CHAPTER ONE

Introduction to Economics

Afework B. (Ass. Professor),

Department of Economics
CBE,WSU

1 WSU, CBE, Department of Economics by Afework B (assistant professor) 04/08/2024

 Outlines of this Chapter
Definition of Economics
Rationales of economics
Scarce resources
Scope of Economics and Methods of Economic analysis
Scarcity, Choice and the Production Possibility Frontier
(PPF)
Basic Economic problems
Alternative Economic Systems

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 1. 1 Definition of economics
There is no universally accepted definition of
economics (its definition is controversial).
This is because different economists defined
economics from different perspectives:
a. Wealth definition
b. Welfare definition
c. Scarcity definition, and
d. Growth definition

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 Hence, its definition varies as the nature and scope of the subject
grow over time.
 But, the formal and commonly accepted definition is as follow.
 Economics is a social science which studies about efficient
allocation of scarce resources so as to attain the maximum
fulfillment of unlimited human needs.

 As economics is a science of choice,

 it studies how people choose to use scarce or limited
productive resources (land, labour, equipment, technical
knowledge and the like) to produce various commodities.

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  The following statements are derived from the above
definition.
 Economics studies about scarce resources
 It studies about allocation of resources
 Allocation should be efficient
 Human needs are unlimited

The aim (objective) of economics is to study how

to satisfy the unlimited human needs up to the
maximum possible degree by allocating the
resources efficiently.

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 1.2 The rationales of economics

There are two fundamental facts that provide the

foundation for the field of economics.
 1) Human (society‘s) material wants are unlimited.
2) Economic resources are limited (scarce).

The basic economic problem is about scarcity and

choice since there are only limited amount of resources
available to produce the unlimited amount of goods and
services we desire.

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 Thus, economics is the study of how human
beings make choices to use scarce resources as
they seek to satisfy their unlimited wants.

Therefore, choice is at the heart of all decision-

making.

As an individual, family, and nation, we

confront difficult choices about how to use
limited resources to meet our needs and wants.
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1.3 Scope and method of analysis in economics
 Two major branches:
Microeconomics and
Macroeconomics

A. Microeconomics :- is concerned with the economic

behavior of individual decision making units such as:-
o households
o firms
o markets and industries
 In other words, it deals with how households and firms
make decisions and how they interact in specific
markets.
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 A. Macroeconomics :-is a branch of economics that
deals with the effects and consequences of the
aggregate behaviour of all decision making units in
a certain economy.

 In other words, it is an aggregative economics that examines

the interrelations among various aggregates, their
determination and the causes of fluctuations in them.
 It looks at the economy as a whole and discusses about the
economy-wide phenomena

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 Microeconomics Macroeconomics
 Studies individual economic units of an  Studies an economy as a whole and its
economy. aggregates.
 Deals with individual income, individual  Deals with national income and output
prices, individual outputs, etc and general price level
 Its central problem is price determination  Its central problem is determination of
and allocation of resources. level of income and employment.
 Its main tools are the demand and supply  Its main tools are aggregate demand
of particular commodities and factors. and aggregate supply of an economy as
 It helps to solve the central problem of a whole.
‗what, how and for whom to produce‘ in  Helps to solve the central problem of
an economy so as to maximize profits ‗full employment of resources in the
 Discusses how the equilibrium of a economy.‘
consumer, a producer or an industry is  Concerned with the determination of
attained. equilibrium levels of income and
 Examples: Individual income, individual employment at aggregate level.
savings, individual prices, an individual  Examples: national income, national
firm‘s output, individual consumption, savings, general price level, national
etc output, aggregate consumption, etc
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 1.3.2 Positive and normative analysis

 Positive(descriptive) economics is the method of economic

analysis which provides an actual description of an economic
system.
 It tries to analyze the questions like “what was, what were and
what will be?”
 Essentially, it deals with cause-effect relationships that can be
tested.
Eg. - Increasing money supply leads to higher prices.
- What will be the effect of higher cigarette taxes on the
number of smokers?

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  Normative economics entails value judgment about how
economic problems should be solved in the economic system.
 It is policy economics, not descriptive.
 It attempts to answer the questions “what ought to be, or
what should be?”
 It deals with value judgments and opinions that cannot be
tested.

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 1.3.3 Inductive and deductive reasoning in economics
 The fundamental objective of economics is to establish valid
generalizations(known as theories) about certain aspects of
economic behavior.

 A theory is a simplified picture or Model of reality.

 These theories provide the basis for economic policy analysis

which uses logical reasoning.

 There are two methods of logical reasoning:

 Inductive method and
 Deductive method of reasoning

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 Inductive method of reasoning (from specific
fact to general theory) and
Inductive method involves the following steps.
1. Selecting problem for analysis
2. Collection, classification, and analysis of data
3. Establishing cause and effect relationship
between economic phenomena.

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 Deductive method of reasoning (from general to particular
fact).
 Major steps in the deductive approach include:
 1. Problem identification
 2. Specification of the assumptions
 3. Formulating hypotheses
 4. Testing the validity of the hypotheses

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 1.4 Scarcity, choice, opportunity cost and production possibilities frontier

1. Scarcity
 The fundamental economic problem that any human society faces is
the problem of scarcity.
 Scarcity refers to the fact that all economic resources that a society
needs to produce goods and services are finite or limited in supply.
 But their being limited should be expressed in relation to human
wants. Thus, the term scarcity reflects the imbalance between our
wants and the means to satisfy those wants.

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 Resources:
 Free
resources and
 Scarce (economic) resources:
 Free resources :-
 resource is said to be free if the amount available to a society is greater
than the amount people desire at zero price. E.g. sunshine
 Scarce (economic) resources:
 A resource is said to be scarce or economic resource when the amount
available to a society is less than what people want to have at zero
price.

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The following are examples of scarce resources.
 All types of human resources: manual, intellectual, skilled and
specialized labor;
 Most natural resources like land (especially, fertile land), minerals,
clean water, forests and wild - animals;
 All types of capital resources ( like machines, intermediate goods,
infrastructure ); and
 All types of entrepreneurial resources

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 Economic resources are usually classified into four categories.
 Labour: refers to the physical as well as mental efforts of human
beings in the production and distribution of goods and services.
 The reward for labour is called wage.

 Land: refers to the natural resources or all the free gifts of nature
usable in the production of goods and services.
 The reward for the services of land is known as rent.
 Capital: refers to all the manufactured inputs that can be used to
produce other goods and services. Example: equipment, machinery,
transport and communication facilities, etc.
 The reward for the services of capital is called interest.

 Entrepreneurship: refers to a special type of human talent that

helps to organize and manage other factors of production to
produce goods and services and takes risk of making loses.
 The reward for entrepreneurship is called profit

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 Note: Scarcity does not mean shortage.

 We have already said that a good is said to be scarce if the amount

available is less than the amount people wish to have at zero price.
 But we say that there is shortage of goods and services when people
are unable to get the amount they want at the prevailing or on
going price
 Shortage is a specific and short term problem but scarcity is a
universal and everlasting problem.

20 WSU, CBE, Department of Economics by Afework B (assistant professor) 04/08/2024

 2. Choice
 If resources are scarce, then output will be limited.
 If output is limited, then we cannot satisfy all of our wants.
 Thus, choice must be made.
 Due to the problem of scarcity, individuals, firms and government
are forced to choose as to what output to produce, in what quantity,
and what output not to produce.
 In short, scarcity implies choice. Choice, in turn, implies cost.
 That means whenever choice is made, an alternative opportunity is
sacrificed. This cost is known as opportunity cost.

21 WSU, CBE, Department of Economics by Afework B (assistant professor) 04/08/2024

 3. Opportunity cost
 In a world of scarcity, a decision to have more of one
thing, at the same time, means a decision to have less of
another thing.
 The value of the next best alternative that must be
sacrificed is, therefore, the opportunity cost of the
decision.

Definition:
 Opportunity cost is the amount or value of the next best
alternative that must be sacrificed (forgone) in order to
obtain one more unit of a product.
 For example, suppose the country spends all of its limited
22 resources on the production of cloth
WSU, CBE, Department of Economics
by Afework or computer.
B (assistant professor) 04/08/2024
 o If a given amount of resources can produce either one
meter of cloth or 20 units of computer, then the cost of
one meter of cloth is the 20 units of computer that
must be sacrificed in order to produce a meter of cloth.
When we say opportunity cost, we mean that:
 It is measured in goods & services but not in money
costs
It should be in line with the principle of
substitution.
In conclusion, when opportunity cost of an activity
increases people substitute other activities in its place.

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 4. The Production Possibilities Frontier or Curve (PPF/ PPC
 The production possibilities frontier (PPF) is a curve that shows the
various possible combinations of goods and services that the society
can produce given its resources and technology.
 To draw the PPF we need the following assumptions.
 a. The quantity as well as quality of economic resource
available for use during the year is fixed.
 b. There are two broad classes of output to be produced over the
year.
 c. The economy is operating at full employment and is
achieving full production (efficiency).
 d. Technology does not change during the year.
 e. Some inputs are better adapted to the production of one good
than to the production of the other (specialization).

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 Suppose a hypothetical economy produces food and computer
given its limited resources and available technology


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The PPF describes three important concepts:
 i) The concepts of scarcity: - the society cannot have unlimited
amount of outputs even if it employs all of its resources and utilizes
them in the best possible way.
 ii) The concept of choice: - any movement along the curve
indicates the change in choice.
 iii)The concept of opportunity cost: - when the economy
produces on the PPF, production of more of one good requires
sacrificing some of another product which is reflected by the
downward sloping PPF.
 Related to the opportunity cost we have a law known as the law of
increasing opportunity cost.
 law of increasing opportunity cost:-
 This law states that as we produce more and more of a product,
the opportunity cost per unit of the additional output increases.
 This makes the shape of the PPF concave to the origin.
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 The reason why opportunity cost increases when we produce more
of one good is that economic resources are not completely
adaptable to alternative uses (specialization effect).
 Opportunity cost of a good
= amount of next best alternative sacrificed
amount of the good gained

 example: Referring to table 1.1 above, if the economy is initially

operating at point B, what is the opportunity cost of producing one
more unit of computer?
 Solution: Moving from production alternative B to C we have:
 OC== 0.2
 The economy gives up 0.2 metric tons of food per computer)

27 WSU, CBE, Department of Economics by Afework B (assistant professor) 04/08/2024

 5. Economic Growth and the PPF
 Economic growth or an increase in the total output level occurs when one
or both of the following conditions occur.
 1. Increase in the quantity or/and quality of economic resources.
 2. Advances in technology.
 Economic growth is represented by outward shift of the PPF.

 An economy can grow because of an increase in productivity in one sector

of the economy.
 For example, an improvement in technology applied to either food or
computer would be illustrated by a shift of the PPF along the Y- axis or X-
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axis. This is called asymmetric growth (figure 1.3).
by Afework B (assistant professor)


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 Basic Economic problems
and
Alternative Economic Systems

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 Basic economic problems:
 there are three fundamental and interdependent economic
problems.
1. What goods and services are produced and in what
quantities?
 concerned with the allocation of scarce resources among
alternative uses.
2. How to produce goods and services?
-what techniques should be used to combine inputs to
produce the desired output.
3. For whom to produce and distribute?
-This refers to the problem of who gets how much of what is
produced in the economy.
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 Alternative Economic Systems
 The way in which a nation makes economic choices is called
economic system.
 There are four types of economic systems:
 traditional economy,
 market economy,
 command economy, &
 mixed economy.
1. Traditional Economy
 basic economic questions such as
 What to produce?, How to produce?, For whom to produce?, At
what prices to sell?” are resolved by traditions or longstanding
rules.
Technological changes and innovations are constrained
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by tradition.
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2. Market(Capitalist) Economy/free economy
In market economy there is no government involvement
in economic decisions.
role of the private sector in development is highly
recognized.
For whom to produce G&S are determined by DD and
SS.
the three basic economic questions are determined by the
price mechanism with the theory of the Invisible Hand

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3. Command(Socialist) Economy
determination of prices and distribution of goods and services
are made by government through central planning.
Unlike the capitalist economy, the prime motive is public
interest (social welfare) rather than profit.
4. Mixed Economies
Government and the Market work together in decision
making i.e.
The basic economic problems are resolved by a mixture of
government decisions and market forces of DD and SS.

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[Link]. Major Decision Making Units and Circular Flow of economic activities

1. Decision Making Units

 Household: is defined as a single person, or a group of persons or a
family
 They are economic decision-making units(economic agents) who
provide the economy with resources
 use the money paid for these resources to purchase G and S.
 Firm: An organization that transforms resources (inputs) into products
(outputs).
 make economic decisions on buying resources from households to
produce goods and services.
Government
 Government is an organization that has legal and political power to
exert control over individuals, business firms and markets.
 It provides public goods and services such as national defense, public
health, streetlight and other infrastructures
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2. Circular Flow of Economic Activity
 The circular flow of economic activity is a model showing
the basic economic relationships within a market economy.
 The model shows where money goes and what it is
exchanged for.
 It includes
o households,
o business firms and
o governments.
 Here money is used to purchase goods and services.
 Goods and services flow through the economy in one
direction while money flows in the opposite direction.

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Product or Output markets:
 The markets in which goods and services produced by
businesses are sold to households.
 Flow of money income(revenue) to business firms from the
sell of G & S to hhs.
Input or Factor market:
 a market in which households who own economic resources
supply these resources to firms
 Hhs earn money payment (income of hhs), and firms pay for
resources(expenditure of firms)
 business firms are demanders of resources, but households are
the suppliers.

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 Chapter Two

Theory of Demand and Supply

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 2.1 Theory of demand
 Demand implies more than a mere desire to purchase a commodity.
 It states that the consumer must be willing and able to purchase the
commodity, which he/she desires.
 A poor person is willing to buy a car; it has no significance, since he/she
has no ability to pay for it.
 On the other hand, if his/her desire to buy the car is backed by the purchasing
power then this constitutes demand.
 Demand, thus, means the desire of the consumer for a commodity backed
by purchasing power.
 These two factors are essential.
 If a consumer is willing to buy but is not able to pay, his/her desire
will not become demand.
 Similarly, if the consumer has the ability to pay but is not willing to
pay, his/her desire will not be called demand.

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 More specifically, demand refers to various quantities of a
commodity or service that a consumer would purchase
at a given time in a market at various prices, given
other things unchanged (ceteris paribus).
 The quantity demanded of a particular commodity depends
on the
price of that commodity.
 Law of demand:
 statesthat , price of a commodity and its quantity demanded
are inversely related
 i.e., as price of a commodity increases (decreases) quantity
demanded for that commodity decreases (increases),
ceteris paribus.

42 WSU, CBE, Department of Economics by Afework B (assistant professor) 04/08/2024

 2.1.1 Demand schedule (table), demand curve and demand function

 A demand schedule states the relationship between price and

quantity demanded in a table form.
 Table 2.1 individual houshold demand for orange per week
Combinations A B C D E
Price 5 4 3 2 1
Quantity dd/week 5 7 9 11 13

 Demand curve is a graphical representation of the relationship

between quantity demanded by an individual at different prices
per time period

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 Demand function is a mathematical relationship between price and
quantity demanded, all other things remaining the same.
 A typical demand function is given by: Qd=f(P)
 where Qd is quantity demanded and
 P is price of the commodity, in our case price of orange.

 Example:
 Let the demand function be Q = a+ bP

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 Market Demand: The market demand schedule, curve or
function is derived by horizontally adding the quantity
demanded for the product by all buyers at each price.

45 WSU, CBE, Department of Economics by Afework B (assistant professor) 04/08/2024

 Numerical Example: Suppose the individual demand function
of a product is given by:
 P=10 - Q /2 and
 there are about 100 identical buyers in the market.

 Then the market demand function is given by:

 P= 10 - Q /2 ↔ Q /2 =10-P ↔ Q= 20 - 2P and
 Qm = (20 – 2P) 100 = 2000-200P
 2.1.2 Determinants of demand
 I. Price of the product
 II. Taste or preference of consumers
 III. Income of the consumers
 IV. Price of related goods
 V. Consumers expectation of income and price
 VI. Number of buyers in the market

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 A change in any of the above listed factors except the price of
the good will change the demand,
 while a change in the price, other factors remain constant will
bring change in quantity demanded.
 A change in demand will shift the demand curve from its
original location.
 Changes in demand: a change in any determinant of demand—
except for the good‘s price causes the demand curve to shift

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 Changes in Quantity Demand vs. Changes in Demand
Changes in Quantity Demanded
A movement along a demand curve is the graphical
representation of the effect of a change in price on the
quantity demanded.
=>The change is caused by the change in the price of the
good itself
Changes in Demand
A shift in demand is the graphical representation of the effect
of anything other than price on demand.
=>Caused by the change in the determinants of demand other
than price of the product

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  A change in demand is not
the same as a change in
quantity demanded.

 In this example, a higher

price causes lower quantity
demanded.

 Changes in determinants of
demand, other than price,
cause a change in demand,
or a shift of the entire
demand curve, from DA to
D B.
WSU, CBE, Department of Economics by Afework B (assistant professor)
 Factors that shift the demand curve include:
1. Income
 As income changes (increases or decreases), demand
for a particular good may rise, fall, or remain constant.
 For a normal good,
‫ﺤ‬ X is a normal good: as income↑ , DX ↑
as income↓ , DX ↓
 For an inferior good,
‫ﺣ‬ Y is an inferior good: as income↑, Dy ↓
as income↓, Dy ↑
→ But, for a neutral good, as income rises or falls,
the demand for the good does not change.

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2. Price of Related Goods
There are two types of related goods:
substitutes and complements.
Substitute Goods
 Two goods are substitutes when they satisfy similar needs
or desires. For example; Coca-Cola & Pepsi-Cola; coffee
& tea; corn chips & potato chips; foreign and domestic
cars; etc. are substitutes for many people.
 When the price of a substitute good rises, demand rises
for the good whose price has not changed.
 ↑Price of Pepsi- Cola => people drink less Pepsi-
Cola => purchase more Coca-Cola => ↑D for Coca-
Cola.
51 NoteWSU,that Perfect
CBE, Department substitutes
of Economics by Afew are identical products.
04/08/2024
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 Complementary Goods
Two goods are complements if they are consumed jointly.
 as the price of one good rises (falls), the demand for the
other falls (rises).
 For example, tennis rackets & tennis balls are used
together to play tennis. Higher tennis racket prices will
decrease the demand for tennis balls.
Other examples of complementary goods are cars & tires,
light bulbs & lamps, sugar & tea, etc.

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3. Tastes / Preference
New tastes for the product => Consume more => ↑DD
4. Expectations
↑Price tomorrow => buy today instead of tomorrow => ↑D
5. Number of buyers
↑number of buyers => More of the good is consumed => ↑D

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 A Change in Demand Versus a Change in Quantity Demanded
summarized

Change in price of a good or service

leads to

Change in quantity demanded

(Movement along the curve).

Change in income, preferences, or

prices of other goods or services
leads to

Change in demand
(Shift of curve).
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 The Impact of a Change in Income

• Higher income • Higher income

decreases the demand increases the demand
for an inferior good for a normal good

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 The Impact of a Change in the Price of Related Goods

• Demand for complement good

(ketchup) shifts left

• Demand for substitute good (chicken)

shifts right

• Price of hamburger rises

• Quantity of hamburger
demanded falls
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2.1.3 Elasticity of demand
 Elasticity of demand refers to the degree of responsiveness of quantity
demanded of a good to a change in:-
 price, or
 income, or
 prices of related goods.
 Three kinds of demand elasticity:
 price elasticity,
 income elasticity, and
 cross elasticity.

 i. Price Elasticity of Demand

 Price elasticity of demand means degree of responsiveness of demand to change
in price.
 It indicates how consumers react to changes in price.
 The greater the reaction the greater will be the elasticity, and
 the lesser the reaction, the smaller will be the elasticity.
 computed as the percentage change in quantity demanded divided by the

57
percentage change in price. 04/08/2024
WSU, CBE, Department of Economics by Afework B (assistant professor)
 Demand for commodities like clothes, fruit etc.
changes when there is even a small change in their
price,
 Whereas demand for commodities which are basic
necessities of life,
like salt, food grains etc., may not change even if price
changes,
or it may change, but not in proportion to the change
in price.
 Price elasticity demand can be measured in two ways.
point and
 arc elasticity.

58 WSU, CBE, Department of Economics by Afework B (assistant professor) 04/08/2024

 a. Point Price Elasticity of Demand
 This is calculated to find elasticity at a given point.

 In this method, we take a straight-line demand curve joining

the two axes, and measure the elasticity between two points Qo
and Q1
59 WSU, CBE, Department of Economics by Afework B (assistant professor) 04/08/2024
 Point Price Elasticity cont’d…………..

60 WSU, CBE, Department of Economics by Afework B (assistant professor) 04/08/2024

b. Arc price elasticity of demand
 In arc price elasticity of demand, the midpoints of the old and
the new values of both price and quantity demanded.
 It measures a portion or a segment of the demand curve
between the two points

61 WSU, CBE, Department of Economics by Afework B (assistant professor) 04/08/2024

 Suppose :-
 price of a commodity is Br. 5 and
 quantity demanded at that price is 100 units.
 Assume
 price of the commodity falls to Br. 4
 and the quantity demanded rises to 110 units.
 arc elasticity will be

 Note that:
 Elasticity of demand is unit free because it is a ratio of percentage
change.
 Elasticity of demand is usually a negative number because of the law
of demand.
 If the price elasticity of demand is positive the product is inferior
62 WSU, CBE, Department of Economics 04/08/2024
by Afework B (assistant professor)
63 WSU, CBE, Department of Economics by Afework B (assistant professor) 04/08/2024
Determinants of price Elasticity of Demand
 The following factors make price elasticity of demand
 elastic or inelastic other than changes in the price of the product.

 i) The availability of substitutes:

 the more substitutes available for a product, the more elastic will be
the price elasticity of demand.
 ii) Time: In the long- run, price elasticity of demand tends to be
elastic.
 Because:
 More substitute goods could be produced.
 People tend to adjust their consumption pattern.

 iii) The proportion of income consumers spend for a product:-

 the smaller the proportion of income spent for a good, the less price
elastic will be.
 iv) The importance of the commodity in the consumers’ budget :
 Luxury goods tend to be more elastic, example: gold.
 Necessity goods tend to be less elastic example: Salt.
64 WSU, CBE, Department of Economics by Afework B (assistant professor) 04/08/2024
ii. Income Elasticity of Demand
 It is a measure of responsiveness of demand to change in
income.

65 WSU, CBE, Department of Economics by Afework B (assistant professor) 04/08/2024

 Example:
 Consider the following data which shows the changes in
quantity demanded of good X in response to changes in the
price of good Y
Unit price of Y Quantity demanded of X
10 1500
15 1000

 Calculate the cross –price elasticity of demand between the

two goods.

 Therefore, the two goods are complements.

66 WSU, CBE, Department of Economics by Afework B (assistant professor) 04/08/2024
2.2 Theory of supply
 Supply indicates various quantities of a product that sellers (producers) are
willing and able to provide at different prices in a given period of time
 The law of supply: states that, ceteris paribus, as price of a product
increase, quantity supplied of the product increases, and as price
decreases, quantity supplied decreases.
 It tells us there is a positive relationship between price and quantity
supplied.
 2.2.1 Supply schedule, supply curve and supply function
 A supply schedule is a tabular statement that states the different quantities
of a commodity offered for sale at different prices.

67 WSU, CBE, Department of Economics by Afework B (assistant professor) 04/08/2024

 A supply curve conveys the same information as a supply
schedule. But it shows the information graphically rather than
in a tabular form

 The supply curve slopes upward as we go from the left to the

right. This means, as the price rises, more is offered for sale
and vice-versa.
68 WSU, CBE, Department of Economics by Afework B (assistant professor) 04/08/2024
 Market supply: It is derived by horizontally adding the quantity
supplied of the product by all sellers at each price.

69 WSU, CBE, Department of Economics by Afework B (assistant professor) 04/08/2024

 2.2.2 Determinants of supply
 Apart from the change in price, supply of a particular product is determined by:
 i) Price of inputs ( cost of inputs)
 ii) Technology
 iii) Prices of related goods
 iv) Sellers‘ expectation of price of the product
 v) Taxes & Subsidies
 vi) Number of sellers in the market
 vii) weather, etc.
 i) Effect of change in input price on supply of a product
 An increase in the price of inputs such as labour, raw materials, capital, etc causes a decrease
in the supply of the product which is represented by a leftward shift of the supply curve.
 Likewise, a decrease in input price causes an increase in supply.
 ii) Effect of change in Technology
 Technological advancement enables a firm to produce and supply more in the market. This
shifts the supply curve outward.
 iii) Effect of change in weather condition
 A change in weather condition will have an impact on the supply of a number of products,
especially agricultural products. For example, other things remain unchanged, good weather
condition boosts the supply of agricultural products.
 This shifts the supply curve of a given agricultural product outward. Bad weather condition
70 will have the opposite impact. 04/08/2024
WSU, CBE, Department of Economics by Afework B (assistant professor)
 2.2.3 Elasticity of supply
 It is the degree of responsiveness of the supply to change in
price.
 The percentage change in quantity supplied divided by the
percentage change in price.
 we can measure the price elasticity of supply using point and
arc elasticity methods.
 However, a simple and most commonly used method is point
method.

71 WSU, CBE, Department of Economics by Afework B (assistant professor) 04/08/2024

 The point price elasticity of supply can be calculated as:
 the ratio of proportionate change in quantity supplied of a commodity to a given
proportionate change in its price.

 Price elasticity of supply can be

 elastic, inelastic, unitary elastic, perfectly elastic or perfectly inelastic.

 Elastic when a small change on price leads to great change in supply.

 Inelastic or less elastic when a great change in price induces only a slight
change in supply.
 Perfectly inelastic, it will be represented by a vertical line shown as below.
 Perfectly elastic it will be represented by a horizontal straight line as in
second diagram
72 WSU, CBE, Department of Economics by Afework B (assistant professor) 04/08/2024
73 WSU, CBE, Department of Economics by Afework B (assistant professor) 04/08/2024
2.3 Market equilibrium
 Market equilibrium occurs when market demand equals market
supply.

 any price greater than P will lead to market surplus.

 If price increases to P1 the market will have a surplus of HJ.
 If price decreases to P2 buyers demand to buy more and suppliers
prefer to decrease their supply leading to shortage in the market
which is equal to GF.
74 WSU, CBE, Department of Economics by Afework B (assistant professor) 04/08/2024
 Numerical example:
 Given market demand: Qd= 100-2P, and market supply:
P =( Qs /2) + 10
a) Calculate the market equilibrium price and quantity
b) Determine, whether there is surplus or shortage at P= 25 and P= 35.
Solution:
a) At equilibrium, Qd= Qs
100 – 2P = 2P – 20
4P =120
= 40
b) Qd (at P = 25) = 100-2(25) =50 and Qs(at P = 25 ) = 2(25) -20 =30
Therefore, there is a shortage of: 50 -30 =20 units
Qd( at P=35) = 100-2(35) = 30 and Qs (at p = 35) = 2(35)-20 = 50,
a surplus of 20 units

75 WSU, CBE, Department of Economics by Afework B (assistant professor) 04/08/2024

 Effects of shift in demand and supply on equilibrium
 Given demand and supply the equilibrium price and quantity
are stable.
 However, when these market forces change what will happen
to the equilibrium price and quantity?
 Changes in demand and supply bring about changes in the
equilibrium price level and the equilibrium quantity.
 i) when demand changes and supply remains constant

76 WSU, CBE, Department of Economics by Afework B (assistant professor) 04/08/2024

 ii. When supply changes and demand remains constant
 Changes in supply are brought by changes in technical knowledge
and factor prices.
 The following graph explains the effects of changes in supply

77 WSU, CBE, Department of Economics by Afework B (assistant professor) 04/08/2024

 III) Effects of combined changes in demand and supply
 When both demand and supply increase, the quantity of the product will
increase definitely.
 But it is not certain whether the price will rise or fall.
 If an increase in demand is more than an increase in supply, then the price
goes up.
 If an increase in supply is more than an increase in demand, the price falls
but the quantity increases.
 If the increase in demand and supply is same, then the price remains the
same.
 When demand and supply decline, the quantity decreases.
 But the change in price will depend upon the relative fall in demand and
supply.
 When the fall in demand is more than the fall in supply, the price will
decrease.
 when the fall in supply is more than the fall in demand, the price will rise.
 If both demand and supply decline in the same ratio, there is no change in the
78 equilibrium price, but the quantitybydecreases.
WSU, CBE, Department of Economics Afework B (assistant professor) 04/08/2024
 End
79 WSU, CBE, Department of Economics
ork B (assistant professor)
by Afew 04/08/2024