Micro-

Economics
(Chapter 1 – 6)

Chapter 1: NATURE, SCOPE AND METHODOLOGY OF ECONOMICS

 SUMMARY

DEFINITIONS OF ECONOMICS

Several economists have defined economics taking different aspects into account. The word

‘Economics’ was derived from two Greek words, oikos (a house) and nemein (to manage)

which would mean ‘managing a household’ using the limited funds available, in the most

satisfactory manner possible.

i.) Adam Smith - “An Inquiry into Nature and Causes of Wealth of Nations” (1776)

 He defined economics as the science of wealth. Adam Smith explained how a nation’s

wealth is created. He considered that the individual in the society wants to promote only

his own gain and in this, he is led by an “invisible hand” to promote the interests of the

society though he has no real intention to promote the society’s interests.

ii.) Alfred Marshall - “Principles of Economics” (1890)

 The important features of Marshall’s definition of Economics are as follows: a)

According to Marshall, economics is a study of mankind in the ordinary business of life,

i.e., economic aspect of human life. b) Economics studies both individual and social

actions aimed at promoting economic welfare of people. c) Marshall makes a distinction

between two types of things, e.g. material things and immaterial things. Material things

are those that can be seen, felt and touched, (E.g.) book, rice etc. Immaterial things are

those that cannot be seen, felt and touched. (E.g.) skill in the operation of a thrasher, a

tractor etc., cultivation of hybrid cotton variety and so on. In his definition, Marshall

considered only the material things that are capable of promoting welfare of people.
iii.) Lionel Robbins - “An Essay on the Nature and Significance of Economic Science”

 According to him, “economics is a science which studies human behavior as a

relationship between ends and scarce means which have alternative uses”. The major

features of Robbins’ definition are as follows: a) Ends refer to human wants. Human

beings have unlimited number of wants. b) Resources or means, on the other hand, are

limited or scarce in supply. There is scarcity of a commodity, if its demand is greater

than its supply. In other words, the scarcity of a commodity is to be considered only in

relation to its demand. c) The scarce means are capable of having alternative uses.

Hence, anyone will choose the resource that will satisfy his particular want. Thus,

economics, according to Robbins, is a science of choice.

iv.) Prof. Paul Samuelson

 Economics is “the study of how men and society choose, with or without the use of

money, to employ scarce productive resources which could have alternative uses, to

produce various commodities over time, and distribute them for consumption, now and

in the future among various people and groups of society”. The major implications of

this definition are as follows: a) Samuelson has made his definition dynamic by

including the element of time in it. Therefore, it covers the theory of economic growth.

b) Samuelson stressed the problem of scarcity of means in relation to unlimited ends.

Not only the means are scarce, but they could also be put to alternative uses. c) The

definition covers various aspects like production, distribution and consumption.

SCOPE OF ECONOMICS
Scope means province or field of study. In discussing the scope of economics, we have to

indicate whether it is a science or an art and a positive science or a normative science. It also

covers the subject matter of economics.

i) Economics - A Science and an Art

a) Economics is a science: Science is a systematized body of knowledge that traces the

relationship between cause and effect. Another attribute of science is that its phenomena

should be amenable to measurement. Applying these characteristics, we find that economics

is a branch of knowledge where the various facts relevant to it have been systematically

collected, classified and analyzed. Economics investigates the possibility of deducing

generalizations as regards the economic motives of human beings. The motives of individuals

and business firms can be very easily measured in terms of money. Thus, economics is a

science.

Economics - A Social Science: In order to understand the social aspect of economics, we

should bear in mind that laborers are working on materials drawn from all over the world and

producing commodities to be sold all over the world in order to exchange goods from all parts

of the world to satisfy their wants. There is, thus, a close inter-dependence of millions of

people living in distant lands unknown to one another. In this way, the process of satisfying

wants is not only an individual process, but also a social process. In economics, one has, thus,

to study social behaviour i.e., behaviour of men in-groups.

b) Economics is also an art. An art is a system of rules for the attainment of a given end. A

science teaches us to know; an art teaches us to do. Applying this definition, we find that

economics offers us practical guidance in the solution of economic problems. Science and art

are complementary to each other and economics is both a science and an art.
ii) Positive and Normative Economics is both positive and normative science.

a) Positive science: It only describes what it is and normative science prescribes what it ought

to be. Positive science does not indicate what is good or what is bad to the society. It will

simply provide results of economic analysis of a problem.

b) Normative science: It makes distinction between good and bad. It prescribes what should be

done to promote human welfare. A positive statement is based on facts. A normative

statement involves ethical values. For example, “12 per cent of the labour force in India was

unemployed last year” is a positive statement, which could is verified by scientific

measurement. “Twelve per cent unemployment is too high” is normative statement comparing

the fact of 12 per cent unemployment with a standard of what is unreasonable. It also suggests

how it can be rectified. Therefore, economics is a positive as well as normative science.

METHODOLOGY OF ECONOMICS

Economics as a science adopts two methods for the discovery of its laws and principles, viz.,

(a) deductive method and (b) inductive method.

Economics as a science adopts two methods for the discovery of its laws and principles, (a)

deductive method and (b) inductive method.

a) Deductive method: Here, we descend from the general to particular, i.e., we start from

certain principles that are self-evident or based on strict observations. Then, we carry them

down as a process of pure reasoning to the consequences that they implicitly contain. For

instance, traders earn profit in their businesses is a general statement which is accepted even

without verifying it with the traders. The deductive method is useful in analyzing complex

economic phenomenon where cause and effect are inextricably mixed up. However, the
deductive method is useful only if certain assumptions are valid. (Traders earn profit, if the

demand for the commodity is more).

b) Inductive method: This method mounts up from particular to general, i.e., we begin with the

observation of particular facts and then proceed with the help of reasoning founded on

experience so as to formulate laws and theorems on the basis of observed facts. E.g. Data on

consumption of poor, middle and rich income groups of people are collected, classified,

analyzed and important conclusions are drawn out from the results.

In deductive method, we start from certain principles that are either indisputable or based on

strict observations and draw inferences about individual cases. In inductive method, a

particular case is examined to establish a general or universal fact.

Microeconomics

Microeconomics examines individual economic activity, industries, and their interaction. It has

the following characteristics:

 Elasticity: It determines the ratio of change in the proportion of one variable to another

variable. For example- the income elasticity of demand, the price elasticity of demand, the

price elasticity of supply, etc.

 Theory of Production: It involves an efficient conversion of input into output. For

example- packaging, shipping, storing, and manufacturing.

 Cost of Production: With the help of this theory, the object price is evaluated by the price

of resources.

 Monopoly: Under this theory, the dominance of a single entity is studied in a particular

field.

 Oligopoly: It corresponds to the dominance of small entities in a market.

Macroeconomics

It is the study of an economy as a whole. It explains broad aggregates and their interactions

“top down.” Macroeconomics has the following characteristics:

 Growth: It studies the factors which explain economic growth such as the increase in

output per capita of a country over a long period of time.

 Business Cycle: This theory emerged after the Great Depression of the 1930s. It

advocates the involvement of the central bank and the government to formulate monetary

and fiscal policies to monitor the output over the business cycle.

 Unemployment: It is measured by the unemployment rate. It is caused by various factors

like rising in wages, a shortfall in vacancies, and more.

 Inflation and Deflation: Inflation corresponds to an increase in the price of a commodity,

while deflation corresponds to a decrease in the price of a commodity. These indicators

are valuable to evaluate the status of the economy of a country.

 Chapter 1: NATURE, SCOPE AND METHODOLOGY OF ECONOMICS

Reaction Paper

I must say that the central focus of economics is on scarcity of resources and choices among

their alternative uses. Economics shows how scarce resources can be used to increase wealth

and human welfare. This scarcity induces people to make choices among alternatives, and the

knowledge of economics is used to compare the alternatives for choosing the best among

them.

At its core, Economics is the study of how humans make decisions in the face of scarcity.

These can be individual decisions, family decisions, business decisions or societal decisions. If

you look around carefully, you will see that scarcity is a fact of life. Scarcity means that human

wants for goods, services and resources exceed what is available. Resources, such as labor,

tools, land, and raw materials are necessary to produce the goods and services we want but

they exist in limited supply. Of course, the ultimate scarce resource is time – everyone, rich or

poor, has just 24 hours in the day to try to acquire the goods they want. At any point in time,

there is only a finite amount of resources available.

In the definition of economics, Adam Smith defined economics only in terms of wealth and not

in terms of human welfare; In Marshall’s, he considered only material things. But immaterial

things, such as the services of a doctor, a teacher and so on, also promote welfare of the

people and Marshall’s definition is based on the concept of welfare but there is no clear-cut

definition of welfare. The meaning of welfare varies from person to person, country to country

and one period to another. However, generally, welfare means happiness or comfortable living

conditions of an individual or group of people. The welfare of an individual or nation is

dependent not only on the stock of wealth possessed but also on political, social and cultural

activities of the nation; In Robbin’s, he does not make any distinction between goods

conducive to human welfare and goods that are not conducive to human welfare. In the

production of rice and alcoholic drink, scarce resources are used. But the production of rice

promotes human welfare while production of alcoholic drinks is not conducive to human

welfare. However, Robbins concludes that economics is neutral between ends. And of all the

definitions discussed above, the ‘growth’ definition stated by Samuelson appears to be the

most satisfactory. However, in modern economics, the subject matter of economics is divided

into main parts, viz., i) Micro Economics and ii) Macro Economics. Economics is, therefore,

rightly considered as the study of allocation of scarce resources and of determinants of

income, output, employment and economic growth.

The study of economics can provide valuable knowledge for making decisions in everyday life.

It offers a tool with which to approach questions about the desirability of a particular financial

investment opportunity, whether or not to attend college or graduate school, the benefits and

costs of alternative careers, and the likely impacts of public policies including universal health

care and a higher minimum wage. And a basic understanding of economics makes you a well-

rounded thinker. When you read articles about economic issues, you will understand and be

able to evaluate the writer’s argument. When you hear classmates, co-workers, or political

candidates talking about economics, you will be able to distinguish between common sense

and nonsense. You will find new ways of thinking about current events and about personal and

business decisions, as well as current events and politics.

All in all, economics seeks to understand and address the problem of scarcity, which is when

human wants for goods and services exceed the available supply. Learning about economics
helps you understand the major problems facing the world today, prepares you to be a good

citizen, and helps you become a well-rounded thinker.

 Chapter 2: SCARCITY AND THE ECONOMIC SYSTEM

SUMMARY

Scarcity, or limited resources, is one of the most basic economic problems we face. We run

into scarcity because while resources are limited, we are a society with unlimited wants.

Therefore, we have to choose. We have to make trade-offs. We have to efficiently allocate

resources. We have to do those things because resources are limited and cannot meet our

own unlimited demands.

Without scarcity, the science of economics would not exist. Economics is the study of

production, distribution, and consumption of goods and services. If society did not have to

make choices about what to produce, distribute, and consume, the study of those actions

would be relatively boring. Society would produce, distribute, and consume an infinite amount

of everything to satisfy the unlimited wants and needs of humans. Everyone would get

everything they wanted, and it would all be free. But we all know that is not the case. The

decisions and trade-offs society makes due to scarcity is what economists study.

Making economic choices is another way of dealing with scarcity. The different ways nations

make economic choices result in various economic systems. All nations must address the

problems of resource scarcity, and all nations must allocate their limited resources to meet the

needs of their citizens. When nations allocate resources, they make choices reflecting their

basic human values.

Economic systems can be divided into three types: traditional, market, and command (or

planned) systems.
 The traditional economic system is based on traditional practices of subsistence

agriculture, fishing, or hunting and gathering (or a combination of those pursuits), and

may use barter as a method of exchanging goods. In a traditional economy, a person's

economic role is likely to be the same as that of their parents and grandparents.

Economic decisions involving production are likely to be based on tradition; families

produce what they need, and may use excess production to trade. An example of

traditional economies would be the majority of pre-Columbian societies in the Americas.

 A market economic system may be a pure market economy or a mixed market

economy. In both of these systems, buyers and sellers are the primary controllers of the

marketplace. In the first-mentioned system, consumers' buying decisions determine

what will be produced in a system in which businesses are free to operate as they wish

in order to make a profit, setting prices in competition with other producers. Consumers

are free to purchase what they wish at prices set by this competition between

producers.

 A mixed market economy combines elements of the above with command (or planned)

economies. In a mixed economic system, most economic decisions are made by

consumers or sellers, but some economic decisions are made by the government, such

as those dealing with safety regulations, infrastructure (e.g., roads), education, military

spending, and certification and business licensing, all of these being decisions which

affect the economy in some way. The United States and the United Kingdom are two

such mixed market economies.

  In planned (or command) economies, economic decisions—what is produced and how

resources are allocated—are made by the government or the state. Production is

regulated and economic activities are coordinated via government directives, targets,

and regulation

The above systems usually indicate the types of governments identified with them. If the

government owns and operates all of the nation's means of production then the

political/economic system is generally based on communism. If the government owns and

operates the nation's major industries and utilities, but permits individuals to own smaller

businesses, then the political/economic system is generally based on socialism. Finally, if

almost all stores, factories, and farms are owned and operated by private individuals, then the

political/economic system is generally based on free enterprise and democracy.

The Basic Problems in Economics

Problem # 1. What to Produce and in What Quantities?

The first central problem of an economy is to decide what goods and services are to be

produced and in what quantities. This involves allocation of scarce resources in relation to the

composition of total output in the economy. Since resources are scarce, the society has to

decide about the goods to be produced: wheat, cloth, roads, television, power, buildings, and

so on.

Once the nature of goods to be produced is decided, then their quantities are to be decided.

How many tons of wheat, how many televisions, how many million kws of power, how many

buildings, etc. Since the resources of the economy are scarce, the problem of the nature of
goods and their quantities has to be decided on the basis of priorities or preferences of the

society.

If the society gives priority to the production of more consumer goods now, it will have less in

the future. A higher priority on capital goods implies less consumer goods now and more in the

future. But since resources are scarce, if some goods are produced in larger quantities, some

other goods will have to be produced in smaller quantities.

This problem can also be explained with the help of the production possibility curve as shown

in Figure 1.

Suppose the economy produces capital goods and consumer goods. In deciding the total

output of the economy, the society has to choose that combination of capital goods and

consumer goods which is in keeping with its resources.

It cannot choose the combination R which is inside the production possibility curve

PP1 because it reflects economic inefficiency of the system in the form of unemployment of

resources. Nor can it choose the combination R which is outside the current production

possibilities of the society. The society lacks the resources to produce this combination of

capital goods and consumer goods.

It will, therefore, have to choose among the combinations В, E, or D which give the highest

level of satisfaction. If the society decides to have more capital goods, it will choose

combination B; and if it wants more consumer goods, it will choose combination D.

Problem # 2. How to Produce these Goods?

The next basic problem of an economy is to decide about the techniques or methods to be

used in order to produce the required goods. This problem is primarily dependent upon the

availability of resources within the economy.

If land is available in abundance, it may have extensive cultivation. If land is scarce, intensive

methods of cultivation may be used. If labour is in abundance, it may use labour-intensive

techniques; while in the case of labour shortage, capital-intensive techniques may be used.

The technique to be used also depends upon the type and quantity of goods to be produced.

For producing capital goods and large outputs, complicated and expensive machines and

techniques are required. On the other hand, simple consumer goods and small outputs require

small and less expensive machines and comparatively simple techniques.

Further, it has to be decided what goods and services are to be produced in the public sector

and what goods and services in the private sector. But in choosing between different methods
of production, those methods should be adopted which bring about an efficient allocation of

resources and increase the overall productivity in the economy.

Suppose the economy is producing certain quantities of consumer and capital goods at point A

on PP curve in Figure 2. у adopting new techniques of production, given the supplies of

factors, the productive efficiency of the economy increases. As a result, the PP 0 curve shifts

outwards to P1P1.

It leads to the production of more quantities of consumer and capital gods from point A on

PP0 curve to point С of PP with be the new production possibility curve and the economy will

move from point A to В where more of both the goods are produced.

Problem # 3. For whom is the Goods Produced?

The third basic problem to be decided is the allocation of goods among the members of the

society. The allocation of basic consumer goods or necessities and luxuries comforts and

among the household takes place on the basis of among the distribution of national income.

Whosoever possesses the means to buy the goods may have then. A rich person may have a

large share of the luxuries goods, and a poor person may have more quantities of the basic

consumer goods he needs. This problem is illustrated in Figure 3 where the production

possibility curve PP shows the combinations of luxuries and necessaries.

At point В on the PP curve, the economy is producing more of luxuries ОС for the rich and less

of necessaries ОС for the at whereas at point D more of necessaries OH are being produced

for the poor and less of luxuries OF for the rich.

Chapter 2: SCARCITY AND THE ECONOMIC SYSTEM

Reaction Paper

Scarcity is one of the fundamental issues in economics. The issue of scarcity means we have

to decide how and what to produce from limited resources. It means there is a constant

opportunity cost involved in making economic decisions.

Economics solves the problem of scarcity by placing a higher price on scarce goods. The high

price discourages demand and encourages firms to develop alternatives.

If scarcity did not exist, all goods and services would be free. A good is considered scarce if it

has a non-zero cost to consume. In other words, it costs something. Almost every good we

consume as individuals, or as a society, costs something and is scarce. By consuming one

good, another good is foregone. Therefore, scarcity creates a need for decisions and trade-offs

to be made.

All societies face the basic problem of scarcity. Scarcity makes it necessary for us to make the

most of what we have. In economics, scarcity refers to limitations. For example, insufficient

resources, goods, or alternatives is fundamental to economics. Scarcity happens because

there are unlimited wants and limited resources. Because of scarcity, choices have to be made

by consumers, businesses and governments. For example, over six million people travel

into London each day and they make choices about when to travel, whether to use the bus, the

tube, to walk or to cycle, or whether to work from home.

Assuming rational behavior on the part of decision-making units, like households, firms and the

government, this optimal choice must be one that chooses the most desirable alternative

among the possibilities that the available resources permit. That is, decision-making units

will always choose the alternative which yields them maximum satisfaction. Households, with a

limited income, have to decide the combination of goods and services to purchase which yields

the highest utility. Firms, with limited factors of production, have to decide what goods and

services to produce and which method of production to adopt to yield the highest profits.

Governments with limited tax revenue, have to decide what projects and initiatives to

undertake to maximize society’s welfare. The choices they have to make are related to

the self-interested nature of economic agents.

All societies face the problem of scarcity and hence have to make decisions like a household

does. A society has to decide what and how much to produce, how to produce and for whom

to produce. The society must decide what goods it is going to produce. Such choices usually

take the form of more of one thing and less of another, rather than all of one and none of
another. It needs to choose the composition of total output. Most goods can be produced by a

variety of methods. Wheat can be grown by making use of much labor and little capital, or by

using vast amounts of capital and very little labor. A society must decide on the methods of

production to be adopted.
 Chapter 3: MARKET DEMAND & MARKET SUPPLY

SUMMARY

MARKET

 A market is one of the many varieties of systems, institutions, procedures, social

relations and infrastructures whereby parties engage in exchange. While parties may

exchange goods and services by barter, most markets rely on sellers offering their

goods or services in exchange for money from buyers. It can be said that a market is

the process by which the prices of goods and services are established.

 In mainstream economics, the concept of a market is any structure that allows buyers

and sellers to exchange any type of goods, services and information. The exchange of

goods or services, with or without money, is a transaction.[1] Market participants consist

of all the buyers and sellers of a good who influence its price, which is a major topic of

study of economics and has given rise to several theories and models concerning the

basic market forces of supply and demand. A major topic of debate is how much a given

market can be considered to be a "free market", that is free from government

intervention. Microeconomics traditionally focuses on the study of market structure and

the efficiency of market equilibrium.

Supply and demand is perhaps one of the most fundamental concepts of economics and it is

the backbone of a market economy. Demand refers to how much of a product or service is

desired by buyers. The quantity demanded is the amount of a product people are willing to buy

at a certain price; the relationship between price and quantity demanded is known as the

demand relationship. Supply represents how much the market can offer. The quantity supplied

refers to the amount of a certain good producers are willing to supply when receiving a certain
price. The correlation between price and how much of a good or service is supplied to the

market is known as the supply relationship. Price, therefore, is a reflection of supply and

demand.

A. The Law of Demand

The law of demand states that, if all other factors remain equal, the higher the price of a good,

the less people will demand that good. In other words, the higher the price, the lower the

quantity demanded. The amount of a good that buyers purchase at a higher price is less

because as the price of a good goes up, so does the opportunity cost of buying that good. As a

result, people will naturally avoid buying a product that will force them to forgo the consumption

of something else they value more. The chart below shows that the curve is a downward slope.

A, B and C are points on the demand curve. Each point on the curve reflects a direct

correlation between quantity demanded (Q) and price (P). So, at point A, the quantity

demanded will be Q1 and the price will be P1, and so on. The demand relationship curve

illustrates the negative relationship between price and quantity demanded. The higher the
price of a good the lower the quantity demanded (A), and the lower the price, the more the

good will be in demand (C).

B. The Law of Supply

Like the law of demand, the law of supply demonstrates the quantities that will be sold at a

certain price. But unlike the law of demand, the supply relationship shows an upward slope.

This means that the higher the price, the higher the quantity supplied. Producers supply more

at a higher price because selling a higher quantity at a higher price increases revenue.

A, B and C are points on the supply curve. Each point on the curve reflects a direct correlation

between quantity supplied (Q) and price (P). At point B, the quantity supplied will be Q2 and

the price will be P2, and so on.

C. Equilibrium

When supply and demand are equal (i.e. when the supply function and demand function

intersect) the economy is said to be at equilibrium. At this point, the allocation of goods is at its

most efficient because the amount of goods being supplied is exactly the same as the amount

of goods being demanded. Thus, everyone (individuals, firms, or countries) is satisfied with the
current economic condition. At the given price, suppliers are selling all the goods that they

have produced and consumers are getting all the goods that they are demanding.

As you can see on the chart, equilibrium occurs at the intersection of the demand and supply

curve, which indicates no allocative inefficiency. At this point, the price of the goods will be P*

and the quantity will be Q*. These figures are referred to as equilibrium price and quantity.

In the real market place equilibrium can only ever be reached in theory, so the prices of goods

and services are constantly changing in relation to fluctuations in demand and supply.

SUPPLY & DEMAND EQUILIBRIUM

A. How an Increase in Demand Affects Market Equilibrium

In the above case, we see an increase or upward shift in the demand curve from D1 to D2.

This increase can be because of some factors. The result of this increase in demand while

supply remains constant is that the Supply and Demand equilibrium shifts from price P1 to P2,

and quantity demanded and supplied increases from Q1 to Q2.

B. How A Decrease in Demand Affects Market Equilibrium

In the below case, we see a decrease or downward shift in the demand curve from D1 to D2.

This decrease can be because of some factors that affect demand. The result of this decrease

in demand while supply remains constant is that the equilibrium falls from price P1 to P2, and

quantity demanded and supplied decreases from Q1 to Q2.

C. How an Increase in Supply Affects Market Equilibrium

In the below case, we see an increase or upward shift in the supply curve from S1 to S2. This

increase can occur because of a number of factors. The result of this increase in supply while

demand remains constant is that the Supply and Demand equilibrium shifts from price P1 to

P2, and quantity demanded and supplied increases from Q1 to Q2 .

D. How A Decrease in Supply Affects Market Equilibrium

In the below case, we see an decrease or downward shift in the supply curve from S1 to s2.

This decrease can be because of a number of factors that affect supply. The result of this

decrease in supply while demand remains constant is that the equilibrium falls from price P1 to

P2, and quantity demanded and supplied decreases from Q1 to Q2.

E. What Happens When There is a Decrease in Supply and Demand?

In this case, both Supply and Demand fall from D1 to D2 and S1 to S2 respectively. The result

is price increasing from P1 to P2 and quantity demanded and supplied decreasing from Q1 to

Q2.
 Chapter 3: MARKET DEMAND & MARKET SUPPLY

Reaction Paper

In reflection of this lesson, the chapter focuses on the simple fact, supply is how much of an item

there is, and demand is how many people want to buy something. The laws of supply and

demand explain how the market determines the price and quantity of goods to be sold. This

chapter discussed how an increase in supply can affect demand and on the ways that an

increase in demand can affect future supply.

All in all, demand refers to how much of a product or service is desired by buyers. And it is

determined by the determinants like taste and preferences, income, population and price

expectation. Price must always come first. Consumers are more tend to buy a product if the

price decreases. This kind of behavior on the part of buyers is in accordance with the law of

demand. According to the la of demand, an inverse relationship exists between the price of a

good and the quantity demanded of that good.

As the price of a good goes up, buyers demand less of that good. This law will only be valid if

ceteris paribus assumption is applied that means “all other things are equal or constant”. It

means that the determinants of demand must be constant. This inverse relationship is more

readily seen using the graphical device known as demand curve, which is nothing more than a

graph of the demand schedule. Change in demand means the change in the determinants of

demand. So, an increase in demand shifts the demand curve to the right while a decrease in

demand shifts a demand curve into then left. If there is a change in demand, there is also a

change in quantity demand, this is different to change in demand because it only shows a

movement from one point to another point.

Another thing is the supply, it is the schedule of various quantities of commodities which

producers are willing and able to produce and offer at a given place, price and time. Its

determinants are technology, cost of production, number of sellers, prices of other goods, price

expectation and taxes and subsidies. The law of supply states that “as price increases,

quantity demanded increases and as price decreases, quantity demanded decreases”.

According to the law of supply, a direct relationship exists between the price of a good and the

quantity supplied of that good. As the price a good increase, sellers are willing to supply more

of that good. The law of supply is also reflected in the upward- sloping supply curve. A change

in the quantity supplied is a movement along the supply curve due to a change in the price of

the good supplied and a change in supply, like a change in demand, is represented by a shift

in supply curve.

Law of demand and supply explains that when the demand is greater that supply, price

increases and when supply is greater that demand price decreases. The law of supply and

demand is not an actual law but it is well confirmed and understood realization that if you have

a lot of one item, the price for that item should go down. At the same time, you need to

understand the interaction; even if you have a high supply, if the demand is also high, the price

could also be high. In the world of stock investing, the law of supply and demand can

contribute to explaining a stock price at any given time. It is the base to any economic

understanding.

Supply and Demand is the most fundamental concept in economics and it plays a vital role in

determination of price of goods in the market.

Chapter 4: APPLICATION OF DEMAND AND SUPPLY AND THE CONCEPT OF ELASTICITY

SUMMARY

“You cannot teach a parrot to be an economist simply by teaching it to say “supply” and

“demand”” - Anonymous

Elasticity of Demand and Supply

1.Price elasticity of demand measures the quantitative response of demand to a change in

price. Price elasticity of demand (ED) is defined as the percentage change in quantity

demanded divided by the percentage change in price. That is,

Price elasticity of demand = ED

= percentage change in quantity demanded

percentage change in price

In this calculation, the sign is taken to be positive, and P and Q are averages of old and new

values.

2.We divide price elasticities into three categories:(a) Demand is elastic when the percentage

change in quantity demanded exceeds the percentage change in price; that is, ED > 1. (b)

Demand is inelastic when the percentage change in quantity demanded is less than the

percentage change in price; here, ED < 1.

(c) When the percentage change in quantity demanded exactly equals the percentage change

in price, we have the borderline case of unit-elastic demand, where ED = 1.

3.Price elasticity is a pure number, involving percentages; it should not be confused with slope.
4. The demand elasticity tells us about the impact of a price change on total revenue. A price

reduction increases total revenue if demand is elastic; a price reduction decreases total

revenue if demand is inelastic; in the unit-elastic case, a price change has no effect on total

revenue.

5. Price elasticity of demand tends to be low for necessities like food and shelter and high for

luxuries like snowmobiles and vacation air travel. Other factors affecting price elasticity are the

extent to which a good has ready substitutes and the length of time that consumers have to

adjust to price changes.

6.Price elasticity of supply measures the percentage change of output supplied by producers

when the market price changes by a given percentage.

Applications to Major Economic Issues

 One of the most fruitful arenas for application of supply-and-demand analysis is

agriculture. Improvements in agricultural technology mean that supply increases greatly,

while demand for food rises less than proportionately with income. Hence free-market

prices for foodstuffs tend to fall. No wonder governments have adopted a variety of

programs, like crop restrictions, to prop up farm incomes.

 A commodity tax shifts the supply-and-demand equilibrium. The tax’s incidence (or

impact on incomes) will fall more heavily on consumers than on producers to the degree

that the demand is inelastic relative to supply.

  Governments occasionally interfere with the workings of competitive markets by setting

maximum ceilings or minimum floors on prices. In such situations, quantity supplied

need no longer equal quantity demanded; ceilings lead to excess demand, while floors

lead to excess supply. Sometimes, the interference may raise the incomes of a

particular group, as in the case of farmers or low-skilled workers. Often, distortions and

inefficiencies result.

Elasticity Concepts

Price elasticity of demand, supply, elastic, inelastic, unit-elastic demand, ED = % change in

Q/%change in P, determinants of elasticity, total revenue = P × Q, relationship of elasticity and

revenue change.

Minimum wage Legislation

Fixation of minimum wages by the state can also be presented by demand supply study.

Fixing minimum wages will so increase the earnings of workers that their utilization expenditures

will hike which will in turn direct to enlargement of the consumer’s goods industries and to the

capital goods industries. This will hike employment opportunities, productivity and national

revenue.

Type of Price Elasticity of Demand

  Perfectly Elastic Demand: EP → -∞

Perfect Elastic Demand: The elasticity tends towards -∞.

When the demand is perfect elastic, it drops to zero in the face of a minimal price increase. If

the price is the same of below the point where the demand touches the vertical axis, the

market will demand all the quantity offered.

  Relatively Elastic Demand: -∞ < EP < -1, unit elasticity demand and relatively

inelastic demand

Relatively elastic demand: The elasticity is between -1 and -∞.

Unit Elasticity Demand: EP = -1 , the elasticity is -1.

Relatively Inelastic Demand: -1 < EP < 0 , the elasticity is between 0 and -1.
  Perfect inelastic demand: EP = 0

A perfect inelastic demand has an elasticity of 0. The quantity demanded will not change

despite changes in the price.

 Relatively Inelastic Demand (Ep< 1)

The demand is said to be relatively inelastic if the percentage change in quantity demanded is

less than the percentage change in price i.e. if there is a small change in demand with a

greater change in price. It is also called less elastic or simply inelastic demand.

For example: when the price falls by 10% and the demand rises by less than 10% (say 5%),

then it is the case of inelastic demand. The demand for goods of daily consumption such as

rice, salt, kerosene, etc. is said to be inelastic.

In the given figure, price and quantity demanded are measured along the Y-axis and X-axis

respectively. The demand curve DD is steeper, which shows that the demand is less elastic.

The greater fall in price from OP to OP1 has led to small increase in demand from OM to OM1.

Likewise, greater increase in price leads to small fall in demand.

 Unitary Elastic Demand (Ep = 1)

The demand is said to be unitary elastic if the percentage change in quantity demanded is

equal to the percentage change in price. It is also called unitary elasticity. In such type of

demand, 1% change in price leads to exactly 1% change in quantity demanded. This type of

demand is an imaginary one as it is rarely applicable in our practical life.

In the given figure, price and quantity demanded are measured along Y-axis and X-axis

respectively. The demand curve DD is a rectangular hyperbola, which shows that the demand

is unitary elastic. The fall in price from OP to OP1 has caused equal proportionate increase in

demand from OM to OM1. Likewise, when price increases, the demand decreases in the same

proportion.

Price elasticity of supply

Price elasticity of supply (PES) measures the responsiveness of quantity supplied to a change

in price. It is necessary for a firm to know how quickly, and effectively, it can respond to

changing market conditions, especially to price changes. The following equation can be used

to calculate PES. % change in quantity supplied

% change in price
Chapter 4: APPLICATION OF DEMAND AND SUPPLY AND THE CONCEPT OF ELASTICITY

Reaction Paper

So far in this chapter and in the previous chapter, I have learned that markets tend to move

toward their equilibrium prices and quantities. Surpluses and shortages of goods are short-

lived as prices adjust to equate quantity demanded with quantity supplied.

In some markets, however, governments have been called on by groups of citizens to

intervene to keep prices of certain items higher or lower than what would result from the

market finding its own equilibrium price. In this chapter I have learned that agricultural markets

and apartment rental markets are two markets that have often been subject to price controls. I

also have identified the effects of controlling prices, the reasons why governments have

chosen to control prices in these markets and the consequences of the policies.

Introduction to the concept of "elasticity" in economic analysis was of great importance. The

concept of elasticity serves as an important tool for economic analysis, because in science it is

not enough just to measure, it is also necessary to be able to explain the result obtained.

This chapter was very interesting, and I had to read it twice to fully understand all the various

concepts that were introduced. To help me understand elasticity, I am thinking of it as a rubber

band. If elasticity is a rubber band then it can stretch based on supply or the demand.

inelasticity is the opposite.

Understanding elasticity of demand is valuable in knowing the dynamic response of supply and

demand in a market. Such understanding will enable an enterprising person (businessman

and/or consumer) to achieve a favorable effect (higher revenue/best value of one’s money) or

avoid unintended outcome.

 Chapter 5: THE THEORY OF CONSUMER BEHAVIOR

SUMMARY

The Theory of Consumer Behavior considers how a consumer uses his income in order to

accomplish the most astounding fulfillment or utility. This utility maximization conduct of the

consumer is liable to the demand forced by his constrained income and the prices of the

different things he wishes to expend. The consumer thinks about the distinctive “packs of

products” that he can devour given his income and the prices of the merchandise in the

groups. Also the whole time, he endeavors to focus the package that will provide for him the

maximum fulfillment.

There are two principle methodologies to the theory of consumer conduct to demand in

Economics. The primary methodology to consumer conduct theory is the Cardinalist Approach.

The second is the Ordinalist Approach.

Cardinalist Approach:

Human wants are boundless and they are of diverse power. The means at the transfer of a

man are scarce as well as they have elective employments. As a consequence of scarcity of

assets, the consumer can’t fulfill all his wants. He need to pick as to which want is to be fulfilled

first and which a while later if the assets license. The consumer is faced in settling on a

decision. For instance, a man’ is parched. He goes to the market and fulfills his thirst by

acquiring coca’-cola rather than tea. We are here to look at the budgetary powers which. make

him buy a specific merchandise. The response is basic. The consumer purchases a product in

light of the fact that it provides for him fulfillment. In specialized term, a consumer buys a

merchandise on the grounds that it has utility” for him. We now look at the instruments which

are utilized as a part of the investigation of consumer conduct.

Ordinalist Approach:

“Utility” is the premise on which the demand of a single person for an item depends “Utility” is

characterized as the force of a product or administration to fulfill human want. Utility along

these lines is the fulfillment which is inferred by the consumer by expending the products. For

instance, fabric has a utility for us on the grounds that we can wear it. Pen has a utility for an

individual who can compose with it. The utility is subjective in nature. It varies from individual to

individual. The utility of a container of wine is zero for an individual who is non consumer while

it has a high utility for a consumer Here it may be noted that the expression “utility” may not be

befuddled with delight which a ware provides for a single person. Utility is a subjective

fulfillment which consumer gets from devouring any great or administration. For instance, toxic

substance is damaging to wellbeing however it gives subjective fulfillment to an individual who

wishes to kick the bucket. We can say that utility is quality nonpartisan.

Marginal Utility Analysis

Marginal Utility analysis helps us understand the behavior of a consumer by looking at the way he

spends his income on different goods and services to attain maximum satisfaction. In this article,

we will look at the assumptions, laws, and limitations under marginal utility analysis.

 Total Utility or Full Satiety – is the sum of utility derived from different units of a commodity

consumed by a consumer. Therefore, Total Utility = the sum total of all marginal utility.

 Marginal Utility or Marginal Satiety – is the additional utility derived from the consumption of

an additional unit of a commodity. Therefore, Marginal Utility = the addition made to the

Total Utility by consuming one more unit of a commodity.

Indifference Curve

A popular alternative to the marginal utility analysis of demand is the Indifference Curve Analysis.

This is based on consumer preference and believes that we cannot quantitatively measure

human satisfaction in monetary terms. This approach assigns an order to consumer preferences

rather than measure them in terms of money. Let us take a look.

What is an Indifference Curve?

It is a curve that represents all the combinations of goods that give the same satisfaction to the

consumer. Since all the combinations give the same amount of satisfaction, the consumer prefers

them equally. Hence the name Indifference Curve.

 Chapter 5: THE THEORY OF CONSUMER BEHAVIOR

Reaction Paper

Economics is not just statistics and graphs. It also deals with human behavior and human

wants. The theory of consumer behavior in particular deals with how consumers allocated and

spend their income among all the different goods and services.

The theory of consumer conduct portrays how consumers purchase diverse products and

administrations. Moreover, consumer conduct likewise demonstrates how a consumer

designates its income in connection to the buy of distinctive products and how value influences

his or her choice. There are two speculations that try to demonstrate consumer conduct. These

are the utility theory and the indifference inclination theory.

The utility theory illustrates consumer conduct in connection to the fulfillment that a consumer

gets the minute he expends a great. The utility theory of demand expects that fulfillment might

be measured. The unit of measure of utility is called utils.

The study of Consumer behavior plays an importance role to us students, which need to study

in how individuals, groups and organizations select, buy, use and dispose of goods, services,

idea or experiences to satisfy the needs and wants of the consumers. I learned from this

chapter that some of the factors that may influence consumer purchase decisions are the

cultural influences, social influences, personal factors and psychological factors. It changed my

life in a way that my perspectives in my buying habits and in decision making were changed.

This chapter also taught me how consumers are motivated in buying preferences and how to

come up with a better decision strategies differ between products that differ in their level of

importance or interest. As a result, this impact will surely bring about certain changes in
behaviors based on positive or negative aspects of learning, which more explicitly, positive or

negative experiences in a situation that I will encounter in the market place.

I have learned and read some interesting topic and articles which have impacts on my

understanding of consumer behaviour. However, consumer behaviour is a complex field to

understand it because the behaviour has changed overtime and a consumer affects by several

factors such as psychological, social and cultural elements.

 Chapter 6: THEORY OF PRODUCTION AND COST

SUMMARY

The theory involves some of the most fundamental principles of economics. It is an effort to

explain the principle, by which a business firm decides how much of each commodity that it sells,

it will produce and how much of labour, raw material, fixed capital good, etc., it will use.

This also includes the relationship between the prices of commodities and the wages or rents of

the productive factors used to produce them. On the one hand, it explains the relationship

between the prices of commodities and productive factors, on the other, the quantities of these

commodities and productive factors that are produced or used.

PRODUCTION

 Production means transforming inputs (labor, machines, raw materials etc.) into an

output.

 The production process does not necessarily involve physical conversion of raw

materials in to tangible goods, it also includes conversion of intangible inputs to

intangibles outputs. E.g., lawyer, doctor, social workers etc.

 An input is good or service that goes into the process of production and output is any

good or service that comes out of production

Fixed and Variable Inputs

 A fixed input is one whose supply is inelastic in the short run.

 A variable input is defined as one whose supply in the short run is elastic, e.g. labor,

raw materials etc.

  A fixed input remains fixed up to a certain level of output whereas a variable input

changes with change in output.

Production Function

 A firm has two types of production function:

1. Short run production function

2. Long run production function

Short Run Production

 It refers to a period of time in which the supply of certain inputs (e.g., plant, building,

machines, etc.) are fixed or inelastic.

 Thus an increase in production during this period is possible only by increasing the

variable input.

Long Run Production

 It refers to a period of time I which supply of all the input is elastic, but not enough to

permit a change in technology.

 In the long run, the availability of even fixed factor increases.

 Thus in the long run, production of commodity can be increased by employing more of

both, variable and fixed inputs.

Production Function

 Production refers to the transformation of inputs or resources into outputs of goods and

services. In other words, production refers to all of the activities involved in the

production of goods and services, from borrowing to set up or expand production

facilities, to hiring workers, purchasing row materials, running quality control, cost
 accounting, and so on, rather than referring merely to the physical transformation of

inputs into outputs of goods and services.

Cost Theory – Types of Costs

A. Fixed Cost

Fixed costs are costs that do not vary with different levels of production and fixed costs exists

even if output is zero. Example: rent or salaries.

In the above diagram, the fixed cost remains constant regardless of the quantity produced.

B. Average Fixed Cost

Average Fixed Cost = Fixed Costs/Quantity.

In the above diagram, we see that when the quantity produced is low, the average fixed cost is

very high and this cost lowers as the quantity produced increases.

For example, if the Fixed Cost is $100 and initially you produce two units then the average

fixed cost is $50. If you start creating 20 units, then the average fixed cost falls to $5.

C. Variable Costs

Variable Costs are costs that vary with the level of output. Ex: electricity

In the above diagram, the variable cost curve starts from zero. It means when output is zero,

the variable cost is zero, but as production increases the variable cost increases. It keeps
rising to the point that economies of scale cannot lower the per unit cost anymore hence the

steep incline.

D. Marginal Cost

Marginal Cost is the increase in cost caused by producing one more unit of the good.

The Marginal Cost curve is U shaped because initially when a firm increases its output, total

costs, as well as variable costs, start to increase at a diminishing rate. At this stage, due to

economies of scale and the Law of Diminishing Returns, Marginal Cost falls till it becomes

minimum. Then as output rises, the marginal cost increases.

E. Total Cost

Total Cost = Fixed Cost + Variable Cost

When the output is zero, variable costs are also zero. But we have fixed costs which is where

the Total Costs start. The Total Cost remains parallel to the Variable Cost, and the distance

between the two curves is the Fixed Cost.

F. Average Total Cost

Average Total Cost = Total Cost/Quantity. (Total Cost = Fixed Cost + Variable Cost)

Average Variable Cost = Variable Costs/Quantity.

 Marginal Cost, Average Cost, Average Variable Cost

Note: If average costs are falling then marginal costs must be less than average while if

average costs are rising then marginal must be more than average. Marginal cost on its way

up must cut the cost curve at its minimum point.

If Marginal Cost is less than Average Variable Cost, then Average Cost goes down.

If Marginal Cost is higher than Average Variable Cost, then Average Cost goes up.

If Marginal Cost is equal to Average Variable Cost, then Average Cost will be at minimum.
 Chapter 6: THEORY OF PRODUCTION AND COST

Reaction Paper

The theory of production shows how firms transform inputs into desirable outputs. In the theory

of production, I learned how inputs or factors of production are converted into output or sale to

consumers, other business firms, various government departments, and to the rest of the

world. Inputs are the beginning of the production process and output is the end of the process.

The key concept in the theory of production is the production function. The economist

describes the production process in terms of a production function through which the quantities

of outputs produced are functionally dependent upon the quantities of inputs used.

The firm's primary objective in producing output is to maximize profits. The production of

output, however, involves certain costs that reduce the profits a firm can make. The

relationship between costs and profits is therefore critical to the firm's determination of how

much output to produce.

A firm's explicit costs comprise all explicit payments to the factors of production the firm uses.

Wages paid to workers, payments to suppliers of raw materials, and fees paid to bankers and

lawyers are all included among the firm's explicit costs.

A firm's implicit costs consist of the opportunity costs of using the firm's own resources without

receiving any explicit compensation for those resources. For example, a firm that uses its own

building for production purposes forgoes the income that it might receive from renting the

building out. As another example, consider the owner of a firm who works along with his

employees but does not draw a salary; the owner forgoes the opportunity to earn a wage

working for someone else. These implicit costs are not regarded as costs in an accounting
sense, but they are a part of the firm's costs of doing business, nonetheless. When economists

discuss costs, they have in mind both explicit and implicit costs.

In cost theory, every production function has a cost associated with it and business firms will

try to maximize the profit by using the production method that produces whatever type and

quantity of product the firm wants at the lowest cost. When a firm produces a good or service

using the least-cost method, efficient production and the efficient use of resources occur.