CHAPTER ONE

MANAGERIAL ECONOMICS

1.1 Definition of Managerial Economics

Managerial economics has been generally defined as the study of economic theories, logic and tools
of economic analysis, used in the process of business decision making. It involves the understanding
and use of economic theories and techniques of economic analysis in analyzing and solving business
problems. Managerial economics, meaning the application of economic methods in the managerial
decision-making process, is a fundamental part of any business or management course. Economic
principles contribute significantly towards the performance of managerial duties as well as
responsibilities. Managers with some working knowledge of economics can perform their functions
more effectively and efficiently than those without such knowledge. Taking appropriate business
decisions requires a good understanding of the technical and environmental conditions under which
business decisions are taken. Application of economic theories and logic to explain and analyze these
technical conditions and business environment can contribute significantly to the rational decision-
making process.

1.2 Factors that contributed for the emergence of Managerial Economics

Managerial Economics as a course required for effective resource management was put in place due
to the following developments in the global business environment:
a. Growing complexity of business decision-making processes.
b. Increasing need for the use of economic logic, concept, theories, and tools of economic analysis in
the process of decision-making.
c. Rapid increases in the demand for professionally trained managerial manpower.
These developments have made it necessary that every manager aspiring for good leadership and
achievement of organizational objectives be equipped with relevant economic principles and
applications. Unfortunately, a gap has been observed in this respect among today’s managers. It is
therefore the aim of this course to bridge such gap.
1.3 Scope of Managerial Economics

1 managerial economics
 Managerial economics comprises both micro and macro-economic theories. Generally, the scope of
managerial economics extends to those economic concepts, theories, and tools of analysis used in
analyzing the business environment, and to find solutions to practical business problems. In broad
terms, managerial economics is applied economics. The areas of business issues to which Managerial
economics can be directly applied are divided into two broad categories:
 Operational or internal issues; and,
 Environment or external issues.
Operational problems are of internal nature. These problems include all those problems which arise
within the business organization and fall within the control of management. Some of the basic internal
issues include:
 choice of business and the nature of product (what to produce);
 choice of size of the firm (how much to produce);
 choice of technology (choosing the factor combination);
 choice of price (product pricing);
 how to promote sales;
 how to face price competition;
 how to decide on new investments;
 how to manage profit and capital; and,
 how to manage inventory.
Environmental issues: These are issues related to the general business environment. These are issues
related to the overall economic, social, and political atmosphere of the country in which the business
is situated. The factors constituted under environmental aspect issues include the following:
 the existing economic system
 General trends in production, income, employment, prices, savings and investment, and so on.
 Structure of the financial institutions.
 Magnitude of and trends in foreign trade.
 Trends in labor and capital markets.
 Government’s economic policies.
 Social organizations, such as trade unions, consumers’ cooperatives, and producer unions.
 The political environment.

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 The degree of openness of the economy.
Managerial economics is particularly concerned with those economic factors that form the business
climate. In macroeconomic terms, managerial economics focus on business cycles, economic growth,
and content and logic of some relevant government activities and policies which form the business
environment in general.
1.4.Economic Analysis and Business Decisions
Business decision-making basically involves the selection of best out of alternative opportunities open
to the business organization. Decision making processes involve four main phases, including:
Phase One: Determining and defining the objective to be achieved (identifying target objectives).
Phase Two: Collection and analysis of information on economic, social, political, and technological
environment.
Phase Three: Inventing, developing and analyzing possible course of action.
Phase Four: Selecting and implementing a particular course of action from available alternatives
which best confirm with the target objective. Note that phases two and three are the most crucial in
business decision-making. They put the manager’s analytical ability to test and help in determining
the appropriateness and validity of decisions in the modern business environment. Personal
intelligence, experience, intuition and business acumen of the manager need to be supplemented with
quantitative analysis of business data on market conditions and business environment.
It is in fact, in this area of decision-making that economic theories and tools of economic analysis
make the greatest contribution in business. If for instance, a business firm plans to launch a new
product for which close substitutes are available in the market; one method of deciding whether or
not this product should be launched is to obtain the services of a business consultant. The other
method would be for the decision-maker or manager to decide. In doing this, the manager would need
to investigate and analyze the following thoroughly:
 Production related issues; and,
 Sales prospects and problems.
With regards to production, the manager will be required to collect and analyze information or data on:
 available production techniques;
 cost of production associated with each production technique;
 supply position of inputs required for the production process;
 input prices;
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 production costs of the competitive products; and,
 Availability of foreign exchange, if inputs are to be imported. Regarding the sales prospects and
problems, the manager will be required to collect and analyze data on:
 general market trends;
 the industrial business trends;
 major existing and potential competitors, as well as their respective market shares;
 prices of the competing products;
 pricing strategies of the prospective competitors;
 market structure and the degree of competition; and,
 the supply position of complementary goods.

1.5. Basic Economic Problems

As it has been discussed earlier, human wants are practically unlimited, but the resources available to
produce goods and services to satisfy human wants are limited. Accordingly, the subject matter of
economics deals with problems associated with the production and distribution of economic goods.
Economists, therefore, have identified six basic economic problems that are faced by all societies.
Economists try to find out how decisions on such core problems are made by various economic agents.
The basic economic problems faced by societies are:
a) What to produce b) How to produce c)
For whom to produce d) Full utilization of
resources e) Attainment of efficiency
f) Growth of the economy

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a) What to produce
The problem "what to produce" is the problem of choice between commodities. This problem arises
mainly for two reasons. Firstly, scarcity of resources does not permit production of all the goods and
services that people would like to consume. Secondly, all the goods and services are not equally
valued in terms of their utility by the consumers. Some commodities yield higher utility than others.
Since all the goods and services cannot be produced for lack of resources, and all that is produced
may not be bought by the consumers, the problems of choice between the commodities arise.
Example: Consider a potential businessperson planning to start a business around Debre Markos
University. Given his initial capital, he may have a number of alternative business ideas in his mind,
like running a cafeteria, a photocopy shop, a barber, internet café, grocery etc. Because of resource
limitations, however, he can run only one or two types of businesses. Thus, he has to decide which
business to run. Thus, he has to identify the most attractive business sectors and start producing
commodities (goods or services).
b) How to produce
The problem "how to produce" refers to the methods or techniques of production to be adopted, i.e.
the choice of technology. Here, the problem is how to determine an optimum combination of inputs;
Labor and capital to be used in the production of goods and services. This problem mainly arises
mainly because of scarcity of resources. If labor and capital were available in unlimited quantities,
any amount of labor and capital could be combined to produce a commodity. But, since resources are
not available in unlimited quantity, it becomes imperative to choose a technology which uses
resources most economically. A basic distinction is between capital-intensive production and labor-
intensive production technology. Capital-intensive technology uses large amounts of capital relative
to labor in a production process. While labor-intensive technology uses large amount of labor resource
relative to capital to produce a commodity.
Example: Assume two road construction projects in Bahir Dar city. Project A is construction of a
‘cobblestone’ road, while project B is construction of ‘asphalt’ road. In which one of the two projects
do you think the technology is labor-intensive? Why?
Based on the definitions, the cobblestone project is labor-intensive, as it absorbs many labor input
relative to capital. And Project B is capital intensive as it employs huge capital relative to labor.

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Therefore, a society which decides to construct a road has to decide also how to construct the road,
in other words, which of the available technologies to use.
c) For whom to produce
For whom to produce is the problem related to the distribution of products, i.e. identifying the market
or the users of the commodity what you produce using a certain technical means. In other words, this
problem the problem of synchronizing the supply pattern with demand pattern so that those who have
the ability and willingness to pay the price get the commodity and there is no surplus production.
Identifying the users of a commodity to be produced would help whether to produce that commodity
or not, where to use a capital-intensive or labor-intensive technology, and what amount of the
commodity to produce.
Example: In the case of the road construction projects, if the users of the road are mainly pedestrians
and lightweight cars, the road can be constructed using cobblestone. Otherwise, it should be
constructed using asphalt. Similarly, if the community around the Main Campus has a demand for
photocopy and cafeteria services, the businessperson can start these businesses. Otherwise, he should
think of a better business idea.
d) The problem of resource utilization
Full utilization of resources is the most desirable way of optimization of production and consumption
in the economy. Production of goods and services is always constrained by the scarcity of relevant
resources. When resources are scarce, one would expect that they are utilized fully but there are
examples in different societies of underutilization of resources in spite of demand for goods and
services in whose production the resources can be used. What are the reasons for such unemployment
or underutilization of productive resources is a big question that economists try to respond.
e) The problem of efficiency
Production is said to be inefficient if it would be possible to reallocate resources and to produce more
of at least one good without simultaneously producing less of any other good. The goods (including
services) that are produced are said to be inefficiently distributed if it would be possible to redistribute
them among the individuals in the society and make at least one person better off without
simultaneously making any one worse off. Inefficiencies in both, production and consumption are to
be reduced. That is the same thing as saying that production and consumption in the society have to
be efficient.
f) Problem of Growth of Economy
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The problem of growth of economy is quite serious in most of the countries particularly under-
developed and developing ones. By "growth" we mean increase in productive capacity and actual
production of goods and services from year to year. More goods and services are required by a country
over time because of necessity to meet the demands of growing population. A part from this, the
standard of living of people improves over time due to the impact of education and development of
science & technology. Thus, they need varieties of goods and services which meet their requirements.
An economy has to make necessary arrangements for production of greater amount as well as greater
varieties of goods of services. It is, however, not very easy to achieve the objective of growth of the
economy. There will be several constraints to this which are to be removed. What is to be the rate of
growth, what is the appropriate way to achieve growth and development of the economy? These are
vital questions for which a society must find the answers. The six problems as discussed above are
fundamental and common to all economics.
The first three problems i.e. what to produce, how to produce and for whom to produce are normally
considered more fundamental than the other three but all of them are of equal importance in the
context of contemporary economic complexities The different economic systems try to solve these
problems in different ways. In a free market economy, these problems are solved by a system of
prices. In mixed economy, they are solved partly by a system of prices of and partly by government.
In centralized socialist economy, these problems are solved by a set of public norms or directions by
the government. In brief, we can say that the basic economic problems of different societies are solved
in different ways.

1.6 Alternative Economic Systems

Societies have developed the following different economic systems, or institutions or mechanisms, in
order to resolve the three fundamentals economic problems.
a) Pure Market Economy
In this system, the three basic economic questions are answered as follows. Firms address the ‘what
to produce’ question by producing those goods and services that could give them the maximum
possible profit. The ‘how to produce’ question is answered by choosing the techniques of production
which are least costly. The ‘for whom to produce and distribute’ question is addressed depending on
peoples decision as to how to spend their income. Economic activities are coordinated and directed

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 through market mechanism (or demand and supply). There is no government intervention in the
economy. Rather the private sector, through the forces of demand and supply, is expected to solve the
problems. You should be aware of the fact that no economy in the real world has a characteristic of
pure market economic system, even that of the economy of USA. This is because, although very
rarely, the government of USA intervenes in the economy. However, as compared to many economies
in the world, many of the characteristics of the economy of USA are much closer to the pure market
economic system.
b) Command Economy
It is an economic system where the questions of what, how, and for whom to produce is resolved by
the government through a central planning board. The central planning board studies the needs and
preferences of the society and decides on what, how and for whom to produce. Resources are owned
by the public sector. Example: North Korea and Cuba.
c) Mixed Economy
It is a type of economic system in which decisions of what, how and for whom to produce is provided
by profit making firms via the market system(through the forces of demand and supply) and the
government. It is a midway system between pure market system and strict planned economy. All real
world economies, including that of our economy, are examples of this economic system.

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

i. Decision Making Units

Households, business organizations also called firms and government make important economic
decisions such as consumption, production, exchange and distribution. In short, they make economic
decisions to resolve the basic economic problems.
a) Households: - they are the owner of scarce resources, they are mostly considered as consumers.
Households, as decision making units, decide on:
 The sale of their scarce resources (labor, land, capital and entrepreneur) to firms and the government.
 What and how much of the goods and services to buy.
 Paying tax to the government.
b) Firms:- they are economic agents who transform scarce resources in to final goods and services,
mostly referred as producers. They make economic decision on:
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 What, how and for whom to produce?
 The level of resources they will purchase from the households
 Paying tax to the government
c) Government: - Government is an organization that has legal and political power to exert control over
individuals, firms and market. Sometimes, markets fail to work properly (as required) and hence fail to
allocate scarce resources efficiently. This calls for the intervention of the government in the economy.
ii. The circular flow of economic activities
It shows the interaction of decision-making units.
 Resource market:- are where inputs that are used in the production of goods and services are sold.
 Product market: - are markets where goods and services are traded.
 Real flow: - the flow of goods, services and resources.
 Financial or money flow: - the flow of money (income and expenditure).
Look at the following two-sector circular flow model and critically observe the diagram. The diagram
shows how the decision-making units (households and firms) interact each other in a given economy.
Figure 1.1 Two sector circular flow of economic activities

In the diagram above, firms and households are the two decisions making units. Households supply
resources in the resource market. In return, they receive money income and they spend all the
income to purchase goods and services from firms (i.e. they do not save). Firms buy resources
from households. Then, they combine these inputs and produce goods and services. Finally, they
sell these goods and services to households in the product market and generate income (revenue).
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 1.8.2 Theory of profit –an overview
The term profit means different things to different people. Businesspeople, accountants, tax
collectors, employees, and economists have their individual meaning of profit. Before exposing you
to the theories of profit, it will be helpful for you to distinguish between two often misunderstood
profits concepts: the Accounting profit and the Economic profit. In its general sense, profit is regarded
as income accruing to equity holders, in the same sense as wages accrue to the workers; rent accrues
to owners of rentable assets; and, interest accrues to the money lenders. To the accountant, ‘profit’
means the excess of revenue over all paid out costs, such as manufacturing and overhead expenses. It
is more like what is referred to a ‘net profit’. For practical purposes profit or business income refers
to profit in accounting sense.
The Accounting Profit: Accounting profit may be defined as follows:
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 = 𝜋𝑎 = 𝑇𝑅 – (𝑤 + 𝑟 + 𝐼 + 𝑚)
𝑤ℎ𝑒𝑟𝑒 𝑇𝑅 = 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒;
𝑤 = 𝑤𝑎𝑔𝑒𝑠 𝑎𝑛𝑑 𝑠𝑎𝑙𝑎𝑟𝑖𝑒𝑠;
𝑟 = 𝑟𝑒𝑛𝑡;
𝑖 = 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡; 𝑎𝑛𝑑
𝑚 = 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙𝑠.
You can observe that when calculating accounting profit, it is only the explicit or book costs that are
considered and subtracted from the total revenue (TR).
The Economic or Pure Profit: Unlike accounting profit, economic profit takes into account both the
explicit costs and implicit or imputed costs. The implicit or opportunity cost can be defined as the
payment that would be necessary to draw forth the factors of production from their most remunerative
alternative use or employment. Opportunity cost is the income foregone which the business could
expect from the second best alternative use of resources. The foregone incomes include interest,
salary, and rent, often called transfer costs.
Economic profit also makes provision for (a) insurable risks, (b) depreciation, (c) necessary minimum
payment to shareholders to prevent them from withdrawing their capital investments. Economic profit
may therefore be defined as ‘residual left after all contractual costs, including the transfer costs of
management, insurable risks, depreciation, and payments to shareholders have been met. Thus,
𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑜𝑟 𝑃𝑢𝑟𝑒 𝑃𝑟𝑜𝑓𝑖𝑡 = 𝜋𝑒 = 𝑇𝑅 – 𝐸𝐶 – 𝐼𝐶
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 𝑤ℎ𝑒𝑟𝑒 𝐸𝐶 = 𝐸𝑥𝑝𝑙𝑖𝑐𝑖𝑡 𝐶𝑜𝑠𝑡𝑠; 𝑎𝑛𝑑,
𝐼𝐶 = 𝐼𝑚𝑝𝑙𝑖𝑐𝑖𝑡 𝐶𝑜𝑠𝑡𝑠.
Note that economic profit as defined by the above equation may necessarily not be positive. It may
be negative since it may be difficult to decide beforehand the best way of using the business resources.
Pure profit is a short-term phenomenon. It does not exist in the long-run under perfectly competitive
conditions. To say that products that can be produced profitably will be, and those that cannot be
produced profitably will not begs the question of what we mean by “profit.”What is commonly
thought of as profit by the accountant may not match the meaning assigned to the term by an
economist. An economist’s notion of profit goes back to the basic fact that resources are scarce and
have alternative uses.
To use a certain set of resources to produce a good or service means that certain alternative production
possibilities were forgone. Costs in economics have to do with forgoing the opportunity to produce
alternative goods and services. The economic, or opportunity, cost of any resource in producing some
good or service is its value or worth in its next best alternative use.
Given the notion of opportunity costs, economic costs are the payments a firm must make, or incomes
it must provide, to resource suppliers to attract these resources away from alternative lines of
production. Economic costs (TC) include all relevant opportunity costs. These payments or incomes
may be either explicit, “out-of-pocket” (cash expenditures) or implicit costs which represent the value
of resources used in the production process for which no direct payment is made. This value is
generally taken to be the money earnings of resources in their next best alternative employment. When
a computer software programmer quits his or her job to open a consulting firm, the forgone salary is
an example of an implicit cost. When the owner of an office building decides to open a hobby shop,
the forgone rental income from that store is an example of an implicit cost. When a housewife decides
to redeem a certificate of deposit to establish a day-care center for children, the forgone interest
earnings represent an implicit cost.
In short, any sacrifice incurred when the decision is made to produce a good or service must be taken
into account if the full impact of that decision is to be correctly assessed. Economist’s concept of
profit is the pure profit or ‘economic profit’. Economic profit is a return over and above the
opportunity cost, that is, the income expected from the second alternative investment or use of

11 managerial economics
business resources. In this unit, emphasis will be placed on the various concepts of profit. These
relationships may be summarized as follows:
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡: П𝐴 = 𝑇𝑅 − 𝑇𝐶 𝑒𝑥𝑝𝑙𝑖𝑐𝑖𝑡
𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑝𝑟𝑜𝑓𝑖𝑡: П𝑒 = 𝑇𝑅 − 𝑇𝐶 = 𝑇𝑅 − 𝑇𝐶 𝑒𝑥𝑝𝑙𝑖𝑐𝑖𝑡 – 𝑇𝑐 𝑖𝑚𝑝𝑙𝑖𝑐𝑖𝑡
Example 1.1 Abera operates a small shop specializing in party favors. He owns the building and
supplies all his own labor and money capital. Thus, Abera incurs no explicit rental or wage costs.
Before starting his own business Abera earned Birr 1,000 per month by renting out the store and
earned Birr 2,500 per month as a store manager for a large department store chain. Because Abera
uses his own money capital, he also sacrificed Birr 1,000 per month in interest earned on bonds.
Abera’s monthly revenues from operating his shop are Birr 10,000 and his total monthly expenses
for labor and supplies amounted to Birr 6,000. Calculate Abera’s monthly accounting and
economic profits.
Solution: Total accounting profit is calculated as follows:
Total revenue Birr 10,000
Total explicit costs (6,000)
Accounting profit = Birr 4,000
On the other hand, 𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑝𝑟𝑜𝑓𝑖𝑡: 𝜋𝑒 = 𝑇𝑅 − 𝑇𝐶 = 𝑇𝑅 − (𝑇𝐶𝑒𝑥𝑝𝑙𝑖𝑐𝑖𝑡 + 𝑇𝐶𝑖𝑚𝑝𝑙𝑖𝑐𝑖𝑡)
Accounting profit: 𝜋𝐴 = 𝑇𝑅 − 𝑇𝐶𝑒𝑥𝑝𝑙𝑖𝑐𝑖𝑡
Abera’s accounting profit appears to be a healthy Birr 4,000 per month.
However, if we take into account Abera’s implicit costs, the story is quite different. Total economic
profit is calculated as follows:
Total revenue = Birr10, 000
Total explicit costs (6,000)
Forgone rent 1,000
Forgone salary 2,500
Forgone interest income 1,000
Total implicit costs (4,500)
Total economic costs 10,500
Economic profit (loss) = Birr (500)

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 Economic profits are equal to total revenue less total economic costs, which is the sum of explicit
and implicit costs. Accounting profits, on the other hand, are equal to total revenue less total
explicit costs. It is, of course, a simple matter to make accounting profit equivalent to economic
profit by making explicit all relevant implicit costs. Suppose, for example, that an individual quits
a Birr 40,000 per year job as the manager of a family restaurant to open a new restaurant. Since
this is a sacrifice incurred by the budding restaurateur, the forgone salary is an implicit cost. On
the other hand, this implicit cost can easily be made explicit by putting the restaurant owner “on
the books” for a salary of Birr 40,000.The somewhat arbitrary distinction between explicit and
implicit costs is illustrated in the following problem.
1. Mohamed is the owner of a small grocery store in Kebri Dehar town. Mohamed’s annual
revenue from operating the grocery is Birr200, 000 and his total explicit cost is Birr
180,000 per year. (Mohamed pays himself an annual salary of Birr 30,000).
A. What is Mohamed’s accounting profit?
b. What is Mohamed’s economic profit?
Solution
a. 200,000-180,000=20,000
b. = 𝐵𝑖𝑟𝑟 200,000 − 𝐵𝑖𝑟𝑟 180,000 − 𝐵𝑖𝑟𝑟 30,000
= -Birr 10,000

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 CHAPTER 2
FUNDAMENTAL ECONOMIC CONCEPTS
2.1 EQUILIBRIUM ANALYSIS: SUPPLY AND DEMAND RELATIONSHIP
2.1.1. Demand: Introduction
Demand is an important concept studied in economics. In ordinary usage, demand means desire of
individuals to buy commodity. But in economics it has a special meaning. Mere desire for a
commodity does not considered “demand” in economics. A commodity is said to be demanded, when
the individuals have desire or willingness to buy and ability to buy the commodity. Broadly speaking
the term ‘demand’ implies three elements. Desire on the part of the buyer to buy, Willingness to pay
for it and Ability to pay the specified price for it. Hence the desire backed by purchasing power of
money is known as Demand in economics. Unless all these conditions are fulfilled, the product is said
to have any demand.
Definition: Demand can be defined as” quantities of a good/service that people are willing to buy at
different prices”. Demand always refers to a particular price, place and time. Demand has no meaning
when the price of commodity, place its purchase and time were not mentioned. The reason is that
demand changes with a change in price, place and time. Hence demand has a special meaning and
usage in economics.
2.1.1.1. LAW OF DEMAND
The law of demand denotes the quantitative and inverse relationship between the quantity demanded
and its price. According to this law: If the price increases↑, the quantity demanded will decrease↓
If the price decreases↓, the quantity demanded will increase↑. This means;
 People will buy more quantity of good when the price is less.
 People will buy less quantity of good when the price is high.
 Demand is the buyers’ side of market. But it is based on important assumptions. Those assumptions
are customer Taste and Preference, Population, Discovery of substitutes, Income, Price of other goods
and Weather conditions. The law of demand assumes that these conditions never change/ remain
constant. If these conditions change the law does not hold good.
For example: if the peoples’ income falls down drastically due to draught (especially farmers) people
may not be able to buy more quantities of goods even if the price is less as they do not have enough
money to buy.

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 HYPOTHETICAL LAW OF DEMAND SCHEDULE

HYPOTHETICAL
LAW OF DEMAND 30

QUANTITY DEMANDED
SCHEDULE 25
20

QUANTITY 15
PRICE
DEMANDED 10
5
1 25
0
2 20 1 2 3 4 5
PRICE
3 15
4 10
5 5

2.1.2. SUPPLY
Introduction
Like demand, supply also based on certain assumption. Depending the demand and competitive
conditions, the producers arrange their inputs to cater to the requirements of market. Both supply and
demand are essential for the determination of price. These are the two important terms used in
economics. The demand analysis is the buyer side of market, when the supply analysis seller side of
market.
Definition: Supply can be defined as “quantities of a good/service that people are willing to sell at
different prices”.
2.1.2.1. LAW OF SUPPLY
The law of supply denotes the quantitative and direct relationship between the quantity supplied and
its price. According to this law; If the price increases↑, the quantity supplied will increase↑, If the
price decreases↓, the quantity supplied will decrease↑. This means:
 People will sell more quantity of good when the price is high.
 People will sell less quantity of good when the price is low.

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 Supply is the sellers’ side of market.
But it is based on important assumptions. Most of the assumptions of law of demand are applicable
to law of supply. Besides these, there are some other assumptions such as Changes in the price of
inputs, Changes in technology, Number of sellers in the market, Government Policies, Natural
Causes, Strikes (Bands and lockouts). The law of supply assumes that these conditions never change/
remain constant. If these conditions change the law does not hold good. For example: if the there is
a flood, it will effect on the supply of goods. In this situation even the price is high also people may
not be able to supply more.
HYPOTHETICAL SUPPLY SCHEDULE

hypothetical law LAW OF SUPPLY CURVE

of supply
schedule 30

quantity 25 5, 25
Price
supplied
QUNTITY SUPPLIED

20 4, 20
1 5
15 3, 15
2 10
3 15 10 2, 10

4 20 5 1, 5
5 25
0
0 1 2 3 4 5 6
PRICE

2.2. EQUILIBRIUM
In an ordinary language, equilibrium is nothing but “a state of balance-especially between opposing
forces. In terms of economics, equilibrium is a state of balance between two economic variables.
Equilibrium can be defined as “quantity demanded and quantity supplied are equal at a given price is
called equilibrium” Analysis of hypothetical equilibrium schedule:
A. According to the table , as the price increase quantity demanded decreases, quantity supplied increases
B. The quantity demanded and quantity supplies are equal at the price of 3/-

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C. At the price of 3/- the quantity demanded is 15 and the quantity supplied is 15. It is called equilibrium
position.

EQUILIBRUIM CURVE
HYPOTHETICAL 30
EQUILIBRUIM SCHEDULE
25 1, 25 5, 25

QUNTITY QUANTITY 20 2, 20 4, 20
PRICE
DEMANDED SUPPLIED

DEMENDED/SUPPLIED
QUANTITY
15 3, 15
1 25 5
2 20 10
10 2, 10 4, 10
3 15 15
4 10 20 5 1, 5 5, 5

5 5 25
0
0 1 2 3 4 5 6

Price

D. Only, at the equilibrium position that all buyers and sellers are satisfied i.e. the market is cleared. At
the higher prices, market surplus exists, which means the quantity supplied is more than quantity
demanded. (SS>DD). At the lower prices, market shortage exists, which means the quantity supplied
is less than quantity demanded. (SS<DD). In the case surplus, there is competition among sellers.
Thus, sellers will lower the price to get rid of the surplus. In the case of shortage, there is a competition
among buyers. Thus, potential buyers will push price as there is shortage. Thus we can see that the
forces of demand and supply work together to establish an equilibrium price at which there is no
surpluses or shortages. At the equilibrium price, all the sellers can sell as much as they want and all
the buyers can buy as much as they want. So if we were to shout, “Is everybody happy?” the buyers
and sellers would all shout back yes!
2.2.1 MARGINAL ANALYSIS

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 Marginal analysis is the corner stone of modern economic analysis. Marginal analysis is about
marginal costs & benefits. Marginal costs & benefits are incremental costs & benefits that are
associated with making a decision. So these are important in economics and managerial decision
making. Marginal costs & benefits are typically defined as “changes in costs and benefits are
associated with very small changes in a decision variable.
Whenever manager takes a decision, a question should be raised. Is it worthwhile?
That means Marginal benefits of a particular action should exceed its marginal costs.
(The benefits should be more than the costs.)
CONCEPT OF MARGIN: The concept of margin is central to economic analysis. The following
are the marginal concepts. Marginal Cost, Marginal Revenue, Marginal Output/Physical Product
Marginal Revenue Product
1. MARGINAL COST:
Marginal Cost is the cost incurred by producing one additional/more unit of output.
HYPOTHETICAL MARGINAL COST SCHEDULE
Output total fixed cost total variable cost total cost marginal cost
0 100 0 100 100
1 100 30 130 30
2 100 54 154 24
3 100 72 172 18
4 100 96 196 24
5 100 150 250 54
6 100 216 316 66
7 100 320 420 104
Marginal cost = changes in total cost/Changes in output quantity
2. MARGINAL REVENUE:
Marginal Revenue is the revenue obtained by selling one additional/more unit of output
HYPOTHETICAL MARGINAL REVENUE SCHEDULE
QUNTITY SOLD PRICE TOTAL REVENUE MARGINAL REEVENUE
1 20 20 20

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 2 20 40 20
3 20 60 20
4 20 80 20
5 20 100 20
6 20 120 20
7 20 140 20

Marginal Revenue = changes in total revenue/Changes in quantity sold

Marginal revenue measures the changes in total revenue that occurs when one additional worker is
hired. These marginal concepts help us to figure out exactly;
 What price we should charge
 What output we should produce
 What mix of resources we should use In order to maximize our profits?
2.3. TIME VALUE OF MONEY
The time value of money very well reflected to the proverb “a bird in the hand is more valued than
two birds in the bush”. In general, the value of money today is valued more than the value of money
tomorrow. No doubt the cash in hand at present is valued more because, it gives
 Liquidity
 An opportunity to invest it and earn return (interest) on it. This is called the time value of money.
Ex: suppose that a sum of Birr 100/- held in cash today is deposited in a bank at 10% rate of interest.
After one year, Birr 100/- today will increase to 110/-. The amount (principle + interest)
100+100(10/100) =100+100(0.1) =100+10=110. As the time changes the value of money also
changes. The term value of money is also understood with its purchasing power. In the 1st year Birr
100/- can buy quantity of goods X
In the 2nd year Birr 100/- can buy quantity of goods (X-20%)
We may conclude that the value of money has fallen in the 2nd year as it could purchase less quantity
of goods.

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