Micro Economics

• Consumer Behaviour • Demand • Supply • Different Markets

Micro Economics : ‘mikros ’(small) • Micro Economics is the study of particular firms, particular

households, individual price ,wages ,income, individual industries and particular commodities.

Area of Study : • Consumer Behaviour.

• Product Pricing

• Factor pricing

• Economic conditions of a section of the people

• Study of Firms

• Location of Industry.

Central Economic Problems : • Human wants are unlimited but the resources, raw

materials and capital goods necessary to satisfy those wants are scare.

• What to Produce ?

Eg: How much Wheat ? How many schools? How many machines? How many meters of cloth?

How to produce ? • Eg . Cotton

• Handloom-Labour Intensive Techniques. • Powerlooms-Capital Intensive Techniques.

Whom to Produce ? • The society cannot satisfy all wants of all the people. • How to distribute resources among the different sections.

Factors Of Production : • Land • Labour • Capital • Entrepreneurship

Production Possibilities Curve (PPC): The Production Possibilities Curve (PPC) or “transformative curve” is a graph that shows the different rates of production of two goods that an individual of group can efficiently produce with limited resources.

• Opportunity cost of a choice is the value of the best alternative forgone, in a situation in which a choice needs to be made between several mutually exclusive alternatives given limited resources.

Assumptions : • There is a given amount of productive resource and they

remain fixed.

• Resources are neither unemployed nor underemployed.

• Technology does not change .

• Shape of PPC is Concave to the Origin .

• Opportunity cost goes on increasing as we have more of cloth and less of wheat .

• If the opportunity costs were constant ,PPC would be a straight line. But generally we get increasing opportunity costs.

• This is because a resource is suitable for the production of one good than the other .

Economic Growth and shift in Production Possibility Curve :

Theory of Demand and Supply: Demand : It refers to the quantity of good or service that consumers are willing and able to purchase at various prices during a period of time. It needs : Desire ,Purchasing Power and the willing ness to purchase. Factors affecting Demand : • Price of commodity: Other things being equal demand of a

commodity is inversely proportional to the Price. • Price of related commodities : Complementary goods . Eg:Tea&sugar,automobiles and petrol Substitution goods .eg: Tea and coffee

• Level of House hold income: • Normal goods are any goods for which demand increases

when income increases, and falls when income decreases but price remains constant.

• an Inferior good is a good that decreases in demand when consumer income rises (or rises in demand when consumer income decreases

• Tastes and preferences of consumers : Eg Color TV-replacing Black and white . Demonstration effect : Copying others . Replacing a good even when it is full filling the utility.

• Law of Demand : • The law states that, all else being equal, as the price of a

product increases, quantity demanded falls; likewise, as the price of a product decreases, quantity demanded increases.

Rational for Law of Demand : • Law of Diminishing Marginal Utility • Substitution effect • Income effect • Arrival of New consumers • Different uses

• Exceptions to the law of Demand :

• Conspicuous goods : eg. Diamond • Giffen goods : eg. Britian : increase in consumption of bread Generally those goods that are considered inferior by consumers and which occupy a substantial place in their budget are Giffen goods. • Conspicuous necessities : Demand for the goods is affected by

the demonstration affect. Eg : TV,Fridge etc

• Future expectations about prices : Onion ,

• Demand for necessities : Salt ,rice etc

• Speculative Goods : Shares

Expansion and Contraction of Demand : When other things remain constant. • Income. • Tastes • Propensity to consume. • Price of related commodities.

What happens if there is change in consumers : • Income. • Tastes • Propensity to consume. • Price of related commodities.

Right Shift of demand curve : When more is demanded at each price ,can be caused by rise in income ,rise in price of substitute ,fall in price of a complement increase in population etc. Leftward shift in the demand curve : When less is demanded at each price can be caused by a fall in income ,a fall in the price of substitute ,a rise in the price of a complement , a decrease in population.

Movement along demand curve vs shift of curve: • Increase or decrease in demand : it refers to the shift in whole

curve which may happen due to any of the factors which were assumed to be remain constant .

• Change in Demand

• Change in Quantity Demanded : It means that movement is upwards or downwards the curve.

Elasticity of Demand :Elasticity of demand is define as the responsiveness of the quantity of a good to changes in one of the variables on which demand depends or we can say that it is the percentage change in quantity demanded by the percentage in one of the variables on which demand depends . Price Elasticity : It expresses the response of quantity demanded of a good to a change in price, given consumers income, his tastes and prices of all other goods.

Interpretations of different values of Elasticity : The numerical value of elasticity can range between 0 to Infinity. • Elasticity is zero when there is no change in demand with change

in price .

• Elasticity is one when percentage change in demand is same as percentage change in price.

• Elasticity is greater than one if the change in quantity demanded is more than change in price on a percentage basis. (Demand is elastic)

• Elasticity is less than one when the percentage change in quantity is demanded is less than the percentage change in price(Inelastic Demand.)

Determinants of Price elasticity of Demand : • Availability of Substitutes. Coca-cola –Pepsi(elastic), Common salt (in-elastic)

• Position of commodity in a consumers budget. Demand for common salt,matches is inelastic (very less spending) Clothes (elastic) etc • Nature of a need that a commodity satisfies. eg : Luxury Goods(elastic) ,necessities (inelastic )

• Number of uses to which it can be put use to eg Milk (Multiple uses when prices decreases multiple uses ,price when it increases restricted use. )

• Consumer habits. Taste

Income Elasticity of Demand :

Cross Elasticity : Substitute goods : the cross demand curve slopes upwards(i.e positive )showing that more quantities of commodity will be demanded whenever there is price rise of substitute commodity.

Complementary goods : Change in the price of a good will have an opposite reaction on demand for the other commodity which is closely related.

Demand distinctions : • Producers goods and Consumer Goods : Machines vs Final goods • Durable and Non Durable Goods : Milk vs Bike • Derived and Autonomous demand : Bluetooth device vs Smart phone • Industry and Company demand :

• Short run and Long run Demand : In the short run the demand depends on price change(elasticity) in the long run it stabilizes . Eg Electric users response to increase in price.

Theory of Consumer Behaviour : • In Economics we call the desires, tastes and motives of human beings

as wants .

• Wants of Human beings have some characteristics features : • Wants are unlimited • Every want is satiable • Wants are competitive • Wants are complementary • Wants are alternative • Wants may vary with time, space and person. • Some wants recur again • Wants are influenced by advertisements • Wants become habits and customs.

Classification of wants : Necessaries : These are essential for living and must be satisfied. Comforts : These are the goods that are not essential for living but are required for happy living . Luxuries : These are those wants that are superfluous and expensive . Utility : when will a consumer buy something ? Utility is the want satisfying power of a commodity . It is Subjective and varies from person to person . Utility is different from usefulness .eg Alcohol

Utility hypothesis forms the basis for the theory of Consumers behaviour . • Marginal Utility Analysis propounded-A.H .Marshall.

• Indifference Curve Analysis propounded -Hicks and Allen.

• Marginal Utility Analysis :

• How a Consumer spends his income on different goods and

services so as to attain maximum satisfaction.

Marginal Utility Analysis : Total Utility: It is the sum of the utility derived from an different units of a commodity consumed by a consumer . Total Utility = the sum total of all marginal utility Marginal Utility : It is the additional Utility derived from additional unit of a commodity . Marginal utility =the addition made to the total utility by the additional of consumption of one unit of a commodity.

Assumptions of marginal utility Analysis : • The cardinal Measurability of Utility : utility can be measurable

and quantifiable entity (cardinal ).

• Constancy of the Marginal Utility of Money : The Marginal utility of money is constant throughout .

• The Hypothesis if Independent Utility: The total utility which a person gets from the whole collection of goods purchased by him is simply the sum total of the separate utilities of the goods.

The Law of Diminishing Utility : • The law of diminishing marginal utility is based on an important fact

that while total wants of a person are virtually unlimited ,each single want is satiable .

• Each want is satiable the consumer consumes more than and more units of a good ,the intensity of his wants for the good goes on decreasing and a point is reached where the consumer no longer wants it .

Conclusions : • When the Total Utility rises the maximum utility diminishes . • When the total utility is maximum then the marginal utility is zero. • When the total utility is diminishing then the marginal utility is

negative.

Limitations of the Law : • Homogenous units : the different units consumed should be

identical in all respects .The habit ,taste, treatment and income of the consumer also remain unchanged .

• Standard unit of Consumption : the different units consumed should consist of standard units.If a thirsty man is given water by successive spoonfuls,the utility of second spoonful may conceivably be greater than the utility of the first.

• Element Concept : There should be no time gap or interval between the consumption of one unit and another unit i.e. there should be continuous consumption.

• Law fails for prestigious goods : The Law may not apply to articles like gold,cash, where a greater quantity may increase the lust for it .

• Case of related goods : The shape of the utility curve may be affected by the presence or absence of articles which are substitutes or complements .The Utility obtained from tea may be seriously affected if no sugar is available.

• Consumer Surplus : What a consumer is ready to pay –What he actually pays.

Indifference Curve Analysis : • Consumer behaviour is based on Consumer Preferences.

• Human satisfaction being a psychological phenomena cannot be

measured quantitatively in monetary terms . Assumptions Underlying Indifference Curve Approach : • The Consumer is rational and possesses full information about all the

relevant aspects of economic environment in which he lives.

• The consumer is capable of ranking all conceivable combinations of goods according to the satisfaction they yield. Thus if he is given various combinations say A,B,C,D,E can rank them as first preference ,second preference and so on. If a consumer happens to prefer A to B ,he can not tell quantitatively how much he prefers A to B

Ordinal Analysis : Hicks and Allen An Indifference curve is a curve which represents all those combinations of goods which give same satisfaction to the consumer . Since all the combinations provide same level of satisfaction the consumer prefers them equally and does not mind which combination he gets .

Iso utility Curve :

Indifference Curves :

Properties of Indifference curves : • Indifference curves slope downward to the right • Indifference curves are always convex to the origin. • Indifference curves can never intersect each other. • Higher Indifference curve represents higher level of satisfaction.

Indifference Curves :

• The indifference curve will not touch the axis .

Budget Line :

Consumer Equilibrium : • Assumptions : the consumer has a given indifference map which shows

his scale of preference for various combinations of two goods X and Y . • He has a fixed money income which he has to spend wholly on goods X

and Y .

• Prices of goods X and Y are given and are fixed for him.

• All goods are homogenous and divisible.

• The Consumer acts rationally and maximized his satisfaction .

Theory of Demand and Supply : Supply : The term supply refers to the amount of a good or service that the producers are willing and able to offer to the market at various prices during a period of time . Determinants of Supply : Price of the Good : The higher the price of a good the higher the supply (cost is directly related to profits). Price of Related Goods :If the price of other goods rises then ,the supply of the considered good will reduce . eg : Rice and Pulses/Coarse Seeds. Price of factors of production : eg. Rise of land price will affect Wheat and Automobile production differently.

State of technology : As technology improves ,the efficient utilisation of goods results in increased supply for the same amount of factors of production. Government Policy : Taxes, Subsidies and other price policies can also affect the supply. Law of Supply :Other things remaining same the Quantity of a good produced and offered for sale will increase as the price of the goods rises and decreases as the price falls .

Shift in Supply curve : When the supply increases due to reasons other than increase in price

Movement on the supply curve: When the supply of a good increase a result of an increase in it price we say that there is an increase in the quantity supplied and there is an upward movement on the supply curve.

Elasticity of Supply :It is defined as the Elasticity of a quantity supplied of a good to a change in its price.

Type of elasticity if Supply :

Perfectly Inelastic Supply : If as a result of change in price ,the quantity supplied of a good remain unchanged , we say that elasticity of supply is zero or perfectly in elastic supply.

Relatively less Elastic Supply : In response to Change in the price of a good the supply changes less proportionately .

Relatively greater- Elastic Supply : If elasticity of supply is greater than one .

Unit-Elastic : If the relative change in the quantity supplied is exactly equal to the relative change in the price ,the supply is said to be unitary elastic .

Perfectly elastic supply : When nothing is supplied at lower price but a small increase in price causes supply to rise from zero to an indefinitely large amount .

Equilibrium Price : Equilibrium refers to a market situation where quantity demanded is equal to quantity supplied .The quantity of demand and supply determines the equilibrium price

Theory of Production and cost : Production : In Economics , by production we mean the process by which man utilises or converts the resources of nature working up on them so as to make them satisfy human needs . • Satisfying power of human needs is called utility .

• Production can be defined as creation or addition of utility .

• The Money expenses incurred in the process of production i.e

transforming resources into finished product constitutes the cost of production .

Factors of Production : Land , labour, Capital and Entrepreneurial ability . Production function : Production function states the relationship between inputs and output i.e the maximum amount of output that can be produced with given quantities under given state of technical knowledge. Total Product : Total product is the total output resulting from the efforts of all the factors of production combined at any time . Average Product : Average product is the total per unit of the variable factor . Marginal Product : Marginal product is the change in total product per unit change in the quantity of variable product .

Relationship Between Average product and Marginal Product : • When average product rises as a result of an increase in the quantity

of variable input marginal product is more than average product . • When the average product is maximum ,marginal product is equal to

average product .so marginal product cuts the average product curve at its maximum.

• When the average product falls as a result of a decrease in the quantity of variable input ,marginal product is less than the average product .

Law of Diminishing Returns : Short Run Equilibrium • The Marginal Product of each unit of input will decline as the

amount of that output increases ,holding all other inputs constant .

• The Behaviour of output when the varying quantity of one factor is combined with a fixed quantity of the others can be divided in to three distinct stages .

Stage1: Law Of increasing Returns : Total product increases at an increasing rate up to a point . Marginal product also rises ,Average product also rises . This happens because fixed factors are more intensively and efficiently utilised .

Stage2:Law of diminishing returns : Total product continues to increase at a diminishing rate until it reaches maximum point at H . It is called diminishing returns because both the average and marginal products of the variable factors continuously fall during this stage . This happens because the fixed factor then becomes inadequate relative to the quantity of the variable factor . 3)Law of Negative returns : Total product declines, MP is negative, average product is diminishing . This stage is called the stage of negative returns since the marginal product of variable factor is negative . A Rational Producer will always produce in stage 2.

Returns to scale : A change in scale means all the factors of production are changing are increased or decreased in the same proportion. Constant returns to scale : It means that that with the increase in the scale in some proportion ,output increase in the same proportion. Increasing returns to scale : Increasing returns to scale means that output increases in a greater proportion than the increase in inputs. Decreasing returns to scale : When the output increases in smaller proportion with an increase in all inputs ,decreasing returns to scale operate.

Economies and Diseconomies of Scale : Internal Economies : • Technical economies and diseconomies . Big machines • Managerial economies and diseconomies . Division of Labour • Commercial economies and diseconomies. Bulk orders • Financial economies and diseconomies. Easy finance • Risk bearing economies and diseconomies .

External Economies and Diseconomies : • Cheap raw materials and capital equipment. • Technological external economies. • Development of skilled labour. • Growth of ancillary industries .

Cost analysis : It refers to study of behaviour of cost in relation to one or more production criteria : • Size of output • Scale of operations • Prices of factors of production etc.

Accounting costs: the prices he pays for the factor which are employed for production . Eg: wages , prices of raw materials ,interest on money . Economic Costs for a firm are : • Normal return on money capital invested by the entrepreneur himself

in his own business. • The wages or salary not paid to the entrepreneur ,if he could have

offered his services some where else .

Outlay costs and opportunity costs : Outlay costs :involve actual expenditure of funds on wages, rent , material, interest etc. Opportunity costs : Opportunity costs related to sacrificed alternatives . Fixed Costs and variable costs : These are not a function of output, they do not vary with output up to a certain level of activity. Eg: rent, property taxes, interest on loans . Variable costs : These are costs that are function of output in the production period. Eg wages and cost of raw materials .

Short run total costs : Total Fixed Cost :

Total variable costs :

Cost Function :

Short run Total Cost Curves :

Short run average cost : When at least one variable is constant Average fixed cost (AFC): Average variable Cost (AVC): Average Total cost (ATC): Marginal Cost (MC):

Relationship between Average Cost and Marginal cost : • When the average cost falls as a result of an increase in output ,marginal

cost is less than average cost. • When the average cost rises as result of an increase in output ,marginal

costs is more than average cost .

• When average cost is minimum ,marginal cost is equal to the average cost .when the marginal cost curve cuts average cost curve at its minimum point.

Long run Average Cost Curve and Short run average cost curve :

Changes in Demand and Supply :

• Increase in demand :

Decrease in demand :

Increase in Supply :

Decrease in Supply :

Simultaneous change in demand and supply :

Price Determination in Different Markets : Market : We can define market simply as all those buyers and sellers of a good or service who influence the price . Classification of a Market : Area : • Local Market : • Regional Market : • National market : • International Market : Time : (Alfred Marshall) • Very Short period market : Perishable commodities. • Short period market : At least one factor of production is constant. • Long period market : All factors of production are variable • Very long period

Nature of Transactions • Spot Market • Future market

On the basis of regulation • Regulated market • Unregulated Market

Volume of Business • Whole sale market • Retail Market

Competition • Perfectly Competitive • Imperfect Competition

Perfect Competition : Perfect competition is characterised by many sellers selling identical products to many buyers. Monopolistic Competition : It differs in only one respect ,there are many sellers offering products to many buyers. Monopoly :It is a situation of a single seller producing for many buyers. Its product is necessarily extremely differentiated since there are no competing sellers producing near substitute products.

Oligopoly : There are few sellers completing products for many buyers .

Assumption Market Types

Pure Competition

Monopolistic Competition

Oligopoly Monopoly

Number of sellers

Many Many A few One

Product Differentiation

none slight None to substantial

Extreme

Price Elasticity of Demand for a firm

Infinite Large Small Small

Degree of Control over Price

None Some Some Considerable

Perfect Competition : Characteristics : • There are a large number of buyers and sellers who compete among

themselves and their number is so large that no buyer or seller is in a position to influence the demand and supply in the market .

• The commodity is homogenous in the sense that the goods produced by different firms are identical in nature.

• Every firm is free to enter and move out.

• There is perfect knowledge ,on the part of buyers and sellers .

• Price Takers : All the suppliers have to sell them at a uniform price or same price.

• Monopoly : means “alone to sell ”

• There is only single seller, in practise we don’t find pure monopoly ,but public utilities like transport, water and electricity we find monopoly .

Features : • Single Seller of the product. • Restrictions to entry. • No close substitutes ,so cross elasticity is zero and price elasticity is less

than one .

Price Discrimination : • Price discrimination is a method of pricing adopted by the monopolist

in order to earn abnormal profit .it refers to the practices of charging different prices for the different unit of the same commodity.

• Eg : Railways separate high-value or relativlely small-bulk commodities which cab bear higher freight charges from other categories of goods

Imperfect Competition : Rexona,,Hamam,Dettol,,Liril, Pears,Lifebuoy Plus,Dove . Lux : Beauty Soap. Liril : Freshness. Dettol : Antiseptic Dove : Young smooth skin Features of Monopolistic Competition : • Large number of seller who have a small market. • Product differentiation . • Freedom of entry or exit . • Non-Price Competition. Here the firms try to compete on basis other than price for eg: advertising ,product development, better distribution arrangements .

Oligopoly : Competition among few Types of Oligopoly : • Pure Oligopoly: Product is homogenous in nature. Eg : Aluminium

• Open and closed Oligopoly : In open Oligopoly new firms can enter

market and compete with the existing firms .but in closed oligopoly entry is restricted.

• Collusive and Competitive oligopoly : When few firms of the oligopolist market come to a common understanding or act in collusion with each other in fixing price and output. Eg Cement

Characteristics of Oligopoly Market: • Interdependence : There is interdependence in decision making of the

firms which comprise the industry . An Oligopolistic firm must consider not only the market demand but also the reactions of other firms in the industry to any major decision it takes .

• Importance of advertising and selling costs :

• No price cutting but depend on aggressive marketing and various defensive measures to gain greater share in the market .

• Group behaviour : Each oligopolist closely watches the business behaviour of the other oligopolist in the industry and designs his moves on the basis of some assumptions of how they behave or likely to behave .

• Game Theory :” Prisoner Dilemma” .

Price and output decisions in an oligopolistic market : • Demand curve is difficult to predict as it depends on the behaviour of the

competitor .

• Kinked Demand Curve : Sweezy Model .

• In oligopoly prices remain same though the costs come down .

• If the firm reduces the price the competitors will reduce the price hence no much change in the product sold.

• If the firm increase the price the competitor may not increase the price hence a large change in product sold will be observed.

Form of market Structure

Number of Firms

Nature of Product

Price Elasticity of Demand of a firm

Degree of control over price

Perfect Competition

Large Number of firms

Homogeneous Infinite None

Monopoly One Unique Product without close substitute

Small Very Considerable

Imperfect competition

• Monopolistic Competition

Large number of firms

Differentiated Products

large some

• Oligopoly Few firms Homogeneous or Differentiated products

Small Some