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Unit-1 Introduction Introduction to Microeconomics The term micro is derived from the Greek word ‘mikros’, which means ‘small’. Microeconomics thus deals with the study of small components of the economy or individual i.e. studies the economic behavior of individual units, maybe a person, a particular household, or a particular firm. In this sense, introduction to microeconomics is referred to as a microscopic study of the economy. Basic Concepts of Microeconomics The study of microeconomics involves several key concepts, including (but not limited to): 1.Incentives and behaviors: How people, as individuals or in firms, react to the situations with which they are confronted. 2.Utility theory: Consumers will choose to purchase and consume a combination of goods that will maximize their happiness or “utility,” subject to the constraint of how much income they have available to spend. 3.Production theory: This is the study of production—or the process of converting inputs into outputs. Producers seek to choose the combination of inputs and methods of combining them that will minimize cost in order to maximize their profits. 4.Price theory: Utility and production theory interact to produce the theory of supply and demand, which determine prices in a competitive market. In a perfectly competitive market, it concludes that the price demanded by consumers is the same supplied by producers. That results in economic equilibrium. Types of Microeconomics On the basis of analysis, the equilibrium between two variables in microeconomics is divided into three parts as micro statics, comparative and dynamic which are also called types of microeconomics. The types of Microeconomics is explained separately as stated below; • Micro Statics • Comparative Micro Statics and • Micro Dynamics Micro statics is the analysis of one microeconomics equilibrium. It analyzes the economic situation at a point. Suppose, individual demand and supply are two economic variables, their relationship can be explained with the help of the following figure. fig:micro-statics In this figure, the demand curve (D) intersects the supply curve (S) at a point E to determine the price OP and quality OQ at a given time period. This analysis is a static analysis of equilibrium. Comparative Micro Statics compares two or more equilibrium positions without regard to the transitional period and the process involved in the adjustment. It deals with the comparison of two equilibrium positions of the variable. fig: comparative micro statics: The demand curve shift from D to D1 due to the change in the variable of demand function and a new equilibrium is formed at F, which determine the price OP1 and quantity OQ1. The comparison between the values of the variables between E and F position in Comparative Statics. Microdynamics deals with the time path and process of the adjustment itself. It studies the activities of the variable during the time of adjustment from one equilibrium position to another. fig: micro-dynamics This figure shows how the equilibrium is shifted from E to F. It shows the time path and the change position from E to A, B and C to reach F. It also shows how the variables adjust during the movement between two equilibrium positions. Macroeconomics: Macroeconomics is that specialized field of economics which focuses on the overall economy. It works on the aggregate value of the various individual units, to determine its more substantial impact on the whole nation. All the prominent reforms and policies are based on this concept. Scope of Macroeconomics Theory of National Income: It covers the various topics related to the evaluation of national income, including the income, expenditure and budgeting. Theory of Money: Macroeconomics analyzes the functions of the reserve bank in the economy, the inflow and outflow of money, along with its impact on the employment level. Theory of International Trade: It is a field of study that enlightens upon the export and import of goods or services. In brief, it determines the impact of cross-border trade and duty charged, on the economy. Theory of Employment: This stream of macroeconomics helps to figures out the level of unemployment and prevailing employment conditions in the country. Also, to know how it affects the supply, demand, savings, consumption, expenditure behaviour. Theory of General Price Level: The most important of all is the analysis of product pricing and how these price levels fluctuate because of inflation or deflation. Types of Macroeconomics Macroeconomics has been divided into three types. They are: 1.Simple Macro-statics:- Macro-statics deals with the final equilibrium of the economy at a particular point in time. a. Study of one static equilibrium point of the economy. b. Study of the relationship between aggregate economic variables from a still picture point of view. c. Don’t deal with the process of attaining and breaking the equilibrium points. d. Related with a single point of time. Y=C+I Where Y= Total Income, C= Total Consumption, I= Total Investment. Fig: Simple Macro-statics In the figure, the consumption schedule is shown by C and the combined consumption and investment are shown by C+I. The equilibrium point will be attained at E where the equilibrium national income is OY. This equilibrium position will be studied under simple macro-statics. 2. Comparative Macro-Statics a. Comparative macro-statics makes a comparative study between two equilibriums and draw the conclusions. b. Don’t deal with the process of attaining and breaking equilibrium points. Don’t answer the following questions: i. What are the causes responsible for breaking the initial equilibrium point? ii. What are the causes responsible for attaining the final equilibrium point? iii. What is the actual process in between them? Fig: Comparative macro- statics In the figure let, E1 be the initial equilibrium to the economy with equilibrium income (OY1). But if there is an increase in investment, then the initial level of the equilibrium will be disturbed. The new equilibrium is attained at the point E2, where the new level of equilibrium income OY2. Comparative macro-statics studies these two equilibrium positions E1 and E2 and does not talk about the process through which the equilibrium takes place. It states that when aggregate investment increase and increase aggregate in income will be Y. It also implies that OY1 is greater than OY2. 3.Macro-dynamics a. Macro-dynamics studies the lagged relationship between macroeconomic variables. b.Studies the process of breaking and attaining equilibrium points. c. Analyses the macroeconomic variables from the motion picture point of view. d. It involves the analysis of the period of time rather than a point of time. It answers all the following questions: i. What are the causes responsible for breaking the initial equilibrium point? ii. What are the causes responsible for attaining the final equilibrium point? iii. What is the actual process in between them? Fig: Macro-dynamics In the figure, let E be the initial equilibrium and OY be the initial equilibrium income. Now, there is an investment that leads to an increase in aggregate expenditure. The community would increase its expenditure from EY to YA at the OY level of national income. This increase in community expenditure increase the level of aggregate income in the next period at the level of OY1 at this increase new level of income people will spend more on consumption goods and the final (long-run) equilibrium point E1 is attained where the new level of equilibrium income of OY1. Hence the entire process is studied under macro- dynamics. Goals of Macroeconomics 1.High and sustainable economic growth Economic growth is essential to increase people’s income and standard of living. It is usually seen as the most important macroeconomic goal. When economic growth rises, output increases, and so does income. A growing economy shows an increase in economic output. Businesses increase production, recruit more labor and create more income for the household sector. Thus, without economic growth, people will not be able to achieve a better standard of living. They cannot obtain a wide variety of goods and services in large quantities and higher incomes by working. 2.Price stability Price stability is important because the purchasing power of money is maintained. To get the same number of items, you don’t have to spend more nominal money. Price stability requires a low inflation rate. It is not the same as zero inflation. A stable low-moderate inflation rate is often considered ideal. Some economists said it was 2% inflation, as targeted in some countries such as the United States. 3.High rate of employment High rate of Employment is when the economy uses its productive resources, including labor. That doesn’t mean everyone is working. Instead, those who are able and want to have a job can get one. In full employment, the unemployment rate does not equal zero percent due to structural and frictional problems. Some people are unemployed because they do not have sufficient skills as the market demands. 4.Balance of payments equilibrium Balance of payments equilibrium is reached when the foreign currency entering a country is the same as the foreign currency leaving. Foreign currency inflows and outflows originate from the current account and the capital account. In other words, what we spend and invest abroad is nothing more than the spending and investment of foreigners into the domestic economy. Thus, our international reserves do not increase or decrease. Instruments of Macro economics It can be divided into two subsets: a) monetary policy instruments . Monetary policy is conducted by the central bank of a country or of a supranational region . b) fiscal policy instruments Fiscal policy is conducted by the executive and legislative branches of the government and deals with managing a nation’s budget. Unit 2: Elasticity of Demand and Supply What is elasticity of demand ? explain its types Elasticity of demand is defined as the percentage (proportionate) change in quantity demanded of a goods due to the percentage (proportionate) change in the price of the goods, income of the consumer, prices of related goods or other determinants of demand. There are 3 types of elasticity of demand 1. Price elasticity of demand 2. Income elasticity of demand 3. Cross elasticity of demand 1. Price elasticity of demand: Price elasticity of demand is defined as the percentage ( proportionate) change in quantity demanded of a goods due to the percentage (proportionate) change in its price. There are five types / Degrees of Price elasticity of demand: They are: 1. Perfectly elastic demand (Ep =∞) When a negligible increase in price will bring down the demand to zero and a negligible decrease in price will increase the demand to infinity, it is known as the perfectly elastic demand. This type of change in demand is only theoretical and not seen in real life. The perfectly elastic demand can be shown in a table as below: Price in rupees Demand in Kg 10 100 10.01 0 9.99 ∞ In the table when the price is rupees 10, the demand is 100 Kg. When there is a negligible increase in price from rupees 10 to rupees 10.01, the demand decreases to zero and a negligible decrease in price from rupees 10 to 9.99 rupees, the demand increases to infinity. This is a perfectly elastic demand. It can be shown in a diagram as below: In the diagram, DD is the perfectly elastic demand curve which is a horizontal straight line and parallel to X-axis. This means that a negligible increase in price will bring down the demand to zero and a negligible decrease in price will increase the demand to infinity. 2. Perfectly inelastic demand (Ep=0) Whatever increase or decrease in price, the demand remains constant is a perfectly inelastic demand. This can be shown in a table as below: Price in rupees Demand in Kg 10 100 50 100 2 100 In the table, when the price is rupees 10, the demand is 100 Kg. When the price increases to rupees 50, the demand is constant at 100 Kg and when the price decreases to rupees 2, the demand is constant at 100 Kg. This can be shown in a diagram as below: In the diagram, DD is the perfectly inelastic demand curve which is a vertical straight line and parallel to Y-axis. This means that whatever increase or decrease in price of the goods, the demand remains constant. 3. Unitary Elastic demand (Ep=1) When the percentage change in price is equal to the percentage change in demand, it is unitary elastic demand. The change in price is equal to change in demand. This can be shown in a table as below: Price in rupees Demand in Kg 10 200 15 100 In the table the change in price from rupees 10 to rupees 15 is by 50% and the change in demand from 200 Kg to 100 Kg is also by 50%. This is a unitary elastic demand. It can be shown in a diagram as below: In the diagram, DD is the unitary elastic demand curve which has a gentle slope. The decrease in price from P to P0 is equal to the increase in demand from Q to Q0. 4. Relatively elastic demand (Ep˃ 1) When the percentage change in demand is more than the percentage change in price , it is a relatively elastic demand. A small change in price will bring a bigger change in demand. This can be shown in a table as : Price in rupees Demand in Kg 10 200 15 50
In the table the change in price from rupees 10 to rupees is by 50% and the change in demand from 200 Kg to 50 Kg is by 75%. The change in demand is more than the change in price. This is a relatively elastic demand. It can be shown in a diagram as below: In the diagram, DD is the demand curve which has a flat slope. The decrease in demand from Q1 to Q2 is more than the increase in price from P1 to P2. 5. Relatively inelastic demand (Ep˂ 1) When the percentage change in price is more than the percentage change in demand, it is a relatively inelastic demand. A big change in price will bring about a smaller change in demand. It can be shown in a table as: Price in rupees Demand in Kg 10 100 20 50 In the table the increase in price from rupees 10 to rupees 20 is by 100 % and the decrease in demand from 100 Kg to 50 Kg is by 50 %. The change in price is more than the change in demand. This can be shown in a diagram as below: In the diagram, DD is the demand curve which has a steep slope. The increase in price from P1 to P2 is more than the decrease in demand from Q to Q1. 2.Income Elasticity of Demand Income elasticity is defined as the percentage (proportionate) change in quantity demanded due to the percentage (proportionate) change in the income of the consumer. Types of Income Elasticity of Demand 1.Positive income elasticity of demand (Ey˃0): When the demand for a commodity increases with increase in income and decreases with a decrease in income, it is the positive income elasticity of demand. For most goods, the income elasticity is positive. Such goods are called normal goods. It can be explained in a table as : Income in rupees Demand in Kg 5000 10 6000 15 In the table, when the income increases from rupees 5000 to rupees 6000, the demand also increases from 10 Kg to 15 Kg and vice-versa. This is positive income elasticity of demand. It can be shown in a diagram as below: In the diagram, DD is the positively sloping demand curve. When the income of the consumer increases from I to I1, the demand also increases from Q to Q1 and vice –versa. The positive income elasticity of demand can be further divided into three types as: Income elasticity of demand more than unity (Ey˃1) 2.Negative income elasticity of demand (Ey˂0): When the demand for a commodity increases with a decrease in income and decreases with an increase in income, it is negative income elasticity of demand. The income elasticity will be negative in the case of low quality or Giffen goods. It can be explained in a table as below: Income in rupees Demand in Kg 5000 10 6000 5 In the table, when the income increases from rupees 5000 to rupees 6000, the demand decreases from 10 Kg to 5 Kg and vice-versa. This is negative income elasticity of demand. It can be shown in a diagram as below: In the diagram, DD is the negatively sloping demand curve. When the income of the consumer decreases from I to Io, the demand for the commodity increases from Q to Q1. 3.Zero income elasticity of demand (Ey=0): When the demand for a commodity does not change whatever increase or decrease in the income of the consumer, it is the zero income elasticity of demand. This type of elasticity is seen in case of necessity for life goods. It can be explained with a table as below: Income in rupees Demand in Kg 5000 10 10000 10 2000 10 In the table, when the income increases from rupees 5000 to rupees 10,000 or decreases to rupees 2000, the demand remains constant as 10 Kg. This is zero elasticity of demand. It can be shown in a diagram as: In the diagram, DD is a demand curve vertical straight line and parallel to Y-axis. When the income of the consumer increases from I to I1 or decreases to Io, the demand remains constant at OQ. Cross Elasticity of Demand Cross elasticity of demand is defined as the percentage (proportionate) change in quantity demanded of x goods due to percentage (proportionate) change in price of Y goods (X and Y are substitutes or complementary goods). There are two types of cross elasticity of demand: Positive cross elasticity and Negative cross elasticity. 1. Positive cross elasticity of demand: When the X and Y goods are substitutes, the cross elasticity of demand will be positive. The increase in the price of Y good will lead to the increase in the quantity demanded of X good and a decrease in price of Y good will lead to a decrease in demand of X good. For example: When the price of tea(X goods) increases, the demand for coffee(Y goods) also increases and when the price of tea decreases, the demand for coffee also decreases. The positive cross elasticity of demand can be shown in a table as: Price of Y good in rupees Demand for X good in Kg 100 10 150 15 In the table , when the price of Y good increases fro rupees 100 to rupees 150, the demand for X good also increases from 10 Kg to 15 Kg. This is positive cross elasticity of demand. It can be shown in a diagram as: In the diagram, DD is the positively slopping demand curve. When the price of Y good increases from P to P1, the demand for X good also increases from OM to OM1 and vice-versa. 2. Negative cross elasticity of demand When the X and Y goods are complement, the cross elasticity of demand will be negative. The increase in price of Y goods will lead to a decrease in demand of X goods and decrease in price of Y goods will lead to an increase in demand for X goods. For example: When the price of car increases, the demand for petrol will decrease and when the price of car decreases, the demand for petrol increases. The negative cross elasticity of demand can be shown in a table as below: Price of Y good in rupees Demand for X good in Kg 100 10 150 8 In the table, when the price of Y good increases from rupees 100 to rupees 150, the demand for X good decreases from 10 Kg to 8 Kg. This is negative cross elasticity of demand. It can be shown in a diagram as: In the diagram, DD is a negatively slopping demand curve. When the price of Y good increases from P to P1, the demand for X good decreases from OM to OM1 and vice- versa. Types /degrees of price elasticity of supply There are five types or degrees of price elasticity of supply as: Perfectly elastic supply (Es =∞) When a negligible increase in price will bring down the supply to zero and a negligible decrease in price will increase the supply to infinity is called perfectly elastic supply. This concept is only hypothetical and rarely found in the world. It can be explained din a diagram as below: In the diagram, s is the perfectly elastic supply curve which is a horizontal straight line and parallel to X axis. The change in price cannot be shown and a negligible increase or decrease in price will make the demand zero or infinity. Perfectly inelastic supply (Es = 0) Whatever increase or decrease in price, the supply remains constant is called perfectly inelastic supply. It can be explained in a diagram as below: In the diagram, the vertical curve is the perfectly inelastic supply curve. It is a vertical straight line and parallel to Y-axis. This means whatever increase or decrease in price, the supply remains constant. Unitary elasticity of supply (Es =1) When the percentage change in supply is equal to the percentage change in price, it is called unitary elasticity of supply. It can be explained in a diagram as below: In the diagram SS is the unitary elastic supply curve. It is positively sloping with a gentle slope. The 5 change in supply (10%) is equal to the % change in price(10%). Relatively elastic supply (Es˃1) When the % change in supply is more than the % change in price, it is called relatively elastic supply. It can be explained in a diagram as shown below: In the diagram ss is the relatively elastic supply curve. It is positively sloping with a flat slope. The % increase in supply from Q to Q1 is more than the % increase in price from P to P1. Relatively inelastic demand (Es˂1) When the % change in supply is less than the % change in price, it is called relatively inelastic supply. It can be explained in a diagram as shown below: In the diagram S is the relatively inelastic supply curve. It is positively sloping with a steep slope. The % increase in price from Po to P1 is more than the % increase in supply from Qo to Q1. Explain the total outlet method to measure the price elasticity of demand Total Outlay Method Total outlay method, also known as total expenditure method of measuring price elasticity of demand was developed by Professor Alfred Marshall. According to this method, price elasticity of demand can be measured by comparing total expenditure on a commodity before and after the price change. While comparing the expenditure, we may get one of three outcomes. They are i) Elasticity of demand will be greater than unity (Ep > 1);- When total expenditure increases with fall in price and decreases with rise in price, the value of PED will be greater than 1. Here, rise in price and total outlay or expenditure move in opposite direction. ii) Elasticity of demand will be equal to unity (Ep = 1):- When total expenditure on commodity remains unchanged in response to change in price of the commodity, the value of PED will be equal to 1. iii) Elasticity of demand will be less than unity (Ep < 1):- When total expenditure decreases with fall in price and increases with rise in price, the value of PED will be less than 1. Here, price of commodity and total outlay move in same direction. When the information from the above table is plotted in the graph, we get graph like the one shown below. In the graph, total outlay or expenditure is measured on the X-axis while price is measured on the Y-axis. In the figure, the movement from point A to point B shows elastic demand as we can see that total expenditure has increased with fall in price. The movement from point B to point C shows unitary elastic demand as total expenditure has remained unchanged with the change in price. Similarly, the movement from point C to point D shows inelastic demand as total expenditure as well as price has decreased. Total outlay method of measuring price elasticity of demand does not provide us exact numerical measurement of elasticity of demand but only indicates if the demand is elastic, inelastic or unitary in nature. Therefore, this method has limited scope. Uses of Price elasticity of Demand Uses of Price elasticity of Demand 1. Product Pricing: By using the concept of price elasticity of demand, the business firms can determine whether a decline in price is better or a rise in price is better to increase sales, total revenue, and the profitability of the business. Generally, the lower price is fixed for the elastic product and the higher price is for the inelastic product. 2. Price Discrimination It is the act of charging different prices to different buyers in different markets for identical products. It is one of the major attributes of a monopolist seller. Low price is charged in the market where there is elastic demand and the higher price is charged in the market in which price elasticity is relatively low. 3. Pricing and nationalization of Public Utilities Public utilities are very important for the daily life of all the people living in the country and generally, their demand is inelastic. If they are left at the hand of the private sector, they might be charged a very high price and there will reduction in the people's welfare. Therefore, the elasticity of demand is used while deciding which economic undertaking should be controlled by public authority and which is left on the hand of the private sector. Similarly, the pricing problem of public utility is also solved by price elasticity. 4. Pricing of Product Joint In the case of a joint product like wool and mutton, paddy and straw, chicken and eggs, etc. their pricing issue is solved with the help of price elasticity. The separate pricing is very difficult in such cases or the separate cost of predication is not known in such type of joint product. Thus, the concept of price elasticity of demand is used to determine their separate price. 5. Demand Forecasting The value or coefficient of price elasticity of demand is useful to forecast the future demand of a commodity. The determination of elasticity will let know a business firm about the percentage change in demand with one percentage change in price. So given the value of elasticity of demand, future demand forecasting would become easy. Uses of Income Elasticity: 1. Demand Forecasting If the income elasticity of the particular product, the rate of increase in the income of the target market is known then the firm can easily forecast the demand for its products. Thus the knowledge of income elasticity of demand gives an idea of how much to produce at a different level of income. In the long-run, the demand for luxurious products may become income elastic. Thus the business firms may formulate their business strategies accordingly. 2. Classification of Goods The income elasticity of demand helps to classify the commodities. Whether the product is a normal good, luxurious normal good, essential good, inferior good, or neutral good, we can easily classify with the help of the coefficient of income elasticity of demand. If the coefficient of income elasticity of demand is positive, the commodity is normal, if greater than one, the commodity is luxurious, the coefficient is positive but less than one then the commodity is essential, if it is negative then the good is inferior and when it is zero then the commodity is neutral good. 3. Helpful in Strategic Decisions The business can classify all the people into different classes based on the measurement of income elasticity of demand. They can then produce their product accordingly. The firm produces high-quality expensive products if its strategy is to target the richer class of society. In contrast, they focus to produce normal and low priced goods if they have the strategy to cover the comfort and common type of market and class of people. Thus, the business firm can classify the entire market into different classes based on income elasticity of demand and accordingly formulate business policies and strategies. 4. Helpful to Government for Policy Formulation The governmental organs also use the concept of income elasticity of demand in the formulation of different types of policies. For example, for the imposition of taxation, the government can use the concept of income elasticity of demand. The income elasticity of demand is highly elastic for luxurious goods and it is less elastic for
normal goods. Thus which good is to be taxed can be seen from the point of income elasticity also. Uses of Cross Elasticity: 1. Categorization of Goods The concept of cross elasticity of demand is useful for the categorization of goods. If the cross elasticity is positive then two goods are substitutes and in the case of negative two goods are complementary. Similarly, if cross elasticity is zero then goods are independent. After knowing the commodities the firms can formulate their policies accordingly. 2. Pricing Policy Related to Own Goods The products produced by anyone company are in many ways related to the output of other company's products. Thus their demand is directly affected by the pricing policies of other producing firms. By knowing the cross elasticity the business firm can get information regarding the pricing policies of other competitors and they can formulate the best price for their products. 3. Establishment of Interrelation between Industries Based on the measurement of cross elasticity of demand different industries got to know their relation as to whether they are related to each other complementarily or they are substitutable. In case they are substitutable they cannot raise their prices without making consideration and coordinating with other industries. Similarly, if they are related complementarily, they also cannot directly alter their strategies without negotiating their complement industries. So it establishes a king of interdependence between industries of the economy. 4. Classification of Market The market can be classified based on cross elasticity of demand. The higher the value of cross elasticity of demand between goods, the higher will be the competition in the market and vice-versa. If the cross elasticity is infinite, the market structure is perfectly competitive. If it is zero, the market is a monopoly. 5. Pricing Policy Related to Other's Product Different firms produce a different line of products. They may be substitutes (a cream company produces varieties of creams) and complementary (a company may produce toothpaste and toothbrush). Thus the pricing of such products can be done with the help of the concept of cross elasticity of demand. Unit 3: Theory of Consumer's Behaviour Cardinal utility: Cardinal utility is the utility wherein the satisfaction derived by the consumers from the consumption of good or service can be measured numerically. Ordinal utility states that the satisfaction which a consumer derives from the consumption of product or service cannot be measured numerically. The cardinal utility theory or approach was proposed by classical economists, Gossen (Germany), William Stanley Jevons (England), Leon Walras (France), and Karl Menger (Austria). Later on a neo-classical economist, Alfred Marshall brought about significant refinement in the cardinal utility theory. Therefore, cardinal utility theory is also known as neo-classical utility theory. Assumptions Of Cardinal Utility: Utility is measurable The basic assumption of the cardinal utility approach is that utilities of commodities can be quantified. According to Marshall, money is used to measure the utilities of commodities. This implies that the amount of money that a customer is willing to pay for a particular commodity is a measure of its utility. Marginal utility of money is constant The cardinal utility approach assumes that money must measure the same amount of utility under all circumstances. To put simply, the utility derived from each unit of money remains constant. Utilities are additive As per this assumption, the utility derived from various commodities consumed by an individual can be added together to derive the total utility. Suppose an individual consumes X1, X2, X3,....Xn units of commodity X and derives U1, U2, U3,....Un until respectively, the total utility that the individual derives from n units of the commodity can be expressed as follows: Un = U1(X1) + U2(X2) + ... + Un (Xn) Explain the condition of consumer’s equilibrium According to Utility Analysis. A consumer is in a state of equilibrium when he maximizes his satisfaction by spending his given income on different goods and services. Any deviation or change in the allocation of income under the given circumstance will lead to a fall in total satisfaction. For one-commodity case: Rupee worth of satisfaction actually received by the consumer is equal to the marginal utility of money as specified by the consumer himself. Condition 1 : MU(of good X) = MU(of money) OR , PRICE(of good X) = MU(of money) Reason: Price paid by the consumers should be exactly equal to the money value of MU that he derives. In case P(of X) is lesser than the MU(of money), he should be prompted to buy more of good X. Higher consumption will lead to a fall in MU. The consumption of good X would stop only when P(of good X) will be equal to MU(in terms of money). Likewise, if P(of X) is greater than MU(in terms of money), the consumer will be prompted to buy less of good X, leading to a fall in MU. Condition 2: Marginal utility of money remains constant. Condition 3: Law of marginal utility holds good. For two-commodity case: Rupee worth of marginal utility of money should be same across good X and good Y, and equal to marginal utility of money. Reason: In case rupee worth of satisfaction (MU of good X/ price of good X) is greater for good X than good Y, the consumer will be prompted to buy more of good X and less of good Y. This would lead to a fall in marginal utility of good X and a rise in marginal utility of good Y. This process would continue till MU(of good X)/ Price of good X = MU(OF GOOD Y)/ Price of good Y = MU(of money) . In case rupee worth of satisfaction (MU of good y/ price of good Y) is greater for good Y than good X, the consumer will be prompted to buy more of good Y and less of good X. This would lead to a fall in marginal utility of good Y and a rise in marginal utility of good X. Derivation of Demand Curve: A demand curve has been defined as a curve that shows a relationship between the quantity-demanded of a commodity and its price assuming income, the tastes and preferences of the consumer and the prices of all other goods constant. To draw an individual demand curve the information regarding prices of a commodity at different levels and their corresponding quantities demanded is required. The price-consumption curve can provide this information. Fig. 3.16 illustrates the way in which the individual demand curve can be derived from the price consumption curve. When a demand curve is to be drawn, units of money are measured on the vertical axis while the quantity of a commodity for which demand curve is to be drawn are shown on the horizontal axis. Exception of demand curve: There are a few situations in which the general rule that demand curves slope down doesn’t apply. Giffen goods violate the law of demand because of unique circumstances. On these rare occasions, increasing the price of a good can increase the amount of it people buy. This outcome can occur when the product in question is essential and a price increase crowds out the ability to buy other items. Imagine the price of potatoes goes up, which makes buying meat unaffordable. Consequently, the person diverts what money would have gone to meat toward more potatoes. Veblen goods also violate the law of demand. In these situations, a buyer interprets a higher price for a signal of higher quality. You can imagine this situation playing out with a bottle of wine. If the label looks cheap and has a low price, people assume it’s a low-quality wine. But, if you put that same wine in a fancy bottle with a higher price tag, you might end up with more sales. Information asymmetry can also upset the law of demand and change the shape of demand curves. One example is called a “lemon problem,” in which a buyer and a seller don’t have the same information about a product. Consider a used car. The buyer knows that the seller has more information about the quality of the car than she does. Therefore, she might try to interpret the price as an indication of quality. If the seller puts a low price on the vehicle, the buyer might be put off, thinking the car is a piece of junk. That’s the opposite response to a price reduction a demand curve would expect. Ordinal Utility: In economics, an ordinal utility function is a function representing the preferences of an agent on an ordinal scale. The Ordinal Utility approach is based on the fact that the utility of a commodity cannot be measured in absolute quantity, but however, it will be possible for a consumer to tell subjectively whether the commodity derives more or less or equal satisfaction when compared to another. Assumptions of Ordinal Utility: Rationality: It is assumed that the consumer is rational who aims at maximizing his level of satisfaction for given income and prices of goods and services, which he wish to consume. He is expected to take decisions consistent with this objective. Ordinal Utility: The indifference curve assumes that the utility can only be expressed ordinally. This means the consumer can only tell his order of preference for the given goods and services. Transitivity and Consistency of Choice: The consumer’s choice is expected to be either transitive or consistent. The transitivity of choice means, if the consumer prefers commodity X to Y and Y to Z, then he must prefer commodity X to Z. In other words, if X= Y, Y = Z, then he must treat X=Z. The consistency of choice means that if a consumer prefers commodity X to Y at one point of time, he will not prefer commodity Y to X in another period or even will not consider them as equal. Nonsatiety: It is assumed that the consumer has not reached the saturation point of any commodity and hence, he prefers larger quantities of all commodities. Diminishing Marginal Rate of Substitution (MRS): The marginal rate of substitution refers to the rate at which the consumer is ready to substitute one commodity (A) for another commodity (B) in such a way that his total satisfaction remains unchanged. The MRS is denoted as DB/DA. The ordinal approach assumes that DB/DA goes on diminishing if the consumer continues to substitute A for B. Explain the marginal rate of substitution (MRSxy) suitable graph. The marginal rate of substitution (MRS) is the amount of a good that a consumer is willing to consume compared to another good, as long as the new good is equally satisfying. MRS is used in indifference theory to analyze consumer behavior. The marginal rate of substitution is the slope of the indifference curve at any given point along the curve and displays a frontier of utility for each combination of "good X" and "good Y." When the law of diminishing MRS is in effect, the MRS forms a downward, negative sloping, convex curve showing more consumption of one good in place of another. Formula and Calculation of the Marginal Rate of Substitution (MRS) The marginal rate of substitution (MRS) formula is: .=============================================== Properties of indifference curve: * Indifference curves never cross. If they could cross, it would create large amounts of ambiguity as to what the true utility is. * The farther out an indifference curve lies, the farther it is from the origin, and the higher the level of utility it indicates. As illustrated above on the indifference curve map, the farther out from the origin, the more utility the individual generates while consuming. * Indifference curves slope downwards. The only way an individual can increase consumption in one good without gaining utility is to consume another good and generate the same amount of utility. Therefore, the slope is downwards sloping. * Indifference curves assume a convex shape. As illustrated above in the indifference curve map, the curve gets flatter as you move down the curve to the right. It illustrates that all individuals experience diminishing marginal utility, where additional consumption of another good will generate a lesser amount of utility than the prior. Marginal rate of substation: In economics, the marginal rate of substitution (MRS) is the amount of a good that a consumer is willing to consume compared to another good, as long as the new good is equally satisfying. MRS is used in indifference theory to analyze consumer behavior. Price line and Consumers Equillibrium: The Ordinal Approach to Consumer Equilibrium asserts that the consumer is said to have attained equilibrium when he maximizes his total utility (satisfaction) for the given level of his income and the existing prices of goods and services. The ordinal approach defines two conditions of consumer equilibrium: Necessary Condition or First Order Condition: Under the first order condition, the consumer reaches his equilibrium in the same manner as he does under the cardinal approach of the two-commodity model. isexpressed as: Supplementary or Second Order Condition: The first order condition is necessary but not sufficient. Thus, the second order or supplementary condition requires that the necessary condition must be accomplished at the highest possible indifference curve on the indifference map. In the figure above, there are three indifference curves, Viz. IC1, IC2, and IC3 presenting a hypothetical indifference map of the consumer. AB is the hypothetical budget line. At point ‘E’, the indifference curve IC2 and Budget line AB intersect and hence, therefore, the slope of IC2 = AB. At this point, both the necessary condition and the supplementary condition get fulfilled, and hence, the consumer attains equilibrium at point ‘E’. Price effect: Price effect is the change experienced in the demand of certain good or service after there’s a modification of its price. It can also refer to the consequence that a certain event has in the price of a financial instrument. Derivation of PCC: The price effect can be defined as an effect of a change in price of a product on consumer’s equilibrium and on the quantity consumed of that product by the consumer, price of other product and the income of the consumer remaining same. Such a price effect, with regard to a fall in the price of product X. Based on it, we may observe that — i. The consumer is in a state of equilibrium at point R, given his initial budget line as AB and an indifference map consisting of four indifference curves, IC1 to IC4. At equilibrium, the consumer is on IC1 consuming OX1 of product X. ii. Both the conditions of equilibrium are satisfied at this point. That is, the budget line is forming a tangent at point R on IC1 and the indifference curve is convex to the point of origin. iii. When price of the product X falls, the budget line shifts from point B on the X-axis to point B1 and becomes flatter. This implies that at a lower price, the consumer is capable of buying a larger quantity of X (OB1) than before (OB). Since the price of Y remains unchanged, there will be no change in point A on the Y-axis. As such, the new budget line assumes the shape AB1 and the consumer finds his equilibrium at point S on IC2. At this point, the consumer opts for OX2 of X. Such an effect is also in accordance with the law of demand which implies a larger demand of the product at a lower price. iv. A further fall in the price of X will shift the budget line further away from the point of origin on the X-axis to the point B2 forming a new budget line AB2 and the consumer’s equilibrium at point T on the IC3. The consumption of X, as a result, further increases to OX3. v. The equilibrium point will shift further to the point V on the budget line AB3 when the price of X further falls and the consumption of X will increase to OX4.