System: • In the real world we find that economies are the blend of traditional, planned and market economic systems. • An economic system in which decisions about how resources should be used are make partly by the private sector and partly by the government, or the public sector. • Production decisions are made in both private market and by government • Furthermore, within any economy, the degree of the mix will vary from sector to sector.
4. The Traditional Economy • Goods and services are produced by the family for their personal consumption. • It is shaped largely by custom or religion. • Is the type of economy found in less developed nations, usually in rural areas.
1.6. Types of Goods 1) Based on Supply: The goods are categorized as economic goods and free goods based on the supply criteria • Free Goods: those goods which are provided freely by nature ,their supply is abundant that no price is paid for securing them .e.g. air, water, sunlight ,etc • All free gifts of nature are free goods. • No cost so no choice. No market and zero price. • Economic Goods: are those goods which have utility and which are relatively scarce . • Cost is incurred for producing them and price is paid for purchasing them. • It uses scarce resources, => Limited availability in relation to desired use. • Exchanged through markets
2) Based on Consumption: The Goods are categorized as Consumer goods and Producer Goods. • Consumer goods are those which yield, satisfaction directly. They are used by consumer directly to satisfy the wants Example: food, clothing, etc. • Producer goods are these goods which help us to produce other goods. They give satisfaction indirectly by producing other goods which will yield final satisfaction. • Example: machinery, tools etc. 3) Based on Durability: This classification emphasized on the nature of the goods and their usage. • Mono Period Goods are those goods which can be used only once in the production and consumption process. Example: Seeds, Fertilizers, food etc., • Poly Period Goods are those which can be used repeatedly during the production and consumption process over several periods. Example: refrigerator, machinery, implements, etc.,
1.7. Decision Making Units and The Circular Flow of Economic Activities • The major decision-making units in the economy are: • Households: are consumers of final goods and services produced in the economy. • Business Firms: are the producing unit in the economy. • Government: if there is interference of government in the economy. • In a pure market economy, there are two distinct markets in which firms interact with households. • product market and factor market.
Chapter TwoDemand &Supply 2.1. Definition, law and determinants of demand • Demandrefers to the desire and ability to consume certain quantities at certain prices. • It is desire or want which is supported by the willingness and ability, on the part of the consumer, to pay a price for acquiring the commodity required for satisfying the want. • Demand schedule: a tabular listing that shows the quantity demanded at various prices, ceteris paribus. • The phrase ceteris paribus means other things remain the same.
To derive the demand schedule of an individual (say Mr. Abebe) what is required is just asking him what quantity of the good (say bread) he would buy at different prices of the good, ceteris paribus. • Table 2.1: Demand schedule
Demand curve: a graphical representation of a demand schedule showing the quantity demanded at various prices, ceteris paribus. • Plotting the price-quantity relationships from the demand schedule on a two-axis plane derives the demand curve for a good or service. • Price • 25 • 20 Demand curve • 15 • 10 • 5 • 0 50 100 150 200 250 Quantity
The Law of Demand • The law of demand states that the quantity demanded of a good or service is negatively related to its price, ceteris paribus. Holding other things the same, consumers will buy more of a good or service at a lower price than at a higher price. • As price rises, consumers will demand a smaller quantity of a good or service. • At this point, it is important to make distinction between demand and quantity demanded of a good or service. • Demand refers to the whole set of price-quantity combinations, i.e., demand defines the whole set of relationship between price and quantity. • Quantity demanded, on the other hand, is the amount consumers want to buy at a particular price, i.e., the quantity of a good or service that consumers demand at price Birr 1, the quantity they demand at price Birr 2 etc.
Exceptions to the law of demand • Commodities which are regarded as status symbols: Expensive commodities like jewelry, etc., are used to define status and to display one's wealth. These goods doesn't follow the law of demand and quantity demanded increases with price rise as more expensive these goods become, more will be their worth as a status symbol. • Commodities whose prices are expected to rise: People may, for various reasons, expect the price of a commodity to rise in the future. Hence, they may buy more of the commodity now, even at a higher price to escape from future hardships. • Inferior goods: families with low income spend a large part of their income on essential goods. In case of lower prices of these inferior goods, these people use to consume more from inferior goods and less portion from non-essentials. But as the price of these basic foods rise, just for the sake of adjustment, they ignore the non-basic items and use more of the essential ones.
Determinants of Demand a. The price of the goods and services. b. The prices of related goods and services. Substitutes: If the price of a substitute goes down then the quantity demanded of the good also goes down and vice versa. Complementary goods: If the price of gasoline goes up the quantity demanded of automobiles will go down. Thus the price of complements have an inverse relationship with the demand of a good c. Consumers income: Higher the income of the consumer the more will be quantity demanded of the good. The only exception to this will be inferior goods whose demand decreases with an increase in income level d. Consumers taste. e. Population size. f. Expectations about future prices or income. g. Others (such as religion, weather, …) • Demand is, therefore, a multivariate function: • Qd= f(P, Po T, S, I, E,Z)
Movement along the Demand Curve and Shift in the Demand Curve • Movement along the Demand Curve • Movement along the demand curve refers to that change in the quantity demanded of a good because of changes in the prices of that good while other factors affecting demand (such as price of other goods, income etc.) remaining the same (unchanged). • Called change in quantity demanded. • The consumer buys larger quantities at lower prices and lower quantities at higher prices. • Therefore, such movements take the consumer from one point on the demand curve to another point on the same demand curve.
Shift in the demand curve • The demand curve is drawn on the assumption that other things remain the same. If, however, the factors assumed constant change, their effect would be shifting the demand curve • In other words, shift in the demand curve for a good result from changes in one or more of the factors that affect demand except the price of own good. • Is called change in demand. • Increase in demand is shown by outward shift of the demand curve whereas inward shift of the demand curve represents decrease in demand. • When the tastes of the people change in favor of bread, it would be reflected by an increase in demand for bread.
An increase in income leads to an increase or a decrease in demand depending on the nature of the good. • Depending on the effect of change in income on their quantity demanded, there are two types of goods: normal goods and inferior goods. • Demand increases with increase in income if the good is normal. As an example, consider meat whose demand is directly related with income. • On the other hand, inferior good is a good whose demand decreases with increase in income. If, for example, you decrease your consumption of ‘shiro wet’ as your income increases in order to shift to say meat, then ‘shiro wet’ is going to an inferior good for you.
2.2. Definition, law and determinants of supply • Supply refers to the quantity of goods offered for sale at a particular time or a particular place at alternative prices. • Supply defines the whole set of price-quantity relationship. • It shows the quantities that producers are willing and able to supply at alternative prices, ceteris paribus. • Supply schedule: is a tabular listing that shows quantity supplied at various prices, ceteris paribus.
Supply curve: is a graphical representation of a supply schedule showing the quantity supplied at various prices, ceteris paribus. P 25 Supply curve 20 15 10 5 0 10 20 30 40 Q
The Law of Supply • The law of supply states that the quantity supplied of a good or service is usually a positive function of price, ceteris paribus. • However, this positive relationship between price and quantity supplied fails in two exceptional cases: • The supply will not be upward sloping if there is no enough time to produce more units of the good because production techniques are not flexible in the very short run. Determinants of supply • Price of the product: Since the producer always aims for maximizing his returns/profit, so the quantity supplied changes with increase or decrease in the price of the good.
Technological changes: Advanced technology can yield more quantity and at lesser costs. This may result in the producer to be willing to supply more quantity of the goods • Resource supplies and production costs: Changes in production costs like wage costs, raw material cost and energy costs might impact the producers‟ production and eventually the supply. An increase in such cost might result in lesser quantities produced and thus lesser quantities supplied and vice versa • Tax or subsidy: Since the producer aims to minimize costs and expand profit, an increase in tax will increase the total cost, thereby decreasing the supply. Similarly a subsidy might incentivize the producer to supply more of that goods in order to maximize his/her profits.
Expectations of prices in future: An expectation that the prices of goods will fall in future might lead to lessen the production by the producer and thereby decrease the supply and vice-versa. • Price of other goods: A producer might have several options to produce. Since the money to invest is limited with the producer he would decide to produce the good which offers him the maximum profit. Thus if the producer is currently producing good A and the price of good B increases than he might switch to producing good B as this would result in better returns for him. • Number of producers in the market: If there are large number of producers or sellers in the market willing to sell goods then the supply of good will increase and vice versa
Movement along the Supply • Movement along the supply curve happens due to change in the price of the good and resulting change in the quantity supplied at that price. • Is called change in quantity supplied.
For instance, an increase in the price of the good from P1 to P2 in the figure below results in an increase of quantity supplied of the good from Q1 to Q2. • This movement from point A to point B on the supply curve S due to change in price of the good all other factors of supply remaining unchanged is called movement along the supply curve. Shifts in the Supply curve • Shift in the supply curve is also sometimes referred as a change in supply. This happens due to changes in factors of supply other than that of price of the good • For example, if the price of a factor or of a related good increases the supply curve shifts. Similarly changes in technology and government tools like tax and subsidy tends to shift supply curve.
The supply curve can shift to the right or left as shown in the figure. A shift towards the right i.e. from S1 to S2 curve denotes an increase in supply of the good. • Similarly a shift in the supply curve from S1 to S3 denotes a decrease in supply of the good. • As seen in the figure above a rightward shift in the supply curve from S1 to S2 increases supply from Q1 to Q2 while the price of the good remains same at P1. • Similarly a leftward shift from S1 to S3 decreases supply from Q1 to Q3 whilst the price remaining unchanged at P1
2.3. Market Equilibrium • In a free market system output price as well as the level of output in a market are determined by the forces of demand and supply. • The condition of equality of demand and supply is called equilibrium. • Market equilibriumis a price-quantity combination that results from the interaction of the supply curve and the demand curve such that at the indicated price, the quantity demanded equals the quantity supplied. • The equilibrium has the property that once the market settles on that point it stays there unless either supply or demand shifts. • Additionally, a market that is not at the equilibrium position moves toward that point.
It is important to note that the point representing equilibrium price and equilibrium quantity is not the same thing as the point where the amount sold equals the amount bought. • Quantities bought and quantities sold are always equal. • Excess demand causes an upward pressure on price. Thus price converges to the equilibrium price. • Excess supply causes a downward pressure on price. Thus, price follows a path towards the equilibrium. • Once equilibrium is reached at the point of equality of the demand curve with the supply curve, it remains there as long as demand and supply remain unchanged.
Numerical Approach to Equilibrium • At the equilibrium position, the demand function is exactly equal to the supply function. • Suppose the demand and supply functions in a particular market are given as: Qs= 10+ 4p and Qd= 100- 2p • At equilibrium Qd = Qs • 100-2p = 10+4p • Rearranging 6p = 90 p = 15 • The equilibrium Price is, therefore, P = 15. • The equilibrium quantity is obtained by substitution. • Qd= 100- 2(15) = 70 = Qs
We have discussed that market equilibrium condition is determined by the interaction of demand and supply forces. • This means, any change on one of the two or on both will affect the equilibrium condition. Effects of Change in Demand • When the ceteris paribus conditions (price of other goods, consumers’ income, taste, population size, expectation etc.) change, there will be a shift in the demand curve. Such changes (shifts) in demand result in a shift of the equilibrium position. • Assume first, there is increase in demand, for any one reason, represented by an upward (rightward) shift in the demand curve.
Such rise in demand, with supply constant, creates shortage at the initial equilibrium price, and the unsatisfied buyers bid up the price. • This causes a larger quantity to be produced, with the result that at the new equilibrium more is bought and sold at a higher price. • This change, with supply remaining the same, shifts the equilibrium position from e0 to e1. The equilibrium price rises from P0 to P1and equilibrium quantity rises from Q0 to Q1. • That means, consumers are now demanding larger quantities of the good at every price than before.
On the other hand, fall in demand, ceteris paribus, creates surplus, and the unsuccessful sellers bid the price downwards to clear the surplus. • As a result, less of the commodity is produced and offered for sale. At the new equilibrium, both price and quantity bought and sold are lower than they were originally. • Such fall in demand is represented by a leftward (downward) shift of the demand curve, and causes the equilibrium position to shift from e0 to e2. Accordingly, equilibrium price falls from P0 to P2 and equilibrium quantity falls from Q0 to Q2. • With regard to change in demand the equilibrium price and quantity change in the same direction. The magnitude of the change in price and quantity demanded depends on: • The size (magnitude) of demand change • The slope (elasticity) of supply
