ECONOMIC BUSINESS ECONOMIC BUSINESS ANALYSISANALYSIS

• QAZI MUHAMMAD TOUSEEF QAZI MUHAMMAD TOUSEEF AKHTAR AKHTAR

• DEPARTMENT OF ECONOMICS DEPARTMENT OF ECONOMICS UNIVERSITY OF BALOCHISTAN UNIVERSITY OF BALOCHISTAN QUETTA, PAKISTAN QUETTA, PAKISTAN

MICRO ECONOMICS AND MACRO MICRO ECONOMICS AND MACRO ECONOMCSECONOMCS

Adam smith is usually considered the founder Adam smith is usually considered the founder of the field of of the field of microeconomics, microeconomics, the branch the branch of economics which today is concerned of economics which today is concerned with the behavior of Individual entities with the behavior of Individual entities such as market, firms, and householdssuch as market, firms, and households

• In the wealth of nations smith considered In the wealth of nations smith considered how individual price are set.how individual price are set.

• Studies the determination of price of FOP.Studies the determination of price of FOP.• Identified the remarkable efficiency Identified the remarkable efficiency

properties of markets and saw that properties of markets and saw that economic benefit comes from the self economic benefit comes from the self interested action of Individual.interested action of Individual.

MACROECONOMICS MACROECONOMICS which is which is concerned with the overall performance concerned with the overall performance

of the economy.of the economy.John Maynard KeynesJohn Maynard Keynes

(General Theory of Employment, interest and (General Theory of Employment, interest and Money) 1935.Money) 1935.

He invented the idea of ME it did not even exist in He invented the idea of ME it did not even exist in its modern form until 1935.its modern form until 1935.

In his new theory Keynes developed;In his new theory Keynes developed; What causes unemployment and economic downturns.What causes unemployment and economic downturns. How I and C determined.How I and C determined. How central Bank manage the money and interest rate.How central Bank manage the money and interest rate. Why some nations thrive while others stagnate.Why some nations thrive while others stagnate. He also argued the government’s had an important role He also argued the government’s had an important role

in smoothing out the ups and downs of business cycles.in smoothing out the ups and downs of business cycles.

Positive EconomicsPositive EconomicsPE is related to the explanation of economic events PE is related to the explanation of economic events

as what they areas what they are

It does not state whether the thing is right or wrong It does not state whether the thing is right or wrong it only makes theories to explain the real situation it only makes theories to explain the real situation and to establish cause and effect relationship and to establish cause and effect relationship existing b/w them. It gives no value judgment and existing b/w them. It gives no value judgment and does not explain the rightness or wrongness of does not explain the rightness or wrongness of the economic events. E.g. if a firm pays low the economic events. E.g. if a firm pays low wages to women worker, the PE simply tell us wages to women worker, the PE simply tell us that it is done to reduce the cost. However it does that it is done to reduce the cost. However it does not tell us whether low wages to women is not tell us whether low wages to women is justifiable or not .justifiable or not .

Normative EconomicsNormative EconomicsNE evaluates the state of things as they ought to NE evaluates the state of things as they ought to

be it is related with value judgmentbe it is related with value judgment it means that it gives judgment whether the thing it means that it gives judgment whether the thing

is right or wrong. It evaluates the situation and is right or wrong. It evaluates the situation and prescribes solution for it. It means that prescribes solution for it. It means that

ECONOMICS is not neutral & is not colorless, ECONOMICS is not neutral & is not colorless, e.g. if there is poverty in an economy NE not e.g. if there is poverty in an economy NE not

only explain the situation and causes for it but only explain the situation and causes for it but also provide measure to overcome the problem.also provide measure to overcome the problem.

Overall economics is both N & P science, because Overall economics is both N & P science, because it tell us the real situation as well as provide it tell us the real situation as well as provide

necessary measures. e.g. the poor in Pakistan necessary measures. e.g. the poor in Pakistan are malnourished;are malnourished;

The government should provide them food The government should provide them food subsidy subsidy

Productive EfficiencyProductive EfficiencyEfficiency means that the economy’s resource are Efficiency means that the economy’s resource are

being used as effectively as possible to satisfy being used as effectively as possible to satisfy people’s needs and desires. One important people’s needs and desires. One important

aspect of overall economics efficiency is aspect of overall economics efficiency is productive efficiencyproductive efficiency. .

Pro- eff. occurs when an economy can not produce Pro- eff. occurs when an economy can not produce more of one goods without producing less of more of one goods without producing less of another good. This implies that economy is on its another good. This implies that economy is on its PPF.PPF.

e.g. when we are producing more guns, we are e.g. when we are producing more guns, we are substituting guns for butter. Substitution is the substituting guns for butter. Substitution is the law of life in full employment economy and PPF law of life in full employment economy and PPF depicts the menu of society’s choice.depicts the menu of society’s choice.

Countries are always being forced to Countries are always being forced to decide how much of their limited decide how much of their limited resources goes to their military and how resources goes to their military and how much goes into other activities such as much goes into other activities such as agriculture, industry and social sector.agriculture, industry and social sector.

Some countries like Japan allocate about Some countries like Japan allocate about 1% of their national output to their 1% of their national output to their military. The USA spends 5% the North military. The USA spends 5% the North Korea spends up to 20%.Korea spends up to 20%.

The more output that goes for defense, the The more output that goes for defense, the less there is available for consumption less there is available for consumption and investment on other sector.and investment on other sector.

Economies Relevance to Business Economies Relevance to Business Organization.Organization.

Opportunity CostOpportunity Cost : Life is full of choices because : Life is full of choices because resources are scarce, we always consider how to resources are scarce, we always consider how to

spend our limited incomes or time, when you spend our limited incomes or time, when you decide whether to study economics, buy a car or decide whether to study economics, buy a car or go to university, in each case you must consider go to university, in each case you must consider

how much the decision will cost in term of forgone how much the decision will cost in term of forgone opportunity.opportunity.

The cost of forgone alternatives is the opportunity The cost of forgone alternatives is the opportunity cost of decision.cost of decision.

In a world of scarcity, choosing one thing means In a world of scarcity, choosing one thing means given up some thing else. The opportunity cost of given up some thing else. The opportunity cost of a decision is the value of good or service forgone.a decision is the value of good or service forgone.

THE PRODUCTON POSSIBILTY THE PRODUCTON POSSIBILTY FRONTIERFRONTIER

PPC curve helps us to understand the problem of PPC curve helps us to understand the problem of choice and scarcity of resources.choice and scarcity of resources.

PPC is based on the following assumptions ;PPC is based on the following assumptions ;

1. The economy is operating at full employment level.1. The economy is operating at full employment level.

2. Technology remains constant.2. Technology remains constant.

3. The supplies of FOP are fixed but they can be shift or 3. The supplies of FOP are fixed but they can be shift or reallocated within limits among alternative uses.reallocated within limits among alternative uses.

Societies can not have every thing they want. They are Societies can not have every thing they want. They are limited by resources and the technology available to limited by resources and the technology available to them.them.

Take defense spending as an example?Take defense spending as an example?

The PPC is of much importance in explaining some The PPC is of much importance in explaining some of the basic facts of human life: the problem of of the basic facts of human life: the problem of

unemployment, technological progress, economic unemployment, technological progress, economic growth and economic efficiency.growth and economic efficiency.

Relaxing the assumption of full employment of Relaxing the assumption of full employment of resources, constant production techniques, resources, constant production techniques, economic growth and economic efficiency.economic growth and economic efficiency.

Three efficiencies :Three efficiencies :

Efficient allocation of resources in production and Efficient allocation of resources in production and efficient choice of method of production.efficient choice of method of production.

Efficient selection of goods to be produced.Efficient selection of goods to be produced.

Efficient allotment of the goods produces among Efficient allotment of the goods produces among consumers.consumers.

Alternatives Production Alternatives Production PossibilitiesPossibilitiesPossibilities Butter GunsPossibilities Butter Guns

(In million pound) (thousand)(In million pound) (thousand)

A 0 15A 0 15 B 1 14B 1 14 C 2 12C 2 12 D 3 9D 3 9 E 4 5E 4 5 F 5 0F 5 0 ________________________________________________________________________________________Limitation of scarce resources implies guns-butter trade-Limitation of scarce resources implies guns-butter trade-

off off

Production Possibility Curve

02468

10121416

0 2 4 6

Butter(million pounds)

Gu

ns(t

hou

san

ds)

ILLUSTRATION OF PPFILLUSTRATION OF PPFProduction Possibilities Commodity X Commodity YProduction Possibilities Commodity X Commodity Y

A 0 A 0 2828 B 2 B 2 2626 C 4 C 4 2222 D 6 D 6 1616 E 8 E 8 9 9 F 10 F 10 0 0

Shifting of PPCShifting of PPC- Technological improvements.Technological improvements.- Increase in Capital.Increase in Capital.- Increase in labor forceIncrease in labor force

Factors Of ProductionFactors Of Production

Another term for inputs is FOP, these can be classified into Another term for inputs is FOP, these can be classified into three broad categories.three broad categories.

LAND LABOUR & CAPITALLAND LABOUR & CAPITAL

Land- represent gift of nature to our productive processes.Land- represent gift of nature to our productive processes.

Labour- consist of human time spent in production.Labour- consist of human time spent in production.

Capital- resources form the durable goods of an economy, Capital- resources form the durable goods of an economy, produced in order to produce yet other goods.produced in order to produce yet other goods.

Stating the three economic problem in term of input and Stating the three economic problem in term of input and outputs a society must decide.outputs a society must decide.

1- what output to produce and in what quantity;1- what output to produce and in what quantity;

2- how to produce them i.e. by what technique2- how to produce them i.e. by what technique

3- for whom the out put should be produced and distributed3- for whom the out put should be produced and distributed

INPUTS AND OUTPUTSINPUTS AND OUTPUTS

To answer three questions, every society To answer three questions, every society must make choices about the must make choices about the economy’s inputs and outputs.economy’s inputs and outputs.

INPUTS are commodities or services INPUTS are commodities or services that are used to produce goods and that are used to produce goods and services.services.

OUTPUTS are the various useful goods OUTPUTS are the various useful goods or services that result from the or services that result from the production process and either production process and either consumed or employed in further consumed or employed in further production.production.

The Three Problems of The Three Problems of Economics OrganizationEconomics Organization

Fundamental questions of economic organization Fundamental questions of economic organization

WHAT , HOW and FOR WHOMWHAT , HOW and FOR WHOM

As crucial today as they were at the dawn of As crucial today as they were at the dawn of human civilization. Let’s look more closely at human civilization. Let’s look more closely at them.them.

What commodities are produces & in What What commodities are produces & in What quantities?quantities?

We will produce consumption goods or We will produce consumption goods or investment goods (either pizza or pizza making investment goods (either pizza or pizza making machines) or ( less costly commodities or machines) or ( less costly commodities or many cheap commodities)many cheap commodities)

How are goods produces?How are goods produces?

Society must determine who will do Society must determine who will do production, with resources, and production, with resources, and

what production techniques, they what production techniques, they will use.will use.

Who farm and who teaches.Who farm and who teaches.

Is electricity generated from oil, Is electricity generated from oil, from coal or from sun? with much from coal or from sun? with much

air pollution or with little.air pollution or with little.

For Whom are goods produced ?For Whom are goods produced ?

Who get to eat the fruit of economic activity ?Who get to eat the fruit of economic activity ?

How the national product divided among How the national product divided among different households ?different households ?

Are many people poor and a few rich?Are many people poor and a few rich?

Do high incomes go to managers or athletes Do high incomes go to managers or athletes or workers or landlords ?or workers or landlords ?

Will society provide minimal consumption to Will society provide minimal consumption to the poor, or they work if they are to the poor, or they work if they are to survive?survive?

MARKET, COMMAND AND MIXED MARKET, COMMAND AND MIXED ECONOMICSECONOMICS

WHAT are the different ways that society can answer WHAT are the different ways that society can answer the question of WHAT, HOW and FOR WHOM ?the question of WHAT, HOW and FOR WHOM ?

Different societies are organized through alternate Different societies are organized through alternate economics system and economics studies the various economics system and economics studies the various mechanisms that a society can use to allocate its mechanisms that a society can use to allocate its scare resources.scare resources.

These systems are These systems are A market economyA market economy (USA) (USA) (Laissez – faire)(Laissez – faire)

Command Economy (Former USSR)Command Economy (Former USSR)No Contemporary society falls completely into either of No Contemporary society falls completely into either of

these polar category. Rather all societies are these polar category. Rather all societies are Mixed Mixed EconomiesEconomies

Economics is a social science. Its development is Economics is a social science. Its development is related with the socio-economic and political related with the socio-economic and political development of society.development of society.

Definition of economics have been changing Definition of economics have been changing through time and circumstances major through time and circumstances major definitions can be presented as;definitions can be presented as;

A- Economics : A science of wealth.A- Economics : A science of wealth.

B- Economics : A science of material welfare.B- Economics : A science of material welfare.

C- Economics science of scarcity or science of C- Economics science of scarcity or science of .choices..choices.

D- Economics :A science of economic growth.D- Economics :A science of economic growth.

Economics:Economics: A science of wealth ( Classical)A science of wealth ( Classical)Adam Smith - Adam Smith - “ An Enquiry into the nature and “ An Enquiry into the nature and

causes of wealth of nations.causes of wealth of nations.Distinguish man into two group vise economic man and non-Distinguish man into two group vise economic man and non-

economic man.economic man.

Other Classical economists;Other Classical economists;J B Says- Eco is science which treats of wealth.J B Says- Eco is science which treats of wealth.F A Walker- Eco is body of knowledge which relates to wealth.F A Walker- Eco is body of knowledge which relates to wealth.J S Mill- “it is practical science of production and distribution of J S Mill- “it is practical science of production and distribution of

Wealth.Wealth.CriticismCriticism- Too much emphasis on wealth.Too much emphasis on wealth.- Concept of Economic Man.Concept of Economic Man.- No mention of human welfare.No mention of human welfare.- Narrow definition.Narrow definition.

Economics : A science of material welfare.Economics : A science of material welfare.(Neo classical)(Neo classical)

Alfred Marshal- economics is the study of man's action in the Alfred Marshal- economics is the study of man's action in the ordinary business of life; it enquiresordinary business of life; it enquires

How he gets his income and how he uses it. Thus, it is on one How he gets his income and how he uses it. Thus, it is on one side study of wealth and on the other side study of man.side study of wealth and on the other side study of man.

Other neo-classical Economists.Other neo-classical Economists.A C Pigou- Economics deals with the part of social welfare that A C Pigou- Economics deals with the part of social welfare that

can be bought directly or indirectly into relation with the can be bought directly or indirectly into relation with the measure rod of money. measure rod of money.

Edwin Cannan – it is the study of general methods by which man Edwin Cannan – it is the study of general methods by which man cooperate to meet their material needs.cooperate to meet their material needs.

Criticism.Criticism.- Classical rather than analytical in nature.- Classical rather than analytical in nature.- Difficult to separate material and no-material things.Difficult to separate material and no-material things.- Connection b/w economics and welfare.Connection b/w economics and welfare.- Social science ( welfare)Social science ( welfare)- Quantitative measurements of welfare.Quantitative measurements of welfare.- Economic as normative.Economic as normative.

Economics: A Science of Scarcity orEconomics: A Science of Scarcity orScience of Choice.Science of Choice.

Lionel Robbins:” Economics studies human behavior as a Lionel Robbins:” Economics studies human behavior as a relationship b/w ends and scarce means which have relationship b/w ends and scarce means which have alternatives uses.”alternatives uses.”

The nature and significance of economics science published The nature and significance of economics science published in 1932in 1932

The Fundamental characteristics of definition;The Fundamental characteristics of definition;- Unlimited endsUnlimited ends- Limited meansLimited means- Alternative uses of meansAlternative uses of means- Problem of choice.Problem of choice.CriticismCriticism- It does not cover macroeconomicsIt does not cover macroeconomics- Difficult to separate means and endsDifficult to separate means and ends- It ignores development economics.It ignores development economics.

EconomicsEconomics : A Science of Economics growth : A Science of Economics growth

Paul A Samuleson : “ Economics is the study of how men and Paul A Samuleson : “ Economics is the study of how men and society choose, with or without the use of money, to employ society choose, with or without the use of money, to employ scarce productive resources which could have alternative uses scarce productive resources which could have alternative uses to produces various commodities over time and distribute them to produces various commodities over time and distribute them for consumption more and in future among various people and for consumption more and in future among various people and group of society” Economics Published in 1964.group of society” Economics Published in 1964.

He considered economics as much more that the theory of value He considered economics as much more that the theory of value or resource allocation.or resource allocation.

He was widened the definition of economics based on the concept He was widened the definition of economics based on the concept of Robbins.of Robbins.

He considered economics as a dynamic science.He considered economics as a dynamic science.He defined and explained the use of factors over different period He defined and explained the use of factors over different period

of time.of time.He is capable of including the nature of economics activities.He is capable of including the nature of economics activities.Under capitalistic economy as well as socialistic economy.Under capitalistic economy as well as socialistic economy.He also Covers welfare aspect.He also Covers welfare aspect.

The Demand FunctionThe Demand FunctionDemand : Desire back with purchasing power.Demand : Desire back with purchasing power.Demand= wish + will + Purchasing power.Demand= wish + will + Purchasing power.Qd = f( p) , Qd = f ( P1, P2, Y, T, Pop, S)Qd = f( p) , Qd = f ( P1, P2, Y, T, Pop, S)Demand is a function of rice of that commodity which is Demand is a function of rice of that commodity which is

demanded, price of other commodities, average demanded, price of other commodities, average income of Consumer, taste of consumer population of income of Consumer, taste of consumer population of that area and special influences. Amount of that area and special influences. Amount of commodity people buy depends on its price. Law of commodity people buy depends on its price. Law of Demand the higher the prices of commodity, the fewer Demand the higher the prices of commodity, the fewer units consumers are willing to buy. The lower its units consumers are willing to buy. The lower its market price, the more units of it are bought. Ceteris market price, the more units of it are bought. Ceteris paribus.paribus.

There exists a definite relationship b/w the market price There exists a definite relationship b/w the market price of a good and the quantity demanded of that good, of a good and the quantity demanded of that good, other things held constant. The relationship b/w price other things held constant. The relationship b/w price and quantity bought is calledand quantity bought is called

Demand Schedule or the Demand Curve.Demand Schedule or the Demand Curve.

Demand ScheduleDemand SchedulePrices: 0.6 0.5 0.4 0.3 0.2 0.1Prices: 0.6 0.5 0.4 0.3 0.2 0.1Quantity: 10 20 30 40 50 60Quantity: 10 20 30 40 50 60

0

10

20

30

40

50

60

70

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7

Prices ( Rs)

Un

its

individual demand curve

Causes of Downward sloping demand curve;Causes of Downward sloping demand curve;1- The law of demand is based on the law of diminishing marginal 1- The law of demand is based on the law of diminishing marginal

utility (MU), when a consumer buys more units of a commodity utility (MU), when a consumer buys more units of a commodity MU That commodity continues to decline. Therefore, the MU That commodity continues to decline. Therefore, the consumer will buy more units of that only when its price fall this consumer will buy more units of that only when its price fall this this will prove that demand will be more at a lower price and it this will prove that demand will be more at a lower price and it will be less at higher price that’s why demand curve is will be less at higher price that’s why demand curve is downward sloping.downward sloping.

2- Everyone commodity has certain consumers but when its prices 2- Everyone commodity has certain consumers but when its prices falls, New consumer start consuming it as a result demand falls, New consumer start consuming it as a result demand increases, on the contrary with increase in its prices many increases, on the contrary with increase in its prices many consumers either to reduce or stop its consumption and consumers either to reduce or stop its consumption and demand will be reduced thus due to price effect, when demand will be reduced thus due to price effect, when consumers consume more or less, the demand cure slopes consumers consume more or less, the demand cure slopes downward.downward.

3- When price of commodity falls, the real income of consumer 3- When price of commodity falls, the real income of consumer increase because he has to spend less in order to buy the increase because he has to spend less in order to buy the same quantity. On the contrary, with the rise in the price of a same quantity. On the contrary, with the rise in the price of a commodity the real income of consumer falls. This is called the commodity the real income of consumer falls. This is called the income effect.income effect.

4- With the fall in the price of a commodity, the prices of its 4- With the fall in the price of a commodity, the prices of its substitute remaining the same it is known as substitution effect, substitute remaining the same it is known as substitution effect, consumer will buy more of the same rather than the substitutes. consumer will buy more of the same rather than the substitutes. On the contrary, with the rise in the price of commodity its On the contrary, with the rise in the price of commodity its demand will fall, given the prices of its substitute.demand will fall, given the prices of its substitute.

5- There are different income groups in every society, but the 5- There are different income groups in every society, but the majority relates to low income group, the downward sloping majority relates to low income group, the downward sloping demand curve depends upon this group. Ordinary people buy demand curve depends upon this group. Ordinary people buy more when prices falls and less when prices rises. The rich do more when prices falls and less when prices rises. The rich do not have any effect, because they are capable to buy same not have any effect, because they are capable to buy same quantity even at higher prices.quantity even at higher prices.

6- There are different uses of certain commodities and services 6- There are different uses of certain commodities and services that are responsible for negative slope, with the increase in the that are responsible for negative slope, with the increase in the of such products, they will be used only for more important of such products, they will be used only for more important uses, and their demand will fall. On the contrary, with fall in uses, and their demand will fall. On the contrary, with fall in prices, they will be put to various uses and their demand will prices, they will be put to various uses and their demand will rise .g. with increase in electricity charges, power will be used rise .g. with increase in electricity charges, power will be used for domestic lighting, but if charges are reduced, people will use for domestic lighting, but if charges are reduced, people will use power for cooking, heating etc.power for cooking, heating etc.

Exceptions of Law of DemandExceptions of Law of Demand- In certain cases the demand curve slopes up from left to right. In certain cases the demand curve slopes up from left to right.

Many causes are attributed to an up ward D- curve.Many causes are attributed to an up ward D- curve.1- War : If shortage is feared in anticipation of war, people may 1- War : If shortage is feared in anticipation of war, people may

start buying for building stocks, even price rises.start buying for building stocks, even price rises.2- Depression : during, prices of commodity very low, the demand 2- Depression : during, prices of commodity very low, the demand

for them is also less because of less purchasing power.for them is also less because of less purchasing power.3- Giffen Paradox : if a commodity happens to be a necessary of 3- Giffen Paradox : if a commodity happens to be a necessary of

life like wheat and prices goes up, consumer are forced to life like wheat and prices goes up, consumer are forced to curtail the consumption of more expensive foods like meat and curtail the consumption of more expensive foods like meat and fish, and wheat being still the cheapest, they will consume more fish, and wheat being still the cheapest, they will consume more of it.of it.

4- Demonstration Effect : If the consumer are affected by the 4- Demonstration Effect : If the consumer are affected by the principles of demonstration effect, they will like to buy more of principles of demonstration effect, they will like to buy more of those commodities which confer distinction on the possessor, those commodities which confer distinction on the possessor, when their prices rise. On the other hand, with the fall in the when their prices rise. On the other hand, with the fall in the price of such commodities, their demand falls as the case with price of such commodities, their demand falls as the case with diamonds.diamonds.

Do not Confuse movement along the curve with Do not Confuse movement along the curve with shift of curveshift of curve

(See the figures 3 E & F)(See the figures 3 E & F)Factors affecting demand curve;Factors affecting demand curve;

1- Average income : As income increases, people 1- Average income : As income increases, people purchasing more.purchasing more.

2- Population : As growth of population 2- Population : As growth of population increases, purchases of goods increases.increases, purchases of goods increases.

3- Prices Of related Goods : Higher prices, 3- Prices Of related Goods : Higher prices, reduces the demand for Goods.reduces the demand for Goods.

4- Taste: Having distinct things become a status 4- Taste: Having distinct things become a status symbol. symbol.

5- Special Influences : Availability of alternates. 5- Special Influences : Availability of alternates.

SupplySupplyThe supply side of market typically involves the terms on The supply side of market typically involves the terms on

which business produced and sell their product.which business produced and sell their product.Quantity of commodity supplied in a market for sale at Quantity of commodity supplied in a market for sale at

certain or prevailing prices is called supplycertain or prevailing prices is called supplyQs = f (P)Qs = f (P)

Qs = f (P1, P2,…n, Tech, Input, GP, SI) Qs = f (P1, P2,…n, Tech, Input, GP, SI) Quantity Supplied is function of price of that commodity Quantity Supplied is function of price of that commodity

which is supplied, prices of related goods, technology, which is supplied, prices of related goods, technology, input, prices, government policies, Special Influences.input, prices, government policies, Special Influences.

The supply schedule or supply curve for a commodity The supply schedule or supply curve for a commodity shows the relationship b/w its market price and the shows the relationship b/w its market price and the amount of that commodity that producers are willing to amount of that commodity that producers are willing to produce and sell, other things held constant.produce and sell, other things held constant.

Supply ScheduleSupply SchedulePrices (Rs) : 1 2 3 4 5Prices (Rs) : 1 2 3 4 5Quantity (Units) : 2 4 6 8 10Quantity (Units) : 2 4 6 8 10

0

2

4

6

8

10

12

0 1 2 3 4 5 6

Prices ( Rs)

Qu

an

tity

(u

nit

s)

Indivdual supply curve

There is positive relationship b/w market price and There is positive relationship b/w market price and quantity supplied so supply curve going up ward left to quantity supplied so supply curve going up ward left to right.right.

One important reason for the upward slope is the “ law One important reason for the upward slope is the “ law of diminishing returns”of diminishing returns”

Factors affecting the supply curve:Factors affecting the supply curve:Technology – Computerized manufacturing lowers Technology – Computerized manufacturing lowers

production cost and increase supply.production cost and increase supply.Input prices – a reduction in the wage paid to workers, Input prices – a reduction in the wage paid to workers,

lower production costs and increase supply.lower production costs and increase supply.Prices of related goods - When oil prices increase Prices of related goods - When oil prices increase

sharply, increase production cost ad lower the supply.sharply, increase production cost ad lower the supply.Government Polices – Improving quota and tariff and Government Polices – Improving quota and tariff and

imported goods, domestic supply increases.imported goods, domestic supply increases.Special Influences – If govt lowers the prices of gas kits, Special Influences – If govt lowers the prices of gas kits,

more environment friendly cars on the roads.more environment friendly cars on the roads.

Equilibrium Of Supply and DemandEquilibrium Of Supply and DemandEquilibrium is a state of balance : when two opposite Equilibrium is a state of balance : when two opposite

forces are interact at point. The market equilibrium forces are interact at point. The market equilibrium comes at that price and quantity where the forces of comes at that price and quantity where the forces of supply and demand are in balance. At this point the supply and demand are in balance. At this point the amount buyers want to buy is just equal to the amount amount buyers want to buy is just equal to the amount the seller want to sell.the seller want to sell.

The reason we call this an equilibrium is that when the The reason we call this an equilibrium is that when the forces of supply and demand in balance there is no forces of supply and demand in balance there is no reason for price to rise or fall,reason for price to rise or fall,

As long as other things remains unchanged.As long as other things remains unchanged.Equilibrium with supply and demand curvesEquilibrium with supply and demand curves

(see figure A)(see figure A)Effect of shift in supply or demandEffect of shift in supply or demand

( See figures B and C )( See figures B and C )

Market EqulibriumFIGURE-A

0123456

0 5 10 15 20 25 30

Q

P

Surplus

S>D

shortage

S<D

Equilibrium

-101234567

0 5 10 15 20 25 30

Q

P

Factors Affecting The Price Elasticity Of Factors Affecting The Price Elasticity Of Demand :Demand :

-Nature of CommodityNature of Commodity-Substitute Substitute -Variety of UsesVariety of Uses-Joint demandJoint demand-Deferred ConsumptionDeferred Consumption-HabitsHabits-Income GroupIncome Group-Proportion of SpentProportion of Spent-Level of PriceLevel of Price-Time factorTime factor

Elasticity of demand and SupplyElasticity of demand and SupplyThe law of demand does not solve the problem of degree of The law of demand does not solve the problem of degree of

change in demand to a change in credit goes to Marshall change in demand to a change in credit goes to Marshall who offered a solution by formulating the concept of who offered a solution by formulating the concept of elasticity of demand in these words,” The elasticity (or elasticity of demand in these words,” The elasticity (or Responsiveness) of demand in a market is greater or Responsiveness) of demand in a market is greater or smaller according as the amount demanded increases smaller according as the amount demanded increases much on little for a given fall in price and diminish much or much on little for a given fall in price and diminish much or little for a given rise in price.” Modern economist define little for a given rise in price.” Modern economist define elasticity of demand in a mathematical manner. Lipsey’s elasticity of demand in a mathematical manner. Lipsey’s word” is the ratio of percentage in demand to percentage word” is the ratio of percentage in demand to percentage change in price.” Robinson definition is more clear “ The change in price.” Robinson definition is more clear “ The elasticity of demand at any price or at any out put , is the elasticity of demand at any price or at any out put , is the Proportional change of amount purchased in response to a Proportional change of amount purchased in response to a small change in price, divided by proportional change of small change in price, divided by proportional change of price thus it is the ratio of percentage in amount price thus it is the ratio of percentage in amount demanded to a percentage change in price.demanded to a percentage change in price.

Its importance in Government PoliciesIts importance in Government PoliciesThe application of Ed in formulation of government polices in various The application of Ed in formulation of government polices in various

fields.fields.1.1. While granting protection : G consider the Ed of the product of While granting protection : G consider the Ed of the product of

those industries which apply for grant of subsidy or protection. It those industries which apply for grant of subsidy or protection. It is given to those industries whose product have an elastic is given to those industries whose product have an elastic demand. As a consequences they are unable to face foreign demand. As a consequences they are unable to face foreign competition unless their prices are lowered through subsidy or competition unless their prices are lowered through subsidy or by raising the prices of imported goods by imposing heavy by raising the prices of imported goods by imposing heavy duties on themduties on them

2.2. Whole deciding about public utilities: G decision to declare Whole deciding about public utilities: G decision to declare certain industries as public utility depends upon Ed for their certain industries as public utility depends upon Ed for their product, these are taken over and run as public utility by the product, these are taken over and run as public utility by the state. Demand for those product is inelastic the G in this way state. Demand for those product is inelastic the G in this way provide essential g/s to the public at reasonable rates thus provide essential g/s to the public at reasonable rates thus eliminating monopolists exploitation.eliminating monopolists exploitation.

3.3. In facing minimum price of farm products: G policies of In facing minimum price of farm products: G policies of guaranteeing minimum price for form products, price support guaranteeing minimum price for form products, price support programmed and creating the buffer stocks are meant for programmed and creating the buffer stocks are meant for stabilizing the agriculture price.stabilizing the agriculture price.Paradox of Bumper Crop….?Paradox of Bumper Crop….?

Importance to Finance Minister :Importance to Finance Minister :It has paramount importance to FM. He has to find about how he It has paramount importance to FM. He has to find about how he

can bring more revenue to exchequer? He must now the Ed can bring more revenue to exchequer? He must now the Ed of the product on which the tax has to be imposed. Let us of the product on which the tax has to be imposed. Let us illustrate with the Help of diagram whether a tax on a product illustrate with the Help of diagram whether a tax on a product which elastic demand or inelastic demand would bring larger which elastic demand or inelastic demand would bring larger revenue to the exchequer. revenue to the exchequer.

Importance in the problem of the international trade:Importance in the problem of the international trade:The Ed has great practical importance in analyzing complex The Ed has great practical importance in analyzing complex

problems of IT.problems of IT.1.1. In Determination of the Gain from IT: The TOT refer to the In Determination of the Gain from IT: The TOT refer to the

rate which a country exchanges her exports for her imports rate which a country exchanges her exports for her imports from the other country. The exact rate at which exchange will from the other country. The exact rate at which exchange will take place, will be determined by the relative elasticity of take place, will be determined by the relative elasticity of demand of two countries for each other’s product, the gain demand of two countries for each other’s product, the gain from trade in turn depend , among others, on the Ed and the from trade in turn depend , among others, on the Ed and the term of trade. We will gain from IT If we export goods with term of trade. We will gain from IT If we export goods with less Ed and import those goods for which or demand is less Ed and import those goods for which or demand is elastic . In the first case, we will charge high price for our elastic . In the first case, we will charge high price for our product and in later case, we will be paying less for the goods product and in later case, we will be paying less for the goods obtained from other country. Thus we gain both way and shall obtained from other country. Thus we gain both way and shall be able to increase the volume of our imports and exports.be able to increase the volume of our imports and exports.

2.2. In tariff Policy: tariff tend to raise the prices of the domestic In tariff Policy: tariff tend to raise the prices of the domestic products , internal price rise depends on the Ed of products , internal price rise depends on the Ed of protected goods in the demand of protected goods is protected goods in the demand of protected goods is elastic, their sales will be reduce with the rise in prices, elastic, their sales will be reduce with the rise in prices, conversely, if the demand is less elastic , people will have conversely, if the demand is less elastic , people will have to bear the Burdon of higher prices as a result of tariff to bear the Burdon of higher prices as a result of tariff policy.policy.

3.3. Basis of policy of devolution: The consideration of elastic of Basis of policy of devolution: The consideration of elastic of demand for M and X is Important of a country which is demand for M and X is Important of a country which is thinking of correcting her adverse BOPs By devolution, thinking of correcting her adverse BOPs By devolution, Devolution makes X cheaper and M dearer of the country Devolution makes X cheaper and M dearer of the country adopting it. Suppose we resort the devolution, its first effect adopting it. Suppose we resort the devolution, its first effect will be that the price of a M will rise and we will induce to will be that the price of a M will rise and we will induce to reduce or M, But this depends on the Ed for M on the other reduce or M, But this depends on the Ed for M on the other hand, the fall in foreign price for X will induce us to X more, hand, the fall in foreign price for X will induce us to X more, But its depends upon the Ed of Foreigner for our products But its depends upon the Ed of Foreigner for our products thus the extend to which we are in a position to reduce the thus the extend to which we are in a position to reduce the gap b/w receipts and expenditure of foreign exchange gap b/w receipts and expenditure of foreign exchange depends upon the elasticity of demand for X and M.depends upon the elasticity of demand for X and M.

Cross Elasticity Or Complementry goods (Jointly Demanded)Cross Elasticity Or Complementry goods (Jointly Demanded)=If two goods are jointly demanded the rise in the price of one =If two goods are jointly demanded the rise in the price of one

(Cars) lead to a fall in the demand for other ( petrol) or vise (Cars) lead to a fall in the demand for other ( petrol) or vise versa. versa.

=if the change in quantity demanded B exactly in the same =if the change in quantity demanded B exactly in the same proportion as change in price of A.proportion as change in price of A.

(Eba = 1)..i.e ▲Qb / ▲Pa = 1(Eba = 1)..i.e ▲Qb / ▲Pa = 1=when the change in the demand for good B is more than =when the change in the demand for good B is more than

proportionate to the change in the price of good A. proportionate to the change in the price of good A. (Eba>1). i.e. ▲Qb / ▲Pa>1(Eba>1). i.e. ▲Qb / ▲Pa>1=when change in quantity of B is less in response to change in =when change in quantity of B is less in response to change in

price of A.price of A. (Eba<1) i.e. ▲Qb/ ▲Pa<1.(Eba<1) i.e. ▲Qb/ ▲Pa<1.=when an infinestimal change in the price of A causes infinity =when an infinestimal change in the price of A causes infinity

large change in the purchase of B. large change in the purchase of B. (Eba=(Eba=άά) i.e. ▲Qb / ▲Pa= ) i.e. ▲Qb / ▲Pa= άά= when the price of A Remains almost the same and demand of B = when the price of A Remains almost the same and demand of B

increases. increases. (Eba=0) i.e. ▲Qb / ▲Pa =0(Eba=0) i.e. ▲Qb / ▲Pa =0

Formula maybe written as:Formula maybe written as:

Ed= % change in amount demanded Or Ed= % change in amount demanded Or ▲q/q▲q/q % change in price ▲p/p% change in price ▲p/pIf percentage for quantity rises are known the If percentage for quantity rises are known the

value of coefficient can be calculated, price value of coefficient can be calculated, price elasticity may be unity, greater than unity, less elasticity may be unity, greater than unity, less than unity and 0 or infinity, these five cases than unity and 0 or infinity, these five cases are explain with help of diagram ( see A,B,C,D are explain with help of diagram ( see A,B,C,D and E).and E).

1.1.Method of measuring elasticity:Method of measuring elasticity: The percentage Method.The percentage Method. The point Method (Geometrical Method).The point Method (Geometrical Method). The Arc Method (Geometrical Method).The Arc Method (Geometrical Method). The outlay Method. The outlay Method.

Income ElasticityIncome Elasticity: The Ey Expresses the responsiveness of a : The Ey Expresses the responsiveness of a consumer’s demand (expenditure or consumption) for any consumer’s demand (expenditure or consumption) for any good X to change in his income, it may be defined as the good X to change in his income, it may be defined as the percentage change in the quantity demanded of good X to percentage change in the quantity demanded of good X to the percentage change in income.the percentage change in income.

EY= percentage change in quantity demanded of XEY= percentage change in quantity demanded of X Percentage change in incomePercentage change in income

OrOr▲▲q/q // ▲y/y = ▲q/q x y/ ▲y = ▲q/ ▲y x y/q = Eyq/q // ▲y/y = ▲q/q x y/ ▲y = ▲q/ ▲y x y/q = EyPromotional Elasticity:Promotional Elasticity: It is the knowledge of concept of It is the knowledge of concept of

elasticity that prompts producer to spend large sums of elasticity that prompts producer to spend large sums of money on advertising their products for they know that money on advertising their products for they know that advertisement makes the demand for that product less advertisement makes the demand for that product less elastic so that rising the price will not reduce its sales lead elastic so that rising the price will not reduce its sales lead to the concept of promotional elasticity which measure the to the concept of promotional elasticity which measure the responsiveness of sales to change in the advertising and responsiveness of sales to change in the advertising and other promotional expenses the formula for this:other promotional expenses the formula for this:

Change in sales / sums of sales multiply by Change in sales / sums of sales multiply by Sum of promotional expenses / change in promotional Sum of promotional expenses / change in promotional

expenses. expenses.

The Point Method: Marshall devised a The Point Method: Marshall devised a geometrical method for measuring elasticity at geometrical method for measuring elasticity at a point ion the demand curve this is now as a point ion the demand curve this is now as point elasticity of demandpoint elasticity of demand

Formula: Ed= Lower segment / Upper segmentFormula: Ed= Lower segment / Upper segment

With the help of point method it is easy to point With the help of point method it is easy to point out the elasticity at any point along the demand out the elasticity at any point along the demand curve.curve.

Suppose that the straight line demand curve DC Suppose that the straight line demand curve DC in figure Fin figure F

(See Slide)(See Slide)

Arc elasticity: we have studied the measurement of the Arc elasticity: we have studied the measurement of the elasticity at a point on demand curve, but when elasticity at a point on demand curve, but when elasticity is measured b/w two point on the same elasticity is measured b/w two point on the same demand curve it is now as Arc Elasticity Arc elasticity demand curve it is now as Arc Elasticity Arc elasticity is a measure of the average responsiveness to the is a measure of the average responsiveness to the price change exhibited by a demand curve over some price change exhibited by a demand curve over some finite stretch of the curve- Baumalfinite stretch of the curve- Baumal

Any two points on the demand curve make an arc.Any two points on the demand curve make an arc.

Formula: Ed=q1-q2/q1+q2//p1/p2/p1+p2Formula: Ed=q1-q2/q1+q2//p1/p2/p1+p2

Where q1, q2 and p1, p2 are two prices respectively arc Where q1, q2 and p1, p2 are two prices respectively arc elasticity on figure G (see the Slide) where q=q1-q2 elasticity on figure G (see the Slide) where q=q1-q2 and p=p1-p2 therefore elasticity b/w point B and C is and p=p1-p2 therefore elasticity b/w point B and C is

q/q1+q2//p/p1+p2q/q1+q2//p/p1+p2

Difference in q/sum of q// difference in p/sum of p = EdDifference in q/sum of q// difference in p/sum of p = Ed

The outlay Method: Marshall evolved the total outlay, The outlay Method: Marshall evolved the total outlay, Total revenue or total expenditure method as a Total revenue or total expenditure method as a measure of elasticity. By comparing the total measure of elasticity. By comparing the total expenditure of a purchaser both before and after the expenditure of a purchaser both before and after the change in price can be now whether his demand for change in price can be now whether his demand for good is elastic, unity or less elastic.good is elastic, unity or less elastic.

Total out lay= price x quantity demanded.Total out lay= price x quantity demanded.

Demand for goods is elastic, when a fall in its price lead Demand for goods is elastic, when a fall in its price lead to a larger expenditure on it other wise vice versa.to a larger expenditure on it other wise vice versa.

It is unitary, whenIt is unitary, when

Total expenditure remains un changed with the fall and Total expenditure remains un changed with the fall and

Rise in the price of goods.Rise in the price of goods.

Demand is inelastic when total expenditure falls, with the Demand is inelastic when total expenditure falls, with the fall in price and rise with the rises in the price. fall in price and rise with the rises in the price.

The percentage MethodThe percentage MethodOne of the most satisfactory method of measure ment is One of the most satisfactory method of measure ment is

to record elasticity as ratio of percentage change in to record elasticity as ratio of percentage change in the amount demanded to the percentage change in the amount demanded to the percentage change in price of commodityprice of commodity

Formula Ed= ▲q / q // ▲p/p = ▲q/qx ▲p/-p =- ▲q/p x Formula Ed= ▲q / q // ▲p/p = ▲q/qx ▲p/-p =- ▲q/p x ▲p/q▲p/q

The coefficient of price elasticity of demand is always The coefficient of price elasticity of demand is always negative because when price change the demand negative because when price change the demand moves in opposite direction. Let us measure Ed with moves in opposite direction. Let us measure Ed with the aid of formula, suppose that.the aid of formula, suppose that.

Quantity demanded PriceQuantity demanded Price5Kg5Kg 10Rs.(Initial price and 10Rs.(Initial price and

quantity)quantity)6Kg6Kg 6Rs. less elastic. 6Rs. less elastic.4kg4kg 12 Rs. Unity 12 Rs. Unity4Kg4Kg 11 Rs. More elastic 11 Rs. More elastic

Cross Elasticity of demand: It is the duration between percentage change in Cross Elasticity of demand: It is the duration between percentage change in quantity demanded of a good to percentage change in the price of quantity demanded of a good to percentage change in the price of related good. The crossrelated good. The cross

Elasticity of demand b/w good A and B is Elasticity of demand b/w good A and B is Eba = %change in the quantity of B / % change in price of a Eba = %change in the quantity of B / % change in price of a

i.e. Eba= ▲qb/qb// ▲pa/pa= ▲qb/qb x pa/qbi.e. Eba= ▲qb/qb// ▲pa/pa= ▲qb/qb x pa/qbIt can also be measured with the formula of arc elasticityIt can also be measured with the formula of arc elasticityi.e. Eba= Diff in qb / sum of qb x sum of pa / diff pa.i.e. Eba= Diff in qb / sum of qb x sum of pa / diff pa.There are two types of related goods; substitute and Complementry.There are two types of related goods; substitute and Complementry.

Cross elasticity of substitute;Cross elasticity of substitute;In case of substitutes, if a change in the price of good A leads to more than In case of substitutes, if a change in the price of good A leads to more than

proportionate change in demand for good B , the cross E is +ve and proportionate change in demand for good B , the cross E is +ve and large the higher the coefficient of cross E such goods are close large the higher the coefficient of cross E such goods are close

substitute. (Eba>1)substitute. (Eba>1)If change in the price of A causes the same change in the quantity of B. If change in the price of A causes the same change in the quantity of B.

( Eba=1)( Eba=1)When he quantity demanded of good B changes less than proportionate When he quantity demanded of good B changes less than proportionate

change in the price of good A (Eba<1) The goods are poor substitute. change in the price of good A (Eba<1) The goods are poor substitute. En Change in price of good A has no effect on demand of good B than En Change in price of good A has no effect on demand of good B than

(Eba=0)(Eba=0)Unrelated goods – in case two goods are perfectly substitute then (Eba= Unrelated goods – in case two goods are perfectly substitute then (Eba= άά))It may be –ve if the PA falls, the DA being inelastic, than less of A will be It may be –ve if the PA falls, the DA being inelastic, than less of A will be

purchased because it is cheaper, and more of B will be bought.purchased because it is cheaper, and more of B will be bought.

Income Demand: QD=f (Average income of consumer Y)Income Demand: QD=f (Average income of consumer Y)The Income- demand relationship is usually direct, the The Income- demand relationship is usually direct, the

demand for commodity increases with the rise in income demand for commodity increases with the rise in income backward sloping income demand curve (see fig-1)backward sloping income demand curve (see fig-1)

A.A. In case of normal goods.In case of normal goods.B.B. In case of inferior goods.In case of inferior goods.Cross demand: Qd = f (prices of related goods P2…..n)Cross demand: Qd = f (prices of related goods P2…..n)How the change in price of one effect the demand of other.How the change in price of one effect the demand of other.Related goods are of two type, substitute and Related goods are of two type, substitute and

complimentary.complimentary.In case of subs a rise in price of one good A raises the In case of subs a rise in price of one good A raises the

demand for other good B, the price of B remaining the demand for other good B, the price of B remaining the same, opposite holds in case of fall the price of A when same, opposite holds in case of fall the price of A when demand for B falls so the cross demand curve for demand for B falls so the cross demand curve for substitute is positively sloping .(See fig 2A)substitute is positively sloping .(See fig 2A)

- In Case of Complementry goods, a rise in the price of one - In Case of Complementry goods, a rise in the price of one good A will bring a fall in the demand for B (see fig 2B). good A will bring a fall in the demand for B (see fig 2B). In case of Complementry goods cross demand curve is In case of Complementry goods cross demand curve is negatively sloping.negatively sloping.

Elasticity of DemandElasticity of Demand

Cardinal Approach and Consumer equilibrium:Cardinal Approach and Consumer equilibrium:The theory demand is based in the cardinal The theory demand is based in the cardinal

measurement of utility. Utility denotes satisfaction, if measurement of utility. Utility denotes satisfaction, if commodity or service satisfies and economics want it commodity or service satisfies and economics want it possesses utility if a market A has higher utility than possesses utility if a market A has higher utility than market B, this ranking indicates that consumer prefer market B, this ranking indicates that consumer prefer A over B. utility is subjective pleasure or usefulness A over B. utility is subjective pleasure or usefulness that a person drives from consuming a good and that a person drives from consuming a good and services.services.

Economist explain consumer demand by the concept of Economist explain consumer demand by the concept of utility which denotes relative satisfaction that a utility which denotes relative satisfaction that a consumer obtained from using different commodities.consumer obtained from using different commodities.

In the theory of demand, we say that people maximize In the theory of demand, we say that people maximize their utility which means that they choose the bundle their utility which means that they choose the bundle of consumption gods that they most preferred.of consumption gods that they most preferred.

Ordinal Utility: Ordinal Utility: Economist to day generally rejected the nation of a cardinal, Economist to day generally rejected the nation of a cardinal,

measurable utility that is attached to consumption of ordinary measurable utility that is attached to consumption of ordinary goods like shoes or eggs. We can easily derive demand curve goods like shoes or eggs. We can easily derive demand curve with out ever mentioning the nation of utility. What counts for with out ever mentioning the nation of utility. What counts for modern demand theory modern demand theory is the principal of ordinal utility. is the principal of ordinal utility.

Under this approach we examine only the preference ranking of Under this approach we examine only the preference ranking of bundle of commodities. Ordinal utility asks” is A preferred to bundle of commodities. Ordinal utility asks” is A preferred to B” which does not require that we know how much A is B” which does not require that we know how much A is preferred to B --- is called Opreferred to B --- is called Ordinal or Dimensionless. rdinal or Dimensionless. Ordinal Ordinal variable are ones that we can rank in order, but for which variable are ones that we can rank in order, but for which there is no measure of there is no measure of quantity differencequantity difference between situations. between situations.

Equi-Marginal PrincipalEqui-Marginal Principal: The : The fundamental condition of fundamental condition of maximum satisfactory. It states that a consumer having a maximum satisfactory. It states that a consumer having a fixed income and facing given market prices of goods will fixed income and facing given market prices of goods will achieve maximum satisfactiom when the marginal utility of achieve maximum satisfactiom when the marginal utility of last ripee spent on ech good is exactly the same as the last ripee spent on ech good is exactly the same as the marginal utility of last rupee spent on any other good. The marginal utility of last rupee spent on any other good. The common marginal utility per rupee of all commodities in common marginal utility per rupee of all commodities in consumer equilibrium is alled the narginal utility of income.consumer equilibrium is alled the narginal utility of income.

Assumptions:Assumptions: The method of measuring utility is based on a set of The method of measuring utility is based on a set of

assumptions;assumptions; Consumer must be rationalConsumer must be rational Perfect knowledge of choice open to himPerfect knowledge of choice open to him There are no substitute.There are no substitute. Utility are measurable in term of money.Utility are measurable in term of money.

The theory of consumer demand is based on the cardinal The theory of consumer demand is based on the cardinal measurement of utility. How does utility apply to theory of measurement of utility. How does utility apply to theory of

demand;demand;e-g Consuming a unit of commoditye-g Consuming a unit of commodity

as we consumes some additional unit of commodity, we will get as we consumes some additional unit of commodity, we will get some additional satisfaction or utility --- the increment to one some additional satisfaction or utility --- the increment to one unit is called Marginal Utility. The expression “marginal” is the unit is called Marginal Utility. The expression “marginal” is the

key term in economics and always means extra.key term in economics and always means extra.Marginal utility denotes additional unit arising from consumption Marginal utility denotes additional unit arising from consumption

of an additional unit of commodity.of an additional unit of commodity.Marginal mean extra or incremental utility.Marginal mean extra or incremental utility.

Law of diminishing marginal utility.Law of diminishing marginal utility.A century ago, when economists thought about utility, they A century ago, when economists thought about utility, they

enunciated the law of diminishing marginal utility.enunciated the law of diminishing marginal utility.This law states that the amount of extra or marginal utility This law states that the amount of extra or marginal utility

declines as a person consume more and more of a declines as a person consume more and more of a goods.goods.

What is the reason for this law? Utility tends to increase as What is the reason for this law? Utility tends to increase as you consume more of a good. However, according to you consume more of a good. However, according to DMU as you consume more and more your total utility DMU as you consume more and more your total utility will grow at a slower and slower rate. Growth in total will grow at a slower and slower rate. Growth in total utility slows because, your marginal utility (the extra utility slows because, your marginal utility (the extra utility added by the last unit consumed of a good) utility added by the last unit consumed of a good) diminishes as more of a good is consumed.diminishes as more of a good is consumed.

The law of diminishing marginal utility states that, as the The law of diminishing marginal utility states that, as the amount of a good consumed increases the marginal amount of a good consumed increases the marginal utility of that good tends to diminish.utility of that good tends to diminish.

Limitation of law of diminishing marginal utility.Limitation of law of diminishing marginal utility. The law holds under certain conditions;The law holds under certain conditions; A single commodity with homogenous units.A single commodity with homogenous units. No change in taste, habit, custom, fashion and income.No change in taste, habit, custom, fashion and income. Continuity in consumption.Continuity in consumption. Unit of commodity, a suitable size.Unit of commodity, a suitable size. Prices of substitutes, remains the same.Prices of substitutes, remains the same. Indivisible commodity.Indivisible commodity. Act rationally.Act rationally. Ordinary type commodity.Ordinary type commodity. The The Marshallian Marshallian demand analysis is based on the demand analysis is based on the

concept of cardinal utility assumes that utility is concept of cardinal utility assumes that utility is measurable and additive.measurable and additive.

It is expressed as a quantity measured in hypothetical It is expressed as a quantity measured in hypothetical unit which are called “utils”. If a consumer imagines that unit which are called “utils”. If a consumer imagines that one mango has 8 utils and an apple 4 utils, it implies that one mango has 8 utils and an apple 4 utils, it implies that the utility of one mango is twice than of an apple.the utility of one mango is twice than of an apple.

Equiv. – Marginal Utility:Equiv. – Marginal Utility:To use utility theory to explain consumer demand and to To use utility theory to explain consumer demand and to

understand the nature of demand curves. For this purposes, understand the nature of demand curves. For this purposes, we need to know the condition under which a consumer we need to know the condition under which a consumer most satisfied with the market basket of consumption goods. most satisfied with the market basket of consumption goods. We say that consumer attempts to maximize his utility which We say that consumer attempts to maximize his utility which means that the consumer chooses the most preferred means that the consumer chooses the most preferred bundle of goods from what is available. Can we see what a bundle of goods from what is available. Can we see what a rule for such an optimal decision would be?rule for such an optimal decision would be?

Certainly I would not expect that the last egg I am buying Certainly I would not expect that the last egg I am buying brings exactly the same marginal utility as the last pair of brings exactly the same marginal utility as the last pair of shoes I am buying , for shoes cost much more per unit than shoes I am buying , for shoes cost much more per unit than eggs. A more sensible rule would be; if goods A cost twice a eggs. A more sensible rule would be; if goods A cost twice a much as good B, than buy goods A only when its marginal much as good B, than buy goods A only when its marginal Utility is at least twice as grate as good B’s marginal utility. Utility is at least twice as grate as good B’s marginal utility. This leads to the This leads to the Equi-marginal principal that I should Equi-marginal principal that I should arrange my consumption tit heat every single goods is ring arrange my consumption tit heat every single goods is ring me the same marginal utility per rupee of expenditure. So I me the same marginal utility per rupee of expenditure. So I am attaining maximum satisfaction from my purchases.am attaining maximum satisfaction from my purchases.

The Fundamental Condition of consumer The Fundamental Condition of consumer equilibrium can be written in term of marginal equilibrium can be written in term of marginal

utilities (MUs) and prices (Ps) of different goods utilities (MUs) and prices (Ps) of different goods in the following compact way;in the following compact way;

MU goods / P1=MU goods2/P2=,…,MUN/PN=MU per Rs. MU goods / P1=MU goods2/P2=,…,MUN/PN=MU per Rs. of income.of income.

e-g we have the example of Quetta market.e-g we have the example of Quetta market.Bolan ShopBolan Shop Rs.1000Rs.1000 (35 Essential Items)(35 Essential Items)Qudusi ShopQudusi Shop Rs.1250Rs.1250 (35 Essential Items)(35 Essential Items)Shaibi StoreShaibi Store Rs.1300Rs.1300 (35 Essential Items)(35 Essential Items)Ahmed StoreAhmed Store Rs.1500Rs.1500 (35 Essential Items)(35 Essential Items)Utility StoreUtility Store Rs.990Rs.990 (35 Essential Items)(35 Essential Items)

Consumer IncomeConsumer Income == Rs. 5000 / Rs. 5000 / monthmonth

Equiv. Marginal Utility.Equiv. Marginal Utility.EquationEquation Y=PY=PAA x A +P x A +PBB x B+,………..P x B+,………..PNN x N x N

Consumer’s income – 50 rupeesConsumer’s income – 50 rupees

Spent on A+BSpent on A+B

40 P X 4 = 1.6040 P X 4 = 1.60

20 P X 4 UTILS = 0.8O20 P X 4 UTILS = 0.8O

Y= 2.40Y= 2.40 maximum satisfactionmaximum satisfaction

Rearrangement – by purchasing one util of apple Rearrangement – by purchasing one util of apple he gain 1 x 40 P= 40 util shown by the area he gain 1 x 40 P= 40 util shown by the area aa,aaa,a2,2,aa3 3 while he losses 40 util of bananas, loss while he losses 40 util of bananas, loss shown by the area bbshown by the area bb11 b b22 b b3 3 ..

The loss of util The loss of util

A

y

X

Apple

MUA / PA

Gain

A3

A2 A1

Unit of A Unit of B

Banana

MUB / PA

Loss

B3

B2

B

B1

Equiv. – Marginal Utility

Marginal Utility

0

1

2

3

4

5

6

0 1 2 3 4 5 6

Quantity

Marg

inal

Uti

lity

Q of Good Q of Good consumedconsumed

Total UtilityTotal Utility Marginal Marginal UtilityUtility

00 00 00

11 44 44

22 77 33

33 99 22

44 1010 11

55 1010 00

Total Utility

0

2

4

6

8

10

12

0 1 2 3 4 5 6

Quantity consumed

To

tal

Uti

lity

Utility rises with the consumption

A. TU rises with consumption, but it rises at a decreasing rate, showing DMU. This observation led early economists to formulate the law of down ward sloping demand.

B. Show the extra utility added by each unit of commodity.

Geometrical Analysis of Geometrical Analysis of Consumer’s equilibrium:Consumer’s equilibrium:

Pareto developed what are today called indifference Pareto developed what are today called indifference curves:curves:

The modern theory of indifference curves analysis The modern theory of indifference curves analysis examines the consumer behavior with that new toolexamines the consumer behavior with that new tool

Indifference curve and its properties.Indifference curve and its properties.Indifference MapIndifference MapConsumer’s equilibrium.Consumer’s equilibrium.

Indifference CurveIndifference Curve

Indifference curveIndifference curveStart by assuming that you are a consumer who buys Start by assuming that you are a consumer who buys

different combinations of two commodities at a given different combinations of two commodities at a given set of prices. For each combination the two goods, set of prices. For each combination the two goods, assume that you prefer one to the other or are assume that you prefer one to the other or are indifferent between the pairs then asked to choose indifferent between the pairs then asked to choose b/w combination you might.b/w combination you might.

1.1. Prefer A to BPrefer A to B2.2. Prefer B to APrefer B to A3.3. Be indifferent b/w A and BBe indifferent b/w A and BThe curved contour of linking up. It is an The curved contour of linking up. It is an

INDIFFERENCE CURVE.INDIFFERENCE CURVE.The point of the curve represents consumption bundles The point of the curve represents consumption bundles

among which the consumer is indifferent, all equally among which the consumer is indifferent, all equally durable.durable.

The level of satisfaction same on all point at IC.The level of satisfaction same on all point at IC.

A Family of ICs which IC is most preferred by the A Family of ICs which IC is most preferred by the consumer.consumer.

Assumption of IC analysis:Assumption of IC analysis:i.i. Consumer act rationally.Consumer act rationally.ii.ii. There are two goods X and Y.There are two goods X and Y.iii.iii. Consumer possesses complete information of prices of Consumer possesses complete information of prices of

the goods.the goods.iv.iv. Prices of two goods are given.Prices of two goods are given.v.v. The consumer’s taste, habit, custom & income remain the The consumer’s taste, habit, custom & income remain the

same.same.vi.vi. ICs are convex to the origin.ICs are convex to the origin.vii.vii. He can arrange the two goods in a scale of preference He can arrange the two goods in a scale of preference

which means that he has both preference and which means that he has both preference and indifference.indifference.

viii.viii. Both preference and indifference are transitive. If A is Both preference and indifference are transitive. If A is preferable to B and B to C than A is preferable to C.preferable to B and B to C than A is preferable to C.

ix.ix. We can order all possible combinations.We can order all possible combinations.

Indifference MapIndifference Map

Budget line or Budget ConstraintBudget line or Budget ConstraintGiven consumer Y fixed. Rs60/ Day to spend and Given consumer Y fixed. Rs60/ Day to spend and

he is confronted with fixed prices for each Unit.he is confronted with fixed prices for each Unit.

It is clear that he could spend his money on any It is clear that he could spend his money on any of the variety of alternative combination .of the variety of alternative combination .

At one extreme he could buy Good X no unit of At one extreme he could buy Good X no unit of good Y. good Y.

Budget Line Budget Line

The Consumer’s EquilibriumThe Consumer’s Equilibrium

The Consumer’s EquilibriumThe Consumer’s EquilibriumConsumer equilibrium is attained at the point where the Consumer equilibrium is attained at the point where the

budget line is tangent to the IC. At that point A, the budget line is tangent to the IC. At that point A, the consumer’s substitution ratio is Just equal to the slope consumer’s substitution ratio is Just equal to the slope of the budget line.of the budget line.

At differentlyAt differentlyThe substitution ratio or the slope of the IC is the ratio of The substitution ratio or the slope of the IC is the ratio of

the marginal utility of good X to the marginal utility of the marginal utility of good X to the marginal utility of Good Y so our tangency condition is just another way Good Y so our tangency condition is just another way of stating that ratio of price must be equal to the ratio of stating that ratio of price must be equal to the ratio of marginal utility. i.e.of marginal utility. i.e.

PY/PX = substitution ratio = MUY/MUX orPY/PX = substitution ratio = MUY/MUX orIn equilibrium, the consumer is getting the same In equilibrium, the consumer is getting the same

marginal utility from the last coin spent on Good X on marginal utility from the last coin spent on Good X on the last coin spent on Good Ythe last coin spent on Good Y

Law of SubstitutionLaw of SubstitutionICs are drawn as bowl-shaped or convex to the origin, how ever, ICs are drawn as bowl-shaped or convex to the origin, how ever,

as we move down ward and to the right…..a movement that as we move down ward and to the right…..a movement that implies increasing the QX and Decreasing QY.implies increasing the QX and Decreasing QY.

The curve drawn in a way to illustrate a property which we call “ The curve drawn in a way to illustrate a property which we call “ Law of Substitution”.Law of Substitution”.

Find the slope of resulting line (neglecting its negative sign) has a Find the slope of resulting line (neglecting its negative sign) has a values of substitution ratio or some called itvalues of substitution ratio or some called it

MARGINAL RATE OF SUBSTITUTION.MARGINAL RATE OF SUBSTITUTION.MRS = ▲Y/ ▲X between two goods.MRS = ▲Y/ ▲X between two goods.As the size of movement along the curve becomes very small, the As the size of movement along the curve becomes very small, the

chooser the substitution ratio comes to the actual slope of the chooser the substitution ratio comes to the actual slope of the IC.IC.

The slope of IC if the measure of the goods “relative marginal The slope of IC if the measure of the goods “relative marginal utilities”utilities”

An IC that is convex to origin conforms to the law of substitution.An IC that is convex to origin conforms to the law of substitution.

Substitution EffectSubstitution EffectOn the basis of method of compensating variation, the On the basis of method of compensating variation, the

substitution effect measures the effect of the change substitution effect measures the effect of the change in relative prices, with income (nominal) constant.in relative prices, with income (nominal) constant.

It is assumed that when the price of food falls Y It is assumed that when the price of food falls Y becomes relatively dearer. The increase in the real becomes relatively dearer. The increase in the real income of consumer, as a result of the fall in the income of consumer, as a result of the fall in the prices of good X. There is no change in his nominal prices of good X. There is no change in his nominal income, he is neither better off nor worse off.income, he is neither better off nor worse off.

Key Points.Key Points.1.1. Nominal Income unchanged.Nominal Income unchanged.2.2. Price of commodity changes.Price of commodity changes.3.3. Real income changes.Real income changes.This is called Substitution effect.This is called Substitution effect.

Substitution EffectSubstitution Effect

X2

X1

Eb

I3

I2

xa

Ea

The new optimum on I3 is at Ec. The

movement from Ea to Ec is the

substitution effect

Ec

xc

Substitution Effect

Income EffectIncome Effect

Assume first that the consumer’s daily income (Nomianl Assume first that the consumer’s daily income (Nomianl income or money Income) is halved while prices of two income or money Income) is halved while prices of two commodities remain unchanged.commodities remain unchanged.

We should find that new budget line occupies the positon. We should find that new budget line occupies the positon. The line has made a parallel shift inward. The The line has made a parallel shift inward. The consumer now free to move along this new (and lower) consumer now free to move along this new (and lower) budget line to maximize his satisfactionbudget line to maximize his satisfaction

Key Points.Key Points.1.1. Nominal Income Changes.Nominal Income Changes.2.2. Prices of commodities remain unchange.Prices of commodities remain unchange.This is called “ Income effect”. This is called “ Income effect”.

Income EffectIncome Effect

X2

X1

Eb

I3

I2Ea

The remainder of the total price effect is the Income Effect.

The movement from Ec to Eb.

Ec

xc

Income Effect

xb

Price EffectPrice Effect

Now again return of our consumer to his previous Now again return of our consumer to his previous dally income. But assume that price of good X dally income. But assume that price of good X rises while the prices of good Y is unchanged.rises while the prices of good Y is unchanged.

We must examine the budget line changes its We must examine the budget line changes its position from one end. It has pivoted on point I position from one end. It has pivoted on point I and rotate from I to I’’ is called price effect.and rotate from I to I’’ is called price effect.

Key PointsKey Points1.1. Nominal Income remain unchanged.Nominal Income remain unchanged.2.2. Price of one commodity unchanged.Price of one commodity unchanged.3.3. Price of other commodity changes.Price of other commodity changes.4.4. Real income changes.Real income changes.

Price EffectPrice Effect

y

X

Eb

I1

I2

xa xb

Ea

The new optimum is Eb on I2.

The Total Price Effect is xa to xb

Price Effect