Utility AnalysisThe most important tools for economics are-

•Utility analysis

•Demand

•Supply analysis

Price

•Price for a product depends on the demand for and supply of it

Theory of Demand –

It is the need for goods and the factors that determine the need like income, price of related goods etc.

Dₔ = f(Pₔ, I, Pₓ, Pₑ )

D = demand for a good a

Pₔ= Price of good a

I = Income of individual

Pₓ, Pₑ = prices of related goods

Income and Wealth

• Income is the sum of all households wages, salaries, profits, interest payments, rents, and other forms of earnings in a given period of time. It is a flowmeasure

• Wealth, or net worth, is the total value of what a household owns minus what it owes. It is a stockmeasure

Related Goods and Services• Normal Goods are goods for which demand goes up when

income is higher and for which demand goes down when income is lower.

• Inferior Goods are goods for which demand falls when income rises

• Substitutes are goods that can serve as replacements for one another; when the price of one increases, demand for the other goes up. Perfect substitutes are identical products.

• Complements are goods that “go together”; a decrease in the price of one results in an increase in demand for the other, and vice versa.

Supply and Demand• Demand curve

– When the price of a product is high, consumers don’t buy much of it

– When the price of a product drops, consumers are willing to buy more

– Thus the demand curve slopes downward

Supply and Demand

• Supply curve

– If a product sells at a low price, producers make little of it

– As the price rises, producers are willing to make more of the product

– The supply curve thus slopes upward

Supply and Demand

• Price reaches an equilibrium at the intersection of the supply curve and the demand curve.

• If price is higher than this point:– Producers will want to

produce more

– Customers will want to pay less

– Thus price drops back to equilibrium

Supply and Demand

• Consumers are pursuing their own best interest

• Producers are pursuing their own best interest

• “Invisible Hand” matches supply with demand

– Adam Smith

Supply and Demand

• Works for

– Individual consumers and producers

– Aggregate of all consumers and all producers

• Aggregate Supply

• Aggregate Demand

Shift in Demand Curve • Demand curve may shift to the left

– Not willing to pay as much

– Thus price drops

– Due to drop in income

• Demand curve may shift to the right

– willing to pay more for product

– Due to:

• Increased population

• Increased income

• Changes in taste

Demand curve shift to the left

Shift in Supply Curve

• If it becomes easier to produce a product, supply curve will shift to right

– More farmland

– More children for labor

– Fertilizer available

– Water available

– Technology available

• Price drops

Supply curve shifts down

The Basic Decision-Making Units

• A firm is an organization that transforms resources (inputs) into products (outputs). Firms are the primary producing units in a market economy.

• An entrepreneur is a person who organizes, manages, and assumes the risks of a firm, taking a new idea or a new product and turning it into a successful business.

• Households are the consuming units in an economy.

The Circular Flow of Economic Activity

• The circular flow of economic activity shows the connections between firms and households in input and output markets

• Output, or product, markets are the markets in which goods and services are exchanged.

• Input markets are the markets in which resources—labor, capital, and land—used to produce products, are exchanged.

Payments flow in the opposite direction as

the physical flow of resources, goods, and

services (counterclockwise

Input Markets

Input markets include:

• The labor market, in which households supply work for wages to firms that demand labor.

• The capital market, in which households supply their savings, for interest or for claims to future profits, to firms that demand funds to buy capital goods.

• The land market, in which households supply land or other real property in exchange for rent.

Determinants of Household Demand

A household’s decision about the quantity of a particular output to demand depends on:

• The price of the product in question.

• The income available to the household.

• The household’s amount of accumulated wealth.

• The prices of related products available to the household.

• The household’s tastes and preferences.

• The household’s expectations about future income, wealth, and prices.

Quantity Demanded

Quantity demanded is the amount (number of units) of a product that a household would buy in a given time period if it could buy all it wanted at the current market price

Demand Schedule & demand Curve

Demand schedule

• A demand schedule is a table showing how much of a given product a household would be willing to buy at different prices.

• Demand curves are usually derived from demand schedules

The Demand Curve• The demand curve is a graph

illustrating how much of a given product a household would be willing to buy at different prices

Price

Demand Curve

0

Quantity Demanded

Other Properties of Demand Curves

• Demand curves intersect the quantity (X)-axis, as a result of time limitations and diminishing marginal utility.

• Demand curves intersect the (Y)-axis, as a result of limited incomes and wealth.

The Law of Demand

Price

P => Q

P => Q

7

3

2 8 Quantity Demanded

• The law of demand states that there is a negative, or inverse, relationship between price and the quantity of a good demanded and its price.

• This means that demand curves slope downward.

Assumptions of Demand Law

• Income of buyer stays same

• Taste of buyer is same

• Prices of compliments and substitutes remain same

• No close substitutes found

Limitations of Demand Law

• Change in habit, customs and income

• Necessities of life

• Fear of future shortage

• Fear of future price rise

• Distinct articles

• Giffen Goods

• Ignorance

Price Elasticity of demandDegree of responsiveness of quantity demanded of a good due to price

change

Price elasticity of demand =>

=> proportionate change in quantity demanded

proportionate change in price

=> ΔQ x P

ΔP Q

Types-• Perfectly elastic demand

• Perfectly inelastic demand

• Unitary elastic demand

• Relative elastic demand

• Relative inelastic demand

Arc Elasticity of Demand

The price elasticity of demand at a point

=> Resultant change in quantity demanded are infinitely small

=> e(p) = ΔQ X P

ΔP Q

Income elasticity of Demand=> proportionate change in quantity demanded

proportionate change in income

Income elasticity of Demand=> % change in quantity demanded of Y

% change in price of X

=> ΔQx X Py

Qx ΔPy

Law of Marginal Utility Analysis

Assumptions-

• Cardinal Concept- it is measurable and quantifiable

example- utility derived from consumption from 20 units of good A and 40 units of good B

• Constancy of Marginal Utility of Money- The utility of commodities may vary but marginal utility of money remains constant. If money as unit of measurement varies then it cannot yield the correct measurement of utility.

• Introspective Method- An individual tires to understand the how other people’s mind works under certain circumstances.

Marginal Utility

Law of Diminishing Marginal Utility states that-

The additional benefit derived from a given increase in stock of things diminishes with every increase in stock that he already has- Marshall

Assumptions-

• Total wants of humans are virtually unlimited and satiable

• Different goods are not perfect substitutes for each other in satisfaction of various particular wants

Marginal Utility

Principal of Equi-marginal utility-

A person with fixed income has to allocate funds between different goods and services

Assumptions-

• Consumer is rational

• Decisions are based on marginal utilities of goods and services

• Prices of different goods

Deductions

• Demand is inversely proportionate to price

• This identifies the downward sloping demand curve

• Marginal utility of money is never 0 or negative

• When a consumer is in equilibrium, he/she derives maximum utility in spending a certain fixed sum for different goods

• When any factor changes, it will lead to shift in demand for products

Shift of Demand Versus Movement Along a Demand Curve

P

price falls when

demand rises

P₂

DB

P₁

DA

0

Q ₁ Q ₂ Q

• A change in demand is not the same as a change in quantity demanded

• In this example, a higher price causes lower quantity demanded.

• Changes in determinants of demand, other than price, cause a change in demand, or a shift of the entire demand curve, from DA

to DB.

A Change in Demand Versus a Change in Quantity Demanded

P

P₁

P₂

Qₔ Qₑ

0 Qₔ₁ Qₔ₂ Qₑ₁ qₑ₂ Q

When demand shifts to the right, demand increases. This causes quantity demanded to be greater than it was prior to the shift, for each and every price level.

Deductions

• Change in income, preferences, orprices of other goods or services

leads to Change in demand

=> (Shift of curve).

• Change in price of a good or service

leads to Change in quantity demanded

=> (Movement along the curve).

The Impact of a Change in Income• Higher income decreases the demand for an inferior good

• Higher income increases the demand for a normal good

The Impact of a Change in the Price of Related Goods• Demand for complement good (ketchup) shifts left

• Demand for substitute good (chicken) shifts right

Example-

Price of hamburger rises=> Quantity of hamburger demanded falls

From Household to Market Demand

• Demand for a good or service can be defined for an individual household, or for a group of households that make up a market.

• Market demand is the sum of all the quantities of a good or service demanded per period by all the households buying in the market for that good or service.

Supply in Output Markets

• A supply schedule is a table showing how much of a product firms will supply at different prices.

• Quantity supplied represents the number of units of a product that a firm would be willing and able to offer for sale at a particular price during a given time period.

The Supply Curve and the Supply Schedule

• A supply curve is a graph illustrating how much of a product a firm will supply at different prices

• The law of supply states that there is a positive relationship between price and quantity of a good supplied.

• This means that supply curves typically have a positive slope.

P P Q

S

P2

P1

0 Q1 Q2 Q

Determinants of Supply

• The price of the good or service

• The cost of producing the good, which in turn depends on:

– The price of required inputs (labor, capital, and land),

– The technologies that can be used to produce the product,

• The prices of related products.

A Change in Supply Versus a Change in Quantity Supplied

• A change in supply is not the same as a change in quantity supplied

• In this example, a higher price causes higher quantity supplied, and a move along the demand curve

• In this example, changes in determinants of supply, other than price, cause an increase in supply, or a shift of the entire supply curve, from SA to SB.

• When supply shifts to the right, supply increases. This causes quantity supplied to be greater than it was prior to the shift, for each and every price level.

P SA

SB

P₂

P₁

0 Q

QA₁ QB₁ QA₂ QB₂

Deductions

• Change in price of a good or service

leads to change in quantity supplied

=> Movement along the curve

• Change in costs, input prices, technology, or prices of related goods and services leads to change in supply

=> Shift of curve

From Individual Supply to Market Supply

• The supply of a good or service can be defined for an individual firm, or for a group of firms that make up a market or an industry.

• Market supply is the sum of all the quantities of a good or service supplied per period by all the firms selling in the market for that good or service.

• As with market demand, market supply is the horizontal summation of individual firms’ supply curves.

Market Equilibrium

• The operation of the market depends on the interaction between buyers and sellers.

• An equilibrium is the condition that exists when quantity supplied and quantity demanded are equal.

• At equilibrium, there is no tendency for the market price to change.

Market Disequilibria

• Excess supply, or surplus, is the condition that exists when quantity supplied exceeds quantity demanded at the current price.

• When quantity supplied exceeds quantity demanded, price tends to fall until equilibrium is restored.

P

S

P2

P1

D

0 Q

Q1 Qₑ Q2

Increases in Demand and Supply

• Higher demand leads to higher equilibrium price and higher equilibrium quantity.

• Higher supply leads to lower equilibrium price and higher equilibrium quantity

P D2 S

D1

P2

P1

0 Q1 Q2 Q

P S1 S2

P1

P2

D

0

Q1 Q2 Q

Decreases in Demand and Supply

• Lower demand leads to lower price and lower quantity exchanged

• Lower supply leads to higher price and lower quantity exchanged

P S

P1

P2

D1

D2

0

Q2 Q1 Q

P

D S2

P2 S1

P1

0 Q2 Q1 Q

Relative Magnitudes of Change

• When supply and demand both increase, quantity will increase, but price may go up or down

Q = Quantity

P = Price

• The relative magnitudes of change in supply and demand determine the outcome of market equilibrium

S = Supply

D = Demand