F.Y.B.A.

SEMESTER - I (CBCS)

ECONOMICS PAPER - I
MICRO ECONOMICS

SUBJECT CODE : UBA1.35

 © UNIVERSITY OF MUMBAI
Prof. Suhas Pednekar
Vice-Chancellor,
University of Mumbai

Prof. Ravindra D. Kulkarni Prof. Prakash Mahanwar

Pro Vice-Chancellor, Director,
University of Mumbai IDOL, University of Mumbai

Programme Co-ordinator : Prof. Rajashri Pandit

Assistant Professor of Economics,
IDOL, University of Mumbai, Mumbai

Course Co-ordinator : Ms. Pratiksha Narayan Tikar

Assistant Professor of Economics,
IDOL, University of Mumbai
Course Writer : Prof. Shubhangi Vartak
Vice Principal and Head, Dept. of Economics
Ram Niranjan Jhunjhunwala College ofArts,
Science & Commerce,
Ghatkopar (W), Mumbai

: Prof. Krishnan Nandela

Dept. of Economics
Dr. T. K. Tope Arts & Commerce
Senior Night College, Parel, Mumbai

: Prof. Vitthal S. Sontakke

Vice Principal,
Kirti M. Doongurse College ofArts
Science and Commerce,
Dadar (W), Mumbai
: Prof. Rajashri Pandit
Assistant Professor of Economics,
IDOL, University of Mumbai, Mumbai

August 2021, Print - I, ISBN : -978-93-91735-01-2

Published by : Director,
Institute of Distance and Open Learning ,
University of Mumbai,
Vidyanagari, Mumbai - 400 098.

DTP Composed & : Mumbai University Press

Printed by Vidyanagari, Santacruz (E), Mumbai - 400098
 CONTENTS
Unit No. Title Page No.

MODULE I
1. Introduction to Microeconomics 1
2. Basic Concepts in Microeconomics 15

MODULE II
3. Ten Principles of Economics - I 35
4. Ten Principles of Economics- II 42

MODULE III
5. Markets, Demand and Supply 52
6. Elasticity of Demand 82

MODULE IV
7. Consumer's Behaviour 103
8. Indifference Curve Analysis 112


 I

F.Y.B.A.
Semester – I (CBCS)
Microeconomics – I
(Academic Year: 2021-22 at IDOL)
Preamble: This course is designed to expose the students to the
basic principles of microeconomic theory. The emphasis will be on
the development of analytical thinking with the help of statistical
tools among the students and develop the skill of application of
microeconomics concepts to analyze the real life situations.

Module - I: Introduction to Microeconomics

Microeconomics: Meaning, Scope, Nature, Importance and
Limitations; Basic Economic Problems; Role of Price Mechanism in
a Market Economy; Positive Economics and Normative Economics;
Concepts of Equation, Functions, Graphs, Diagrams, Line, Slope
and Intercept

Module - II: Ten Principles of Economics

Trade-Off Faced by the Individuals; Significance of Opportunity
Cost in Decision Making; Thinking at the Margin; Responses to
incentives; Benefits from Exchange; Organization of Economic
Activities through Markets and its Benefits; Role of Government in
improving Market Outcomes; Dependence of Standard of Living on
Production; Growth in Quantity of Money; Inflation and
Unemployment Trade Off

Module - III: Markets, Demand and Supply

What is a Market; What is Competition; Demand Curves:
Market Demand versus Individual Demand, Movements along the
Demand Curve, Shifts in the Demand Curve; Supply Curves:
Market Supply and Individual Supply, Shifts in Supply Curve;
Market Equilibrium - Three Steps to Analyze Changes in
Equilibrium; Price Elasticity of Demand, Methods of Measuring
Price Elasticity of Demand – Total Outlay Method, Percentage
Method and Point Method; Concepts of Income Elasticity of
Demand, Cross Elasticity of Demand and Promotional Elasticity of
Demand

Module IV: Consumer’s Behavior

Introduction to Cardinal and Ordinal Approaches; Indifference
Curve Analysis - Properties of Indifference Curves, Budget Line,
and Consumer’s Equilibrium; Income, Price and Substitution Effect;
Derivation of Demand Curve; Consumer’s Surplus: Strong Ordering
and Weak Ordering
 II

References :

1. N. Gregory Mankiw, (2015), “Principles of Microeconomics” 7th

edition- Cengage Learning.
2. Sen Anindya, (2007), “Microeconomics Theory and
Applications” Oxford University press, New Delhi.
3. Salvator D, (2003) “Microeconomics Theory and Applications”
Oxford University press, New Delhi.
4. M. L. Jhingan, (2006) “Microeconomics Theory”, 5th edition
Vrinda Publication (P) Ltd.
5. H. L. Ahuja, (2016) “Advance Economics Theory” S. Chand &
Company Ltd.
6. Paul Samuelson and W. Nordhaus, (2009): Economics, 19th
Edition McGraw Hill Publications.


 1

Module - I

1
INTRODUCTION TO MICROECONOMICS
Unit Structure :

1.0 Objectives
1.1 Introduction
1.2 Meaning and Nature of Micro Economics
1.3 Scope of Micro Economics
1.4 Usefulness of Microeconomics
1.5 Limitations of Microeconomics
1.6 Macro Economics
1.6.1 Distinguish between Micro and Macro Economics
1.7 Basic economic problems
1.8 Approaches to deal with basic economic problems
1.9 Questions

1.0 OBJECTIVES

After having studied this unit, you should be able

 To Understand the fundamentals of Micro Economics

 To Know the nature of micro Economics
 To Study the concept of Macro economics
 To understand difference between Micro & Macro economics
 To study basic economic problems
 To study approaches to deal with basic economic problems
and role of price mechanism in a market economy

1.1 INTRODUCTION

Economics is about economizing; that is, about choice

among alternative uses of scarce resources. Choices are made by
millions of individuals, businesses, and government units.
Economics examines how these choices add up to an economic
system, and how this system operates. (L.G. Reynolds) Scarcity is
central to economic theory. Economic analysis is fundamentally
about the maximization of something (leisure time, wealth, health,
happiness—all commonly reduced to the concept of utility) subject
to constraints. These constraints—or scarcity—inevitably define a
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tradeoff. For example, one can have more money by working
harder, but less time (there are only so many hours in a day, so
time is scarce). One can have more apples only at the expense of,
say, fewer grapes (you only have so much land on which to grow
food—land is scarce). Adam Smith considered, for example, the
trade-off between time, or convenience, and money. He discussed
how a person could live near town, and pay more for rent of his
home, or live farther away and pay less, “paying the difference out
of his convenience”.

Economics as a subject came into being with the publication

of very popular book in 1776, “An Enquiry into the Nature and
Causes of Wealth of Nations”, written by Prof. Adam Smith. At that
time it was called Political economy, which remained operational at
least up to the middle part of the 19th century. It is since then that
the economists developed tools and principles using inductive and
deductive reasoning. In fact, the ‘Wealth of Nations’ is a landmark
in the history of economic thought that separated economics from
other social sciences.

The word ‘Economics’ was derived from the Greek words

‘Oikos’ (a house) and ‘Nemein’ (to manage), which meant
managing a household, using the limited money or resources a
household has.

Let us explain a few important definitions frequently referred

to in the economic theory. In other words, economics is not a
science of wealth but a science of man primarily. It may be called
as the science which studies human welfare. Economics is
concerned with those activities, which relates to wealth not for its
own sake, but for the sake of human welfare that it promotes.
According to Cannan, “The aim of political economy is the
explanation of the general causes on which the material welfare of
human beings depends.” Marshall in his book, “Principles of
Economics”, published in 1890, describes economics as, “the study
of mankind in the ordinary business of life; it examines that part of
the individual and social action which is most closely connected
with the attainment and with the use of the material requisites of
well being”.

On examining the Marshall’s definition, we find that he has

put emphasis on the following four points:

(a) Economics is not only the study of wealth but also the study of
human beings. Wealth is required for promoting human welfare.

(b) Economics deals with ordinary men who are influenced by all
natural instincts such as love, affection and fellow feelings and not
merely motivated by the desire of acquiring maximum wealth for its
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own sake. Wealth in itself is meaningless unless it is utilized for
obtaining material things of life.

(c) Economics is a social science. It does not study isolated

individuals but all individuals living in a society. Its aim is to
contribute solutions to many social problems.

(d) Economics only studies ‘material requisites of well being’. That

is, it studies the causes of material gain or welfare. It ignores non-
material aspects of human life.

This definition has also been criticized on the ground that it

only confines its study to the material welfare. Non-material aspects
of human life are not taken into consideration. Further, as Robbins
said the science of economics studies several activities, that hardly
promotes welfare.

The activities of producing intoxicants, for instance, do not

promote welfare; but it is an economic activity.

1.2 MEANING AND NATURE OF MICRO ECONOMICS

Microeconomics (from Greek prefix micro- meaning "small"

+ "economics") is a branch of economics that studies the behavior
of individual households and firms in making decisions on the
allocation of limited resources. Typically, it applies to markets
where goods or services are bought and sold. Microeconomics
examines how these decisions and behaviors affect the supply and
demand for goods and services, which determines prices, and how
prices, in turn, determine the quantity supplied and quantity
demanded of goods and services.

This is in contrast to macroeconomics, which involves the

"sum total of economic activity, dealing with the issues
of growth, inflation and unemployment." Microeconomics also deals
with the effects of national economic policies (such as
changing taxation levels) on the aforementioned aspects of the
economy. Particularly in the wake of the Lucas critique, much of
modern macroeconomic theory has been built upon 'micro
foundations' — i.e. based upon basic assumptions about micro-
level behavior.

One of the goals of microeconomics is to analyze market

mechanisms that establish relative prices amongst goods and
services and allocation of limited resources amongst many
alternative uses. Microeconomics analyzes market failure, where
markets fail to produce efficient results, and describes the
theoretical conditions needed for perfect competition. Significant
fields of study in microeconomics include general equilibrium,
 4
markets under asymmetric information, choice under uncertainty
and economic applications of game theory. Also considered is
the elasticity of products within the market system.

Applied microeconomics includes a range of specialized

areas of study, many of which draw on methods from other
fields. Industrial organization examines topics such as the entry and
exit of firms, innovation, and the role of trademarks. Labour
economics examines wages, employment, and labor market
dynamics. Public economics examines the design of government
tax and expenditure policies and economic effects of these policies
(e.g., social insurance programs). Political economy examines the
role of political institutions in determining policy outcomes. Health
economics examines the organization of health care systems,
including the role of the health care workforce and health insurance
programs. Urban economics, which examines the challenges faced
by cities, such as sprawl, air and water pollution, traffic congestion,
and poverty, draws on the fields of urban geography and
sociology. Financial economics examines topics such as the
structure of optimal portfolios, the rate of return to capital,
econometric analysis of security returns, and corporate financial
behavior. Law and economics applies microeconomic principles to
the selection and enforcement of competing legal regimes and their
relative efficiencies. Economic history examines the evolution of the
economy and economic institutions, using methods and techniques
from the fields of economics, history, geography, sociology,
psychology, and political science.

The term ‘Micro’ and ‘Macro’ economics have been coined

by Prof. Ragnar Frisch of Oslo University during 1920’s. The word
micro means a millionth part. In Greek mickros means small.

Thus microeconomics deals with a small part of the whole

economy. For example, if we study the price of a particular
commodity instead of studying the general price level in the
economy, we actually are studying microeconomics. Precisely,
microeconomics studies the behaviour of individual units of an
economy such as consumers, firms, and industry etc. Therefore, it
is the study of a particular unit rather than all units combined
together. Microeconomics is called Price theory, which explains the
composition, or allocation of total production.

In short, microeconomics is the study of the economic

behaviour of individual consumers, firms, and industries and the
distribution of production and income among them. It considers
individuals both as suppliers of labour and capital and as the
ultimate consumers of the final product. On the other hand, it
analyses firms both as suppliers of products and as consumers of
labour and capital.
 5

1.3 SCOPE OF MICRO ECONOMICS

Microeconomics seeks to analyze the market form or other

types of mechanisms that establish relative prices amongst goods
and services and/or allocates society’s resources amongst their
many alternative uses. In microeconomics, we study the following:

1. Theory of product pricing, which includes-

(a) Theory of consumer behaviour.
(b) Theory of production and costs.

2. Theory of factor pricing, which constitutes-

(a) Theory of wages.
(b) Theory of rent.
(c) Theory of interest.
(d) Theory of profits.

3. Theory of economic welfare.

Microeconomics has occupied a very important place in the
study of economic theory. In fact, it is the stepping–stone to
economic theory. It has both theoretical and practical implications.

1.4 USEFULNESS OF MICROECONOMICS

1. Determination of demand pattern: The study of

microeconomics has several uses. It determines the pattern of
demand in the economy, i.e., the amounts of the demand for the
different goods and services in the economy, because the total
demand for a good or service is the sum total of the demands of all
the individuals. Thus, by determining the demand patterns of every
individual or family, microeconomics determines the demand
pattern in the country as a whole.

2. Determination of the pattern of supply: In a similar way, the

pattern of supply in the country as a whole, can be obtained from
the amounts of goods and services produced by the firms in the
economy. Microeconomics, therefore, determines the pattern of
supply as well.

3. Pricing: Probably the most important economic question is the

one of price determination. The prices of the various goods and
services determine the pattern of resource allocation in the
economy. The prices, in turn, are determined by the interaction of
the forces of demand and supply of the goods and services. By
determining demand and supply, microeconomics helps us in
understanding the process of price determination and, hence, the
process of determination of resource allocation in a society.
 6
4. Policies for improvement of resource allocation: As is well-
known, economic development stresses the need for improving the
pattern of resource allocation in the country. Development polices,
therefore, can be formulated only if we understand how the pattern
of resource allocation is determined. For instance, if we want to
analyse how a tax or a subsidy will affect the use of the scarce
resources in the economy, we have to know how these will affect
their prices. By explaining prices and, hence, the pattern of
resource allocation, microeconomics helps us to formulate
appropriate development policies for an underdeveloped economy.

5. Solution to the problems of micro-units: Finally, it goes

without saying that, since the study of microeconomics starts with
the individual consumers and producers, policies for the correction
of any wrong decisions at the micro-level are also facilitated by
microeconomics. For example, if a firm has to know exactly what it
should do in order to run efficiently, it has to know the optimal
quantities of outputs produced and of inputs purchased. Only then
can any deviation from these optimal levels be corrected. In this
sense, microeconomics helps the formulation of policies at the
micro-level. In every society, the economic problems faced by
different economic agents (such as individual consumers,
producers, etc.) can be analysed with the help of microeconomic
theories. This shows that economics is a social science which aims
at analysing the economic behavior of individuals in a social
environment.

1.5 LIMITATIONS OF MICROECONOMICS

However, microeconomics has its limitations as well:

1. Monetary and fiscal policies: Although total demand and total

supply in the economy is the sum of individual demands and
individual supplies respectively, the total economic picture of the
country cannot always be understood in this simplistic way. There
are many factors affecting the total economic system, which are
outside the scope microeconomics. For example, the role of
monetary and fiscal policies in the determination of the economic
variables cannot be analysed completely without going beyond
microeconomics.
2. Income determination: Microeconomics also does not tell us
anything about how the income of a country (i.e., national income)
is determined.

3. Business cycles: A related point is that, it does not analyse the

causes of fluctuations in national income. The ups-and-downs of
national income over time are known as business cycles.
Microeconomics does not help us in understanding as to why these
cycles occur and what the remedies are.
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4. Unemployment: One of the main economic problems faced by
an economy like India is the problem of unemployment. This, again,
is one of the areas on which microeconomics does not shed much
light. Because, if we are to find a solution to the unemployment
problem, we must first understand the causes of this problem. For
that, in turn, we must understand how the total employment level in
the economy is determined. This is difficult to understand from
within the confines of microeconomics.
Check your progress :
1. What is the subject matter of microeconomics?
2. What are the limitations of microeconomics?

1.6 MACRO-ECONOMICS

In Macro-economics, we are essentially concerned with the

economic system as a whole. Macroeconomics concerns itself with
those aggregates which relate to the whole of the economy.
According to Kenneth Boulding, “Macroeconomics deals not with
individual quantities but with aggregates of these quantity, not with
individual incomes but with national income, not with individual
prices but general price-level, not with individual output but with the
national output”. We are here concerned with the aggregates and
averages of the entire economy such as National Income, output,
employment, total consumption, saving, investment, aggregate
demand, aggregate supply and the general level of prices. It also
refers to the study of trade cycles and business fluctuations, and
the theory of economic growth. The hyper-inflation after the World
War I and the Great Depression of the 1930s’ were chiefly
responsible for the development of Macro-economic approach.

1.6.1 Distinction between Micro and Macroeconomics

1. The dimensional difference Micro-economics, as seen earlier
deals with the analysis of individual behaviour, whereas in
macroeconomics we are concerned with the study the economy as
a whole.

Thus in Micro-economics we analyse the behaviour of an

individual consumer or an individual producer, pricing of product or
 8
a factor whereas in Macroeconomics we analyse the National
output, general level of price etc.
2. The Methodological difference: The methodology applied in the
study of micro-economics is more ‘individualistic’ in nature;
whereas in the study of macroeconomics it is more ‘aggregative’ in
nature. For instance in Microeconomics we apply the technique of
‘slicing’. Whereas in Macroeconomics we resort to the technique of
‘lumping’.

3. Fields of Enquiry : Microeconomics is basically concerned with

the theory of product and factor-pricing.

Whereas Macroeconomics is primarily concerned with

National Income, problems of growth and economic stability.

4. Derivation of Economic functions : The distinction between

micro and macro-economics is based on how the economic
functions are derived; if from aggregative data, we have macro-
economic function and if the function has been built up from a
careful study of individual units, then we have micro- economic
function. Thus micro-economics is concerned with the micro
variables such as individual demand, individual supply, price of a
particular commodity or factor etc. Whereas Macroeconomics is
concerned with macro variables; general price level, national
output, aggregate saving, investments and the level of employment
for the economy as a whole.

Micro Economics Macro Economics

1 Unit of Study: Individual Aggregate
2 Method: Slicing Lumping
3 Subject Matter : Study of Study of National Income,
product arid factor pricing general level of prices, trade
etc. cycle
4 Basis : Based on Based on Interdependence
independence
5 Core of study: Price Income Theory
Theory
6 Advocated by : Alfred John Maynard Keynes
Marshall
7 Vision : Worms eye view : Birds eye view Forest as a
study of a tree whole
8 Approach: Individualistic Aggregative
9 Quality of Analysis : Difficult and complicated.
Simple and easy
 9
Complementarity of two approaches:
However, these two approaches cannot be insulated from
each other in water-tight compartments. The two approaches are
essentially complementary in nature. Ignoring one and
concentrating attention on the other alone may often lead not only
to inadequate or wrong explanation but also to inappropriate or
even disastrous remedial measures. The two approaches are,
therefore, not in any way mutually exclusive and as such must be
properly integrated to secure fruitful results. To quote Paul
Samuelson; “There is really no opposition between Micro and
Macro-economics. Both are absolutely vital. You are less than half
educated if you understand the one while being ignorant of the
other”. Modern economic analysis is a combination of micro and
macro approaches. Economics is both theoretical and empirical in
nature. Micro and Macro-economics are complementary.

1.7 BASIC ECONOMIC PROBLEMS

The main purpose of every economic activity is to combine

available resources in order to produce output that will satisfy our
needs and wants. Needs are the basic necessities of life of human
beings such as food, clothing and shelter without which one cannot
survive. Wants are the things which are required by the human
beings to live a comfortable life. Availability of resources is scarce
compared to these unlimited wants. The scarcity of resources is the
root cause of all economic problems. It further leads to the problem
of choice. Scarcity forces individuals to make choices about what to
have and what to give up, it also forces societies to make choices.
The larger and more advanced a society is, the more numerous
and complex these choices may be. In the end, however, these
choices leads to three basic economic questions.

1. What goods and services should we produce and in what

quantities?
`Because of scarcity of resources, no society can produce
everything its people might want. This raises the question: What
goods and services are most wanted and needed? Every society
must decide on how much of each of the many possible goods and
services it will produce by using available resources. Whether to
produce more of necessary or to have more of luxury goods.
Whether to have more agricultural goods or to have industrial
products and services. Whether to use more resources in education
and health or to use more resources in building military services.

2. How these goods and services to be produced?

Goods and services are produced by combining the factors
of production: land, labor, and capital. But how is this done, exactly,
and in what combination? Whether to use more labour or more
 10
machines. Which of the available technologies to adopt in the
production of each of the goods?

3. For whom these goods and services to be produced?

Goods and services are distributed in a variety of ways. Who
gets how much of the goods that are produced in the economy?
How should the produce of the economy be distributed among the
individuals in the economy? Who gets more and who gets less?
Whether or not to ensure a minimum amount of consumption for
everyone in the economy.

Thus, every economy faces the problem of allocating the

scarce resources to the production of different possible goods and
services and of distributing the produced goods and services
among the individuals within the economy. So theallocation of
scarce resources and the distribution of the final goods andservices
are the central economic problems.

Production possibility curve / Production Possibility Frontier

(PPC/PPF)
PPC shows different combinations of two different goods which can
be produced by an economy by using all of its resources in the best
possible ways under the given circumstances. The assumptions of
PPC are as following:
a) Economy produces just two goods
b) Resources are given
c) There are no technological changes
d) Resources are fully employed
e) Average cost of production is minimum in all over the economy

Fig 1.1
In the above diagram, X axis measures production of sugar
and Y axis measures production of cotton. At point A economy is
producing 120 units of sugar and 70 units of cotton. If it opts to
produce at point B, it can produce 75 units of sugar and 100 units
of cotton. It could be seen that opportunity cost of producing 30
additional units of cotton is 45 units of sugar. Performance of an
economy can also be explained with PPC. For example in the
above diagram if economy produces either at point „A‟ or „B‟,
there is an efficient use of resources i.e. economy is producing at
 11

its optimum level. However, point ‟D‟ determines in-efficient or

underemployment of resources i.e. economy is not producing at its
optimum level. Whereas, in the fig. point „E‟ is unattainable under
given conditions.

Shifts in PPC
There is a complete rightwards shift in PPC if there is an
increase in the quantity and quality of natural resources or increase
in the quality and quantity of capital or improvement in health,
education, motivation and skill of the labour force or due to
research and development and even international specialization or
trade shift PPC outward. In the above diagram point „E‟ is
attainable if PPC shifts outwards. Whereas there may be an inward
shift of PPC due to scarcity of these resources due to uncertainties
such as natural calamities, wars etc.

Fig. 1.2

Shapes of Production possibility Curve

PPC shapes depend upon the opportunity cost (rate of
transformation) and opportunity cost depends upon the gradient of
the curve. If gradient increases opportunity cost increases and the
shape of the PPC will be concaved i.e. outwards bending. If
gradient is constant, PPC will have a linear curve which means
opportunity cost is constant and if the gradient decreases,
opportunity cost will be decreased and the shape of the curve will
be convex that is bending toward origin.

Fig 1.3
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1.8 APPROACHES TO DEAL WITH BASIC ECONOMIC

PROBLEMS:

All societies face the three economic problems and how

these are answered depend on the type of economic goals and
ideologies adopted by the system.

1. The Centrally planned economic system:

In centrally planned economic system all the resources are
owned and controlled by the state. There is no scope for private
ownership. All land, housing, factories, power stations, transport
systems etc. are owned by the government. The idea of public
ownership in these societies is based upon the desire for a more
equitable distribution of income and wealth.

In this system all of the decisions, what to produce, how to

produce and how to distribute are taken by the state. Therefore
production decisions are very complex in nature. This system is
bureaucratic by nature, hence, changing decisions are very
complex and time consuming. Usually workers are paid equally
without considering their ability and productivity; therefore, there is
lack of incentive to work hard. Due to lack of profit motive; there is
no incentive to innovate. As a result firms operate inefficiently. In
such economies usually goods are of poor quality as well as no
variety is available to consumer, as a result they do not enjoy better
living standard. The closed example of Centrally planned economy
is China.

2. The Market economy:

This system is based on laissez-faire policy. It means let the
people do without any interference of the government. In this
system resources are allocated on the basis of price mechanism.
Market forces, that is, demand and supply are allowed to change
freely in allocation of resources. Therefore, decisions are made
easily and quickly by seeing the changes in demand and supply
forces in the market. Government plays very limited role in this
system. Private ownership of resources plays an important role in
this system. In this system there is a freedom of choice and
enterprise. Consumers are free to spend their income as they want.
On the other hand entrepreneurs may use their resources so as to
maximize their profit. Consumers are considered sovereign in this
system because goods and services are produced according to
their desires. To earn maximum profit is the main motive which
gives incentive to innovate. Another important feature of this
system is competition. Competition leads to increase in efficiency of
enterprises. United States of America is a closed example of the
Market economy.
 13
This system has several flaws. Firstly, this system produces
only those good and services which bring profit for the business.
There is no importance to the production of public goods like parks,
roads etc. Similarly merit goods like education and health are
underdeveloped. On the other hand, demerit goods like weapon,
drugs, cigarettes are produced more to generate heavy profit. In
market economies, to gain higher profit, firms reduce their cost of
production by neglecting negative externalities. It is the cost which
incur by the whole society due to a production process. Firms only
employ those factors of production which bring more profit to the
firm. As a result many of the factors of production remain either
unemployed or underemployed. It is said that consumers are
sovereign in market economy but in reality there is a producer
sovereignty, which produce goods and force consumer to buy
them. In market economies monopolies are established. These
monopoly practices exploit consumers due to weak role of the
state. Another major drawback of this system is inequalities in the
distribution of income and wealth. This system creates a wide gap
between rich and poor.

3. Mixed economy:
In reality, there is no such existence of pure planned
economies and pure market economies. Usually we have mixed
economies. However, in some of the mixed economies government
plays major role and in some of the economies individuals are
stronger.

In mixed economies, usually there are two sectors; private

sector and public sector. Private sector is controlled by individuals.
It possesses most of the features of market economies like private
ownership, economic freedom for producers and consumers, profit
is the main motive, competition etc. This sector also possesses
some of the evils of market economies like under provision or no
provision of public goods, similarly, self interest as the dominating
motive which may exploit interest of the society. Public sector is
controlled by the state. In many of the developed and emerging
economies this sector has very limited role to play. However, this
sector produces those goods and services which are not produced
by the private sector. It makes laws which protect consumers and
society from the disadvantages of the market economy. It forms
competition policies which control monopolies by regulating and
controlling quality, quantity and to the certain extent prices of
products. It also makes laws against pollution, redundancies and
unfair trade practices to serve the interest of the masses.
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1.9 QUESTIONS

1. Explain the concept and meaning of Micro Economics.?

2. Explain the Nature & Scope of Microeconomics?
3. Explain the Concept of Macro Economics and Distinguish
between Micro and Macro Economics?
4. Discuss various basic economic problems.
5. Explain the production Possibility Curve.
6. Discuss the role of price mechanism in a market economy.


 15

2
BASIC CONCEPTS IN MICROECONOMICS
Unit Structure :

2.0 Objectives
2.1 Introduction
2.2 Meaning of Ceteris Paribus
2.3 Concept of Partial Equilibrium
2.4 Concept of General Equilibrium
2.5 Positive Economics
2.6 Normative Economics
2.7 Basic tools in economics
2.8 Summary
2.9 Questions

2.0 OBJECTIVES

After having studied this unit, you should be able

 To Understand the assumption of Ceteris paribus in Micro

Economics
 To Know the nature of Partial & General Equilibrium
 To Study the concept of Positive & Normative economics
 To study different basic tools used in economics

2.1 INTRODUCTION

Ceteris paribus or caeteris paribus is a Latin phrase,

literally translated as "with other things the same," or "all other
things being equal or held constant." It is an example of
an ablative absolute and is commonly rendered in English as "all
other things being equal." A prediction, or a statement
about causal or logical connections between two states of affairs, is
qualified by ceteris paribus in order to acknowledge, and to rule out,
the possibility of other factors that could override the relationship
between the antecedent and the consequent.

2.2 CONCEPT OF CETERIS PARIBUS

A ceteris paribus assumption is often fundamental to
the predictive purpose of scientific inquiry. In order to formulate
 16
scientific laws, it is usually necessary to rule out factors which
interfere with examining a specific causal relationship. Under
scientific experiments, the ceteris paribus assumption is realized
when a scientist controls for all of the independent variables other
than the one under study, so that the effect of a single independent
variable on the dependent variable can be isolated. By holding all
the other relevant factors constant, a scientist is able to focus on
the unique effects of a given factor in a complex causal situation.

Such assumptions are also relevant to the descriptive

purpose of modeling a theory. In such circumstances, analysts
such as physicists, economists, and behavioral psychologists apply
simplifying assumptions in order to devise or explain an analytical
framework that does not necessarily prove cause and effect but is
still useful for describing fundamental concepts within a realm of
inquiry.

In Economics this phrase is used quite often to assume all

other factors to remain the same, while analysing the relationship
between any two variables. This assumption eliminates the
influence of other factors which may negativate the efforts to
establish a scientific statement regarding the behaviour of
economic variables. e.g. If we try to establish the relationship
between demand and price, there may be other variables which
may also influence demand besides price. The influence of the
other factors may invalidate the hypotheses that quantity
demanded of a commodity is inversely related to its price. If rise in
price takes place along with an increase in income or a change in
fashion, then the effect of price change may not be the same. A
change in fashion may in fact raise the demand, despite the rise in
price. Thus, we try to eliminate the disturbing influences of other
variables by assuming them to remain constant.

2.2.1 Merits of ‘Ceteris Paribus’

i) This assumption helps us in making predictions about the
future.
ii) The assumption makes the analysis simple and easy.
iii) It is applicable to solution of practical problems in the real
world.
iv) Such an assumption is very useful in analysis of behaviour of a
firm or a consumer or a factor of production.
v) It is easy to collect data when the field of inquiry is restricted by
this assumption.
 17
2.2.2 Limitations of ‘Ceteris Paribus’

i) Ceteris Paribus neglects the interdependence between the forces

and makes the analysis over-simplified.
ii) The assumption makes the analysis unrealistic. In the real world
‘Other things never remain constant.’ Everything is always
changing.
iii) This assumption makes the principles and theories restrictive in
nature. Therefore the analysis has limited applicability.
iv) The analysis is made static and less relevant to real world
situation.
v) Ceteris Paribus’ makes the explanation incomplete because it
analyses the functional relation between a few selected
variables and neglects others.

2.3 PARTIAL AND GENERAL EQUILIBRIUM

2.3.1 Meaning and Definitions of Equilibrium

Concept of equilibrium, which forms the basis of various
theories in different economic activities, is borrowed from Physics.
Unlike its meaning in Physics i.e. an absence of activity, m
economic sense it implies absence of tendency or urge to change.
It thus means a state of balance.

“Equilibrium is a position from which there is no tendency to

‘move”. - Prof. Stigler
“Equilibrium denotes absence of change in the movement
and not the absence of movement itself’. - Prof. J.K. Mehta

“A market or an economy or any other group of persons and

firms is in equilibrium, when none of its members feels impelled to
change his behaviour”. — Scitovsky

All the above definitions bring home the point that

equilibrium in economic sense implies a position of rest. It does not
imply absence of movement but suggests absence of change in the
movement. Number of examples of equilibrium can be mentioned
e.g. a firm is in equilibrium when it is maximising its profits; the
consumer is in equilibrium when he maximises his level of
satisfaction, within given constraints of his income and prices.

2.3.2 Types of Equilibrium

1. Stable — Unstable - Neutral Equilibrium
2. Static and Dynamic Equilibrium
3. Single and Multiple Equilibrium
4. Short Term and Long Term Equilibrium
5. Partial and General Equilibrium.
 18
All these varieties are important in their own ways. However
the concepts of Partial and General Equilibrium are of particular
significance. Hence we shall concentrate on them here,.

2.3.3 PARTIAL EQUILIBRIUM

Partial Equilibrium analyses the position of rest i.e.
equilibrium of an individual unit such as a consumer, a firm, an
industry etc. It is thus a microeconomic concept. In order to analyze
the position of equilibrium of an individual unit, it becomes
necessary to assume that all other variables are constant. Thus if
we intend to establish the conditions of equilibrium of an individual
consumer, we have to ignore (assume to be constant) other forces
that affect the behaviour of the said individual. Hence we ignore the
changes in tastes and preferences of consumers, prices of other
goods etc. while discussing the individual equilibrium.

“A partial equilibrium is one which is based on only restricted

range of data, a standard example is price of a single product;
the prices of all other products being held fixed during the
analysis’. It assumes ‘Ceteris Paribus’. Prof. Stigler

In short Partial Equilibrium implies:

• Equilibrium of an individual or a single unit
• It isolates an individual unit from others
• It ignores the independence and hence is based on independence
of individual units.
• It excludes other variables and relies on a restricted data.
• It assumes, ’Other things remaining the same’.

2.3.4 Assumptions of Partial Equilibrium:

The Partial equilibrium isolates an individual unit from other
influences. Naturally, it has to make a variety of assumptions many
of which may be quite unrealistic.

Following are assumed to exist.

1. Constancy of price of the product and income, habits etc. of
consumer.
2. Prices of other goods are constant. For a firm prices and
availability of resources is given and constant.
3. Perfect factor mobility.
4. Existence of perfect competition etc.

2.3.5 Limitations of Partial Equilibrium

1. Narrow approach.
2. Limited applicability due to restrictive assumptions.
3. Neglect of interdependence among unit.
4. Inadequate
5. Inability to explain interdependence among units.
 19
2.3.6 Significance of Partial Equilibrium
Although Partial equilibrium approach is exposed to number
of limitations. Yet it has a considerable practical and theoretical
significance.

1. Explanation of determination in product and factor prices.

2. Analysis of change in individual unit.
3. Explanation of consequences of change in behaviour of single
unit
4. Description of effect of policy changes.
5. Help in solving economic problem.
6. Simplification of important issues.
7. Foundation of understanding interdependence.
8. Assistance in general equilibrium analysis.

2.4 GENERAL EQUILIBRIUM

“Theory of general equilibrium is the theory of inter

relationship among all parts of economy.”‘ - Prof. Stigler

Above definition is self explanatory and fully reveals the

meaning and nature of general equilibrium. It is obvious that this
approach concentrates on the entire economy i.e. whole as against
partial equilibrium analysis which deals with ‘a part’ or an individual
unit. It is a macro approach undertaking extensive and
comprehensive study of the different variables, their interrelations
and inter-dependence, etc. It primarily tries to arrive at equilibrium
of the entire system. A general equilibrium occurs when every
individual unit attains equilibrium simultaneously. Thus what
general equilibrium does is to bring out the link between different
individual units in a system.

2.4.1 Assumptions of General Equilibrium

Following are the basic assumptions of general equilibrium
analysis.
1. Existence of perfect competition in product and factor
markets.
2. Perfect factor mobility
3. Identical cost conditions for all firms.
4. Homogeneity of productive resources.
5. Given and constant state of technology
6. Full employment of resources.
7. Constant Returns to scale.

2.4.2 Limitations of General Equilibrium

1. Unrealistic Assumptions of this approach weaken its

importance. The assumptions like perfect competition, full
 20
employment, perfect mobility etc. can hardly be experienced in
practice.

2. Neglect of changing conditions is yet another defect of this

approach. It assumes the constancy of most of the variables which
in reality are frequently changing. Such a static model cannot
effectively analyse the real dynamic scenario. It is aptly remarked,
“Since the given Walrasian conditions are continuously changing,
the movement towards general equilibrium is ever thwarted and its
attainment has ever remained wishful ideal’.

3. Limited Validity is the fate of Walrasian general equilibrium

model. They are applicable only when conditions are fulfilled i.e.
assumptions are valid. This is true only in restricted situations. The
validity depends upon proper solutions to various simultaneous
equations.

2.4.3 Significance of General Equilibrium

1. It provides a wide and comprehensive explanation of the
inevitable mutual interdependence in a free enterprise economy.
2. This approach provides a thorough explanation of the functioning
of the entire economy.
3. General equilibrium analysis simplifies the market complexities
by revealing the inter-relations between individual units.
4. The approach clearly explains the role and functions of the
market mechanism and reveals how economic decisions are
arrived at.
5. The Input-Output analysis of Prof. Leontiff is developed on the
basis of general equilibrium analysis.
6. The Walrasian model provides the starting point for almost all
economic theories. In almost every field of economic enquiry
such as money, trade, welfare etc. the approach proves very
useful.

Check your progress :

1. What do you understand by Ceteris Paribus assumption?
2. Distinguish between Partial Equilibrium approach and
General Equilibrium Approach.
 21

2.5 POSITIVE ECONOMICS

Positive economics is the study of what and why an

economy operates as it does. It is also known as Descriptive
economics and is based on facts which can be subjected
to scientific analysis in order for them to be accepted.

It is based on factual information and uses statistical data,

and scientific formula in determining how an economy should be. It
deals with the relationship between cause and effect and can be
tested.

Positive economic statements are always based on what is

actually going on in the economy and they can either be accepted
or rejected depending on the facts presented.

2.6 NORMATIVE ECONOMICS

Normative economics is the study of how the economy

should be. It is also known as Policy economics wherein normative
statements like opinions and judgments are used. It determines the
ideal economy by discussion of ideas and judgments.

In normative economics, people state their opinions and

judgments without considering the facts. They make distinctions
between good and bad policies and the right and wrong courses of
action by using their judgments.

Normative economic statements cannot be tested and

proved right or wrong through direct experience or observation
because they are based on an individual’s opinion.

Although these two are distinct from each other, they

complement each other because one must first know about
economic facts before he can pass judgment or opinion on whether
an economic policy is good or bad.

2.7 BASIC TOOLS OF ECONOMICS ANALYSIS

Economic theories are formulated to explain different

phenomenon. They try to explain the relationship between two or
more variables. While formulating theories a number of tools are
used by experts in this field. The tools of economic analysis are
found in the realm of Mathematics. Mathematics is being profusely
used in modern economic analysis. Mathematics is regarded as
the second language for the students of economics. Geometry is
being increasingly resorted to in order to provide pictorial
presentation of economic behavior. Diagrams and Graphs provide
 22
visual impact and help to grasp and learn economics with interest
and ease. A Chinese proverb says “A picture is worth a thousand
words”.

Modern economists have turned to Calculus, Matrix, Algebra

and Derivatives to use them as fundamental tools to express
complicated aspects of economic theories and models more
precisely and accurately. All these applications of mathematics are
significant as a tools and techniques to impart conciseness,
precision and rigour to economic analysis.

In brief, get acquainted with the terms such as Variables,

Ceteris Paribus, Functions, Equations, Identities, Graphs and
Diagrams, Lines and Curves, Slopes, Limits and Derivatives, Time
Series and so on. These are the basic tools of economic analysis.

2.7.1 VARIABLES
Variables play an important role in economic theories and
models. A variable is a magnitude of interest can be defined and
measured. In other words a variable is something whose magnitude
can change. It assumes different values at different times or places.
Variables that are used in economics are income, expenditure,
saving, interest, profit, investment, consumption, imports, exports,
cost and so on. It is represented by a symbol.
Variables can be endogenous and exogenous. An
endogenous variable is a variable that is explained within a theory.
An exogenous variable influences endogenous variables, but the
exogenous variable itself is determined by factors outside the
theory.

2.7.2 CETERIS PARIBUS

Ceteris paribus is a Latin phrase meanings, “all other things
remaining the same” or all relevant factors being equal. In
Economics the term “Ceteris Paribus” is used quite often to assume
all other factors to remain the same, while analyzing the
relationship between any two variables.

Ceteris Paribus is an assumption which we are compelled to

make due to complexities in the reality. It is necessary for the sake
of convenience. The limitations of human intelligence and capacity
compel us to make this assumption. Besides, without the
assumption we cannot reach on economic relations, sequences
and conclusions. In fact, there are large number of variables
interacting simultaneously at a given time. If our analysis has to be
accurate we may have to examine two variables at a time which
makes it inevitable to assume other variables to remain unchanged.

For instance, if we try to establish the relationship between

demand and price, there may be other variables which may also
 23
influence demand besides price. The influence of other factors may
invalidate the hypothesis that quantity demanded of a commodity is
inversely related to its price. If rise in price takes place along with
an increasing in income or a change technology, then the effect of
price change may not be the same. However, we try to eliminate
the interrupting influences of other variables by assuming them to
remain unchanged.

The assumption of Ceteris Paribus thus eliminates the

influence of other factors which may get in the way of establishing a
scientific statement regarding the behavior of economic variables.
Ceteris Paribus is an assumption which we are compelled to make
due to complexities in the reality. It is necessary for the sake of
convenience. The limitations of human intelligence and capacity
compel us to make this assumption. Besides, without the
assumption we cannot reach on economic relations, sequences
and conclusions. In fact, there are large number of variables
interacting simultaneously at a given time. If our analysis has to be
accurate we may have to examine two variables at a time which
makes it inevitable to assume other variables to remain unchanged.

2.7.3 FUNCTION
A 'function' explains the relationship between two or more
economic variables. A simple technical term is used to analyze and
symbolizes a relationship between variables. It is called a function.
It indicates how the value of dependent variable depends on the
value of independent or other variables. It also explains how the
value of one variable can be found by specifying the value of other
variable.

For instance, economist generally links demand for good

depends upon its price. It is expressed as D = f (P). Where D =
Demand, P = Price and f = Functional relationship.

Functions are classifieds into two type namely explicit

function and implicit function. Explicit function is one in which the
value of one variable depends on the other in a definite form. For
instance, the relationships between demand and price Implicit
function is one in which the variables are interdependent.

2.7.4 EQUATIONS
Economic theory is a verbal expression of the functional
relationships between economic variables. When the verbal
expressions are transformed into algebraic form we get Equations.
The term equation is a statement of equality of two expressions or
variables. The two expressions of an equation are called the sides
of the equation. Equations are used to calculate the value of an
unknown variable. An equation specifies the relationship between
 24
the dependent and independent variables. Each equation is a
concise statement of a particular relation.

For example, the functional relationship between

consumption (C) and income (Y) can take different forms. The most
simple equation; C = a (Y) states that consumption (C) is related to
income (Y). It says nothing about the form that this relation takes.

Here ‘a’ is constant and it has a value greater than zero but
less than one (0<a<1). Thus the equation shows that C is a
constant proportion of income. For instance, if ‘a’ is 1/2then the
consumer would always spend 50% of the income on consumption.
The equation shows that if income is zero, consumption will also be
zero.

C = a + b Y is yet another form of consumption function. Here value

of a is positive and b is 0<b<1.

2.7.5 IDENTITIES
An identity explains an equilibrium condition or a definitional
condition. A definitional identity explains that two alternative
expressions have exactly the same meaning. For example, total
profit is defined as the excess of total revenue over total cost, and
we can denote as:
π ≡ TR - TC

Where π is total profit, TR is total revenue and TC is total cost.

Similarly, saving is defined as the difference between income and
consumption expenditure and we can say;
S≡ Y-C
You are required to note that an identity is denoted by a three - bar
sign (≡).

The distinction between an identity and an equation is very

subtle and important. An identity is a relation that is true for all
values of the variables; no values can be found that will contradict
it. For instance, (x + y)2 = x2 + 2xy + y2 is an expression which is
true for any numerical value of x and y. Identities are statements
that are compatible with any state of the universe. In case of
National Income accounting we have an important identity between
National Income (Y) ≡ National Output (O) ≡ National Expenditure
(E)
Hence; Y ≡ O ≡ E
Identities are mere “truisms”, they cannot form the basis of any
theory.

2.7.6 GRAPHS AND DIAGRAMS

A graph or a diagram presents the relationship between two
or more sets of data or variables that are related to one another.
 25
Graph is most commonly used tool in modern economics. Graph
depicts the functional relationship between two or more economic
variables. The use of graph provides a better understanding of the
economic generalizations. Graph presents a visual picture of an
abstract idea. Also it is useful for accuracy and precision.

Graph can be drawn only two dimensional figures on a plain

paper. It represents the values of only two variables at a time. The
common method of constructing a graph or a diagram is
described below:

A graph has a horizontal line termed as X axis and a vertical

line termed as Y axis. The point of intersection between X and Y
axis is termed as 'origin' point.

The surface is divided into four parts, each part is called a

quadrant. The four quadrants are numbered in anticlockwise
direction as depicts in following diagram.

Fig. 2.1

The first quadrant depicts the positive values of both X and

Y. It is called positive quadrant. Generally, economic theories are
deals with the positive quadrants.

At times the terms “Graph” and “Diagram” are used

interchangeably. Diagrams, like graphs, are pictorial presentations.
Diagrams may be in the form of figures such as explaining the
circular flow of national income. Graphs are quite meticulous
whereas diagrams can be based on abstraction. For instance, Pie
diagram is a best example of a diagram that indicates through
slicing the percentage- wise composition of a phenomenon, such
 26
as how much percentage of national income is generated from
which sector of the economy.

2.7.7 LINES AND CURVES

The functional relationship between the variables may be
linear or non-linear. A line or a curve is nothing but the locus of
various points. A line depicts the relationship between the
variables. For example, the relationship between consumption and
income as shown in the following diagram:

Fig. 2.2

Line CC1 is a straight line and has a positive slope. It depicts that
aggregate consumption is positively related to aggregate
disposable income. It explains that, an increase in disposable
income will promote to an increase in consumption. Many
economists try to set up the relationship between economic
variables in different ways. One of the most popular and easy
method is through curves. A non linear function of graph is depicted
in terms of curve. Let us consider the following curves.
 27

Fig. 2.3

In the following diagram,DD1 is a smooth downward sloping

non linear demand curve. It explains the relationship between
quantity demanded of good X at various prices. Moreover, SS1 is
an upward sloping supply curve. It is also a non-linear curve and
shows relationship between quantity supplied of good X at various
prices.

2.7.8 SLOPE
Slope is an important term in modern economic analysis.
The slope indicates change in one variable due to a change in
other variable. Slope is defined as the amount of change in the
variable measured on the vertical or Y axis per unit change in the
variable measured on the horizontal or X axis. It is expressed
as ∆Y/∆X, where delta (∆) stands for a change in the variable. The
slope of a curve is an exact numerical measure of the relationship
between the change in the variable Y to change the variable X.

Slope is also popularly termed as ‘the rise over the run’.

Here rise is the vertical distance while run is the horizontal
distance. The measurement of slope can be shown as follows:
 28

Fig. 2.4

In both the diagrams (A) and (B) slope = vertical

distance/horizontal distance. i. e. CD / BC. However, in diagram
(A), slope is negative as the relationship between X and Y is
inverse. Here units of Y decrease with increase in the units of X. In
Diagram (B) the curve is slopping upwards, indicating a positive
relationship between X and Y. Here units of Y increase with
increase in the units of X.

If the curve is non-linear, then its slope changes at various

points. Slope on a non-linear curve is measured at a given point by
drawing a tangent at the given point and is then measured as the
vertical distance/horizontal distance. This is shown in the following
diagram with a non-linear curve. We measure slope at point 'a' by
drawing a tangent at point 'a'. Y1X1 is the tangent drawn at point 'a'.
Slope of the curve at point 'a' is given as 0Y1/0X1

Fig. 2.5
 29
The main properties of slope are:
i) It can be numerically measured.
ii) In case of a straight line, the slope is constant throughout the
curve.
iii) In case of a non-linear curve, the slope changes throughout the
curve.
iv) The nature of the relationship between two variables can be
indicated with the help of slope. If the slope is negative then it
indicates inverse relationship between the two variables and if
the slope is positive, it indicates direct relationship.

Slope of Linear Functions

The concept of slope is important in economics because it is
used to measure the rate at which changes are taking place.
Economists often look at how things change and about how one
item changes in response to a change in another item.

It may show for example how demand changes when price

changes or how consumption changes when income changes or
how quickly sales are growing.

Slope measures the rate of change in the dependent

variable as the independent variable changes. The greater the
slope the steeper the line.

Consider the linear function:

y = a + bx
b is the slope of the line. Slope means that a unit change in x, the
independent variable will result in a change in y by the amount of b.
Slope = change in y/change in x = rise/run

Slope shows both steepness and direction. With positive

slope the line moves upward when going from left to right.
With negative slope the line moves down when going from left to
right.

If two linear functions have the same slope they are parallel.

Slopes of linear functions

The slope of a linear function is the same no matter where
on the line it is measured. (This is not true for non-linear functions.)
 30

Fig. 2.6

An example of the use of slope in economics

Demand might be represented by a linear demand function such as
Q(d) = a - bP
Q(d) represents the demand for a good
P represents the price of that good.

Economists might consider how sensitive demand is to a change in

price.

This is a typical downward sloping demand

curve which says that demand declines as
price rises.

This is a special case of a horizontal

demand curve which says at any price
above P* demand drops to zero. An
example might be a competitor's product
which is considered just as good.
 31

This is a special case of a vertical demand

curve which says that regardless of the price
quantity demanded is the same. An example
might be medicine as long as the price does
not exceed what the consumer can afford.

Fig. 2.7

Supply might be represented by a linear supply function such as

Q(s) = a + bP
Q(s) represents the supply for a good
P represents the price of that good.

Economists might consider how sensitive supply is to a change in

price.

This is a typical upward sloping supply curve which says that

supply rises as price rises

An example of the use of slope in economics

The demand for a breakfast cereal can be represented by
the following equation where p is the price per box in dollars:
d = 12,000 - 1,500 p

This means that for every increase of $1 in the price per box,
demand decreases by 1,500 boxes.

Calculating the slope of a linear function

Slope measures the rate of change in the dependent
variable as the independent variable changes. Mathematicians and
economists often use the Greek capital letter D or  as the symbol
for change. Slope shows the change in y or the change on the
vertical axis versus the change in x or the change on the horizontal
axis. It can be measured as the ratio of any two values of y versus
any two values of x.

Fig. 2.8
 32
Example 1
Find the slope of the line segment connecting the following points:
(1,1) and (2,4)
x1 = 1 y1 = 1
x2 = 2 y2 = 4

Example 2
Find the slope of the line segment connecting the following points:
(-1,-2) and (1,6)
x1 = -1 y1 = -2
x2 = 1 y2 = 6

Example 3
Find the slope of the line segment connecting the following points:
(-1,3) and (8,0)
x1 = -1 y1 = 3
x2 = 8 y2 = 0

2.7.9 INTERCEPT
The horizontal line at the base of the graph is called as
the x-axis and the vertical line on the left hand side of the graph is
called as the y-axis. In economics, generally we use graphs where
price is (p) represented on the y-axis, and quantity (q) is
represented on the x-axis.

An intercept is a point where a line on a graph crosses

(“intercepts”) either x-axis or y-axis. In mathematically, the x-
intercept is the value of x when y = 0. Similarly, the y-intercept is
the value of y when x = 0. The point where two lines on a graph
cross is called an intersection point. In previous section we have
discussed about the slope. Let us discuss this with the help of an
example.
Suppose y = mx + b
Where, m is the slope and b is the y-intercept.
Let us discuss this with the help of a supply curve.
 33
Since the demand curve shows a positive relation between quantity
supplied and price, the graph of the equation representing it must
slope upwards. If the supply equation is linear, it will be of the form:
P = a + b Qs
wherea is the intercept along the Y-axis (the lowest price anyone
would sell for) and b is the slope of the line. Graphically it is
represented as follows:

Fig. 2.9

Where the lowest price anyone would sell for is Rs.50and in

order to supply 100 units of the good, the price must be at a
minimum Rs.250.

2.8 SUMMARY

1. Positive economics deals with what is while normative

economics deals with what should be.
2. Positive economics deals with facts while normative economics
deals with opinions on what a desirable economy should be.
3. Positive economics is also called descriptive economics while
normative economics is called policy economics.
4. Positive economic statements can be tested using scientific
methods while normative economics cannot be tested.
5. Variables, Ceteris Paribus, Functions, Equations, Identities,
Graphs and Diagrams, Lines and Curves, Slopes, Limits and
Derivatives, Time Series etc. are the basic tools of economic
analysis.
 34

2.9 QUESTIONS

1. Explain the concept of ‘Ceteris Paribus’ in detail. Mention its

assumption and importance in economics.
2. What do you mean by Partial Equilibrium? What is the subject
matter of partial equilibrium?
3. Explain the importance of Partial equilibrium?
4. Explain the concept of General equilibrium? Discuss its
assumptions & limitations?
5. Explain the importance of General equilibrium?
6. Distinguish between Positive and Normative economics.
7. Explain in brief various mathematical tools used in economic
analysis.




 35

Module - II

3
TEN PRINCIPLES OF ECONOMICS - I
Unit Structure:

3.0 Objectives
3.1 Introduction
3.2 Principles of Individual Decision Making
3.3 Individual face trade off
3.4 Significance of opportunity cost in decision making
3.5 Rational people think on the margin
3.6 People respond to incentives
3.7 Questions

3.0 OBJECTIVES

1. To study basic principles of economics

2. To study marginal profit principle
3. To study how people respond to incentives
.
3.1 INTRODUCTION

The word ‘Economics’ is originated from the Greek Work

‘Oikonomikos’ which can be divided into two parts.

a) ‘Oikos’ which means ‘Home’ or ‘House’ and

b) Nomos means ‘Management’.

Thus in simple terms, economics means ‘Home

Management’ or ‘Management’ of a Household.

This management becomes essential because our wants are

unlimited and the resources at our disposal are limited. Thus
scarcity of resources is the root cause of economic problem. Thus
economics explains the optimum allocation of scarce resources to
satisfy as many wants as possible.

Economics deals with people and is a reflection of how they

interact with each other when they go about making decisions
regarding their lives. It explains how people make decisions say
how, when, where, what, whom, how much to sell, what to buy,
where to work, whom to sell etc.
 36
Basically the 10 principles are divided into three broad
categories

(I) (II) (III)

Principles of How How the

Decision people Economy as
Making Interact a whole works.

3.2 PRINCIPLES OF DECISION MAKING

Out of 10 principles the first four economic principles are in

principles of Individual Decision Making.

3.3 PRINCIPLE 1 :INDIVIDUAL FACE TRADE OFF

(PEOPLE FACE TRADE OFF)

Trade off means a situation where we have to give up one

thing in order to have another. Thus it is said that ‘There is no such
thing as free lunch’. Thus to get something we like we usually have
to give up something we don’t like. Thus in simple terms to get one
thing we have to sacrifice or give up another thing.

This situation arises because our wants are unlimited and

the resources which are used to satisfy these wants are limited.

Now in this case we have only one plot of land. If we use it

for the school building then we have to give up or sacrifice other
alternatives i.e. industry agriculture, playground etc.

Society comes across several trade-offs like to have guns

(military goods) or Butter (civilian goods). If we spend more on
national defence to protect the country from external aggression
then we will have to spend less on personal goods which will
increase the std. of living of people.

Similarly for a student, if he decides to go out to watch a film

with friend then he is losing out the time for studies
 37
In this case though you with to have both (shirt and shoes),
you cannot have it due to limited income. Thus if you decide to buy
a shirt then you will lose shoes and vice versa.

Another trade-off faced by the society is between efficiency

and equality.

Efficiency means that society is getting the maximum

benefits from its scarce resources. Equality means that those
benefits are distributed uniformly among society’s members. Thus
efficiency refers to the size of economic pie and equality refers to
how the pie is distributed into individual slices.

When the government tries to cut the economic pie into

more equal slices, the pie gets smaller. Government policies get
this conflict between efficiency and equality. For e.g. Govt. policies
of unemployment insurance or welfare system will help the most
needy people in the society. This will bring equality. But other
policies say like personal income tax, then only those who earn
more will pay more tax. More on rich, no or less on poor. This will
bring equality. But it might reduce efficiency. It is so because when
wealth gets distributed from rich to poor then people will feel that
why to work hard and earn more. They will work less and produce
less goods and services.

Of course it does not mean what decisions they will or

should make. Society should not stop protecting the environment
just because environmental regulations reduce our material std. of
living or the poor should not be ignored just because helping them
disturbs the work incentives.

Nonetheless, people are likely to make good decisions only

if they understand the options which are available to them. Thus
study of economics starts by acknowledging life’s trade-offs.

3.4 PRINCIPLE 2 :SIGNIFICANCE OF OPPORTUNITY

COST IN DECISION MAKING

Scarcity of resources forces the people to make trade-offs.

This people must always consider how to spend their limited
 38
income or time to satisfy their unlimited wants or needs. This
decision making requires comparing the costs and benefits of
alternative uses or course of action.

Here we use the term ‘opportunity cost’. It means the next

best alternative given up by the factor. For e.g. The opportunity cost
of playing football today evening is perhaps the foregoing or giving
up the chance to play cricket. When we eat ice-cream then we
forego or sacrifice or give up the chance of using that money for
some other purpose.

Let us take another example let us assume that a person

say Mr. A is having Rs. 1000/- with him. Now he has two options.
One option is that he can keep this money in the banks fixed
deposit and earn 5% rate of interest per annum (year). It means he
will get interest of Rs. 50/-. The other option is that Mr A can invest
this money in some business activities which gives him 10/- returns
(income) per year. i. e. Mr. A will earn Rs. 100/-

Now Mr. A will choose the best. ie he will use that money in
business activity. It gives him Rs. 100/- on Rs. 1000/-. But to
remain in business activity, Mr. A has to sacrifice or forego or give
up the option of keeping in fixed deposit and earn Rs. 50/-. Thus
the opportunity cost of remaining in business is to give up Rs. 50/-.

Another example is that a person has Rs. 50/- with him. He

is going to spend the income on samosa and Idli whose price is Rs.
10/- per unit.

Samosa Idli
A5 0
4 1
3 2
2 3
1 4
0 5
 39

Figure 3.1

First take point D. It shows that he will have 2 idlis (Rs. 20) +
3 samosa (Rs. 30) = Rs. 50. Now if the consumer wishes to have 4
idlis (4 x Rs. 10 = 40/-) then he will have to give up or sacrifice the
samosas. Now at point F, the consumer will have 4 idlis (Rs. 40/-)
and only one samosa (Rs. 10) = Rs. 50/-. Thus the opportunity cost
of getting more idli is to sacrifice few samosas.

Economics normally assumes that people are rational.

Rational people systematically and purposefully do the best to
achieve their objectives. For e.g. A rational consumer tries to
maximise his satisfaction (TU i.e. Total Utility) and the producer
tries to maximize profit rational people make the best use of
available opportunities.

3.5 PRINCIPLE 3 : RATIONAL PEOPLE THINK ON

THE MARGIN

Marginal changes are small, incremental changes to an

existing plan of action.

For e.g. a student who is pondering whether she should add

one more study course next semester. As a rational decision
maker, she will add the extra course as long as her marginal
benefits of carrying extra course is greater than the marginal cost of
doing that course.

Let us take another example. We know that marginal means

additional or extra or one more or incremental etc. let us assume
that a person is producing cricket ball. Now after producing one
more cricket ball there is some additional cost and benefit. Let us
say that the additional cricket bats is sold at r 50/- and I’ts cost is
only Rs. 20/- Now here the person will produce the additional
 40
cricket ball because the profit is of Rs. 30/-. But on the other hand,
if the price of cricket bat falls to Rs. 15, but the cost remain Rs. 20/-
only. Now it is not correct to produce additional cricket ball because
the cost of making additional ball (Rs. 20/-) is greater than the
revenue which can be earned from it (Rs. 15/-).

The cost of additional ball is called as marginal cost (MC)

and revenue obtained by selling extra ball is called marginal
Revenue (MR) Now if MR > MC then there is a sense in producing
additional ball.

Let us take an example of airline Company. It is about how

much the airline should charge the passengers who fly standby, for
e.g. Let us assume that the airline is flying a plane with 100 seats. It
costs Rs. 50,000/- to the airline. Now the average cost of each seat
is Rs. 500/- (Rs. 50,000/- 100/-). Now we might conclude that the
airline should never sell a ticket for less than Rs. 500/-.

But a rational firm will always try to find out different ways to
increase its profit. For that it will have to think at margin. Suppose, if
the plane is about to take off with 10 empty seats and if the standby
passenger will pay less for a seat. Here the airline should sell the
ticket at little low price. If the plane has empty seats then the cost of
adding one more passenger is very less. Although the Ac is r 500/-.
Yet the MC is very less. Here selling the ticket is profitable as long
as the standby passenger pays more than MC.

3.6 PRINCIPLE 4 : PEOPLE RESPOND TO

INCENTIVES

Incentive is something that induces a person to act.

Incentives are the motivating forces. Incentives may be positive or
negative.

Prices act QS incentives and signals changes in price act as

incentives. For e.g., if price rises then it acts as an incentive to the
seller to sell more. The firm may now divert the resources from the
production of low price product to the production of high price
product. It is done to get more profit. It is done to get more profit.

Another e.g. is of public policy towards seat belts and auto

safety. In 1960s, Palph Nader’s book. ‘Unsafe at Any speed’
influenced the congress to pass a law which required that the car
makers must make the seat belts as standard equipment on all
cars. The direct effect of this law is to save lives.

Wages also actas incentives. Increment in wage may

improve the efficiency of the labourer.
 41
Societies where the disincentives to tax evasion are very
high will produce honest tax payers. But if the incentives to tax
evasion (i.e. non-payment of tax) were outweigh the incentives to
being honest, then the same tax payer will become dishonest.

If the returns on coming to the meeting on time are high then

the people will be more punctual. But if people get high returns on
coming late then those who come on time than the rational
individual will decide not to be punctua (will come late).

Incentives to keep small size of family will lower birth

3.7 QUESTIONS

1. What is opportunity cost? Explain the significance of opportunity

cost in decision making.
2. Explain ‘People respond to incentives’.
3. Explain four principles of economics in individual decision
making.
4. Explain how individuals face trade off in decision making.


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4
TEN PRINCIPLES OF ECONOMICS - II
Unit Structure:-

4.0 Objectives
4.1 How people interact
4.2 Organisation of economic activities through market
4.3 Role of government in improving market outcomes
4.4 Macroeconomic instability
4.5 Growth in the quantity of money and inflation
4.6 Inflation and unemployment trade off
4.7 Questions

4.0 OBJECTIVES

1) To study how do people communicate with each other

2) To understand how does whole economy work
3) To study the relationship between increase in quantity of money
and inflation
4) To study the relationship between inflation and unemployment

4.1 HOW PEOPLE INTERACT

It includes following principles.

PRINCIPLE 5 :- INDIVIDUALS AND NATIONS BENEFIT FROM

EXCHANGE
This principle states that trade can make every one better
off. As an individual consumer we consume a variety of products.
But as an individual producer we cannot produce all the things
which we consume. So we concentrate on the production of few
and for remaining products we depend on others. Then we fulfill all
our wants by entering into exchange.

Adam Smith’s pointed out the basic propensity to truck,

barter and exchange. Exchange gives you benefit let us take a 2 x
2 x 1 model i.e. 2 countries, 2 Commodities and 1 labour model.

Commodity x Commodity y
Country A 10 25
Country B 25 10
 43
Suppose in country ‘A’ a laboures produces 10 units of com.
x and 25 units of com. y and in country B, the labourer produces 25
units of com. x and 10 units of com y. Now instead of producing
both the goods, country A should specialize in the production of
commodity y and country B must specialse in the production of
com. x and then they should exchange. In that case both the
countries will get more of x and y.

Division of labour also results in specialization and increases

the efficiency of labour. This will result in more production. This
higher output will be exchanged to get some other thing which is
less in supply.

4.2 PRINCIPLE 6 :- ORGANISATION OF ECONOMIC

ACTIVITIES THROUGH MARKET

Most of the time it is more efficient to organize economic

activity through market. Market provides exchange. A variety of
goods and service are exchanged in the market. We come across
different types of markets. For e.g.

Markets can be local or global :- Market for groceries, market for

Marathi films in Maharashtra etc. is local. Whereas market for crude
oil is international.

Market can be Physical or Virtual :Physical market is where

actual sell and purchase takes place for e.g. vegetable or fish
market in a your local area. Similarly we get virtual market where
buyers and sellers don’t know each other directly (one to one) for
e.g. selling on internet, teleshopping etc.

The organisation of economic activities depend on the

economic system which prevails in an economy. An economic
system is composed of people, institutions and their relationship to
resources. It deals with the problem of scarcity and allocation of
resources. We come across 3 economic systems.

a) Command Economy : Here the economy is controlled by the

government or bureaucracy. The government, through the central
planning makes all decisions about how, when, where, what, how
much etc. to produce.

b) Market economy : Here the decision making activity is done by

firm and individuals. The forms decide on how, when, where, what
etc. to produce and individuals decide on how, when, where, at
what price to buy. The demand and supply decisions of individuals
and firms are transmitted through the price system. In this system,
self interest is the main motive.
 44
c) Mixed Economy : It is a mixture of command and market
economy.

Now In a market economy price mechanism plays an

important role. Equilibrium is attained through price mechanism.
Allocative Function is the most important role of the market. It
brings efficient allocation of scare resources by the firm and the
household. It is done through invisible hand and market forces.
Market price acts as a signal to producers, whether to produce
more or less.

Market also performs the creative function. It provides an

environment for change that helps the expansion of production and
consumption.

Thus, following are the important functions of market.

a) Market economy functions automatically
b) It is highly competitive
c) It gives incentives to producers to produce goods needed by
consumers.
d) It provides an incentive to acquire useful skill.
e) It encourages to conserve resources.
f) There is a high degree of economic freedom. i.e. freedom to
take economic decisions.

4.3 ROLE OF GOVERNMENT IN IMPROVING

MARKET OUTCOMES

Problems of Market Economy: The markets do not achieve

maximum efficiency in the allocation of scarce resources and
governments feel it necessary to intervene to rectify this and other
problems of the market. The conditions required for markets to
perform their allocative and creative functions in an optimal manner
are not likely to be satisfied in any economy. The important
problems of a market economy are:

1) Domination by few : Competition between firms is often

limited. A few large firms may dominate the industry. In these
cases they may charge high prices and make large profits.
Rather than responding to consumer wishes, they may attempt
to persuade consumers by advertising. Consumers are
susceptible to advertisements for products that are unfamiliar to
them.

2) Removes incentive to be efficient : Lack of competition and

high profits may remove the incentive for firms to be efficient.
 45
3) Unequal distribution : There is nothing in the market that
guarantees an equitable distribution of income in the society.
Power and property may be unequally distributed. Those who
have power and property will gain at the expense of those
without power and property.

4) Externality : Presence of externality leads to market failure.

Externalities arise whenever an individual or firm can take an
action that directly affects others without paying for a harmful
one. When externalities are present, firms and individuals do not
bear all the consequences of their action. A very good example
of an externality is the pollution emitted by a firm. When the firm
do not pay for the pollution their cost would be low and hey
would produce more. Presence of externalities leads to
inefficient allocation of resources.

5) Imperfect information : The role of invisible hand in a market

is based on the assumption that the market participants such
as consumers, firms, government, workers, etc. have perfect
information. They have full information about their opportunities,
availability of goods, characteristics of goods and so on.

In reality the market participants are not perfectly informed.

Imperfect information inhibits the ability of markets to perform the
tasks that they carry out well when the information is complete.

The imperfect information possess the problem of

asymmetric information Asymmetric information is a market
situation in which one party in a transaction has more information
than the other party. This can affect the firm’s strategy. It can lead
to market failures. For instance, asymmetric information can lead to
poorly-functioning markets, that is, too much or too little of a good
may be produced. Contracting can be difficult. Fraud is possible.
Consumers may fear purchasing goods when they know that the
seller knows more about the quality of a good than they do. The
problem of buyer ignorance allows rogue traders to operate. The
greater the information asymmetry between sellers and consumers,
the greater the scope for deception and fraud. Under these
circumstances rogue traders are more likely to thrive. For instance,
take the case of builders; by cutting corners and using inferior
materials lower quality builders can undercut higher quality
builders. However, consumers, due to information asymmetry, may
simply believe ‘hat all builders are much the same and may go with
the cheapest cost. As a result, reputed builders may be forced to
cut their costs, by reducing the quality of their work, simply to stay
in business. Thus, imperfect information leads to the market
inefficiencies and market failures. Thus, governments have to make
measures to help improve the information for consumers, investors
and other market participants.
 46
6) Fail to provide public goods : The public goods are those
goods that the marginal cost of providing a pure public good to an
additional person is zero and it is impossible to exclude people from
receiving the good. In other words, public goods are characterized
by two important features, that is, non-rival in consumption and
non-excludability. Non-rival in consumption means that the
consumption of one individual does not reduce the benefits derived
by other individuals. Thus, it would not be appropriate to exclude
others from enjoying such benefits. The provision of such goods
cannot be undertaken through market forces because market
failure occurs.

Since the benefits of such goods are available to all,

consumers will not voluntarily pay for those goods. This is the free-
rider problem that accompanies public goods. Since it is difficult to
exclude anyone from using them, those who benefit from the public
goods have an incentive to avoid paying for them. Hence, the
market failure occurs in the provision of public goods.

The examples of public goods are defence, law and order

and so on.

4.4 PRINCIPLE 8:- MACROECONOMIC

INSTABILITY

A market economy may lead to macroeconomic instability.

There may be periods of recession with high unemployment and
falling output, and other periods of rising prices.

Role of Government:-
Since there are many problems and failures of market
economy we need government to correct market failures or at least
to lessen them. The government has an important role to play in the
economic development of a country, but not so much as a direct
provider of goods and services, rather as an agency to correct
market failures.

The government can play an important role to correct market

failures and improve economic efficiency. The government
intervention is needed in the economy.

i) To improve economic efficiency by correcting market failures.

ii) To pursue social values of equity by altering market outcomes.
iii) To pursue other social objectives by the provision of public and
merit goods and at the same time prohibiting the consumption of
merit goods.

According to R. A. Musgrave and P. B. Musgrave,

government policy is needed to guide, correct, and supplement the
 47
market mechanism in certain respects. The operation of
government includes not only financing but has broad bearing on
the level and allocation of resource use, the distribution of income,
and the level of economic activity. These functions are carried out
through government budget.

1) The government has an important role to play in

development process. It is essential to correct market
imperfections : Government regulation and measures will be
needed to secure the conditions necessary for the functioning of
market mechanism. Government has an important role at
correcting market failures arising from imperfect information,
imperfect competition, externalities and public goods. In the case of
imperfect competitions, firms use their market power to raise prices
and reduce output. The MRTP Act or Competition Policy Act of the
government can help to maintain competitive force and restrain
firms from abusing their monopoly power. Similarly, imperfect
information can lead to inefficient functioning of product and labour
markets. Government can set up regulatory authorities such as
SEBI (Securities Exchange Board of India) to compel the firms to
provide information about their financial conditions.

2) To correct problems of imperfect information : Asymmetric

information refers to the imbalance of knowledge in a market
between buyers and sellers. For example, in the market for bank
loans the borrowers know more about their own circumstances than
the lenders. As consequences, banks could make bad loans. (i.e.
adverse selection) which makes them cautious and leads to credit
rationing. It would be very costly for banks of obtain all the
information about high-risk customers. In this case the government
has to make provisions to make the banks to lend to high risk
customers at concessional rates. Similarly, in the insurance market,
the individuals know more about their health than the suppliers of
insurance. Those who know they are prone to illness are more
likely to take out insurance, and also more likely to be turned down.
Moral hazard is present when the possession of insurance
encourages the activity that is insured leading to resource waste
and higher insurance premium to all. In this case where prob. and
the government may have to regulate private insurance companies
or to provide the service itself at a lower cost.

3) To provide legal structure : The contractual arrangements

and exchanges needed for market operation cannot exist without
the protection and enforcement of a governmentally provided legal
structure. In this respect, government can provide necessary legal
structure and ensure their implementation by the firms and other
parties in the market.
 48
4) To provide public goods and merit goods : Even if the legal
structure is provided and barriers to competition are removed, the
production or consumption characteristics of certain goods like
public goods and merit goods are such that they cannot be
provided through the market. In the case of public goods there is
the free-rider problem due to its characteristics. The important
characteristics of a public good are :i) It is non-rival in
consumption, that is, the consumption by one user does not
reduce the supply available to others, ii) It is non-excludable i.e.
users cannot be prevented from consuming the public good. As a
consequence the market fails in the provision of public goods.
Thus, government has to ensure their provision. The important
public goods that are very important for economic development are
defence, law and order, and the provision of basic infrastructure
such as roads, sewers, clean water and so on.

On the other hand merit goods are the goods that the
government consider to be good for the people, for example
education, health, etc. if they are provided by the market people
may under consume such good. Thus they having to be subsidised
or provided free by the government. Merit goods have to be
provided by the private sector as well as by the state.

5) To correct the problems arising from externalities : There

will arise problems of “externalities” which lead to “market failure”.
This requires correction by the government either by way of
budgetary provisions, subsidy or taxation. In the case of goods with
positive externalities (like research) the firms produce too little of
goods and in the case of goods with negative externalities (such as
that generate pollution) the firms production of goods with positive
externalities. Most infrastructure projects, such as transport
facilities, power generation, irrigation schemes and so on, and
social, capital, such as education and health facilities come under
this category. They have greater social returns than the private
returns and therefore they will be underprovided from a social point
of view unless the private providers in the market are compensated
or subsidised.

The activities with negative externalities (those that pollute

the environment) impose costs on the society that are not paid for
by the provider and hence the market oversupplies those goods
from a social point of view. Government can curb negative
externalities through regulation or taxation.

6) To correct unequal distribution of income and wealth : The

distribution of income and wealth which result from the market
system and form the transfer of property rights through inheritance
is likely to be unequal. In the market system, individual’s incomes
are related to their ownership of assets and their productivity. In
 49
most of the countries, wealth is concentrated in the hands of the
few. In many countries inequalities are linked to inheritance. The
government has to take variety of programs aimed at the poor.
These programs aimed at redistribution of income from the rich to
the poor through welfare programs and taxation policies.

7) To provide an institutional environment : The state has to

provide the appropriate institutional environment for markets to
flourish and operate efficiently including the maintenance of
macroeconomic stability. In this sense the markets and
governmental intervention are complementary. Economic, social
and sustainable development is not possible without an effective
state. State should act as partner and facilitator than director. State
should work to complement markets, not replace them. Good
economic policies including the promotion of macroeconomic
stability is needed for sustainable growth and the reduction of
poverty.

8) To secure important social objectives : The market system

does not necessarily bring high employment, price level stability,
socially desired rate of growth, poverty eradication and economic
development. Measures should be taken to improve health and
nutrition in developing countries. The living standards of the poor
has to be improved by providing clean water, adequate sanitation
and ensuring basic amount of food to the poor. Government
policies are needed to secure these objectives.

9) To provide social security : The market system cannot

provide the social security to its citizens, suffering from
unemployment, sickness, old age disability and so on. The
government has to step in to provide social security to the citizens.

10) To guide the use of natural resources : The market

mechanism cannot bring about appropriate allocation of natural
resources for the present and future generations similarly, the
market mechanism may not be able to control the pollution of
environment. Therefore, consumption of natural resources,
pollution control, etc. should be guided by government policies.

It should be noted, while the government policies can

improve on market outcomes, government measures always may
not succeed. This is because government policy is not made by
angels but by a political process that is far from perfect.

4.5 PRINCIPLE 9 :- GROWTH IN THE QUANTITY OF

MONEY AND INFLATION

Inflation is a situation of a continuous, uninterrupted, long

term increase in price level.
 50
It is a situation of too much of money supply chasing too few
goods. This can be explained with an example we wish to
overcome the problem of poverty. We think that the people are poor
because they do not have enough money. Then people might think
that let’s ask the central bank (RBI in India) of the country to print
new notes and distribute them amount people. But the problem is
that when they have enough money to buy goods, and if the
Quantity of goods remains constant then the prices will start rising.
It shows that people have enough money to buy goods but goods
are not available. This is a case of too much money, chasing too
few goods. This leads to inflation i.e. price rise.

But of course if this higher money supply is used to bring full

utilisation of unused resources then the production will increase.

But generally mere increase in money supply leads to price

rise.

Figure 4.1

4.6 PRINCIPLE 10 :- INFLATION AND

UNEMPLOYMENT TRADE OFF

Inflation – Unemployment Trade-off is a situation where

increased employment is accompanied by increased inflation and
lower inflation is accompanied by lower growth.
People wish to have less inflation and less unemployment is
less then inflation is high and when unemployment is high, inflation
is less. This is explained in the Phillips curve.
 51

Figure 4.2

At point ‘A’ unemployment is less. It is only OU1. It means

more people are employed. They get income. They get income.
Their purchasing power and so demand for goods increases. As
this is not matched by the supply of goods, we get high price
situation (OP1) i.e. inflation.

If unemployment is high i.e. OU2 then a large number of

people do not have sufficient income – thus they have less
purchasing power – so demand for goods is less – prices fall (OP2)
– so less inflation.

Similarly if prices are high (P1) i.e. if there is inflation then

the profit of producer is high – so high investment – so more
employment and less unemployment (OU1).

But if prices are low (OP2) i.e. if inflation is low – low profit –
low investment – less demand for labour and other resources – so
low employment – i.e. high unemployment.

4.7 QUESTIONS

1) Explain ‘trade is good for all’ by giving example.

2) Explain the role of government in improving market structure.
3) Write notes on
a) Private market and role of government
b) Inflation and unemployment
c) Market failure


 52

Module III

5
MARKETS, DEMAND AND SUPPLY
Unit Structure:

5.0 Objectives
5.1 Market: (Market and Competition)
5.2 Meaning of tem demand
5.3 Determinants of demand
5.4 Law of demand
5.5 Individual demand and market demand
5.6 Changes in demand (Increase and decrease in Demand
5.7 Supply
5.8 Law of supply
5.9 Individual supply and market supply
5.10 Change in supply
5.11 Market equilibrium
5.12 Questions

5.0 OBJECTIVES

1. To study the concept of market

2. To understand law of demand and demand curve
3. To study the concepts of individual demand and market demand
4. To study the concept of market equilibrium
5. To study the difference between individual supply and market
supply

5.1 MARKET:- (MARKET AND COMPETITION)

Market, in economics, means, a network of dealings

between buyers and sellers irrespective of any geographical
specification. Thus, market brings together the buyers and sellers
of a particular goods or services. Demand and supply explain the
behaviour of people and their interactions with one another in a
competitive market economy. Demand and supply are the two
basic tools which
a) are at the core (centre) of exchange economy
b) make the economies work
c) affect the events and policies in an economy
 53
Depending on the number of buyers and sellers, nature of
the commodity, concept of entry and exit etc. we come across
different types of markets such as perfect competition, monopoly,
monopolistic competition, Oligopoly, duopoly etc. for e.g.

 Perfect Competition is a market of large number of buyers and

large number of sellers, selling homogeneous product. (Seller
as Price taker)
 Monopoly is a market of large number of buyers and single
seller, selling homogeneous product (Seller / monopolist as
Price maker)
 Monopolistic competition is a market of large number of buyers
and sufficiently large number of sellers selling heterogeneous or
differentiated product.
 Oligopoly is a market of large number of buyers and few sellers
selling differentiated products (Kinked Demand curve)
 Duopoly is a market of large number of buyers and two sellers
selling differentiated products (Special case of oligopoly.)

Similarly we also have

 Local Market mainly for perishable goods and services.
 State or National market for durable items. Other case is
Marathi films have bigger market in Maharashtra state. But
Hindi films have national market.
 International Market is for different goods and services like
financial services.
 We also come across share (Stock Market) bullion Market (for
precious metals like gold / silver etc.), Real Estate market.

We come across competition in the market. Competition is

the effort of two or more parties to ensure their position and
efficiency. Competition brings out the best of quantity and quality. It
ensures the most efficient or optimum allocation of productive
resources.

5.2 MEANING OF TERM DEMAND

In an ordinary language, demand means a desire or a want

for something. But a mere desire or willingness is not a demand in
economics. In economics demand means any desire or willingness
backed by purchasing power. Thus demand = willingness to Buy +
Ability to pay.
 54
E.g. If Mr. X wants to buy BMW car but does not have the ability
then want will not be converted into demand. Similarly Mr. Y may
have the ability to buy chicken but has no desire or willingness to
buy it as he is vegetarian.

In both the cases there is no demand because willingness

and ability both do not go together.

5.3 DETERMINANTS OF DEMAND

(Factors influencing Demand for a product.)

Demand for a particular commodity or a product depends on
the following factors:-

1) Price of the product (P)

Price is the basic determinant of demand. Demand for any
product depends on the price of that product. Usually, there is an
inverse relationship between the two i.e. higher the price, lower is
the demand and lower the price, higher is the demand.

2) Prices of substitutes (Psub) :

Demand for a particular product depends not only on the
price of that product but also on the prices of other substitutes
available in the market. If ‘X’ and ‘Y’ are two substitutes (Pepsi /
coke), then demand for x depends not only on the price of x but
also on the price of Y.

3) Income (Y):
Demand for a product depends on the disposable income of
the individual usually; income and demand are directly related.
Income reveals the purchasing power. Thus higher the income,
greater is the demand and lower the income, lower is the demand.

4) Taste and Preference (T/P) :

Demo and for several products like ice creams, cakes etc.
depends on the taste of a person. At the same time, different
people have different preferences for different products. For e.g.
Non-vegetarian person will give higher preference to non-veg food
than veg. food.

5) Habit (H) :
Demand for a product also depends on the habit. When the
person is habituated to the consumption of a particular commodity
then he creates demand for it. For eg. Demand for cigar, tobacco,
liquor, pan masala etc.
 55
6) Fashion (F) :
When the consumption or use of a particular product is in
fashion trend, then demand for that product rises. Once the
consumption goes out of fashion the demand decreases.

(7) Expectations about future price change :- (Fp)

If the consumer expects some change in future price then
his present demand for the product gets affected. For e.g. If the
consumer expects that the price is going to rise in future, then his
present demand for the product increases.

8) Advertising (A) :
In the competitive market, the demand for many products
depends on advertisements and sales propaganda. Demand for
many products such as soaps, toothpastes etc. is determined by
the advertisement

9) Government Policy (GP) :

If a govt. imposes a tax on the commodity then its demand
falls due to a price. If the govt. offers the subsidy on the product
then its demand rises.

10) Climate / Season :- (CI)

Demand for certain products depends on the climatic
conditions and seasonal changes. For e.g. Demand for umbrella in
rainy season.

11) Social Factor (S) :

Demand for a commodity is also affected by social factors
like customs, traditions, value system, culture etc. For e.g. Demand
for traditional sweets.

5.4 LAW OF DEMAND

The law of demand establishes a functional relationship

between the price and demand for a commodity.

Demand for any product depends on several factors like

Price of the product, income, taste, habit, fashion etc. But, if we
allow all of them to change then the analysis becomes complicated.
To avoid this we make use of the assumption ‘Ceteris Paribus’ i.e.
‘other things being equal’ or ‘other things remaining same or
constant and take relation between P and D.’ This gives us the law
of demand.

The law of demand states that other things being equal,

Quantity demanded of any commodity (say X) varies inversely with
the Price of that commodity (i.e. X). Thus when Price rises, the
demand falls and when price falls, the demand rises.
 56


Dx  f Px , Y , Y , P, H , A, F ,..... 
Dx  f  Px 
Px  Dx  and Px  Dx 

Demand Schedule :-
Demand schedule is a tabular presentation of a relation
between Price and Quantity demanded. It snows the quantities of
the goods that people plan to buy at various prices.

Price per Unit (com. x) Quantity Demanded (com. x)

(Rs.) (units)
50 8 Q
40 12 R
30 20 S
20 30 T
10 50 U
5 65 V
Table 5.1

The above schedule or table shows an inverse relationship

between price and demand. It shows that when price falls from Rs.
50 to Rs. 5 per unit, the quantity demanded rises from 8 units to 65
units. Similarly when price rises from Rs. 5 to Rs. 50 per unit, the
quantity demanded falls from 65 units to 8 units. Thus, higher the
price (Rs. 50),lower is the demand (8 units) and lower the price (Rs.
5), higher is the quantity demanded (65 units).

Demand Curve :- Demand curve is a graphical presentation of a

relation between price and quantity demanded.
 57

Figure 5.1

The demand (dependent variable) is shown on the X-axis

and price Independent variable is shown on the Y-axis. DD is a
demand curve which slopes downwards from left to right. It shows
an inverse relationship between price and quantity demanded.
Each and every point on the demand curve gives a specific
relationship between price and quantity demanded. For e.g. At
some point ‘T’, the price is Rs. 20 and Quantity demanded is 30
units. The inverse relationship between price and demand is true
for almost all goods in the economy.

Assumptions of the law of Demand

Law of demand is based on following assumption
1. Income remains constant :- There is no change in income – i.e.
neither increase nor decrease.
2. There is no change in the prices of substitutes.
3. There is no change in the taste and preference of the consumer.
4. There is no change in fashion and advertisement.
5. No change in govt. Policy. There is neither increase nor
decrease in taxes or subsidies.
6. Consumer does not expect any change in the future price.
7. The quantity of money in circulation remains constant.
 58
Demand function for price
Law of demand explains the functional relationship between
price and quantity demanded.

Qx  f  Px 
Qx  Quantity Demanded of commodity X
f  Functional relationship
 Px   Price of commodity X
Qx  a  bPx
Qx  100  5x

Price Per Unit Quantity Demanded in Unit

` Qx  100  5x

0 100
1 95
2 90
3 85
4 80
5 75
Table 5.2

It shows an inverse relationship between price and quantity

demanded.

Demand
Figure 5.2

 Individual Demand v/s Market Demand is a desire backed by

purchasing power.
 59

5.5 INDIVIDUAL DEMAND AND MARKET DEMAND

Individual Demand:
Individual demand is the demand for a commodity by an
individual buyer, at a particular price and at a particular point of
time in the market. It is a part of market demand.

Individual Demand schedule gives us the tabular

presentation of a relation between price and Quantity demanded by
an individual.

Let us take the price of some commodity X and the Quantity

demanded of commodity X by two individuals, say individual A and
individual ‘B’ separately.

Price of Demand Price of Demand

Com. X Individual A Com x Individual A
50 1 50 2
40 2 40 4
30 3 30 6
20 4 20 8
10 5 10 10
Table 5.3

The above tables show that as the price of commodity x

falls, the demand for commodity x, rises for both the individuals.
From these two schedules we can draw two demand curves for
individual A and B respectively.

Figure 5.3
In both cases the demand curve slopes downwards from left
to right, indicating inverse relationship between price and quantity
demanded.
 60
Market Demand :
If refers to the sum of (aggregate or total) all the individuals
demand in the market for a particular commodity, at a particular
price and time in the market. Market demand is a summation of
individual demands.
Market Demand scheduler is a tabular presentation of the
relation between quantity demanded and different prices of com. X
by all consumers in the market. It is calculated at a point of time.

Price of Com. X Quantity Demanded Market Demand

Individual A Individual B
50 1 2 03
40 2 4 06
30 3 6 09
20 4 8 12
10 5 10 15
Table 5.4

Market Demand curve

Figure 5.4

Demand on x axis and price on y-axis

The above diagram shows that the demand curves of
individual A, B and the market demand curve (D x A + B) slope
downwards from left to right. This indicates an inverse relationship
between price and demand. Market demand curve (D x A + B)
being the summation of D x A and D x Bis bit flatter.
 61
Variation in Demand and changes in Demand. (Movement Vs
shift in Demand curve)

Variation in demand :- There are many factors that determine

demand. One of the important factors is price. When he demand
changes only due to changes in price then we get variation in
demand. It is explained in two ways namely Extension(Expansion)
and Contraction of demand.

In this we keep all other variables constant and bring change

in price of the product alone.


Dx  f Px , Psub , Y , T , P, H , A, F ,..... 
Dx  f  Px 

(com-x)

Figure 5.5

Demand is shown on the x-axis and price on the y-axis. DDx

is a demand curve which slopes downwards from left to right. Let
us take two points viz. A and B on this demand curve.

At point ‘A’ the price is OP1 and the demand is OM 1 . At point

‘B’ the price is OP2 and the demand is OM 2 .

Now when Price falls from OP1 to OP2 then the demand
expands from OM 1 to OM 2 . The consumer moves from point A to
point B, but remains on the same demand curve DD. This is called
as the Extension or expansion of demand. Similarly when price
rises from OP2 to OP1 , then demand contracts from OM 2 to OM 1 .
The consumer moves from point B to A, but remains on the same
demand curve DD. This is called as contraction of Demand.
Thus in expansion (extension) and contraction of demand
we get two important things :
 62
1. Change in price of commodity alone. (Keeping other variables
constant.)
2. Movement along a given demand curve

For e.g. If government increases the tax on a soft drink say

‘Goldy’ to discourage the consumption. Now due to the imposition
of tax the price of ‘Goldy’ drink rises and thus the demand
contracts. But if the tax is removed then the price of ‘Gloldy’ falls
and the demand expands.

5.6 CHANGES IN DEMAND(INCREASE AND

DECREASE IN DEMAND) (SHIFT IN D CURVE)

Demand for any product depends on the price of that product and
also on several factors like prices of substitutes, income, taste,
preference etc. In changes in demand we remove the assumption
other things remaining the same and bring a change in all demand
determinants.
Thus the price may or may not change but the change in
factors other than price gives us either increase or decrease in
demand.
Increase in Demand :

Figure 5.6

In this diagram, the demand is shown on the x-axis and the

price on the y-axis. DD is the original demand curve and op is the
original price.

Now increase in demand is shown in two ways

1. At a higher price (OP1), same quantity is demanded i.e. OM and

2. At a same price (OP) more quantity is demanded i.e. OM1.

We get a shift in the demand curve from DD to D1D1. The

demand curve shifts to the right of the original demand cure
 63
This happens due to
i) Increase in income ii) change in taste and preference in favour of
that commodity iii) Rise in prices of substitutes iv) Change in
fashion v) Rise in population etc.

Decrease in Demand:-

Figure 5.7

Demand on the x-axis and price on the y axis. DD is the

original demand curve. OP is the original price and OM is the
original quantity demanded. Now the decrease in demand is shown
in two ways.

3) At same price (OP1) less quantity is demanded i.e. OM2 and.

4) At a lower price (OP2), same quantity demanded i.e. OM1.

In this case, the demand curve shifts from DD to D2D2. The

demand curve shifts to the left of the original demand curve.

This happens due to

i) Fall in income
ii) Change in taste and preference against the commodity
iii) Consumption goes out of fashion.
iv) Fall in prices of substitutes
v) Fall in population etc.

Thus in increase and decrease in demand we get 2 things

I) Change in factors other than price (price may or may not
change)
II) A shift in the demand curve. To the right increaseand to the left
decrease.

A combined case (you can draw a linear or non-

linear demand.)
 64

Figure 5.8

Variation in Demand Change in Demand

1) It occurs due to change 1) It occurs due change in
in price alone factors other than price
2) It gives us movement 2) It gives us a shift in
along a given demand demand curves
curve
3) It is explained with 3) It is explained with
Expansion (Extension) increase and decrease
and Contraction of in Demand.
Demand.

Figure 5.9

5.7 SUPPLY (S)

The supply side of the market explains the behaviour of the

seller. In economics supply means, the amount of the commodity
which the seller is able and willing to offer for sale at a particular
price, during a particular period of time. Supply is a relative term. It
 65
is always referred in relation to price and time. Supply & price are
directly related.

In economics, supply means. “the amount of the commodity

which the seller (producer) is able & willing to offer for sale at a
particular price, during certain period of time.

Determinants of supply :- (factors influencing supply) Factors

affecting supply of a commodity are –
1) Price of the commodity :- Price is the single largest factor
influencing the supply of a commodity. More is supplied at a
lower price & less at a higher price.
2) Seller’s expectations :- sellers expectations about the future
price affects the supply. If a seller expects the price to rise in the
future, he will with- hold his stock at present and there will be
less supply now.
3) Natural Conditions :- Supply of some commodities such as
agricultural products, depends on the natural environment or
climatic conditions like rain fall, temperature etc. e.g. A good
monsoon will produce a good harvest, so the supply of the
agricultural products will increase.
4) Transport Conditions :- There should be well connected
proper approach routes, quick & cheap modes of transportation
& effective and quick communication systems. This will increase
supply.
5) Price of Related products :- Prices of substitutes or related
products also influence the supply of a commodity. If the price of
wheat rises, farmers may grow more of wheat & wheat & less of
rice so supply of wheat will rise.
6) Cost of Production :- When the cost of production rises the
supply decreases. E.g. When factor payments (rent, wages etc.)
increases, the cost of production rises & supply falls.
7) The state of Technology :-The supply of the commodity
depends upon the methods of production. An improvement in
technique of production reduces cost & so supply increases.
8) Factors outside the Economic sphere :- Fire, wars,
earthquakes etc. may destroy productive assets of the
commodity and restrict future supplies.
9) Govt. policies(Taxes & subsidies) :- With an increase in the
rate of a tax on a commodity, the supply of that commodity
would decrease & vice versa. On the other hand, with an
increase in the amount of a subsidy on a commodity, its supply
would increase and vice versa.
10)Nature of Market :- Supply of a commodity would be higher
when there is a competitive market. But in monopoly, the supply
 66
may be low. This is so because a monopolist may create
artificial scarcity to raise the price.
11)Period of time :- In a very short period, the supply of a
commodity may be fixed, whatever may be the price. But over a
period of time, the supply is adjusted with demand.
12)Self – Consumption :- If a farmer keeps a large stock for self –
consumption then the supply is less.
Sx = f (Px, Psub, Sex p, Mat, Cond, …)

5.8 LAW OF SUPPLY

The law of supply explains the relationship between price

and quantity supplied. The law of supply states that ‘other things
remaining the same, quantity supplied of any Commodity (say x)
varies directly with the price of that commodity (i.e. x). Thus when
price rises, the supply rises and when the price falls, the supply
also falls.


S x  f Px , Psub , I , G, T , G p ,..... 
S x  f  Px 
Px  S x , Px  S x 
(I = Investment, G = Goal, T = Technology etc.)

Supply Schedule :- Supply schedule is a tabular presentation of a

relation between price and quantity supplied of a particular
commodity. It shows the quantities of the good that the seller plans
to sell at various prices.
Table 5.5

Price () (Com. X) Supply (Com. X)

50 500 T
40 400 U
30 300 V
20 200 W
10 100 X

The above table (schedule) shows the direct relationship

between the price and Quantity supplied. It shows that when price
falls from Rs. 50/- to Rs. 10/- then the supply also falls from 500
units to 100 units. Similarly, when the Price rises from Rs. 10/- to
Rs. 50/- then the supply prices from 100 units to 500 units. Thus,
higher the price (Rs. 50/-), higher is the supply (500 units) and
lower the price (Rs. 10/-), lower is the Quantity supplied (100 units).
 67
Supply Curve: It is a graphical (diagrammatic) presentation of a
relation between price and quantity supplied.

Figure 5.10

Supply on x–axis and price on the y-axis. SS is the supply

curve which slopes upwards from left to right. It shows a direct
relationship between price and quantity supplied. Each and every
point, on the supply curve gives us a specific relationship between
price and supply at that point. For e.g. Point ‘V’ shows that the price
is Rs. 30/- and the supply is 300 units. This direct relationship
between price and supply is true for almost all goods in the
economy.

Assumptions of Law of supply

Assumptions :- The law of supply is based on following
assumptions.

1) Self-consumption :- The law assumes that the producer of a

commodity dose not increase his own consumption of a
commodity.
2) Technology :- The law assumes that there is no change in the
technique of production. The technology or the method of
production remains constant. i.e. absence of technological
change.
3) Cost of Production :- The law of supply assumes that the cost
of production remains constant. There is no change in the cost
of production. E.g. Wages, Interest etc. are unchanged.
4) Fixed Scale of Production :- During a given period of time it is
assumed that the scale of production remains constant. If the
scale of production changes, then the level of supply will also
change irrespective of change in the price of the product.
 68
5) Govt. Policies :- Govt. Policies like taxation policy, trade policy
etc. are assumed to be constant. There is no change in
subsidies also.
6) No change in Transport Cost :- The law assumes that
transport facilities & transport costs are unchanged. There are
given means of transport.
7) No speculation :- The law assumes that the sellers don’t
speculate about the future changes in the price of the product.
8) Prices of Competitive Goods :- It is assumed that the prices of
all competitive goods which are substitute to a product remain
constant.
9) Weather Conditions :- The law assumes that the weather
conditions are normal e.g. Normal rain fall, absence of natural
calamities etc.

5.9 INDIVIDUAL SUPPLY AND MARKET SUPPLY

Supply is the quantity (amount) of a commodity which the

seller is able and willing to sell at a particular price and at a
particular time in the market.

Individual supply: It is the supply of a commodity by an individual

seller at a particular price and at a particular point of time in the
market.

Individual supply schedule :It gives us the price and quantity

supplied of a commodity by an individual seller.

Let us take the price of some commodity X and the quantity

supplied of commodity X by say two sellers A and B.
Table 5.6
Price of Supply of X Price of Supply of X
Com. X by Seller A Com x by Seller B
50 5 50 10
40 4 40 8
30 3 30 6
20 2 20 4
10 1 10 2

The above tables show that for both the sellers (A and B),
sell less of X when price falls and supply more of commodity x
when price of commodity x rises.
 69
Individual supply curve :- It is a graphical presentation of a
relation between price and supply.

Supply curve Supply curve

(Seller - A) (Seller - B)

Figure 5.11

Upward sloping supply curve (SxA and S x B) give direct

relationship between price and supply.

Market supply :- It refers to a sum of (aggregate / total) all the

sellers supply in the market of a particular commodity, at a
particular price and time in the market. Market supply is the
summation of all individual supply.

Market supply schedule :- It is a tabular presentation of a relation

between quantity supplied at different prices of com. x by all the
sellers in the market. It is calculated at a point of time.

Price of Com. X Quantity Supplied Market Supply

Seller A Seller B
50 5 10 15
40 4 8 12
30 3 6 9
20 2 4 6
10 1 2 5
Table 5.7
 70
Total Market supply curve :-

Supply

Figure 5.12

Supply on the x-axis and price on the y-axis. The above

diagram shows that the supply curves of sellers A and B and the
market supply curve (Sx A+B), slopes upwards from left to right.
This shows a direct relationship between price and supply. The
market supply curve (S x A + B) being the commission of s x A and
S x B is flatter.

 Variation in supply and changes in supply (Movement V/S

shift in supply curve)

Variation in Supply :Supply of any commodity depends on several

factors such as price of that product, prices of substitutes,
investment outlay, goal, technology etc. But in variation in supply
we assume that all other variables remain constant and we take
note of change in price alone that affects the supply. It is explained
in two ways viz. extension (Expansion) and contraction of supply.
In this case we keep all other variables constant and bring
change in price of the product alone, which affects supply.


S x  f Px , Psub , I , T , G p ,..... 
S x  f  Px 
 71

Figure 5.13

Supply is shown on the x axis and price on the y-axis. SSx is

he supply curve which slopes upwards from left to right. We select
two points on supply curve as A and B.

At point ‘A’ the price is OP1and supply is OM1. At point ‘B’,

the price is OP2 and the supply is OM2.

Now, when price rises from OP1 to OP2 then the supply
expands from OM1 to M2. The seller moves from point A to B but
remains on the same supply curve i.e. SS. This is called as
Expansion (Extension) of supply.

Similarly, when price falls from OP2 to OP1, the supply

contracts from OM2 to OM1. Now the seller moves from point B to
point A but remains on the same supply curve i.e. SS. This is called
as contraction of supply.

Thus in extension and contraction of supply, we get i) change in

price alone ii) movement along a given a supply.

5.10 CHANGES IN SUPPLY – SHIFT IN SUPPLY

CURVE (INCREASE AND DECREASE IN
SUPPLY)

Supply of any product or commodity depends on the price of that

product and also on the technology, govt. policy, goal or objective
etc. In, changes in supply we remove the assumption ‘other things
remaining constant’ and bring a change in all variables.

Thus the price may or may not change but change in factors
other than price gives us either increase or decrease in supply. We
get a shift in supply curve.
 72
Increase in Supply :

Figure 5.14

Supply on the x-axis and y-axis. SS is the upward sloping

supply Curve (original). The original Prince is OP and Original
Quantity supplied is OM. Now, increase in supply is shown in two
ways.

1. At same price (OP), more quantity is supplied i.e. OM1 and

2. At a lower price (OP1), same quantity is supplied i.e. OM.
We get a shift in the supply curve from SS to S1S1. The
supply curve shifts to the right of the original supply curve.
This happens due to
i) Fall in cost of production,
ii) Improvement in technology
iii) Favourable change in govt. Policy
iv) Increase in investment etc.
Decrease in supply :

Figure 5.15

SS is the Original supply curve. OP is the original price and

OM is the original quantity supplied. Now increase in supply is
shown in two ways :-

3) At same price (OP), less quantity is supplied i.e. OM2 and

4) At a higher price (OP2), same quantity is supplied, OM.
 73
In this case the supply curve shifts to the left of the original
supply curve (SS to S2S2)

This happens due to

i) Rise in cost
ii) govt. policy becomes unfavourable
iii) fall in investment outlay
iv) Transport bottleneck etc.

Thus in increase and decrease in supply we get

I) Change in factors other than price
II) Shift in the supply curve – to the right then increase and to the
left then decrease in supply.

Figure 5.16

Variation in Supply Change in Supply

1) It occurs due to change in 1) It occurs due change in
price alone factors other than price
2) It gives us movement 2) It gives us a shift in
along a given supply curve supply curves
3) It is explained with 3) It is explained with an
Extension and Contraction increase and decrease
of supply. in supply. If the curve
shifts to the right then
increase and if to the left
then decrease
 74

Figure 5.17

5.11 MARKET EQUILIBRIUM

Market is a network of dealings between buyers and sellers

irrespective of any geographical specification.

Equilibrium is a state of rest or balance where two opposite

forces are balanced with each other in such a way that any further
movement away from that position is not possible as well as
profitable.
As to cut a piece of cloth we need two blades of scissors,
similarly to determine the market price of a commodity we need two
economic variables viz. demand and supply. Demand and supply
together give us the market equilibrium.

The demand and price are inversely related and the demand
schedule and curve explains the quantities that individual plan to
demand at various prices.
Similarly the supply and Price are directly related and the
supply schedule and supply curve explains the quantities that a
seller plans to sell at various prices.

Price (`) Demand Supply Pressure on Price

50 100 500 Downward
40 200 400 Downward
30 300 300 Neutral
20 400 200 Upward
10 500 100 Upward

Table 5.8
To begin with, let us assume that the price is Rs. 50/- At this
price the supply (500 units) is greater than the demand (100 units).
Due to the excess supply we get a downward pressure on the price
(too much of anything reduces its value). Now the price falls to Rs.
 75
40/- Now there is some increase in demand and fall in supply, yet
the supply is greater than the demand. Thus we get a further
downward pressure on price. The process continues till we reach
equilibrium point i.e. price (Rs. 30/-) where D = S (300 units).
Similarly at the price Rs. 10/-, we find that the supply (100
units) is less than the demand (500 units). It shows scarcity (S<D)
and scarcity gives higher value to the product. Thus there is an
upward pressure on price. It rises till it reaches the equilibrium
point, i.e. E.
Thus Rs. 30/- is the equilibrium price where D = S. No
further movement is possible as well as profitable. 300 units is the
equilibrium quantity. This equilibrium price is also called a ‘market
clearing price’ because at this price everyone in the market is
satisfied.

It is explained in the following diagram

Figure 5.18

Units of commodity (D and S) are shown on the x-axis and

price on the y-axis. The downward sloping demand curve DDx cuts
the upward sloping supply curve SSx at equilibrium point ‘E’. At this
point the equilibrium price is ‘OP’ (Rs. 30/-) and equilibrium quantity
is OM. (300 units).

Now, let us assume that the price rises from OP to OP1.

Now we find that the supply P b is greater than the demand P1a.
Due to surplus, there is a downward pressure on the price and it
falls back to OP.
 76
Similarly at OP2 price, the supply P2d is less than the
demand P2C. Now, due to scarcity the price rises till it comes back
to the original price OP.
In this way, with the necessary changes in demand and
supply, the system comes back to the original point of equilibrium
(e.g. A ball kept at the bottom of the bowl.)

Example
Equilibrium Price
Demand Equation:-
Dx  a  bPx
Where Dx =Demand for commodity x
a = constant parameter giving Quantity demanded
irrespective of price.
b = Constant parameter giving relation between P x and
Dx
Px = Price of Commodity X.
As ‘b’ has negative sign the relationship is inverse.

Supply Equation:-
S x  c  dPx
S x  Supply of commodity x
c  Constant parameter giving quantity supplied irrespective
of price
d = Constant Parameter giving relationship between Px and
Sx
Px = Price of commodity X

Here ‘d’ has a positive sign. Thus the relationship is direct.

Let us assume that

Dx  34  3Px and Sx  6  4Px

Now at equilibrium :
Dx  S x
 34  3Px  6  4 Px
 34  6  4 Px  3Px
 28  7 Px
28
 Px 
7
 Px  4

Now let us insert price ‘4’ in the equations of demand and

supply.
 77

Dx  34  3Px S x  6  4 Px
Dx  34  3  4  S x  6  4  4 
Dx  34  12 S x  6  16
Dx  22 S x  22

Px  4 is the equilibrium price where Quantity demanded

equals quantity supplied. (i.e. 22 units)

Market Not in Equilibrium :

Market not in equilibrium explains a situation of
disequilibrium in the market. It is a situation where D> S or S <D.
Thus there is either shortage or surplus.

At equilibrium S = D but if S  D then

(I) (II)
S>D S<D
(surplus) (scarcity)

Figure 5.19

I) In diagram I, we find that at OP1 price the supply P1 b (OM2) is

greater than the demand P1 a (OM1). It shows that there is
surplus in the market. The seller wishes to sell more but
demand is less. Thus to attract the buyers, the seller will lower
the price. The process continues till we reach the equilibrium
point (E), price (OP) and quantity (OM).

II) In diagram II, we find that at OP2 Price, the supply P2d (OM,) is
less than the demand P2C (OM2). It shows that there is a
scarcity or shortage of goods. The buyers are willing to buy
more but the supply is less. Now the seller will take advantage
of this situation and will raise the price. The process continues
till the system reaches the equilibrium point (E), Price (OP) and
quantity (OM).
 78
Thus the activities of buyers and sellers always push the
market price towards the equilibrium price. The shortages and
surpluses are temporary. Reaching equilibrium point (fast or slow)
differs from market to market.

Three steps to analyse changes in Equilibrium :

The position of the demand and supply determines
equilibrium price and quantity. Due to the changes in factors other
than price we get a shift in the demand and supply curves. These
factors are changes in prices of substitutes, income, investment
outlay, govt. policy etc. it gives us either increase or decrease in
demand and supply.
The effects of shift in demand and supply on market
equilibrium are studied in three steps.
a) A change due to shift in demand curve.
b) A change due to a shift in supply curve
c) A change due to shift in both i.e. the demand and supply.

A) Change in Market equilibrium due to a shift in demand curve.

Figure 5.20

Let us explain the situation with an example of Air-

conditioners (ACs). In the above diagram ‘E’ is the original point of
equilibrium, OP is original equilibrium price and OM is original
equilibrium quantity (D=S).

a) Case of increase in demand :

Let us assume that it is a summer. Due to the rise in heat we
get an increase in demand of ACs in spite of no change in price.
When the demand for ACs increases we get a shift in the demand
curve (to the right) from DD to D1D1. It cuts the supply curve (SS)
at a new equilibrium point E1. Now the price rises from OP to OP1.
This rise in price brings higher supply and at new equilibrium point,
the demand equals supply at OM1.
 79
In this case we get two important things. One is we get a
shift in demand curve from DD to D1D1. i.e. increase in demand.
Another is that at new equilibrium point E1 there is an expansion of
supply as we remain on the same supply curve.

b) Case of Decrease in Demand :-

During winter the demand for ACs falls due to cold. Thus the
demand curve shifts to D2D2i.e. decrease in demand. It cuts the
supply curve (SS) at new equilibrium point E2. The price falls to
OP2. Now due to fall in price, the seller will contract the supply. Now
the new quantity will be OM2. In this we get decrease in demand
where we shift over to a new demand curve D2D2. We also get a
contraction of supply (movement on the same supply curve SS).

B) Change in market equilibrium due to a shift in supply curve.

Figure 5.21

In both the diagrams DD is the original demand curve cutting

SS which is original supply curve. Original equilibrium point is E,
equilibrium price is OP and equilibrium quantity is OM.

Let us take e.g. of production of sugarcane and sugar,

affecting its supply.

a) Increase in supply :-
Let us assume that due to sufficient rainfall, the production of
sugarcane increases. Thus the supply of sugar increases which
results in the fall in price of sugar. Thus the supply curve shifts to
the right S1S1 and cuts the demand curve at new equilibrium point
E1. The price falls from OP to OP and supply increases to OM1.

Now due to the fall in price of sugar, the demand for sugar
will rise. More sweets will be created due to fall in cost of input i.e.
sugar. Thus higher supply will be matched by higher demand (OM1)
at new equilibrium price OP1. Here (at E1) we get an increase in
supply where supply curve shifts to the right (S1S1) and expansion
of demand i.e. movement along a given demand curve DD.
 80
b) Decrease in supply :-
Let us assume that due to a bad monsoon, the production of
sugarcane falls. Thus the supply of sugar decreases. The curve
shifts to the left (S2 S2) and we get a new equilibrium point E2.
Now the price rises to OP2. Now new quantity supplied (OM2) will
be matched by contraction of demand to OM2. (fall in supply of
sugarcane reduces the supply of sugar OM2). Thus price of sugar
rises to OP2.

In this case we get decrease in supply i.e. shift in supply

curve SS to S2S2 and contraction of demand i.e. movement from E
to E2 along a given demand curve DD.

c) Change in market Equilibrium due to a shift in both i.e.

Demand and supply.
In this case we observe and study a simultaneous increase
or decrease in demand and supply. We can explain this with the
help of several situations like increase in supply, decrease in
demand and vice versa and even the change in extent (more or
less).

In this case let us observe two situations with increase in

demand and decrease in supply.

Figure 5.22

In both the cases the original point of equilibrium is E (D =

S), OM is original quantity and OP is original equilibrium price.

a) In this we find that demand increases more than proportionately.

We get a large increase in demand. Thus demand curve shifts from
DD to D1D1 (greater distance). Say due to festival demand for
sugar increases very fast.
 81
But we get a decrease in supply may be due to bad season.
But here supply decreases slightly from SS to S1S1.

Now the new equilibrium point is E1 and price rises sharply

from OP to OP1 due to very high increase in demand.

b) In his case we get a moderate increase in demand from DD to

D2D2. But due to a very bad season the supply of sugarcane and
so sugar decreases sharply from SS to S2S2. Now the price again
rises sharply from OP to OP2 and Quantity falls from OM to OM2.

Thus in both the cases, the price rises sharply from OP to

OP1. In one case (a) the quantity rises and in other it falls (b).

5.12 QUESTIONS

1) What is market?
2) What is competition?
3) Write a note on Demand Curve.
4) Explain the difference between Individual demand and
market demand.
5) Explain the difference between individual supply and market
supply.
6) Explain the concept of market equilibrium.
7) Write notes on
 Law of demand
 Law of supply


 82

6
ELASTCITY OF DEMAND
Unit Structure :-

6.0 Objectives
6.1 Introduction
6.2 Various Concepts of Demand Elasticity
6.3 Price elasticity of Demand.
6.3.1 Measurement of Price Elasticity of Demand
6.3.2 Degrees of Price elasticity on Demand Curve
6.3.3 Different degrees of elasticity
6.3.4 Price Elasticity of demand and changes in total
expenditure
6.3.5 Determinants of price elasticity of demand
6.4 Income elasticity of Demand
6.4.1 Income elasticity and proportion of income spent.
6.4.2 Income elasticity : Necessities, Luxuries and Inferior
goods.
6.5 Cross Elasticity of Demand
6.6 Promotional Elasticity of Demand.
6.7 Summary
6.8 Questions

6.0 OBJECTIVES

After reading this unit you will come to know :-

 The concept of elasticity of demand
 Price elasticity of demand
 Measurement of price elasticity
 Different Degrees of price elasticity
 Determinants of price elasticity
 Income elasticity of demand
 Cross elasticity of demand
 Promotional elasticity of demand

6.1 INTRODUCTION

When the price of a good falls, its quantity demanded rises

and when the price of the good rises its quantity demanded falls,
 83
except in case of a Geffen good. This is generally known as law of
demand. This law of demand indicates only the direction of change
in quantity demanded in response to a change in price. This does
not tell us by how much or to what extent the quantity, demanded of
a good will change in response to a change in its price. This
information as to how much or to what extent the quantity
demanded of good will change as a result of a change in its price is
provided by the concept of elasticity of demand. The concept of
elasticity of demand forms the subject matter of the present
chapter. The concept of elasticity has a very great importance in
economic theory as well as in applied economics.

6.2 VARIOUS CONCEPTS OF DEMAND ELASTICITY :-

It is price elasticity of demand which is usually referred to as

elasticity of demand. But, besides price elasticity of demand. There
are various other concepts of demand elasticity. As we know, that
demand for a good is determined by its price, incomes of the
people price of related goods etc. Quantity demanded of a good will
change as a result of a change in the size of any of these
determinants of demand. Accordingly, there are there kinds of
demand elasticity : Price elasticity income elasticity, and cross
elasticity.

Price elasticity of demand relates to the responsiveness of quantity

demanded of a good to the change in its price.
Income elasticity of demand refers to the sensitiveness of
quantitative demanded to the change in income.
Cross elasticity of demand refers to the degree of responsiveness
of demand for a good to a change in the price of a related good,
which may be either a substitute for it or a complementary with it.
Besides these three Kinds of elasticity’s there is another type
of elasticity of demand called elasticity of substitution which refers
to the change in quantity demanded of a good in response to a
change in its relative price alone, real income of the individual
remaining the same.

6.3 PRICE ELASTICITY OF DEMAND :-

As said above, price elasticity of demand expresses the

response of quantity demanded of a good to changes in its price,
given the consumers income his tastes and prices of all other
goods. In other words, price elasticity of demand is a measures of
relative change in quantity purchased of a good in response to a
relative change in its price. Price elasticity can be precisely defined
 84

as the proportionate change is quantity demanded in response to a

small change in price, divided by the proportionate change in price.
Thus,
Pr oportionate change in quantity demand
Pr iceElasticity 
Pr oportionate change in price.

Change in quantity demand / Quanity demand


Change in price / Pr ice
or in symbolic terms ,
q / q q p
ep   
p / p q p
q p
 x
q p
q p
 x
p q

Where epStands for price elasticity

Q Stands for quantity
P Stands for price
 Stands for infinitesimal changes.
Mathematically speaking price elasticity of demand (Cp) is
negative, since the change in quantity demanded is in opposite
direction to the change in price. But for the sake of convenience in
understanding the magnitude of response of quantity demanded to
the change in price we ignore the negative sign and take into
account only the numerical value of the elasticity e.g. if 2% change
in price leads to 4% change in quantity demanded of good A and
8% change in that of B then the above formula of elasticity will give
the value of price elasticity of good A equal to 2 and of good B
equal to 4. It indicated that the quantity demanded of good B
changes much more than that of good A in response to a give to a
given change in price But if we had written minus signs before the
numerical values of causticities of two goods, that is, if we write the
elasticity of two goods, that is, if we write the elasticity’s as 2 and 4
respectively as strict mathematics would require us to do then since
-4 is smaller than -2, we would be misled in concluding that price
elasticity of demand of B is less than that of A hence it is better to
ignore minus signs and draw conclusions from the numerical values
of elasticity.
 85
5.3.1. Measurement of Price Elasticity of Demand :-
There are two methods of measuring price elasticity of Demand.
A] Point Elasticity of Demand.
B] Arc Elasticity of Demand.
A. Measurement of elasticity at a point on the Demand
Curve :-

Let a straight line demand curve DD1 be given and it is

required to measure elasticity at point R on this curve. In fig. 5.1
corresponding to point R on the demand curve DD1price is OP and
quantity demanded at is OQ. With a small fall in price from OP to
OP1, quantity demanded increases from OQ to OQ1.

{
{

Figure 6.1

Pr oportionat e change in quanity demands

Pr iceelastic ity 
Pr oportionat e change in price
u sin g symbols ,
q p
ep  
q p

q p q p
 x  x         ( i )
q p p q
 86

In figure 6.1 when price falls from OP to OQ1 quantity demanded

increases from OQ to OQ1. This change in price by PP1 Causes
change in quantity demanded (ΔQ) by OQ1. Substituting these in (i)
above, we get.

Q P QQ 1 OP
ep  x  x
P Q PP 1 OQ

Since in Fig. 6.1, QQ1 = MR1 and PP1 = RM and

OP = QR

MR 1 QR
Therefore ep  x      ( ii )
RM OQ

Now take triangles RMR1 and RQD1 in fig 6.1

MR1 R  QD 1 R( CorrespondingS )

RM 1 R  RQD 1 ( RightS )
TheirMRR' is common to both the triangles

Therefore triangles RMR 1 and RQD 1 are similar. A property of

similar triangles is that their corresponding sides are proportional to
each other. From this it follows that

MR1 QD1

RM QR
QD1 MR1
Writing in place of inequation( ii ),we
QR RM
QD1 QR
haveep  x
QR OQ

QD 1
ep 
OQ

Now the triangles QD1R and PDR are similar as their corresponding
angles are equal. Therefore, we have

QD1 RD1

PR RD
It Will be seen from figure 6.1 PR = OQ. Thus, substituting OQ for
PR in (iii) above, we have

QD 1 RD 1
ep  
OQ RD
 87

Hence from above we find that price elasticity at point R on the

straight line demand eave DD’ is

RD 1 LowerSegme nt
 
RD UpperSegme nt

Measurement of price elasticity on a Demand Curve

Alternative Ways :-
I] Vertical Axis formula
Ii] Horizontal Axis formula
There are two alternative ways of measuring point price
elasticity of demand with the help of formula one measuring price
elasticity as ratio of distance on the vertical axis and the other
measuring it as ratio of distance on the horizontal axis.
Vertical Axis formula Consider a linear demand curve DD’ in
Figure 6.2. where we are required to measure price elasticity of
demand at price OP at which OQ quantity of commodity X is
demanded.
The measure of price elasticity of demand is given by
Q P
ep  
P Q

Fig 6.2 Measuring point elasticity on a Demand Curve

Q
The First term in this formula namely is the reciprocal of the
P
slope of the demand curve (Note that the slope of the liner demand
 88

P
curve DD1 is equal is , which remains the same all along the
Q
liner demand curve DD1).
Thus,  P /  Q is a measure of the slope of the linear demand
curve which is equal to PD/PR. Thus,
1 OP
ep  
PD / PR PR
PR OP OP
  
PD PR PD
Thus, price elasticity at price OP can be obtained from measuring
the ratio of distance OP and PD on the vertical axis (i.e. price axis)
Horizontal Axis Formula: Likewise we can measure the point
elasticity of demand as a ratio of the distances on the horizontal
axis (i.e. the quality axis). We do this by taking another expression
for the slope of the demand curve DD1. Now, starting from point R
downward in Figure 6.2, the slope of the demand curve DD1 is
P QR

Q QD1

Substituting this in our elasticity measures we have

Q P 1 P
ep    
P Q P / Q Q
1 QR QD 1 QR QD 1
    
QR / QD 1 QD 1 QR OQ OQ

Thus price elasticity of point R on the linear demand curve or at the

given price OP can be measured by three alternative ways :
OP
Using vertical axis formula ep 
PD

QD 1
Using horizontal axis formula ep 
OQ

RD1
Using the ratio of distances on the demand curve ep=
RD
 89
Non linear Demand Curve :-

Measuring Point Price

Elasticity of Demand on
a non-linerar Demand curve

Figure 6.3
Measuring point price Elasticity of Demand on a Non linear
Demand Curve
But it the demand curve is not linear like DD1, but is as is usual a
real curve as given in Fig. 6.3 then, in order to measure elasticity in
this case, we have to draw a tangent TT1 to the given point R on
the demand curve DD and then measure elasticity by finding out
RT 1
the value of
RT
6.3.2. Degrees of Price Elasticity on Demand Curve :-

Fig 6.4.
Point price elasticity differs
at various points of a
Linear Demand Curve

Figure 6.4
 90

Now again, taken the straight line demand curve DD1 (Fig 6.4). If
point R lies edacity at the middle of this straight line demand curve,
RD1
then elasticity will be equal to = 1, as lower segment is equal to
RD
upper segment.
Similarly elasticity will go on decreasing as we move towards point
D1. This is because lower segment will become smaller and
smaller, whereas upper one will be increasing. At point D1, the
elasticity will be zero.
On the contrary, as we move towards point D, elasticity will go on
increasing as lower segment will become greater and greater than
the upper segment and at point D, elasticity will be infinity.

6.3.3. Different Degrees of Elasticity :-

1. Perfectly Inelastic Demand Ep = 0

When the demand for a

commodity is not responsive
to any change in price
demand is perfectly inelastic.
In this case, the demand
curve will be a vertical line in
Fig 6. andEp is equal to zero
at every point on this demand
curve e.g. The demand for
salt is not likely to change with
the change in price.
Figure 6.5(a)

2. Perfectly Elastic Demand :- Ep= 

Demand is perfectly
elastic when the purchases are
prepared to buy all that is
available in the market at a
particular price. In this case,
the demand curve is horizontal
at given price OP as in Fig 6. If
price increases even
marginally, nothing will be
purchased.

Figure 6.5 (b)

 91
3. Unit Elasticity of Demand Ep = 1.

Demand is unitary elastic when

the percentage change in
quantity demanded equals the
percentage change in price. In
this case, the demand demand
curve is a rectangular
hyperbola as in Fig 6.
At any point on this curve the
value of elasticity is equal to
unity.

Figure 6.5(c)

4. Relatively Inelastic Demand E p < 1

Demand is Relatively inelastic

when the percentage change in
quantity demanded is less than
percentage change in price in
this case, the demand curve is {
steeper as in Fig 6. and
therefore  p >  Q
{

Figure 6.5 (d)

 92
5. Relatively Elastic Demand E p > 1

Demand is relatively classic

when the percentage change in
quantity demanded is greater
than percentage change in
price. In this case the demand {
curve is flatter as in Fig 6. and
therefore  p <  Q.

{
Figure 6.5(e)

The different degrees of price elasticity is summarized in

Table 6.1
Table 6.1 : Degrees of price Elasticity of Demand

Coefficient of Elasticity Categories of Implication

Elasticity

Ep = O Perfectly Inelastic Quantity demanded

does not change as
price change

Ep= Perfectly elastic At a particular Price

demand is unlimited

Ep=1 Unit Elasticity Percentage change in

quantity demanded
equals the percentage
change in price

Ep<1 Relatively Inelastic Percentage change in

quantity demand is
less than the
percentage change in
price

Ep>1 Relatively Elastic Percentage change in

quantity demand is
large then the
percentage change in
price
 93

6.3.4. Price Elasticity of Demand and Changes in Total

Expenditure
It is often useful to know what happens to total expenditure model
by the consumers on a good when its price changes.

Figure 6.6

In Figure 6.6, a demand curve DD of a good is shown. When

the price of good is OP, its quantity demanded is OQ. Since the
total expenditure is price multiplied by the quantity of the good
purchased, therefore consumers total expenditure
= OP x OQ
= area OQRP
Now if the price of the good falls from OP to OP1 the quantity
demanded increases from OQ to OQ1. At new price OP1, therefore
Total expenditure = OP1 X OQ1
= area OQ1R1P1
Now, whether the total expenditure rises or falls or remains
the same with the changes in the price of the good depends upon
the price elasticity of demand. The following is the relationship
between changes in total expenditure and price elasticity of
demand.
As seen above, the price elasticity of demand measure the
ratio of proportionate change is quantity demanded to the
proportionate change in price. That is, ignoring signs
 94
Q / Q % Q
ep  or
P / P % P

If price elasticity of demand is greater than one, then

ignoring the signs %  Q > %  P. On the other hand, if price
elasticity of demand is less than one %  Q<%  P. And if price
elasticity equals one or in other words, demand is unitary elastic, %
 Q =  P For the sake of convenience, we write the results of this
relationship in table 6.1.
Table 6.2 Relationship between Price Elasticity (ep) and Total
Expenditure (TE)
Price Change Elasticity Elasticity less Elasticity equal
greater than then one to one
one

(ep> 1) (ep< 1) (ep = 1)

Price falls TE increases TE decreases No Change in

TE

Price rises TE decrease TE increases No Change in

TE

6.3.5. Determinants of Price Elasticity of Demand

We have explained above the concept of price elasticity of
demand and also new it is measured. Now an important question is
what are the factory determine whether the demand for a good is
elastic or inelastic. The following are the main factors which
determine the price elasticity of demand for a commodity.
1] Availability of Close Substitutes :-
Of all the factors determining price elasticity of demand the
number and closeness of substitutes available for a commodity is
the most important factor. If for a commodity close substitutes are
available its demand tends to be elastic. If the price of such a
commodity rises, the people will shift to its close substitutes and as
a result the quantity demanded of the commodity will greatly
decline. The greater the possibility of substitution, the greater the
price elasticity of demand for it. If for a commodity substitutes are
not available people will have to buy it even when its price rises,
and therefore its demand would tend to be inelastic. For instance, if
the price of tea were to inverse sharply many consumers would turn
to coffee and as a result the quantity demanded of tea will decline
very much. On the other hand if the price of tea falls, may
consumer will change from coffee to tea. Thus, the demand for tea
 95

is elastic. If is the availability of close substitutes that makes the

consumers sensitive to the changes in the price of tea and this
makes the demand for tea elastic. On the other hand, demand for
common salt is inelastic because good substitutes for common salt
are not available. If the price of common salt rises slightly the
people would consume almost the same quantity of salt as before
since good and close substitutes are not available.
2] The importance of a commodity in consumers Budget :-
Another important determinant of the elasticity of demand is
how much it accounts of the consumer’s budget. In other worlds,
the proportion of consumers income spent on a particular
commodity also influences the elasticity of demand for it The
greater the proportion of income spent on a commodity the greater
will generally be its elasticity of demand and vice versa. The
demand for common salt, soap, matches and such other goods
tends to be highly inelastic because the households spends only a
fraction of their income on each of them. When the price of such a
commodity rises, it does not make such difference in consumers
budget and therefore they continue to buy almost the same quantity
of such commodity and therefore, the demand for them is inelastic.
On the other hand, demand for cloth in a county like India tends to
be elastic since household spend a good part of their income on
clothing. If the price of cloth falls, it will mean a great saving in the
budget of many household and therefore they will then to increase
the quantity demanded of the cloth. On the other hand if the price of
cloth rises many households will not afford to buy as much quantity
of cloth as before and therefore, the quantity demanded to cloth will
fall.
That the higher the proportion of income spent on a
commodity the greater the price elasticity of demand for the
commodity can be lazily seen from the elasticity equation stated
below :-
exp  ( 1  Kx ) es  Kx ei

Where exp represents price elasticity of demand for good X,

es the substitution elasticity, Kx the proportion of income spent on
good X and ei the income elasticity for good X. Thus, the higher Kx
given es and ei remaining the same, the higher will be the price
elasticity of demand for good X.
3] The Number of Uses of a Commodity :-
The greater the number of uses to which a commodity can
be put, the greater will be its price elasticity of demand. If the price
of a commodity having several uses is very high, its demand will be
 96

small because at a higher price it will be put to only the most

important uses and if the price of such a commodity falls it will be
put to less important uses also and consequently it quantity
demanded will rise significantly. To illustrate, milk has several uses.
If its price sharply rises it will be used only for essential purposes
such as feeding the children and sick persons. It the price of milk
falls, if would be devoted to other uses such as preparation of and
eve ram and sweets. Therefore the demand for milk tends to be
elastic.
4] Complementarily between Goods :-
Complementarily between goods or joint demand for goods
also afferents the prices elasticity of demand. Households are
generally less sensitive to the charges in price of goods that are
complementary with each other or which are jointly used than in
case of changes in the prices of those goods which have inferences
demand or used alone e.g. demand for common self is inelastic.
5] Time for adjustment :-
The element of time also inferences the elasticity of
demands for a commodity. Demand tends to be more elastic if the
time involved is long. This is because in the long run consumers
can find ways of economizing a particular good and also discover
substitute goods for a commodity. In the short run, substitution of
one commodity by another is not so easy. Hence, the demand is
generally more inelastic in the short run then in the long run.

Fig. 6.7
Demand is more
elastic in the log run.

Figure 6.7
Figure 6.7 graphically depicts that demand for a good is more
elastic in the long run when more time is allowed for adjustment
than in the short run. DSR is the short run demand curve for a good
which shows the reaction of consumers immediately following the
changes in the price of a commodity say poetry on the other hand,
 97

DLR depicts the changes in the quantity demanded of a good

consequent to changes in its price when consumers have made full
adjustment to price changes. The two curves DSR and DLR are
intersecting at point C and long run demand curve DLR is flatter than
the short run demand curve D sr. if the price rises from Op, to OP2
in the short run following this rise in price consumers make some
adjustments and redneck the quantity demanded to M. It will be
seen from Fig. 6.7 that due to fewer possibilities of adjustment and
substitution in the short run the consumers reduce their demand
only by a small amount QM. However, in the long run after the rise
in price of the goods, it is possible to make full adjustments in order
to economies consumption of the petrol and also to use cheaper
substitutes in its place. Over a period of time people may switch to
gas based automobiles, use public transport instead of their private
vehicles or even may rent residential flat nearer to their place of
employment. In the long run, they make full adjustment and reduce
their quantity demanded by a large amount to ON.
It is worth mentioning here that for influencing elasticity of demand
for a commodity all the above factors must be taken into account.
Check your Progress:
1. Discuss various degrees of price elasticity of demand.
2. Explain how price elasticity is measured.
3. What are the determinants of price elasticity of demand.

6.4 INCOME ELASTICITY OF DEMAND

Another important concept of elasticity of demand is income

elasticity of demand Income elasticity of demand shows the degree
of responsiveness of quantity demanded of a good to a small
change in the income of consumers. The degree of response of
quantity demanded to a change in income is measured by dividing
the proportionate change in quantity demanded by the
proportionate change in income.
 98

Pr oportionate Change in purchase of a good

IncomeElasticity 
Pr oportionate Change in income
Q
Q
i .e. ei :
M
M
Q M
 X
Q M
Q M
 
M Q

M = Initial Income
Q = Original quantity
ΔM = Change in income
ΔQ = change in Quantity
If for instance, consumers income rises from Rs. 100 to Rs.
102 the quantity purchased of good X by him increases from 25
units to 30 units per week, his income elasticity of demanded for x
is :-
5 1
ei = 25  5  10
2 1
100 50

6.4.1. Income Elasticity and Proportion of Income spent :-

There is a useful relationship between income elasticity for a
good on the one hand and proportion of income spent on it. The
relationship between the two is described in the following there
propositions.
1. If Proposition of income spent on the good remains the same as
income increases, then income elasticity for the good is equal to
one.

2. If proposition of income spent on the good increases as income

increases, then the income elasticity for the good is greater than
one.

3. If proposition of income spent on the good decreases as income

reassess then income elasticity for the good is less then one.
 99

6.4.2. Income elasticity : Necessities, Luxuries and Inferior

Goods
Income elasticity varies depending upon whether the good is
a necessity, luxury or an inferior good.
If the good is a necessity income elasticity is positive but
less then unity and the quantitative demanded increases less then
proportionately to increases in income.
On the other hand, in case of luxuries, income elasticity is
greater than one. As income increases the consumer spends more
than proportionate increases in income on them. Income elasticity
of a luxury good increases at higher levels of income.
Finally, in case of inferior goods, income elasticity in
negative and consumers quantity demanded of these goods
declines as their income increases.

6.5 CROSS ELASTICITY OF DEMAND :-

Very often demands for two goods are so related to each

other that when the price of any of them changes the demand for
the other goods also changes, when its own price remains the
same. Therefore, the changes in the demand for one good in
response to the change in price of another good represents the
cross elasticity of demand of one good for the other.
Coefficient of cross
Elasticity of demand of =
Pr oportionate change in the quantity demanded of X
Pr oportionate change in the price of good Y
qx
qx qx py
ec   
pypy qx py
qx Py
 x
qx Py
qx Py
 
Py qx

Where, ec stands for cross elasticity of demand of X for Y.

qx : original quantity demanded of X
qx : Change in quantity demanded of X
 100
Py : original price of good Y.
Py : a small change in the price of Y.
Now take an example, if the price of coffee rises from rupees 7.50
per hundred grams to rupees 8 per hundred grams and aa result
the consumers demand for tea increases from 60 hundred grams to
70 hundred grams. The cross elasticity of demand of tea for coffee
can be found out as following :-
In the above example
 qx = 70 – 60 = 10 hundred grams.
qx = 60 hundred grams.
 Py = 8 7.50 = 50 paisa
Py = 7.50 Rupees = 750 paisa
qx Py
 x
Py qx
10 750
Cross elasticity of demand =  x
50 60
5
  2 .5
2
When two goods are substitutes of each other, then as a
result of the rise in price of one goods, the quantity demanded of
the other good increases.
Therefore, the cross elasticity of demand between the two
Substitute goods is positive.
On the other hand, when the two goods are complementary
with each other just as bread and butter tea and milk etc. the rise in
price of one good brings about the decrease in demand for the
other. Therefore, the cross elasticity of demand between the two
complementary goods in negative.
 101

(a) Demand for Good X (b) Demand for Good Y

Demand Relation Between Two Substitutes Good

Figure 6.8

6.6 PROMOTIONAL ELASTICITY OF DEMAND :-

Promotional Elasticity of Demand refers to the proportionate

change in the quantity demand demanded due to proportionate
change in the promotional expenditure incurred by the entrepreneur
or manager.
Ep = Proportionate change in quantity demanded
______________________________________
Proportionate Change in
Promotional Expenses (S)
Q / Q
Ep 
S / S
Q S
 X
S Q

 Q : Change in quantity
 S : Change in promotional expenses
Q Original Quantity
S Original Promotional expenses.
 102
Check your Progress:
Write notes on:
1. Types of income elasticity of demand.
2. Types of Cross elasticity of demand.
3. Promotional elasticity of demand.

6.7 SUMMARY

Thus you must have understood that the concept of elasticity of

demand is quite useful in deciding the direction and magnitude of
change in quantity demented of a commodity due to change in any
of a commodity due to change in any of its determinants price,
income, price of related goods and promotional expenditure).

6.8 QUESTIONS

1. Define the following :

a] Elasticity
b] Price elasticity of demand,
c] Income elasticity
d] Promotional elasticity.
2. What is price elasticity of demand? Brings out different degrees
of price elasticity of demand.
3. Explain the determinants of price elasticity of demand.
4. Write notes on the following :
a] Price elasticity of demand
b] Income elasticity of demand
c] Cross price elasticity of demand
d] Promotional elasticity of demand.


 103

Module IV

7
CONSUMER’S BEHAVIOUR
Unit Structure :

7.0 Objectives
7.1 Introduction to Cardinal And Ordinal Utility Approaches
7.2 Marshaallian Utility Analysis
7.3 Law of Equi-marginal utility
7.4 Consumer’s Surplus
7.5 Summary
7.6 Questions

7.0 OBJECTIVES

 To understand the meaning of cardinal and ordinal

measurement of utility approaches
 To understand the various laws of demand.
 To understand the different determinants of demand.
 To understand the different concepts of elasticity of demand, its
measurement and its practical use.
 To understand the concept of consumer’s surplus and its uses.

7.1 INTRODUCTION TO CARDINAL AND ORDINAL

UTILITY APPROACHES

Measurement of utility is an important concept while

understanding the behavior of the consumer. There are two
different approaches in this regard of measurement of utility as
following:

(A) Cardinal measurement of utility: Neo-classical economists, such

as Alfred Marshall, Walrus believed that utility is cardinal and
can be measured quantitatively like other mathematical
variables, such as height, weight, velocity, temperature, etc.
Therefore, these economists developed cardinal utility concept
to measure the utility derived from a good. They developed a
unit of measuring utility, which is known as utils. For example,
according to the cardinal utility concept, an individual gains 20
utils from ice-cream and 10 utils from coffee.
 104
The cardinal utility concept is based on the following assumptions:
a. One util equals one unit of money
b. Utility of money remains constant

However, the major limitation of cardinal measurement of

utility is that the exact or absolute measurement of utility is not
possible. This is because of the fact that the utility derived by a
consumer from a good depends on various subjective factors, such
as changes in consumer’s moods, tastes, and preferences.

These subjective factors are not possible to determine and

measure in quantitative terms or not possible to give them
numbers. Therefore, no such technique has been devised by
economists to measure utility. Utility; thus, is not measureable in
cardinal terms. However, it has a prime importance in consumer
behavior analysis.

(B) Ordinal measurement of utility

However, modern economists, such as J.R. Hicks,
introduced the concept of ordinal measurement of utility. According
to this concept, utility cannot be measured numerically, it can only
be ranked as 1, 2, 3, and so on. For instance, an individual prefers
ice-cream than coffee, which implies that utility of ice-cream is
given rank 1 and coffee as rank 2.According to them, it may not be
possible to measure exact utility, but it can be expressed in terms
of usefulness of a good such as more or less.

According to neo-classical economists, cardinal

measurement of utility is possible in practical situations. Moreover,
they believed that the concept of cardinal utility is useful in
analyzing consumer behavior. However, modern economists
believed that utility is related to psychological aspect of consumers;
therefore, it cannot be measured in quantitative terms.In addition,
they advocated that the ordinal utility concept plays a significant
role in consumer behavior analysis. Modern economists also
believed that the concept of ordinal utility meets the theoretical
requirements of consumer behavior analysis even when there is no
cardinal measure of utility is available.

7.2 MARSHALLIAN UTILITY ANALYSIS

Alfred Marshall introduced a system of defining and

measuring utility objectively. This is known as the cardinal
approach to utility. According to Marshall, ‘utility is the want
satisfying ability of a good’. Thus, when a consumer uses a good,
he derives utility. Further, it is possible to measure utility objectively
and so, we can clearly find out the satisfaction derived by the
consumption of a given commodity. Following are the main features
of the cardinal utility analysis:
 105
a. Objective measurement of Utility: A consumer expresses the
utility derived from the use of a good in absolute numbers. Like,
consumption of good A gives 10 units of utility, B gives 12 units, C
gives 15 units and so on. Marshall argued that money can be used
a measure of utility. The price that a consumer is willing to pay
rather than go without buying a good is the marginal utility of that
good and hence money is the measuring rod of utility.

b. Independent Utilities: According to cardinal utility approach, the

utility that a consumer derives from a good is a function of the
quantity of that good only. In other words, utility of a good is not
linked to the quantities of other goods that the consumer
consumes. Thus, the total utility that a consumer derives from the
use of a given basket of goods is nothing else but the total of
individual utilities. Therefore, utility is “additive”.

c. Constant Marginal Utility of Money: An important assumption

of cardinal utility analysis is the assumption that the marginal utility
of money is constant. Since the marginal utility of money is
constant, it can measure the utility. This is because, for any
consumer money spent on any particular commodity will be a small
portion of his/her total expenditure. We can ignore any change in
real income due to a change in the price of any one particular
commodity.

d. Method of Introspection: The Marshallian utility analysis is

based on observing one’s own experiences and then extending the
logic to the behaviour of the consumer. The law of diminishing
marginal utility is based on this particular observation.

7.3 LAW OF EQUI-MARGINAL UTILITY

A) Law of Equi-marginal Utility:

An important step in the cardinal utility analysis is the law of
equi-marginal utility. Marshall uses this law to explain the
consumer’s equilibrium when he/she purchases more than one
commodity. For equilibrium,
MUA/PA = MUB/PB = MUm

Let the income of the consumer be Rs. 100 and the

consumer buys to goods, A and B. The prices of which are given
as: Rs. 20 and Rs. 10 respectively. If the marginal utilities of these
two goods are given, we can derive the consumer equilibrium as
under:
 106

Units Marginal Utility of A Marginal Utility of B

1 120 90
2 100 80
3 80 70
4 40 60
5 20 50
6 15 40
7 18 30
8 20 20
9 21 10

From the above table if we compare the ratios of the marginal

utilities and the prices, we see that when the consumer buys 3 units
of A and 4 units of B, the ratios are equal (4 each) hence at this
point, (80/20) = (40/10) = 4 or MUA/PA = MUB/PB = MUm. The
consumer spends Rs. 60 on A and Rs. 40 on B. Thus, the law of
equi-marginal utility allows us to explain the consumer’s equilibrium
when he is purchasing more than one good.

B) Law of Demand and the Derivation of the Demand Curve:

Using the principle of additive utility, Marshall derived the law
of demand and the demand curve. Assuming that the income of the
consumer, his preferences and the price of one good remain the
same, we can derive that as the price of a good falls, the demand
for it will increase. When the price of good A falls, other things
being the same, the MUA/PA will be greater than MUB/PB and MUm.
In such a case, marginal utility of A must be reduced. Therefore,
the consumer has to buy more units of the good whose price has
decreased. The proportionality rule requires that as the price of a
goods falls, the quantity demanded of that good has to increase. In
figure 7.1 we show the derivation of the demand curve.

Figure 7.1
 107

Figure 7.2

The upper plane (Panel A) shows the equilibrium of the

consumer. Given his money income, OX is the marginal utility of
money, MUm. As the price of A falls, the MUA/PA will shift from
MUA/PA1toMUA/PA2 and toMUA/PA3. The consumer will increase his
purchase of good A to maintain a constant marginal utility of
money. The lower panel (Panel B) shows the derivation of the
demand curve. As the price of A falls from P1 to P2 and to P3, the
consumer increases his purchases from qA1 to qA2 and qA3. Thus, a
fall in the price of a good, results in larger demand, ceteris paribus.

C) Limitations of Cardinal Utility Analysis:

Following are some of the limitations of the Marshall’s
cardinal approach to utility:

1. As utility is a psychological concept and hence subjective, it is

not possible to measure utility objectively in quantitative terms. A
consumer can only say whether the satisfaction derived from the
consumption of different goods gave more or less satisfaction and
will never be able to quantify the utility.

2. Marshall assumed that the utility is independent of the utility of

other goods consumed. However, given the money income, utility
of any one goods is linked to the utility of other goods that are used
by the consumers. Moreover, some goods are complementary
while others are substitutes. Hence, the utility derived from any one
good is invariably linked to the utility of other goods consumed.

3. The assumption of constant marginal utility of money is also not

valid. As the consumer spends money on one good, the money left
with him/her reduces. Therefore, the marginal utility of the
remaining money income increases instead of remaining constant.
Further, as the price of a good changes the real income of the
consumer also changes. With the change in real income, the
marginal utility of money also changes. This would have an effect
 108
on the demand for the good that is being studied as well as on the
demand for other goods as well. Therefore, the assumption of
constant marginal utility of money is both conceptually and
practically untenable. If the marginal utility of money changes we
cannot use it to measure utility objectively.

4. The Marshallian analysis cannot explain the Giffen’s paradox.

This is a case when the price of a product falls the consumer
purchases more units of the cheaper good.

5. The cardinal utility analysis can be used only in case of a single

commodity. If there are more than one good, the consumer can
substitute his purchase of one good with that of another. In case of
more than one good the assumption of constant marginal utility of
money would be incompatible with utility analysis.

6. The most important limitation of cardinal utility analysis is its

failure to distinguish between the income and substitution effects of
a price change. When the price of a good changes, the real income
of the consumer changes. At the same time, the relative price of the
other good also changes. As a result, the consumer will change
his/her purchases of both the goods. This situation cannot be
explained using the case of single good.

Check your progress:

1. What is utility?
2. Distinguish between cardinal and ordinal measurement of utility.
3. What is the law of Equi-marginal utility?

7.4 CONSUMER’S SURPLUS

Marshall introduced the concept of consumer’s surplus to

explain the welfare aspects of pricing. It is defined as ‘the excess of
price which a consumer would be willing to pay rather than go
without a thing over that which he actually does pay is the
economic measure of this surplus satisfaction’. Since the amount of
money which the consumer is willing to pay indicates his utility, we
can use the price the consumer is ready to pay as a measure of his
surplus. Thus, we have:
 109
Consumer’s Surplus = Σ Marginal Utility – Total Outlay. We can
show the consumer’s surplus with the help of an example.

Units of the Good 1 2 3 4 5 6 7 8 9 10

Price 30 28 25 22 19 15 12 10 8 5
Marginal Utility 50 45 40 30 20 15 8 0 -5 -10

In the above table we see that as the price falls the marginal
utility also declines. At a price of 8, the marginal utility is zero and
turns negative. At a price of 15, the marginal utility equals the price
and the consumer buys six units of the good. The consumer’s
surplus would be: 200 – 90 = 110.

The following figure explains the concept of consumer’s surplus.

Figure 7.3

In the above figure, x-axis shows the quantity demanded and

y-axis shows the price. DD is the demand curve. When the price is
OP, the consumer buys OQ units. The consumer is willing to pay
ODAQ and he pays only OPAQ. Therefore, ∆PDA is the
consumer’s surplus.

Merits and Demerits of Consumer’s Surplus:

1. Governments use extensive use of the concept of consumer’s in
pricing public utilities, educational and health facilities. It highlights
the significance of value-in-use rather than the value-in-exchange.

2. Firms use this concept to fix their prices. They will fix the prices
in such that a way that they can squeeze the maximum consumer’s
surplus without forcing the consumer to give up buying the product.

3. As we often see, some of the residential areas are provided with

special and exclusive access to amenities. This will add to the
consumer’s surplus of the residents of these localities. Though they
may carry higher prices, the utility of these services is higher than
the prices.
 110
4. The concept of consumer’s surplus helps us to understand the
adverse effects of indirect taxes. Economic theory recommends the
use of direct taxes since they do not cause a direct loss of
consumer’s surplus.

5. The concept of consumer’s surplus is based on the cardinal

utility and hence all the limitations of that analysis are applicable to
this. Since utility cannot be objectively measured, we cannot talk of
measurable utility derived from the consumption of a given
commodity.

6. The assumption that different units of the given good provide

different amounts of satisfaction is central to this concept. However,
in reality the consumer may derive the same marginal utility from
each additional unit of the good consumed by him/her. In such a
situation it may not be possible to measure the consumer’s surplus.

7. This concept is based on the assumption that the consumer has

control on the price. However, in reality the consumer often may not
have the ability to influence the price and he/she has to buy the
given good. In such a case, we can never measure the consumer’s
surplus.

Despite its many limitations, this concept has important

implications for policy and is often used in determination of prices.
The drug pricing policy in India is one example where the
government uses this concept to protect the interests of the
consumers.

Check your progress:

1. What is a demand function?
2. How Consumer surplus can be measured

7.5 SUMMARY

1. Cardinal utility is the measurement of utility in an objective

manner.
2. Marshall assumes the consumer of the income, tastes and
preferences and income of the consumer to be constant to
explain cardinal utility.
3. Law of equi-marginal utility requires the marginal utility of money
to be constant.
 111
4. Law of demand states that the demand for a product is inversely
related to its price, other things being the same.
5. Cardinal utility cannot explain Giffen’s paradox.
6. Consumer’s surplus is the relationship between the price and
utility of a good.

7.6 QUESTIONS

1. Explain the concept of cardinal utility analysis. What are its main
limitations?
2. Explain the law of equi-marginal utility.
3. Explain the concept of consumer’s surplus and its uses.


 112

8
INDIFFERENCE CURVE ANALYSIS
Unit Structure :

8.0 Objectives
8.1 Introduction
8.1.1 Scale of Preferences
8.1.2 Indifference Curve
8.1.3 Properties of Indifference Curves
8.1.4 Budget Line of Price Line
8.1.5 Consumer’s Equilibrium
8.2 A Income, Substitution and Price effects
8.2.1 Income Effect
8.2.2 Substitution Effect
8.2.3 Price Effect
8.3 Breaking-up of the Price Effect
8.3.1 Price Effect of a Normal Good
8.3.2 Price Effect of a Giffen Good
8.4 Derivation of the Demand Curve
8.5 The Revealed Preference Theory
8.6 Summary
8.7 Questions

8.0 OBJECTIVES

 To understand the concept of indifference curves

 To understand the derivation of consumer’s equilibrium
 To understand different effects of changes in prices and income
 To understand the derivation of the demand curve
 To understand the concept of revealed preference

8.1 INTRODUCTION:INDIFFERENCE CURVE ANALYSIS

Sir John Hicks introduced the concept of indifference curve

analysis to explain the consumer behaviour. The starting point of
the indifference curve analysis is the understanding that it is not
possible to objectively measure utility. Since utility depends on the
thinking of the consumer, we can only say whether the utility of the
consumer is more or less. No precise measurement of utility is
possible. This is known as the ‘ordinal utilityanalysis’. This analysis
 113
is based on the premise that unlike in the Marshallian analysis, the
consumer in real life purchases two or more goods at any given
time. The indifference curves help to understand the consumer’s
equilibrium in a situation where it is not possible to objectively
measure utility. Hicks developed a few concepts to facilitate the
analysis. We shall now examine them.

8.1.1 Scale of Preferences:

A scale of preferences is a mental construct where the
consumer ranks the different combinations of two goods that give
equal level of satisfaction. The following table shows the concept of
a scale of preference.

Combination Units of Good Units of Marginal Rate of

X Good Y Substitution (MRS)
1 25 50 --
2 27 43 -7
3 29 37 -6
4 31 32 -5
5 33 28 -4

In the above table we show five different combinations of the

two goods X and Y that give equal level of satisfaction. As the
consumer moves from combination 1 to 2, he gets two extra units
of good X and is ready to give up seven units of good Y. As he
moves on to combination 3, he gets another two additional units of
X, but is ready to give up only seven units of Y. As he moves to
combination 4 he is willing to give up five units of good Y to get two
additional units of good X. In the last combination, he is willing to
sacrifice only four units of good Y to obtain two additional units of X.
In other words, when a consumer is offered equal increases in one
of the two goods, he would prefer to sacrifice lesser and lesser
units of the other good. The rate at which the consumer prefers to
substitute one good for another is known as the marginal rate of
substitution. In order to keep the level of satisfaction at the same
level, we have to have a situation where the consumer gives up
lesser additional units of one good. This is because as the units of
one good available increase the marginal utility of the other good
increases and so the consumer would not be willing to sacrifice
more units of this good. Therefore, the marginal rate of substitution
is also the ratio of the marginal utilities of the two goods.

M arg inal utility of Good X X

Symbolically MRSX,Y = 
M arg inal utility of Good Y Y

8.1.2 Indifference Curve:

An indifference curve is a graphic representation of the scale
of preferences. Therefore, it is also the graphic representation of
 114
the ratios of the marginal utilities of the two goods. Following the
diminishing marginal utility, the indifference curve is a downward
sloping, curve that is convex to the origin. Figure 5.1 shows an
indifference curve. We see that as the consumer moves from
combination A to B to C, his level of satisfaction remains the same
as indicated by the given indifference curve, IC0.

Figure 8.1

In the above diagram x-axis measures the units of good X

and y-axis measures the units of Y. IC0 is the indifference curve. A,
B, and C are the various points on the indifference curve each
indicating the same level of satisfaction.

8.1.3 Properties of Indifference Curves:

Let us now examine the properties of indifference curves.

Figure 8.2

1. An Indifference Curve is Convex to the origin:

Since an indifference curve indicates the diminishing
marginal rate of substitution between the two goods, it is convex to
the origin. If it is concave to the origin as in figure 8.2 a), it indicates
increasing marginal rate of substitution. That is the consumer will
be ready to give up more and more units of one commodity in order
to get equal increases in the other good. Since this is contrary to
 115
the law of diminishing marginal rate of substitution, an indifference
curve cannot be concave to the origin. At the same time, an
indifference curve cannot be a straight line as in figure 8.2 b). This
is because in this case the marginal rate of substitution remains the
same along the indifference curve. This is contrary to the
assumption of diminishing marginal utility. Therefore, an
indifference curve is convex to the origin.

2. Two Indifference Curves cannot intersect:

This property implies that when two indifference curves
intersect each other at that point the level of satisfaction is same
along the two indifference curves. In figure 8.3 we explain this
property.

Figure 8.3

At point E the two indifference curves IC1 and IC2 intersect.

At this point the level of satisfaction on the two indifference curves
is the same (consumer gets Ox units of X and Oy units of Y). If we
move to another point say A on IC1, the consumer has Ox1 units of
X and Oy1 units of Y. But at this point on IC2 the consumer has Oy1
units of Y and Ox2 units of X. Point to be noted is the level of
satisfaction at point A and B and E are the same following the
definition that an indifference curve indicates the same level of
satisfaction. Thus, no two indifference curves can intersect each
other.

3. Higher indifference curve indicates higher level of

satisfaction:
Since a higher indifference curve is away from the origin, it
indicates larger units of both the goods which in turn indicate higher
levels of satisfaction. Therefore, higher indifference curve indicates
higher level of satisfaction. We show this in figure 8.4.
 116

Figure 8.4

In the above figure, as the consumer moves from point A to

B to C along the different indifference curves, he/she obtains larger
amounts of both X and Y. Therefore, higher the indifference curve,
higher will be the level satisfaction.

8.1.4 Budget Line or Price Line:

This is the graphical representation of the various
combinations of two goods that an individual consumer can buy
with his given income at the given prices of the two goods. For
example, if the income of the consumer is 100 and price of X and Y
are 5 and 10 respectively the consumer can buy 20 units of X or 10
units of Y or any combination of in between. The budget line
indicates all these combinations. Therefore, the slope of the budget
line is the ratio of the prices of the two goods. Figure 8.5 shows the
budget line.

Figure 8.5

In the above figure AB is the Budget line. The consumer can

buy OA units of good Y or OB units of good X. If the income of the
consumer increases and/or the prices of the goods fall the
consumer can buy larger units of the two goods. The budget line
 117
will in that case shift outwards (A1B1). Conversely if the income falls
and/or prices increase, the budget line shifts inwards (A2B2) and the
consumer will be able to buy lesser units.

8.1.5 Consumer’s Equilibrium

Using the concepts of indifference curves and the budget
line J.R. Hicks derived the consumer’s equilibrium within the ordinal
utility framework. We make certain simplifying assumptions to
arrive at the consumer’s equilibrium:

1. The consumer is rational and tries to maximize the utility or

satisfaction.
2. The income of the consumer is given and remains the same.
3. The prices of the two goods X and Y are given and remain the
same.

Given the above assumptions, we say that the consumer

maximizes his/her satisfaction when the following conditions are
met:

a. The price ratio is equal to the marginal rate of substitution.

b. At that point the indifference curve is convex to the origin.
The first condition is known as the necessary condition and is
X P X
given as MRS X ,Y   where MRSX,Y is the marginal
 Y PY
rate of substitution between X and Y, PX, and PY are the price of
X and Y respectively. This condition is known as ‘the tangency
solution’. The second condition indicates that at the point of
tangency the indifference curve is convex to the origin. We can
X P X
write this as: MRS X ,Y    . This condition implies that
 Y PY
at the point of tangency the diminishing marginal rate of
substitution is in operation. As we have seen in the properties of
indifference curves, without this assumption it is not possible to
arrive at the concept of same level of satisfaction along the
indifference curve. Figure 8.6 shows the consumer’s
equilibrium.
 118

Figure 8.6

In the above figure x-axis shows units of good X and y-axis

shows units of good Y. AB is the budget line. At point E and E1 the
budget line is tangent to the indifference curves IC0 and IC1. At E
the MRSX,Y = P X
. It satisfies the necessary condition. But at this
P Y
point the indifference curve is concave to the origin and indicates a
positive marginal rate of substitution which is incompatible with the
assumption of equal level of satisfaction. Therefore, point E is not
the equilibrium point. Only at point E1 the condition of diminishing
marginal rate of substitution is satisfied at this point. Or at E1:
X P X
  .
Y PY
Check your progress:
1. Ordinal utility measures utility objectively. Explain
2. What is a scale of preferences?

8.2 INCOME, SUBSTITUTION AND PRICE EFFECTS

The most important contribution of the indifference curve

analysis is in terms of its ability to distinguish between the income
and the substitution effects. When the income of a consumer
changes his/her demand will change. The changes in demand due
to changes in income it is called ‘income effect’. The real income of
the consumer also changes when the price of a good changes,
other things being the same. This change in the real income causes
changes in the demand. This is the ‘income effect’ of a price
 119
change. At the same time, the psychology of a consumer is to
substitute the costlier good with the cheaper one. That is he/she will
buy more of the cheaper good. This is the ‘substitution effect’. We
will examine each of them.

8.2.1 Income Effect:

As noted above, if the prices of the two goods X and Y are
the same, if the money income of the consumer changes, he can
buy more of the two goods. In this case, his budget line will shift
outwards. This we have seen earlier while explaining the concept of
budget line. The income effect can be positive or negative. Positive
income effect implies that when the income of the consumer
increases, he tends to buy more of a particular good. This happens
in the case of normal goods. Negative income effect is seen when
the consumer buys lesser of the good when his/her income
increases. This happens in case of inferior goods and Giffen goods.
The income effect is based on the assumptions that the consumer
is rational and the prices of the two goods are given. Hicks
introduced the concept of the Income Consumption Curve (ICC) to
explain the nature of effect of a change in income on the demand
for a good. The ICC starts from the origin since demand is zero
when there is no income. Figure 8.7 shows the impact of a change
in income on the demand for different goods.

Figure 8.7 (a)

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Figure 8.7 (b)

In Figure 8.7 (a) we show the changes in consumer’s

equilibrium when his income increases. A0B0 is the initial budget
line. The consumer is in equilibrium at E0. As his income increases,
his budget line shifts from A0B0 to A1B1 and further to A2B2. As his
income increases, the consumer moves to E0 to E1 to E2. In this
process, his purchase of good X decreases and that of Y increases.
So good X is inferior and this is reflected in the slope of ICC which
moves away from good X. Figure 8.7 (b) shows the changes in the
consumer’s equilibrium when good X is normal and good Y is
inferior. A0B0 is the initial budget line. The consumer is in
equilibrium at E0. As his income increases, his budget line shifts
from A0B0 to A1B1 and further to A2B2. As his income increases, the
consumer moves to E0 to E1 to E2. In this process, he purchases
more units of good X and lesser units of good Y. Therefore, good X
is normal and good Y is inferior. The ICC in this case moves away
from good Y. Figure 8.8 shows the different possible combinations
of ICC depending upon the nature of the two goods.

Figure 8.8
 121
In the above figure the three ICCs show the nature of each of the
two goods.

8.2.2 Substitution Effect:

Hicks explained the substitution effect in terms of changes in
the money income of the consumer. Thus, when the price of one
good changes the money income of the consumer is also changed
in such a way that the consumer has the same level of satisfaction.
This is known as ‘compensating variation’. It is defined as ‘the
amount by which the money income of the consumer is changed so
that the consumer is neither better off nor worse off than before’.
That is, the consumer remains on the same indifference curve.
Figure 8.9 shows the substitution effect.

Figure 8.9

In the above figure A0B0 is the original price line. The

consumer is in equilibrium at E. He purchases Oy0 units of Y and
Ox0 units of X. As the price of X falls while that of Y remains the
same, the budget line shifts to A0B1. Using the compensating
variation, the new budget line is P0P1. This line is parallel to the
budget line A0B1 indicating that the relative prices are the same. At
point E1 the indifference curve IC is tangent to the budget line. The
consumer now purchases Ox1 units of X and Oy1 units of Y. The
consumer would always prefer to buy more of the cheaper good.
The substitution effect is always positive.

8.2.3 Price Effect:

The price effect shows the behaviour of the consumer to
changes in the price of one good while his money income, tastes
and preferences and prices of other goods remain the same. When
the price of a good falls, other things being the same, the consumer
would move be able to buy more of the good and vice versa when
the price increases. Figure 8.10 explains the price effect.
 122

Figure 5.10

In the above diagram x-axis shows good X and y-axis shows

good Y. We assume that the price of good Y and the money
income of the consumer remain the same. AB0 is the original price
line. The consumer is in equilibrium at E. He purchases Ox0 units of
X and Ex0 units of Y. As the price of X falls, the price line shifts to
AB1. As a result the consumer moves from point E to E1 and he
purchases more units of X (x0x1). Further as the price of X falls, he
moves on to E2 and purchases Ox2 units of X. the movement from
E to E1 to E2 is traced along the Price Consumption Curve (PCC).
PCC is ‘the locus of all equilibrium points when the price of one
good and the money income of the consumer remain the same and
only the price of the other good changes’. Figure 8.11 shows the
possible slopes of the PCC.

Figure 8.11

In the above figure PCC1 shows changes in consumer

equilibrium when both the goods are normal and the price of one
good changes while the price of the other good and income are the
same. PCC2 shows the changes in consumer equilibrium when
good X is a Giffen good and good Y is normal. The consumer will
buy lesser units of X when the price of X falls. PCC3 shows the
case when good X is neutral and good Y is normal. In this case
 123
when the price of X falls the consumer will continue to buy the
same units. PCC4 shows the case when good Y is neutral and good
X is normal. PCC5 shows the case when good Y is a Giffen good
and good X is a normal good.

8.3 BREAKING-UP OF THE PRICE EFFECT

We can show that the price effect is a total of the income and
substitution effects. We assume that the consumer is rational,
his/her income of is given, price of Y remains the same, price of X
falls. We shall examine the price effect of a normal good first and
then examine the price effect of a Giffen good.

5.3.1 Price Effect of a Normal Good:

In case of a normal good a fall in the price results in a rise in
the demand and a rise in the price causes the demand to fall.
Figure 8.12 shows the price effect of a normal good.

Figure 8.12

In the above figure x-axis shows good X and y-axis shows

good Y. A0B0 is the original price line. The consumer is in
equilibrium at point E where the price line is tangent to the
indifference curve IC1. He/she purchases Ox0 units of good X. As
the price of X falls, the budget line shifts to A0B1. The consumer
moves to point E1 on indifference curve IC2. The consumer buys
Ox2 units of X. By the principle of compensating variation, if we
reduce the income of the consumer to retain him at the original
level of satisfaction, the budget line will shift downwards to A1B2.
The consumer reaches equilibrium at E2 and buys Ox1 units of X.
The movement from E to E1 is the total price effect (change in
demand due to a change in the price of the good, x0x2). Of this,
movement from E to E2 is the substitution effect (x0x1) and
movement from E2 to E1 is the income effect (x1x2). Thus price
effect = income effect + substitution effect
x0x2=x1x2 + x0x1
 124
8.3.2 Price Effect of a Giffen Good:
In case of a Giffen good a fall in the price results in a rise in
demand and a rise in price causes the demand to fall. Figure 8.13
explains the price effect of a Giffen good.

Figure 8.13

In the above figure x-axis shows units of good X and y-axis

shows units of good Y. A0B0 is the original price line and the
consumer is in equilibrium at E on IC0 and purchases Ox0 units of
X. As the price of X falls, the budget line shifts to A0B1 and the
consumer moves to E1 on IC1. The units of X purchased reduces to
Ox1. If we compensate for the fall in price of X, the budget line will
shift to A1B2 and the consumer moves to E2 on the original
indifference curve. Movement from E to E1 is the price effect.
Movement from E to E2 is due to the substitution effect while
movement from x2 to x1 is due to the negative income effect. Thus,
in case of Giffen goods the negative income effect outweighs the
positive substitution effect and the consumer will buy lesser units of
the good whose price has fallen.

Thus price effect = income effect + substitution effect

-x0x1=x1x2- x0x2

The following table shows the break-up of price effect of different

goods depending upon their nature:

Nature of the Price Income Substitution

Good effect Effect Effect
1. Normal Goods Positive Positive Positive
2. Inferior Good Positive Negative Positive
3. Giffen Good Negative Negative Positive
 125

8.4 DERIVATION OF THE DEMAND CURVE

The most important use of the indifference curve analysis is

to derive the consumer demand curve. We show this with the help
of the following figure. We assume that the consumer is rational, his
money income and price of Y remain the same and only the price of
X falls.

Figure 8.14

In the above the upper panel shows the price effect of the
fall in price of good of X while the money income of the consumer
remains the same. He moves from point E to E1 to E2 as the price
of X falls and his budget line shifts from AB0 to AB1 to AB2. PCC is
the price consumption curve. The lower panel shows the various
quantities purchased and the corresponding prices. As the price
falls from P0 to P1 and to P2, the consumer increases his purchases
from OA to OB to OC. Thus, we see the inverse relationship
between the price and the quantity demanded, ‘other things being
the same’.
 126
Check your Progress:
1. Write notes on :
a) Income effect b) Substitution effect c) Price effect

8.5 THE REVEALED PREFERENCE THEORY

One of the most important developments in the area of

consumer’s choice is “the revealed preference theory”. This
approach was developed by P. A. Samuelson to overcome the
shortcomings of both the Marshallian and Hicksian approaches.
This approach is based on the ‘observed behaviour of the
consumer’ and not on ‘contemplations based on psychological
constructs’. Thus, Samuelson observed ‘choice reveals preference’.
When a consumer chooses a particular good or a combination of
goods, he/she revealed the preference for that over all other
available alternatives. In other words, the consumer is not
indifferent to the choices available. This approach is also known as
the ‘behaviouristordinalist approach’ since it is based on the actual
behaviour of the individual consumer.

In Samuelson’s Choice reveals preference hypothesis when

a consumer chooses a combination A, it means he considers all
other alternative combinations which he could have purchased to
be inferior to A. That is, he rejects all other alternative combinations
open to him in favour of the chosen combination A. Thus, choice of
the combination A reveals his definite preference for A over all the
other rejected combinations. With the help of this hypothesis we
can obtain definite information about the preferences of a consumer
from the observations of his behaviour in the market. By comparing
preferences of a consumer revealed in different price-income
situations we can obtain certain information about his preference
scale.

Following are the main arguments of the revealed

preference theory. When the consumer chooses a particular
combination of goods, for him all others are ‘revealed inferior’, that
is he rejected all other combinations from his choice. Figure 8.15
shows this.
 127

Figure 8.15

In the above figure given the price line y0x0 the consumer
chooses combination A. Combination B is ‘revealed inferior’ since it
lies below the budget line. Combination C is ‘revealed superior’
since it falls outside the budget line and is not within the reach of
the consumer. Hence, given the price-income situation, A is the
optimum combination.

Samuelson’s revealed preference theory is based upon the

strong form of preference hypothesis. In revealed preference
theory, strong- ordering preference hypothesis has been applied.
Strong ordering implies that there is definite ordering of various
combinations in consumer’s scale of preferences and therefore the
choice of a combination by a consumer reveals his definite
preference for that over all other alternatives open to him.

J. R. Hicks in his “A Revision of Demand Theory’ does not

consider the assumption of strong ordering as satisfactory and
instead employs weak ordering hypothesis. Under weak ordering
hypothesis (with an additional assumption that the consumer will
always prefer a larger amount of a good to a smaller amount of it),
the chosen combination A is preferred over all positions that lie
within the triangle oy0x0 and further that the chosen position A will
be either preferred to or indifferent to the other positions on the
budget line y0x0.

“The difference between the consequences of strong and

weak ordering, so interpreted amounts to no more than this that
under strong ordering the chosen position is shown to be preferred
to all other positions in and on the triangle, while under weak
ordering it is preferred to all positions within the triangle, but may be
indifferent to other positions on the same boundary as itself.”

The revealed preference theory is based on certain assumptions.

They are:
 128
1) The income of the consumer is given.

2) There is consistency in the choice of the consumer. Varian

defines this as ‘if combination A is directly revealed preferred to
another combination B, then in any other situation, the combination
B cannot be revealed preferred to combination A by the consumer
when combination A is available’. This is also known as the weak
axiom of revealed preference (WARP).

3) The revealed choices are transitive. This implies that if the

consumer chooses combination A over B and C over B, then
transitivity condition requires that he chooses A over C: If A>B and
B>C, then A>C. Given the above, Samuelson states the
“Fundamental Theorem of Consumer Theory” as under: ‘any good
(simple or composite) that is known always to rise in demand when
money income alone rises must definitely shrink in demand when
its price alone rises’. We prove this theorem with the help of two
figures.

a) Price Rises:
The following figure explains the effect of a price rise on the
consumer’s demand.

Figure 8.16

In the above figure x-axis shows units of good X and y-axis

shows units of good Y. AB is the original price line and point E is
consumer’s choice. If the price of X rises, the budget line will shift
inwards to AB1. That means on the new price line the consumer
cannot buy combination E. If we compensate the consumer by
giving extra money income that would enable him/her to buy the
original combination, the budget line will shift to A1B2. The
consumer will not choose a point on EB2 portion of the new budget
line since he will have lesser units than before. So the choice of the
consumer will be within the A1E portion of the budget line after
compensation. In this portion of the price line he/she is buying
lesser units of X than before. Thus, the Fundamental Theorem is
validated.
 129
b) PriceFalls:
We show the effect of a fall in the price in figure 8.17.

Figure 8.17

In this case the consumer is having AB as the original price

line and he chooses combination E. As the price of X falls, the
budget line shifts to AB1. At this stage, if we take away the
additional income, the new budget line would be A1B2. On this
budget line the consumer will not choose in the A1E portion since it
implies he has lesser units of X than before. Therefore, he will
choose in the area BEB2 which indicates that he is purchasing more
units of X than before the change in the price. Thus, the theorem is
proved that when price falls and income increases demand for that
good also increases.

Appraisal of the Revealed Preference Theory:

1. As noted earlier, the revealed preference theory is based on
actual observed behaviour of the consumer. It does not involve
psychological constructs like the indifference between different
combinations.

2. It provides a scientific basis for explaining the consumer

behaviour by focusing on the consumer’s reactions.

3. The theory is concerned only with positive income effect. It

cannot explain the Giffen’s paradox.

4. It has been observed that though the consumers are consistent

in their choices, they will be indifferent to certain combinations.
 130
Check your Progress:
1. What do you understand by ‘choice reveals preference’?
2. What is meaning of ‘consistency in choice’?
3. What is ‘transitivity’ in consumer choice?

8.6 SUMMARY

1. An indifference curve is a graphic representation of the scale

of preferences.
2. An indifference curve shows equal level of satisfaction at all
points.
3. Marginal rate of substitution is the rate at which the consumer
substitutes one good for another.
4. A concave indifference curve shows the same level of
satisfaction.
5. Price line shows the amounts of two goods that an individual
can buy with the given income.
6. Budget line and indifference curve are tangent at the point of
equilibrium.
7. Income effect measures changes in consumer’s equilibrium
due to changes in income.
8. Substitution effect is always positive.
9. Compensating variation helps the consumer to maintain the
same level of satisfaction.
10. Price effect shows the changes in consumer’s equilibrium
when the price of one good changes.
11. Price effect is the total of income and substitution effects.
12. For a Giffen good the price effect is negative because the
negative income effect is stronger than the positive
substitution effect.
13. Fundamental Theorem of Consumption Theory explains the
effect of changes in price on the demand.
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8.7 QUESTIONS

1. Explain the concept of utility. What are the features of cardinal

utility analysis?
2. Explain the law of equi-marginal utility. What are its limitations?
3. Explain the derivation of the law of demand in the cardinal utility
analysis.
4. Explain the properties of indifference curves.
5. Examine the necessary and sufficient conditions for consumer’s
equilibrium.
6. Explain the income effect and substitution effect.
7. Show that the price effect is the total of income and substitution
effects.
8. Explain the price effect of a Giffen good.
9. Derive the demand curve with the help of the PCC.
10. What do you understand by revealed preference? Explain the
law of demand with the help of revealed preference theory.

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QUESTION PAPER PATTERN
F. Y. B. A. (Sem - I)
1) All Questions are compulsory
2) All Question Carry Equal Marks
3) Figures to the right indicates marks to a Sub – Question

Q.1Attempt any two of the following (On Module – I)

a. ______________________________________ (10 Marks)
b. ______________________________________ (10 Marks)
c. ______________________________________ (10 Marks)

Q. 2) Attempt any two of the following (On Module – II)

a. ______________________________________ (10 Marks)
b. ______________________________________ (10 Marks)
c. ______________________________________ (10 Marks)

Q. 3) Attempt any two of the following (On Module – III)

a. ______________________________________ (10 Marks)
b. ______________________________________ (10 Marks)
c. ______________________________________ (10 Marks)

Q. 4) Attempt any two of the following (On Module – IV)

a. ______________________________________ (10 Marks)
b. ______________________________________ (10 Marks)
c. ______________________________________ (10 Marks)

Q. 5) Attempt any two of the following

a. ______________________________________ (10 Marks)
b. ______________________________________ (10 Marks)
c. ______________________________________ (10 Marks)

