Introductory Economics for Bsc.

Civil Engineering Year II Semester II 2009/201

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1.0 INTRODUCTION

Economics is a social science that studies the production, distribution, and

consumption of goods and services. In other words, it studies the allocation of
limited resources used to produce the goods and serves that satisfy unlimited
consumer wants and needs. It is concerned with decisions on how individuals
and societies seek to satisfy their unlimited needs and wants. Economics is
divided into 2 major branches;

Microeconomics studies the economic behaviour of individual units such as

businesses and households in face of scarcity and government interactions, as
well as the economic consequences of these decisions on other actors. It is
concerned with the economic behaviour of individual decision-making units
including individual consumers, resource owners, business firms and the
operation of individual markets in a free enterprise economy. It examines the
operation of two major markets, ie, the goods markets and resource markets.

Macroeconomics examines an economy as a whole with a view to understanding

the interaction between economic aggregates such as national income,
employment and inflation, business cycles.

The Microeconomic System

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Normative Vs Positive economics

Normative Economics is a branch of economics that seeks to recommend the way
the economy should operate. It is the policy side of economics that is based on
individual preferences and can not be proven right or wrong, that is, it depends
on values, beliefs and self interest of economic goals. Examples are;
a) The price of steel should be $5,000 per roll to give producers a higher
living standard.
b) Uganda would be better off spending 10 billion shillings on national
defense than higher education.
Positive Economics is a branch of economics that seeks to explain the way the
economy actually operates. It is the application of the scientific method and the
process of verifying economics phenomena, referred to as hypothesis testing. In
other words, economic statements can be proven right or wrong with available
data. Examples include;
a) An increase in the price of steel to $5,000per roll gives producers a higher
living standard.
b) Uganda spends 10 billion shillings more on national defense than higher
education.

Fundamental Economic Questions

a) What to produce: This refers to which goods and services the economy chooses
to produce and in what quantities to produce them. No society can produce all
the goods and services it wants thus, it must choose which ones to produce and
which ones to forego, eg, Military Vs civilian goods.
b) How to produce: Refers to the way in which resources or factor inputs
are organized to produce the goods and services that consumers need or
want, eg, labour intensive or capital intensive, finished or intermediate
goods.
c) For whom to produce: This deals with the way the output is distributed
among members of society. It is concerned with the people or consumers
which goods and services are produced for, eg, for the young or old, male
or female, for household or industrial use
d) Where to produce: This entails producing goods and services the sources
of raw materials, near the market, near the transport system, etc, so that
efficiency is attained through cost reduction
e) When to produce: This is concerned with the decision to produce goods
and services at a particular time period eg, long run or short run, during a
recession or depression of a business cycle.

Scarcity, Choice and opportunity Cost.

Economics begins with the premise that resources are scarce and that it is
necessary to choose between competing alternatives.
Scarcity refers to the situation in which resources are in limited supply to satisfy
human wants.

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Choice arises out of scarcity. This implies that an individual has to select one out
of the competing alternative needs and wants, since all of them cannot be
satisfied simultaneously given the limited resources.

Opportunity cost is the alternative that is foregone when choice is made. With
scarcity, choosing one alternative implies forgoing another alternative. The
opportunity cost creates an implicit price relationship between competing
alternatives. In both market oriented and planned economies, scarcity is often
explicitly quantified by price relationships.

The Production Possibility Frontier (PPF /PPC)

The PPF (PPC) is a locus of a combination of two commodities that an economy
can optimally attain when all its production resources are efficiently utilized
given the state of technology. In business, it is a locus of two commodity
combinations that a production firm can realize at maximum when all its
production resources are efficiently utilized given the state of technology. The
PPF is based on the following economic assumptions;
 Production resources are limited in supply (scarce) i.e. land, labor, capital
and skills
 Only two types of commodities can be produced or offered respectively,
for instance, military vs civilian goods.
 Resources are efficiently allocated (optimal resources utilization)
 The objective of the production firm is to optimize (maximize) profits
 Technology is assumed constant/fixed.
Illustration and economic implication(s) of the PPF.

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A
D
Quantity
of Civilian
Goods

Quantity of Military Goods

Points along the PPF such as A and B show the maximum physical combination of
civilian and Military goods which can be produced when all resources are fully
utilized, given the efficient use of technology. Along the PPF, an increase in the
production of one good is a sacrifice of another commodity, that is, to increase
the output Military goods, then that of Civilian goods should be reduced. The PPF
has negative slope and is concave and it increases as one moves from the left to
the right. The slope of the PPF is referred to as the Marginal rate of product
Transformation. It shows the quantities of commodity Y(e.g military goods) that
must be given up in order to produce an additional unit of another commodity X (
Civilian). Mathematically, the slope of the PPF is given as;
MRPTyx = (-) dY/dX
The negative sign implies that to increase the amount of commodity X, that of Y
has to be reduced.

All points inside the PPF e.g point C, shows a combination of Civilian goods and
Military goods that can be produced by the economy using less of the available
resources and technology. In other words, at Point C, the firm or economy can
increase the production of either civilian or military or both without affecting the

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output of the other commodity. In this case, there is underutilization or

resources.
All points outside the PPF are production combinations desired by every
economy because they show greater output of both civilian and military goods.
However, these points can not achieve because of resource and technological
limitations.

SHIFTS IN THE PPF.

The PPF may shift outwards or inwards depending upon a given change in the
amount of available resources, state of technology and the level of efficiency in
resource allocation. A shift from appoint on the PPF to a point outside the PPF
depicts economic growth. An outward shift occurs when there has been a
favorable change in the factors identified above. There are two types of shifts;
the biased and un-biased shift.

a) Un-biased shift arises when the PPF shifts inwards or outwards in terms of
both commodities.

Diagram

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b) Biased shift occurs when the PPF shifts inwards or outwards in terms of only
one commodity.
Diagram

Qn. Using relevant diagrams, explain the various implications of inward shifts in
the PPF.

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Assignment: Shapes of the PPF (Introduction to Microeconomics by John

Mutenyo, (Pg 17 – 20).
a) Concave
b) Convex
c) Linear

2.0 DEMAND AND SUPPLY ANALYSIS

DEMAND
Demand refers to the willingness and ability to purchase a given quantity of the
commodity over a given period of time. The consumer’s willingness is
determined by his or her tastes and preferences for the commodity while the
ability is determined by his or level of income, also referred to as the purchasing
power. Therefore, quantity demanded is the amount of commodity that a
consumer is willing to purchase at a given price in a given period of time.
Determinants of Demand
 The price of the commodity
 The price of related commodities i.e. either complements or
substitutes
 The income of the consumer
 Consumers tastes and preferences
 Consumers expectations
 Advertising expenditures (more awareness therefore demand raises)
 Demonstration effect
 Consumers credit policy
 Population in the country
 Government policy (taxation and subsidization)
 Changing seasons
 Location
 Religion, age and sex

Demand Function
A function is a statement of relationship between two (2) or more variables; one
being independent and the other(s) dependent. The demand function therefore
states the relationship between quantity demanded of the commodity
(dependent variable) and its determinants respective (independent variables).

Let us consider a very simple case of a demand function. Suppose all the
determinants of the demand for commodity X other than its price remain
constant. The quantity demanded of X (Qdx) depends upon its price (Px). This
can be represented as
Qdx =  (px).
In this function Qdx is a dependent variable while Px is the independent variable.
This implies that a change in Px (independent variable) causes a change in Qdx
(dependent variable).
Demand Schedule

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A demand schedule is a tabular representation of the law of demand. It is a table

showing the quantity demanded of the commodity at each respective price.
Illustration:

Demand Curve
This is the graphical representation of the law of demand. In other words, it is a
diagram showing the relationship between the quantities demanded of the
commodity at each respect price.
Illustration:

Change in Demand Vs Change in Quantity Demanded

Change in quantity demanded is the change in quantity demanded of the
commodity arising from a change in the price of that particular commodity. In
other words, it is the increase or decrease in quantity demanded of a commodity
due to a change in the commodity’s own price. Graphically, this is shown as a
movement long the demand curve upward or downwards. As prices change,
respective quantities demanded also change.
Diagram

A Change in demand is the change in quantity demanded of the commodity

arising from a change in other determinants of demand for that particular

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commodity, its price remaining constant. In other words, it is the increase or

decrease in quantity demanded of a commodity due to a change in the
determinants of demand for that commodity other than its own price.
Graphically, this is shown as a shift, inwards or outwards, of the demand curve.
Diagram

The Concept of Market Demand

Market demand is the sum of all individual demand for a given commodity at a
price per unit of time. This can be reflected in the market demand scheduled as
below.

Quantity of X Demanded
Px Consumer A Consumer B Consumer C Market dd
2000 20 10 4
4000 10 5 2
6000 5 3 1

Market demand schedule is a table that shows the total amount of a given
commodity demanded by all consumers in the market at each price level
The market demand curve is the horizontal summation of individual demand
curve for a given commodity at respective prices.
Diagram

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SUPPLY
Supply refers to the willingness and ability to take a given quantity of the
commodity to the market at a given period of time. The producer’s willingness is
determined by the price of the commodity while the ability is determined by the
associated costs of production. Therefore, quantity supplied is the amount of
commodity that a producer is willing and able to take to the market for sale at a
given price in a given period of time.
Determinants of Supply
 The price of the commodity
 The level of the technology
 Cost of production
 Government policy
 Gestation period
 Availability of inputs
 Seasonal factors
 etc

Supply Function
This shows the relationship between the quantity supplied of a given commodity
(dependent variable) and its determinants (independent variable)

Supply Schedule
A supply schedule is a tabular representation of the law of supply. In other words,
it is a table showing the quantity supplied of the commodity at each respective
price.
Illustration:

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Supply Curve
This is the graphical representation of the law of supply. In other words, it is a
diagram showing the relationship between the quantities supplied of the
commodity at each respect price.
Illustration:

Change in supply Vs Change in Quantity supplied

Change in quantity supplied is the change in quantity supplied of the commodity
arising from a change in the price of that particular commodity. In other words, it
is the increase or decrease in quantity supplied of a commodity due to a change
in the commodity’s own price. Graphically, this is shown as a movement long the
supply curve upward or downwards. As prices change, respective quantities
supplied also change.
Diagram

A Change in supply is the change in quantity supplied of the commodity arising

from a change in other determinants of supply for that particular commodity, its
price remaining constant. In other words, it is the increase or decrease in
quantity supplied of a commodity due to a change in the determinants of supply
for that commodity other than its own price. Graphically, this is shown as a shift,
inwards or outwards, of the supply curve.
Diagram

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3.0 MARKET ANALYSIS

A market refers to any organized exchange of goods and services between buyers
and sellers. It could be a place where buyers and sellers interact for purposes of
carrying out business transactions. The buyers create demand for goods and
services while the suppliers make the goods and services available for sale. It is
important to note that the quantity of a given commodity demanded or supplied
is determined by the unit price of the commodity. Price refers to the monetary
value of good, service or asset.

In a market economy, the price of the commodity is determined by market forces

(forces of demand and supply). Under such circumstances, the market is said to
be in equilibrium. Market equilibrium is an economic situation when economic
variables/forces have no tendency to change. Market equilibrium is therefore
obtained when the quantity demanded of the commodity equals to quantity
supplied of the commodity, thus, at equilibrium. Qd = Qs
Graphically the market equilibrium is determined at the point of intersection of
demand and supply curve as indicated below. The price and quantity at this point
are referred to as equilibrium price and equilibrium quantity respectively.

Diagram

From the diagram Pe is the equilibrium price while Qe is the equilibrium quantity.

**Mathematical Illustration of Market Equilibrium – to be Done in Class

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PRICE LEGISLATION POLICIES (DIVERSION FROM THE EQUILIBRIUM)

a) Maximum pricing policy (Price ceiling)

This is a government imposed limit on the price of the commodity and is
intended to benefit the consumers. In this case, government fixes the price below
the equilibrium level and all producers are allowed to sell their output at any
price below but not above the fixed price. The fixed price acts as the maximum
price possible, thus the maximum pricing policy. The effect of such a policy is that
quantity demanded will exceed quantity supplied leading to excess demand on
the market, also referred to as a shortage.
Illustration

Minimum price policy (price floor)

This is a government imposed limit on the price of the commodity and is
intended to benefit the producers. In this case, government fixes the price above
the equilibrium level and all producers are allowed to sell their output at any
price above but not below the fixed price. The fixed price acts as the minimum
price possible, thus the minimum pricing policy. The effect of such a policy is that
quantity supplied will exceed quantity demanded leading to excess supply on the
market, also referred to as a surplus.
Illustration

CONSUMER’S SURPLUS VS PRODUCER’S SURPLUS

Consumer’s surplus

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Consumer’s surplus is the difference between the amount of money that the
consumer is willing to pay for a given quantity of the commodity and what he or
she actually pays for the same quantity. The consumer’s willingness is
determined by his or her demand schedule. Graphically, consumer’s surplus is
given by the area below the demand curve but above the equilibrium price.
Illustration

Producer surplus
This is the difference between the amount of money that the producer is willing
to accept from the sale a given quantity of the commodity and what he or she
actually earns for the same unit of the commodity. The producer’s willingness is
determined by his or her supply schedule. Graphically, producer’s surplus is
given by the area above the supply curve but below the equilibrium price.
Illustration

THE EFFECT OF TAX/SUBSIDY ON MARKET EQUILIBRIUM

a) A Tax: A tax is a compulsory levy or fee on goods and services by government.
The imposition of tax on good, service or factor of production translates in
into increase in the cost of production for producers. Other factors being
constant, the supply curve will shift inwards (to the left) leading to a fall in
quantity supplied. This is because producers would require a much more
amount to produce an extra unit of the commodity. A new equilibrium will be
established with a higher equilibrium price and a lower equilibrium quantity
for a given level of demand. The producers therefore have to compensate
themselves by incorporating the tax in the price, which implies the incidence/
burden of the tax is hared by both producers and consumers. The consumers
pay the tax in form of increase in the prices of the commodity while
producers pay the tax inform of increase in costs of production. The
proportion of tax paid by either the consumer or producers depends upon the
price elasticity of demand for the commodity.

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Diagram

From the above diagram the effect of tax is equivalent to the vertical distance
between the original and the new supply curve in respect to the new equilibrium
position. The amount of tax is therefore equivalent to (a-c) of which the
consumer pays amount (a-b) in form of increase in price while the producer pays
(b-c) in terms of increased cost of production.

b) A Subsidy: A subsidy is any benefit or incentive to producers and consumers

of goods and services. A subsidy translates in into reduction in the cost of
production for producers. Other factors being constant, the supply curve will
shift outwards (to the right) leading to an increase in quantity supplied. This
is because producers would require a much less amount to produce an extra
unit of the commodity. A new equilibrium will be established with a lower
equilibrium price and a higher equilibrium quantity for a given level of
demand. The consumers enjoy the subsidy in form of reduction in the prices
of the commodity while producers enjoy the subsidy inform of reduction in
costs of production. The proportion of subsidy enjoyed by either the
consumer or producers depends upon the price elasticity of demand for the
commodity.
Diagram

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From the above diagram the effect of subsidy is equivalent to the vertical distance
between the original and the new supply curve in respect to the original
equilibrium position. The amount of subsidy is therefore equivalent to (e-g) of
which the consumer enjoys amount (e-f) in form of reduction in price while the
producer enjoys (f-g) in terms of reduced cost of production.

ELASTICITY

In economics, elasticity is the ratio of the proportional change in one variable

with respect to proportional change in another variable. In other words, it is
degree of responsiveness of a proportionate change the dependent variable due
to a proportionate change in the independent variable or variables. Elasticity in
the market takes two broad categories;

Elasticity of demand: This is the percentage change in quantity demanded of a

commodity arising form a given percentage change in the determinants of
demand.

Elasticity of supply: This is the percentage change in quantity supplied of

commodity arising form a given percentage change in the determinants of supply.

Elasticity of demand takes three common measures;

i) Prices elasticity of demand

ii) Incomes elasticity of demand

iii) Cross elasticity of demand

a) Price Elasticity of Demand

Price elasticity of demand is measured as the percentage change in quantity

demanded that occurs in response to a percentage change in price.
Mathematically, price elasticity of demand is computed as;

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In general, a fall in the price of a good is expected to increase the quantity

demanded, so the price elasticity of demand is negative as above. Because both
the denominator and numerator of the fraction are percent changes, price
elasticities of demand are dimensionless numbers and can be compared even if
the original calculations were performed using different currencies or goods. For
example, if, in response to a 10 % fall in the price of a good, the quantity
demanded increases by 20 %, the price elasticity of demand would be 20 %/(−
10 %) = −2.

Example 2:

Forms of Price Elasticity of Demand: The level of elasticity ranges from zero
(perfectly inelastic) to infinity (perfectly elastic). The degree of elasticity is used
to explain different market structures, market conduct and therefore, the market
performance of firms.

i) Perfectly inelastic: When the price elasticity of demand for a good is perfectly
inelastic (εd = 0), changes in the price do not affect the quantity demanded
for the good. The demand curve is a vertical straight line; this violates the
law of demand.

ii) Inelastic: This is when a given percentage change in the price of the
commodity leads to a less than percentage change in quantity demanded. The
price elasticity of demand for a good is inelastic when the computed value of
elasticity lies between zero and one, that is, (0<ε d< 1).

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iii) Unit elastic: This is when a given percentage change in the price of the
commodity leads to an equal percentage change in quantity demanded. The price
elasticity of demand for a good is unit elastic when the computed value of
elasticity is equal to one, that is, (εd=1).

iv) Elastic: This is when a given percentage change in the price of the commodity
leads to a greater than percentage change in quantity demanded. The price
elasticity of demand for a good is elastic when the computed value of elasticity
lies between one and infinity, that is, (1<εd< ∞).

ii) Perfectly elastic: This is when at a given price of the commodity, quantity
demanded is undefined or infinity. The demand curve is a horizontal line. The
price elasticity of demand for a good is perfectly elastic when the computed value
of elasticity is equal to infinity, that is, (εd= ∞).

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An example of a good with a highly inelastic demand curve is salt: people need
salt, so for even relatively large changes in the price of salt, the amount
demanded will not be significantly altered. Similarly, a product with a highly
elastic demand curve is red cars: if the price of red cars went up even a small
amount, demand is likely to go down since substitutes are readily available for
purchase (cars of other colors). It may be possible that quantity demanded for a
good rises as its price rises, even under conventional economic assumptions of
consumer rationality. Two such classes of goods are known as Giffen goods or
Veblen goods.

Determinants of price elasticity of demand:

 Nature of the commodity

 Number of substitutes available to the commodity

 Number of uses of the commodity

 Range of prices

 Proportion of income spent on the commodity

 Habits/consumer behavior

 Time factor

 Durability of the commodity

 Influence of joint demand

Elasticity and Revenue

When the price elasticity of demand for a good is elastic (1<εd<∞), the
percentage change in quantity is greater than that in price. Hence, when the price
is raised, the total revenue of producers falls, and vice versa.

When the price elasticity of demand for a good is inelastic (0<εd< 1), the
percentage change in quantity is smaller than that in price. Hence, when the price
is raised, the total revenue of producers rises, and vice versa.

When the price elasticity of demand for a good is unit elastic (or unitary elastic)
(εd = 1), the percentage change in quantity is equal to that in price. Hence, when
the price is raised, the total revenue remains unchanged.

When the price elasticity of demand for a good is perfectly elastic (εd = ∞), any
increase in the price, no matter how small, will cause demand for the good to
drop to zero. Hence, when the price is raised, the total revenue of producers falls
to zero and the demand curve is a horizontal straight line.

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When the price elasticity of demand for a good is perfectly inelastic (εd = 0),
changes in the price do not affect the quantity demanded for the good. The
demand curve is a vertical straight line; this violates the law of demand.

b) Income Elasticity of Demand (YED)

In economics, the 'income elasticity of demand' measures the responsiveness of

the quantity demanded of a good to the income of the people demanding the
good. Mathematically, YED is defined as;

It is measured as the percentage change in demand that occurs in response to a

percentage change in income. For example, if, in response to a 10% increase in
income, the quantity of a good demanded increased by 20%, the income elasticity
of demand would be 20%/10% = 2.

Example 2

The coefficient or computed value of income elasticity of demand can be positive,

negative or zero.

A negative income elasticity of demand is associated with inferior goods; an

increase in income will lead to a fall in the quantity demanded and may lead to
changes to more luxurious substitutes.

A positive income elasticity of demand is associated with normal goods; an

increase in income will lead to a rise in the quantity demanded. A high positive
income elasticity of demand is associated with luxury goods.

A zero income elasticity of demand is an increase in income without leading to a

change in the quantity demanded of a good.

Many necessity|necessities have an income elasticity of demand between zero

and one: expenditure on these goods may increase with income, but not as fast as

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income does, so the proportion of expenditure on these goods falls as income

rises. This observation for food is known as 'Engel's law.

Cross Elasticity of Demand (CED)

In economics, the 'cross elasticity of demand' or cross price elasticity of demand

measures the responsiveness of the quantity demanded of a good to a change in
the price of another good. Mathematically, CED is defined as;

Example 1

It is measured as the percentage change in demand for the first good that occurs
in response to a percentage change in price of the second good. For example, if, in
response to a 10% increase in the price of fuel, the quantity of new cars that are
fuel inefficient demanded decreased by 20%, the cross elasticity of demand
would be -20%/10% = -2.

The cross elasticity of demand can be positive, negative or zero. In the example
above, the two goods, fuel and cars, are '[complement good|complements] - that
is, one is used with the other. In these cases the cross elasticity of demand will be
negative. In the case of perfect complements, the cross elasticity of demand is
'negative' infinity.

Where the two goods are substitute good|substitutes the cross elasticity of
demand will be positive, so that as the price of one goes up the quantity
demanded of the other will increase. For example, in response to an increase in
the price of fuel, the demand for new cars that are fuel efficient hybrids for
example will also rise. In the case of perfect substitutes, the cross elasticity of
demand is positive' infinity.

Where the two goods are Independence|independent (not related at all), the
cross elasticity demand will be zero, as the price increase the quantity demanded
will be zero, an increase in price 'zero quantity demanded'. In case of perfect
independence, the cross elasticity of demand is zero.

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