micro economics

1. Models and Theories
Demand and Supply
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kaleab

2. Models and theories
Model
 A hypothesis about the relationships among variables.
 Everyone uses models.
 Because a model abstracts from reality it makes mistakes.
 Models can contain two kinds of errors or mistakes:
– the wrong explanatory variables may be included.
– the functional form may be incorrect.
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3. Models cont…
Contents of models
• List of variables, especially a clear statement of what
is to be explained
–Dependent versus independent variables
• Hypothesized relationships among the variables.
• Using tables of values, graphs, or equations.
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4. A model of heights
6/3/2021 kaleab 4
age in years
height H = a + b(A)
a
H
A
b = H/ A

5. A better (nonlinear) model of heights
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age in years
height
nonlinear

6. In a better model :
Height = f(age, gender, parents’ heights,
nutrition, ...)
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7. Gender effects in the better model
• Height = f(age, gender, parents’ heights, nutrition, ...)
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height
age
men
women

8. ECONOMIC MODELS
• Are simplified representations of the real world
that we use to help us understand, explain, and
predict economic events in the real world.
Are abstractions from reality
• So a model is the guideline we follow to analyze
economic problems and predict outcomes.
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kaleab

9. The Production Possibility Curve
• It is an economic model
• Purposes:
– Show scarcity constraint
– Illustrate economic efficiency
– Introduce opportunity cost concept
• Variables
– Quantities of goods that may be produced
• Givens
– Total amounts of inputs available
– Technology of production
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10. • The Production Possibility Curve (Frontier)
shows the maximum amount of a good you can
produce given the amounts of other goods
produced, and given the total amounts of
inputs available, and given the technology of
production.
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11. PPC EXAMPLE
• Assumptions:
– There are only two goods, pizza and spaghetti.
– There are limited inputs and given technology of
production.
• Definition:
– The PPC shows the maximum amount of pizza you
can produce, given the amount of spaghetti to be
produced.
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12. PRODUCTION POSSIBILITY CURVE
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SPAGHETTI
PIZZA
Which points are attainable
and which points are unattainable?
0
100
200
300
400
0 10 20 30 40 50 60

13. PRODUCTION POSSIBILITY CURVE
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SPAGHETTI
PIZZA
attainable
unattainable
0
100
200
300
400
0 10 20 30 40 50 60

14. PRODUCTION POSSIBILITY CURVE
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SPAGHETTI
PIZZA
What’s the effect of an improvement
in the technology for producing spaghetti?
0
100
200
300
400
0 10 20 30 40 50 60

15. SPAGHETTI
PIZZA
An improvement in spaghetti technology
0
100
200
300
400
0 10 20 30 40 50 60
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16. PRODUCTION POSSIBILITY CURVE
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SPAGHETTI
PIZZA
More pizza means less spaghetti
0
100
200
300
400
0 10 20 30 40 50 60

17. OPPORTUNITY COST INCREASES AS MORE OFA
GOOD IS PRODUCED
• Not only does more pizza mean less spaghetti, but
each additional pizza costs more than the one
before it.
• This idea shows up as the PPC being concave to
the origin. (The curve bows out.)
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18. Opportunity cost of more pizza is
constant.
Production Possibility Curve
0
100
200
300
400
0 10 20 30 40 50 60
SPAGHETTI
PIZZA
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19. Cont…
• We will use Production Possibilities Curves that
are straight lines (i.e., that have constant
opportunity cost) to illustrate some important
economic principles.
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20. MODEL OF DEMAND
• The model of demand is an attempt to explain
the amount demanded of any good or service.
DEMAND DEFINED
• The amount of a good or service a consumer
wants to buy, and is able to buy per unit time.
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21. THE “STANDARD” MODEL OF DEMAND
• The DEPENDENT variable is the amount demanded.
• The INDEPENDENT variables are:
– the good’s own price
– the consumer’s money income
– the prices of other goods
– preferences (tastes)
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22. YOU COULD WRITE THE MODEL THIS WAY:
The demand for teff:
QD(teff) = D(Pteff, Income, Pspaghetti, Pbeer,
tastes)
• Economists have hypotheses about how
changes in each independent variable affect
the amount demanded
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23. THE DEMAND CURVE
• The demand curve for any good shows the quantity
demanded at each price, holding constant all other
determinants of demand.
– The DEPENDENT variable is the quantity
demanded.
– The INDEPENDENT variable is the good’s own
price.
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24. THE LAW OF DEMAND
• The Law of Demand says that a decrease in a good’s
own price will result in an increase in the amount
demanded, holding constant all the other determinants
of demand.
• The Law of Demand says that demand curves are
negatively sloped.
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25. A DEMAND CURVE
• A demand curve must look like this, i.e., be negatively
sloped.
6/3/2021 kaleab 26
own
price
quantity demanded
demand
Market for teff

26. The demand curve means:
6/3/2021 kaleab 27
• You pick a price, such a p0, and the demand curve shows how
much is demanded.
own
price
quantity demanded
demand
p0
Q0
Market for teff

27. What if the price of teff were less than p0? How do you show the effect
on demand?
At a lower price, consumers want to buy more.
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own
price
quantity demanded
demand
p0
Q0
plower
Q1
Market for teff

28. AN IMPORTANT POINT
• When drawing a demand curve notice that the
axes are reversed from the usual convention of
putting the dependent (y) variable on the
vertical axis, and the independent (x) variable
on the horizontal axis.
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29. Other factors affecting demand
• The question here is how to show the effects of
changes in income, other goods’ prices, and
tastes on demand.
• Suppose people want to buy more of a good
when incomes rise, holding constant all other
factors affecting demand, including the good’s
own price.
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30. Cont…
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own price
quantity of beer
demand @ I = $1000
Market for beer
How does this affect the
demand curve?
$1/can

31. This is a change in demand. It shows up as a shift to the right of
the original demand curve.
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own price
quantity
demand @ I = $1000
Market for beer
$1/can
demand @ I = $2000

32. Normal and inferior goods
• Normal good: When an increase in income
causes an increase in demand.
• Inferior good: When an increase in income
causes a decrease in demand.
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33. Pizza is a normal good
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own price
quantity
demand @ I = $1000
Market for pizza
What’s the effect on the demand
curve for pizza if income rises
to $2,000?

34. An increase in income increases demand when
pizza is normal.
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own price
quantity
demand @ I = $1000
demand @ I = $2000
Market for pizza

35. Suppose instead that pizza is an inferior good,
6/3/2021 kaleab 36
own price
quantity
demand @ I = $1000
Market for pizza
What’s the effect on the demand
curve for pizza if income rises
to $2,000?

36. Cont…
• If pizza were inferior, the demand would decrease as
income increases. Whether a good is normal or inferior
is a matter of fact, not theory.
6/3/2021 kaleab 37
price
quantity
demand @ I = $1000
demand @ I = $2000
Market for pizza

37. Substitutes
• Substitutes: Two goods are substitutes if an
increase in the price of one of them causes an
increase in the demand for the other.
• Thus, an increase in the price of pizza would
increase the demand for spaghetti if the goods
were substitutes.
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38. The graph shows the demand curve for spaghetti when pizzas
cost $10 each.
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own price
quantity
demand @ pizza price of $10
Market for spaghetti
What’s the effect of an increase in
the price of pizza to $15?

39. An increase in the price of pizza, a substitute for
spaghetti, causes an increase in demand for spaghetti.
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own price
quantity
demand @ pizza price of $10
Market for spaghetti
demand @ pizza price of $15.

40. Complements
• Complements: Two goods are complements
if an increase in the price of one of them
causes a decrease in the demand for the other.
• Thus, an increase in the price of sugar would
decrease the demand for coffee if the goods
were complements.
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41. The graph shows the demand curve for beer when pizzas cost
$10 each.
6/3/2021 kaleab 42
price of
beer
quantity
demand @ pizza price of $10
Market for beer
What is the effect on the
market for beer of an
increase in the price of
pizza to $15?

42. The graph shows the demand curve for umbrellas on
sunny days.
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price of
umbrellas
quantity
demand on sunny days
Market for umbrellas
What’s the effect on demand of
it being a rainy day?

43. DEMAND SUMMARY
• Demand is a function of own-price, income, prices of other
goods, and tastes.
• The demand curve shows demand as a function of a good's
own price, all else constant.
• Changes in own-price show up as movements along a demand
curve.
• Changes in income, prices of substitutes and complements,
and tastes show up as shifts in the demand curve.
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44. MODEL OF SUPPLY
The model of supply is an attempt to explain
the amount supplied of any good or service.
SUPPLY DEFINED
The amount of a good or service a firm
wants to sell, and is able to sell per unit
time.
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45. THE “STANDARD” MODEL OF
SUPPLY
The DEPENDENT variable is the amount supplied.
The INDEPENDENT variables are:
the good’s own price
the prices of inputs used in its production
the technology of production
taxes and subsidies
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46. YOU COULD WRITE THE MODEL THIS WAY:
The supply function for teff
QS(teff) = S(Pteff, Pwheat, Plettuce, Plabor,
Ptomatoes, . . ., technology, taxes &
subsidies)
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47. THE SUPPLY CURVE
The supply curve for any good shows the
quantity supplied at each price, holding
constant all other determinants of supply.
The DEPENDENT variable is the quantity
supplied.
The INDEPENDENT variable is the
good’s own price.
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48. THE LAW OF SUPPLY
The Law of Supply says that an increase in a good’s
own price will result in an increase in the amount
supplied, holding constant all the other determinants
of supply.
 The Law of Supply says that supply curves are
positively sloped.
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49. A SUPPLY CURVE cont..
• A supply curve must look like this, i.e., be
positively sloped.
own
price
quantity supplied
supply
Teff Market
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50. The supply curve means:
• You pick a price, such a p0, and the supply curve
shows how much is supplied.
own
price
quantity supplied
supply
p0
Q0
Teff Market
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51. own
price
quantity supplied
supply
p0
Q0
Teff Market
If the price of teff rises, how is the supply curve
affected?
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52. At a higher price, firms want to sell more.
own
price
quantity supplied
supply
p0
Q0
phigher
Q1
Teff Market
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53. AN IMPORTANT POINT
When drawing a supply curve notice that the axes are
reversed from the usual convention of putting the
dependent (y) variable on the vertical axis, and the
independent (x) variable on the horizontal axis.
• Economists have hypotheses about how
changes in each of the independent variables
affects the amount supplied
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54. Other factors affecting supply
• The question here is how to show the effects
of changes in input prices, technology, and
taxes.
• The answer, of course, is that changes in input
prices, technology, or taxes cause the supply
curve to shift.
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55. Changes in input prices
• Consider the supply of beer, and suppose the price of
hops, a crucial input to beer, falls. Beer firms now
find that beer production is more profitable than it
was before, and they respond to this by increasing the
supply of beer.
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56. The price of hops falls from $300 per ton to $100 per ton.
own price
quantity
supply @ hops price
of $300/ton
BEER MARKET
How will this affect the
supply curve for beer?
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57. This is a change in supply. Beer firms want to
sell more beer at each price of beer.
own price
quantity
supply @ hops price
of $300/ton
supply @ hops
price of $100/ton
BEER MARKET
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58. Change in technology
• An improvement in technology makes it
possible to produce a level of output with
fewer inputs than before.
• Because this lowers the cost of production,
profits rise, and firms will try to supply more.
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59. own price
quantity
supply @ old
technology
BEER MARKET
Suppose beer technology improves,
How does this affect
the supply curve for beer?
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60. own price
quantity
supply @ old
technology
supply @
improved
technology
BEER MARKET
There is an increase in supply. The supply
curve shifts to the right
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61. Supply summary
6/3/2021 kaleab 64
Supply is a function of own price, input
prices, and technology.
The supply curve shows supply as a function
of own price, all else constant.
Changes in a good’s own price show up as
movements along a supply curve.
Changes in input prices, technology, or taxes
show up as shifts in the supply curve.

62. PRICE DETERMINATION IN
MARKETS
• The market demand curve shows the amount
demanded at every price.
• The market supply curve shows the amount
supplied at every price.
• The question now is whether there is some price
at which the quantities supplied and demanded
are the same.
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63. EQUILIBRIUM PRICE
• The equilibrium price of a good is:
–a price at which quantity supplied
equals quantity demanded.
–a price at which excess demand equals
zero.
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At the equilibrium price there is no net
tendency for price to change.

64. Cont…
• Excess demand exists when, at the current
price, the quantity demanded is greater than
quantity supplied.
• Excess supply exists when, at the current price,
the quantity supplied is greater than the
quantity demanded.
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65. Excess supply = Qs - QD
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Market for teff
supply
demand
price
quantity
p = $3
QD QS
EXCESS SUPPLY

66. Excess demand = QD - QS
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Market for teff
supply
demand
price
quantity
p = $1
QD
QS
EXCESS DEMAND

67. •P - price
•Q - quantity of good
•S - supply
•D - demand
•P0 - price of market balance
•A - surplus of demand - when P<P0
•B - surplus of supply - when P>P0
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kaleab

68. Cont…
• When there is EXCESS DEMAND for a good, price
will tend to rise.
• When there is EXCESS SUPPLY of a good, price
will tend to fall.
• When excess demand equals zero, price must be the
equilibrium price, and we say the market is in
equilibrium.
If you want to find out the price at which a market is
in equilibrium, then look for the price where the
excess demand is zero.
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69. Cont…
• Economists are interested in the explaining
equilibrium prices.
• In particular, they are anxious to explain why
equilibrium prices change.
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70. p = $2
P
Q
supply
demand
Teff MARKET
$1
$3
$4
6/3/2021 kaleab 73
What is the equilibrium price in the market for teff?
Show it on the diagram. What is the equilibrium
quantity of teff?

71. p = $2
QE
P
Q
supply
demand
TEFF MARKET
The market for teff is in equilibrium at a price of $ 2
per unit.
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72. How can the price of teff change?
• Only if there is a change in supply, or if there is a change in
demand.
• But remember, we already know the list of reasons why supply
and demand can change
• The following is a series of sample problems showing changes
in the equilibrium prices of some goods.
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73. P
Q
p0
q0
Classes at a Local College are an inferior good. People’s incomes
fall, perhaps due to a recession. What is the effect on a given
tuition and enrollment?
supply
demand @ high income
LC ENROLLMENT
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74. Because classes at LC are inferior, a decrease in income causes
demand to increase. This creates an excess demand and price
tends to rise.
6/3/2021 kaleab 79
P
Q
p0
q0
supply
demand @ high income
demand @ low income
LCC ENROLLMENT
p1
q1
The new equilibrium will
have higher tuition and
enrollment
Excess demand

75. The market for apartments in Gondar is in equilibrium, and
University of Gondar raises the price of dorm rooms. What is
the effect on the market for apartments in Gondar?
P
Q
p0
q0
supply
demand
Gondar Apartments
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76. P
Q
p0
q0
D @ old MSU price
supply
GONDAR APARTMENTS
Excess demand
D @ new (higher) MSU price
p1
q1
The excess demand for
housing causes prices to rise.
The price of Gondar apartments increases.
Here are the steps in the move to a new equilibrium.
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77. Car and gasoline are complements. The price of gasoline rises.
What is the effect on the market for car?
6/3/2021 kaleab 82
P
Q
p0
q0
supply
demand @ old beer price
CAR MARKET

78. P
Q
supply
p0
q0
demand @ old beer price
CAR
demand @ higher beer price
p1
q1
Excess supply
Car and gasoline are complements. The price of gasoline rises.
As a result the demand for car falls. Here's the process:
6/3/2021 kaleab 83
So price and quantity are both
lower.

79. People come to believe that eating apples is good for them. The
more apples they eat, the more likely they are to stay well. What
is the effect on the market for apples?
6/3/2021 kaleab 84
P
Q
p0
q0
APPLE MARKET
supply
demand

80. There is a change in preferences that affects demand. Here's the
process.
6/3/2021 kaleab 85
P
Q
p0
q0
APPLE MARKET
supply
demand
new demand
p1
q1
Demand
increases, so
price and
quantity are
higher.

81. The market for medical care is in equilibrium, and consumers’
incomes increase. What is the effect on market price?
6/3/2021 kaleab 86
p0
Q0
supply
D at lower income
P
Q
MEDICAL CARE MARKET

82. p0
Q0
supply
D at lower income
p1
Q1
P
Q
D at higher income
MEDICAL CARE MARKET
If medical care is normal, the increase in incomes causes an
increased demand for medical care at the price p0. Here's how
the process works.
Excess demand.
The new equilibrium has
higher price and higher
quantity.
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83. SUPPLY/DEMAND SUMMARY
• Market price serves as the adjustment
mechanism to move markets to equilibrium.
• Price changes in response to the existence of
excess demand or excess supply.
• Changes in demand and changes in supply lead
to changes in equilibrium prices and quantities.
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84. ELASTICITY
• Elasticity is the concept economists use to
describe the steepness or flatness of curves or
functions.
• In general, elasticity measures the
responsiveness of one variable to changes in
another variable.
6/3/2021 kaleab 89

85. PRICE ELASTICITY OF DEMAND
• Measures the responsiveness of quantity
demanded to changes in a good’s own price.
• The price elasticity of demand is the percent
change in quantity demanded divided by the
percent change in price that caused the
change in quantity demanded.
6/3/2021 kaleab 90

86. FACTS ABOUT ELASTICITY
• It’s always a ratio of percentage changes.
• That means it is a pure number -- there are no units
of measurement on elasticity.
• Price elasticity of demand is computed along a
demand curve.
6/3/2021 kaleab 91
Elasticity is not the same as slope.

87. LOTS OF ELASTICITIES!
• There are lots of ways to compute elasticity.
So beware! The devil is in the details.
• Most of the ambiguity is due to the many ways
you can compute a percentage change. Be
alert here. It’s not difficult, but care is needed.
6/3/2021 kaleab 92

88. What’s the percent increase in price here because of the
shift in supply?
6/3/2021 kaleab 93
pE = $2
QE
S
D
Q
price
S'
pE = $2.50
CIGARETTE MARKET

89. Cont…
• IS IT:
• A) [0.5/2.00] times 100?
• B) [0.5/2.50] times 100?
• C) [0.5/2.25] times 100?
6/3/2021 kaleab 94

90. Cont…
• From time to time economists have used ALL
of these measures of percentage change
• Notice that the numerical values of the
percentage change in price is different for each
case:
6/3/2021 kaleab 95

91. Cont…
A) [0.5/2.00] X 100 = 25 percent
B) [0.5/2.50] X 100 = 20 percent
C) [0.5/2.25] X 100 = 22.22 percent
• Economists usually use the “midpoint” formula
(option C), above to compute elasticity in cases like
this in order to eliminate the ambiguity that arises if
we don’t know whether price increased or decreased.
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92. Using the Midpoint Formula
6/3/2021 kaleab 97
Elasticity =
% change in p = X 100.
% change in p =
For the prices $2 and $2.50, the % change in p is
approx. 22.22 percent.
P
in
change
%
Q
in
change
%
P
average
P
in
change
100
)
P
P
(
MEAN



93. What’s the percent change in Q due to the shift in supply?
6/3/2021 kaleab 98
pE = $2.00
QE = 10
S
D
Q (millions)
price
S'
pE’ = $2.50
CIGARETTE MARKET
QE = 7

94. Use the midpoint formula again.
• Elasticity =
 % change in Q =
 % change in Q =
• For the quantities of 10 and 7, the % change in Q is
approx. -35.3 percent. (3/8.5 times 100)
6/3/2021 kaleab 99
P
in
change
%
Q
in
change
%
Q
average
Q
in
change
100
)
Q
Q
(
MEAN



95. NOW COMPUTE ELASTICITY
• % change in p = 22.22 percent
• % change in Q = -35.3 percent
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• E = -35.3 / 22.22 = -1.6 (approx.)

96. Cont…
• But you can do the other options as well:
A) If you use the low price, and its corresponding quantity, as
the base values, then elasticity = 1.2
B) If you use the high price, and its corresponding quantity, as
the base values, then elasticity = 2.1 (approx.)
C) And the midpoint formula gave 1.6 (approx.)
• SAME PROBLEM...DIFFERENT ANSWERS!!!
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97. MORE ELASTICITY COMPUTATIONS
6/3/2021 kaleab 102
Q
P
QUANTITY PRICE
0 10
1 9
2 8
3 7
4 6
5 5
6 4
7 3
8 2
9 1
10 0
0
2
4
6
8
10
12
14
0 2 4 6 8 10 12 14
Compute elasticity between
prices of $9 and $8.

98. The % change in Q =
The % change in P =
Therefore elasticity =
USE THE MIDPOINT FORMULA.
6/3/2021 kaleab 103

99. The % change in Q = 66.67 = 1 / 1.5 times 100
The % change in P = 11.76 = 1 / 8.5 times 100
Therefore elasticity = -66.67 / 11.76 = -5.67
(approx.)
6/3/2021 kaleab 104

100. Q
P
QUANTITY PRICE
0 10
1 9
2 8
3 7
4 6
5 5
6 4
7 3
8 2
9 1
10 0
0
2
4
6
8
10
12
14
0 2 4 6 8 10 12 14
So elasticity between these prices
is -5.67.
6/3/2021 kaleab 105

101. Now we try different prices
6/3/2021 kaleab 106
Q
P
QUANTITY PRICE
0 10
1 9
2 8
3 7
4 6
5 5
6 4
7 3
8 2
9 1
10 0
0
2
4
6
8
10
12
14
0 2 4 6 8 10 12 14
Compute elasticity between
prices of $3 and $2.

102. The % change in Q =
The % change in P =
Therefore elasticity =
Go to hidden slide
6/3/2021 kaleab 107

103. The % change in Q = 13.33 = 1 / 7.5 times 100
The % change in P = 40 = 1 / 2.5 times 100
Therefore elasticity = -13.33 / 40 = -.33 (approx.)
6/3/2021 kaleab 108

104. Q
P
QUANTITY PRICE
0 10
1 9
2 8
3 7
4 6
5 5
6 4
7 3
8 2
9 1
10 0
0
2
4
6
8
10
12
14
0 2 4 6 8 10 12 14
So elasticity between these
prices is -.33.
6/3/2021 kaleab 109

105. ELASTICITY IS NOT SLOPE!
6/3/2021 kaleab 110
Q
P Note that elasticity is different
at the two points even though
the slope is the same.
(Slope = -1)
QUANTITY PRICE
0 10
1 9
2 8
3 7
4 6
5 5
6 4
7 3
8 2
9 1
10 0
0
2
4
6
8
10
12
14
0 2 4 6 8 10 12 14
E = -5.67
E = -.33

106. TERMS TO LEARN
• Demand is ELASTIC when the numerical value of elasticity
is greater than 1.
• Demand is INELASTIC when the numerical value of
elasticity is less than 1.
• Demand is UNIT ELASTIC when the numerical value of
elasticity equals 1.
• NOTE: Numerical value here means “absolute value.”
6/3/2021 kaleab 111

107. LIKE THIS!
6/3/2021 kaleab 112
Q
P
QUANTITY PRICE
0 10
1 9
2 8
3 7
4 6
5 5
6 4
7 3
8 2
9 1
10 0
0
2
4
6
8
10
12
14
0 2 4 6 8 10 12 14
Demand is elastic here.
Demand is inelastic here.

108. • There is an important relationship between what
happens to consumers’ spending on a good and
elasticity when there is a change in price.
• Spending on a good = P Q.
• Because demand curves are negatively sloped, a
reduction in P causes Q to rise and the net effect
on PQ is uncertain, and depends on the elasticity
of demand.
6/3/2021 kaleab 113

109. 1
Q
P
At P = $9, spending is $9 (= 1 times $9).
At P = $8, spending is $16 ( = 2 times $8).
When price fell from $9 to $8, spending rose. Q must have
increased by a larger percent than P decreased. So...
0 10
9
2 8
3 7
4 6
5 5
6 4
7 3
8 2
9 1
10 0
0
2
4
6
8
10
12
14
0 2 4 6 8 10 12 14
Demand is elastic here.
6/3/2021 kaleab 114

110. Q
P
At P = $3, spending is $21 (= 7 times $3).
At P = $2, spending is $16 ( = 8 times $2).
When price fell from $3 to $2, spending fell. Q must have
increased by a smaller percent than P decreased. So...
QUANTITY PRICE
0 10
1 9
2 8
3 7
4 6
5 5
6 4
7 3
8 2
9 1
10 0
0
2
4
6
8
10
12
14
0 2 4 6 8 10 12 14
Demand is inelastic here.
6/3/2021 kaleab 115

111. Cont…
• There is an easy way to tell whether
demand is elastic or inelastic between any
two prices.
If, when price falls, total spending
increases, demand is elastic.
If, when price falls, total spending
decreases, demand is inelastic.
6/3/2021 kaleab 116

112. But total spending is easy to see using a demand curve graph:
6/3/2021 kaleab 117
Q
P
The shaded area is P times Q,
or total spending when P = $9.
QUANTITY PRICE
0 10
1 9
2 8
3 7
4 6
5 5
6 4
7 3
8 2
9 1
10 0
0
2
4
6
8
10
12
14
0 2 4 6 8 10 12 14

113. Q
P
The shaded area is P times Q
or total spending when P = $8.
QUANTITY PRICE
0 10
1 9
2 8
3 7
4 6
5 5
6 4
7 3
8 2
9 1
10 0
0
2
4
6
8
10
12
14
0 2 4 6 8 10 12 14
6/3/2021 kaleab 118

114. Q
P
Total spending is higher at the price
of $8 than it was at the price of $9.
= loss in TR
due to fall in P
= gain in TR due to
rise in Q
QUANTITY PRICE
0 10
1 9
2 8
3 7
4 6
5 5
6 4
7 3
8 2
9 1
10 0
0
2
4
6
8
10
12
14
0 2 4 6 8 10 12 14
6/3/2021 kaleab 119

115. Q
P
The shaded area is total
spending (total revenue of
sellers) when P = $3.
QUANTITY PRICE
0 10
1 9
2 8
3 7
4 6
5 5
6 4
7 3
8 2
9 1
10 0
0
2
4
6
8
10
12
14
0 2 4 6 8 10 12 14
6/3/2021 kaleab 120

116. Q
P
Total revenue of sellers (total
spending by buyers) falls when
price falls from $3 to $2.
QUANTITY PRICE
0 10
1 9
2 8
3 7
4 6
5 5
6 4
7 3
8 2
9 1
10 0
0
2
4
6
8
10
12
14
0 2 4 6 8 10 12 14
6/3/2021 kaleab 121

117. Here’s a convenient way to think of the relative elasticity of
demand curves.
6/3/2021 kaleab 122
p
Q
p*
Q*
relatively more inelastic
at p*
relatively more elastic
at p*

118. Exercises
• Referring to the following table, use the mid-point (arc)
formula to calculate the price elasticity of demand between
(a) P = 6 and P = 4;
(b) P = 4 and P = 2.
(c) What do you conclude about the elasticity of a straight-
line demand curve as you move down it?
Price Quantity Demanded
6 20
5 25
4 30
3 35
2 40
6/3/2021 kaleab 123

119. MORE ...
• Doctors through their association restrict the supply of physicians.
How does this affect the incomes of doctors as a group?
• A labor union negotiates a higher wage. How does this affect the
incomes of affected workers as a group?
• A university decides to raise the price of football tickets. How is
income from the sale of tickets affected?
• Airlines propose to raise fares by 10%. Will the boost increase
revenues?
6/3/2021 kaleab 124

120. MORE ...
• A university is considering raising tuition by 7%. Will the
increase in tuition raise revenues of a university?
• Africa Transport Company recently raised bus fares in the long
distance travel. Will this increase ATC’s total receipts?
6/3/2021 kaleab 125

121. Cont…
• The answers to all of these questions depend
on the elasticity of demand for the good in
question. Be sure you understand how and
why!
6/3/2021 kaleab 126

122. DETERMINANTS OF DEMAND
ELASTICITY
• The more substitutes there are available for a good, the more
elastic the demand for it will tend to be. [Related to the idea of
necessities and luxuries. Necessities tend to have few
substitutes.]
• The longer the time period involved, the more elastic the
demand will tend to be.
• The higher the fraction of income spent on the good, the more
elastic the demand will tend to be.
6/3/2021 kaleab 127

123. OTHER ELASTICITY MEASURES
• In principle, you can compute the elasticity
between any two variables.
–Income elasticity of demand
–Cross price elasticity of demand
–Elasticity of supply
6/3/2021 kaleab 128

124. • Each of these concepts has the expected definition. For
example, income elasticity of demand is the percent change
in quantity demand divided by a percent change income:
• EINCOME =
• Income elasticity of demand will be positive for normal
goods, negative for inferior ones.
6/3/2021 kaleab 129
I
in
change
%
Q
in
change
%

125. Market Structures
• Market structure refers to how an industry (broadly
called market) in which a firm is operating and
structured or organized.
• The key ingredients of any market structure are:
– Number of firms in the market/industry
– Extent of barriers to entry
– Nature of product
– Degree of control over price.
6/3/2021 kaleab 131

126. Market Structures …
Knowledge about market structure can help to answer four
questions:
i. How much profit a firm will make (normal or supernormal)
ii. How much quantity it will produce at its profit maximization
point (i.e. whether it will be a large level of output or a small one
relative to the market)
iii. Whether or not a higher level of output would increase the cost
or productive efficiency of the firm or allocative efficiency for
society (see the summary on monopoly for details)
iv. Are the prices set too high, too low, or just right?
6/3/2021 kaleab 132

127. Market Structures…
• Four broad market structures have been
identified by economists:
–Perfect competition
–Monopoly
–Monopolistic competition
–Oligopoly.
6/3/2021 kaleab 133

128. Market Structures …
6/3/2021 kaleab 134

129. Market Structures
1. Perfect Competition
• The main assumptions of perfect competition are:
– Large number of buyers and sellers, therefore firms are price-
takers.
– No barriers to entry (also implies free mobility of factors of
production).
– Identical/homogeneous products.
– Perfect information/knowledge.
6/3/2021 kaleab 135

130. Market Structures…
• The word perfect in perfect competition is not used its
normative sense. Rather it means that competition in the
industry is of an extreme nature. It is used as a benchmark with
which to compare other types of market structures.
• Perfect competition can be thought of as an extreme form of
capitalism, i.e. all the firms are fully subject to the market
forces of demand and supply.
6/3/2021 kaleab 136

131. Market Structures …
2. Monopoly
• Monopoly defines the other pole or extreme of the market structure spectrum.
• Usually refers to a situation where there is a single producer in the market.
However it actually depends upon how narrowly you define the industry.
• Economists are often interested in how much monopoly power any firm (not
necessarily a monopoly) has. Here monopoly stands for the extent to which
the firm can raise prices without driving away all it customers.
• In other words, monopoly power and price elasticity of demand are inversely
related.
6/3/2021 kaleab 137

132. Market Structures …
Monopolies and the public interest:
a. Disadvantages of monopolies:
– Monopolists produce lower quantities at higher prices compared to
perfectly competitive firms.
– Monopolists earn supernormal profits compared to perfectly
competitive firms
– Most of the “surplus” (producer + consumer surplus) accrues to
monopolists.
– Monopolists do not pay sufficient attention to increasing efficiency
in their production processes.
6/3/2021 kaleab 138

133. Market Structures …
b. Advantages of monopolies:
– Natural Monopolies are beneficial and efficient for society.
– Supernormal or monopoly profits can be invested in
development of new innovative products and to sustain a
price war when breaking into new foreign markets.
6/3/2021 kaleab 139

134. Market Structures …
3. Monopolistic Competition
• Monopolistic competition is also characterized by a large
number of buyers and sellers and
• absence of entry barriers. In these two respects it is like perfect
competition. Firms are price-takers but not in the extreme sense
of perfect competition.
• Products are differentiated and in this respect, it is different
from perfect competition.
6/3/2021 kaleab 140

135. Market Structures …
4. Oligopoly
• Similar to monopoly in the sense that there are a small number
of firms (about 2-20) in the market and, as such, barriers to
entry exist.
• Similarity of Oligopoly with other Market Structures:
– It is similar to perfect competition in the sense that firms
compete with each other, often feverishly, which may result
in prices very similar to those that would obtain under perfect
competition.
– It is similar to monopolistic competition since there is a
possibility of having differentiated products.
6/3/2021 kaleab 141

136. Need vs Demand for Treatment
• Need
-physical and behavioral indicators (e.g.,
frequency and quantity of substance use,
diagnoses)
- biological testing
• Demand
- motivation for treatment
- service utilization
- waiting lists
- referrals from other agencies/service systems
6/3/2021 kaleab 142

137. Need vs Economic Demand…
• Need: A level of care or service that
traditionally has been or ought to be
consumed by a population group in order to
attain a desired health status
• Demand: The quantity of services or
personnel which consumers, insurers, or
employers are willing to buy at various prices.
6/3/2021 kaleab 143

138. Factors affecting demand in the future
• Population aging - more
health care demand
• Sicker patients
• Older patients
• Inability to substitute less
knowledgeable labor
• Labor productivity
changes
• New technologies or
medical discoveries
• Expanding roles
outside of the
traditional practice
settings
• The economy
• Government health
care payment policies
6/3/2021 kaleab 144

139. Need vs Demand …
• Need
– considered to be the result of a professional judgment that a
specific service or treatment should be provided to an
individual in order to improve his condition
• Demand
– an individual’s overt request for a service or treatment,
presumably the result of a perceived deficit and a belief in the
benefits of the requested service or treatment
6/3/2021 kaleab 145

140. Need = difference between what
someone wants and what exists
•Applied mostly to public programs often in
context of resource allocations across target
populations or regions
–Relative needs - indices, priorities
6/3/2021 kaleab 149

141. "need" is a value judgement that some
group has a problem that can (should) be
addressed.
6/3/2021 kaleab 150

142. Measures
• Mortality
– Number of deaths per 100,000
• Aggregate, by disease, etc.
• Morbidity
– Prevalence of certain medical conditions
• Restricted activity, incidence rate, etc.
• Where is ‘health status’
– Not often discussed as indicators?
6/3/2021 kaleab 156

143. Measures
• Quality Adjusted of Life Year
– A single value measure
– Combines quality of life and survival duration
• Used to evaluate programs and clinical conditions
– Provides a common unit of measurement
• To calculate:
– (Time spent in an illness)*(relative desirability of the illness
state)
6/3/2021 kaleab 157

144. QALY Example
• Assign a value to each life year using scale of 0
- 1
– Perfect health = 1
– Death = 0
• Values in between are determined by the PATIENT
– Option of living one more year at the current health state
– Valued at 1/x or living 1/x years in the current state
• Multiply by life expectancy at current state
6/3/2021 kaleab 158

145. QALY Example
• 55 y/o male with diabetes
– Life expectancy = 70 vs. 80
– Valued at 1/3 of a perfectly healthy year by the
patient
– 15 remaining years QALY is
• 15 * 1/3, or QALY value of 5
– Basically, value of 15 years with diabetes is equal
to 5 years of perfect health
6/3/2021 kaleab 159

146. • A pure public good is a good or service that is consumed in its
entirety by everyone. When one person consumes another unit
of a public good we all consume more.
• The most common example is national defense.
6/3/2021 kaleab 167
PUBLIC GOODS

147. • Public goods have two special properties compared to private
consumption goods.
• Non-rivalry: When one person consumes a unit of a public
good the amount available to be consumed by everyone else
is not diminished.
• Non-excludability: Once a public good is produced it is
difficult or impossible to exclude people from consuming it.
6/3/2021 kaleab 168

148. • Because public goods are non-rival and/or non-excludable,
these goods will tend to be under produced, or maybe not
produced at all if left to the private market.
• Public goods are not the same as publicly provided goods.
Just because government provides a good does not make it a
public good.
6/3/2021 kaleab 169

149. Examples of public goods:
1) On the air TV and radio signals
2) Public parks without an admission fee
3) Freeways not during rush hour
4) Clean air
5) Ideas
6/3/2021 kaleab 170

150. • Some public goods can be excludable but not rival:
1) Crossing a toll bridge when it isn’t crowded.
2) Scrambled on the air TV signals.
• One way to explain non-rivalry in consumption is by saying
that the marginal cost of providing the good to one more
consumer is zero.
6/3/2021 kaleab 171

151. • Some public goods may be non-excludable but rival:
1) Air that is polluted by smoking.
2) The ocean is not excludable, but fishing is rival.
– Production of public goods is sometimes said to
suffer from the “free rider problem.” This arises
directly from the non-excludability property of public
goods.
6/3/2021 kaleab 172

152. Public good summary:
• If public goods are produced in private markets, they
will be under produced because social benefits will
exceed private benefits.
6/3/2021 kaleab 173

153. Solutions to the public goods problem:
1)Using technologies that provide for exclusion (toll
roads, cable TV)
2) Government ownership
3) Clubs or cooperatives
6/3/2021 kaleab 174