EC0 511 - Lecture Notes On Basic Microeconomics

ECO 511: Microeconomics Analysis
Microeconomics Primer
Dr. Sakib B. Amin

Department of Economics
North South University
1
What is Economics?
o
Economics is the Social Science that studies the

choice that individuals, businesses, governments
and the entire societies make as they cope with
scarcity.
Economics is the study of how societies use scarce
resources to produce valuable commodities and
distribute them among different people.
Scarcity
o
Economics deal with a central problem faced by

all individuals and all societies: The Problem of
Scarcity
Fundamental Reason:
o
Our wants far exceed our resources. So, scarcity

of resources is the key problem.
The excess of Human needs over what can
actually be produced.
Our inability to satisfy all our wants is called

scarcity.
Scarcity
The problem of scarcity means that every time we

take an economic decision (for example, how much
to consume or for a firm how much to produce of a
given good) we face some constraints that affect our
decision.
Scarcity arises because some resources that are

used to produce goods are limited by physical space.
For example, to produce goods and services we
need to use productive resources like Labour, Land
and Raw Materials, Capital (machines, factories,
equipment, etc.etc.).
Scarcity
The amount of Labour is limited both in number and

in skills.
The worlds land area is limited and so are raw

materials (think of petrol).
The stock of capital is limited since we have a
limited
amount
of
factories,
machines,
transportation and other equipment.
Labour, Raw Materials, Land and Capital are what
we call Factors of Production (or productive Inputs).
Scarcity
Furthermore, scarcity arises from other resources,

like time or income (normally we cannot consume
more than what we earn, a firm may not be able to
start a new factory if it not able to get a bank loan,
etc. etc.).
Given the limited amount of resources we con only

produce and consume a limited amount of goods
and services.
Why is scarcity a problem?
If we know that we have limited resources we could

just behave accordingly. The problem arises because
in general human wants and needs are virtually
unlimited. We all would like to have more money to
be able to consume more goods and services. Thus,
scarcity becomes a problem because it implies that
the means of fulfilling human needs are limited.
Therefore economists tend to define scarcity in the
following way:
the excess of human needs over what can actually

be produced.
Scarcity
Scarcity implies that we cannot choose whatever we

want when we decide about what and how much to
consume (I cannot buy today a BMW that costs
50000 if my total income today is 10000, etc.
etc.) or when we decide about what and how much
to produce (I cannot produce a good that requires
1000 workers if only 100 are available, etc. etc.)..
Economic Categories
Four common Economic Categories are:
1.
Microeconomics
2.
Macroeconomics
3.
Positive Economics
4.
Normative Economics
Microeconomics
Adam Smith is usually considered the founder of the

field of Microeconomics. This is the branch of
Economics, which is concerned with the behaviour of
individual entities such as markets, firms and
households.
In The Wealth of Nations, Smith considered how

individual prices are set, studied the determination
of prices of Land, Labour and Capital, and inquired
into the strengths and weaknesses of the market
mechanism.
10
Microeconomics
Microeconomics studies the behaviour of individual

decision-making units, the individual, the household
,the firm, the industry and how these agents interact
in markets.
Microeconomics is the study of the economic
behaviour of single units( a consumer, a household,
a firm, a particular industries, etc.etc) and of the
interrelationship between those units.
11
Microeconomics
A Micro economist might be interested in answering

such questions as:
How does a Market work?
What level of output does a firm produce?
What price does a firm charge for the good it

produces?
How does a consumer determine how much of a
good he/she will buy?
Can Government policy
consumer behaviour?
affect
business
and
12
Microeconomics
Generally Microeconomics looks at the production,

exchange and consumption of goods and services at
the level of an individual producer of the good or the
market in which a single good or service is
exchanged or an individual consumer of the product.
The Key word is individual: Microeconomics deals

with the behaviour of the individual entities that
make up the economy.
13
Macroeconomics
Macroeconomics is the study of the entire economy

in terms of the total amount of goods and services
produced, total income earned, the level of
employment of productive resources, and the
general behavior of prices. Macroeconomics can be
used to analyze how best to influence policy goals
such as economic growth, price stability, full
employment and the attainment of a sustainable
balance of payments.
Rather than worrying about why the price of

gasoline has risen or fallen over the last several
days Macroeconomics is concerned with the inflation
rate, a measure of how the average price of all
goods and services has changed.
14
Macroeconomics
A Macroeconomist might be interested in answering
such questions as:
How does the Economy work?

Why is the unemployment rate sometimes high and
sometimes low?
What causes inflation?
Why do some national economies grow faster than
other national economies?
What might cause interest rates to be low one year

and high the next?
How do the changes in the money supply affect the
economy?
15
Micro vs. Macro
Macroeconomics and Microeconomics are obviously

related and the distinction between them is not as
sharp as it looks at first sight.
In ECO 101 we will deal with Microeconomic
problems whereas in ECO 104 will study
Macroeconomic problems.
16
Positive Economics
Positive economics involves ifthen statements:

e.g. a tax on cigarettes will cause the price to rise
and the quantity consumed to fall.
Positive Economics attempts to determine What is.
It also attempts to describe how the economy
functions.
Generally,
it
relies
on
testable
hypotheses.
Essentially Positive Economics deal with cause-effect

relationships that can be tested.
17
Normative Economics
Normative economics makes recommendations

about what should be based on value judgments:
e.g. the government should put more tax on
cigarettes to cut smoking.
Normative Economics deals with value judgments

and opinions that can not be tested.
18
Positive and Normative Economics
Many topics in Economics can be discussed within

both a positive framework and a normative
framework.
Let us consider a propose cut in Income Taxes.
An economist practicing positive economics would
want to know the effect of a cut in income taxes,
whether it affect the unemployment rate, economic
growth, inflation and so on.
An economist practicing normative economics would

address issues that directly or indirectly relate to
whether income tax should be cut.
He may mention that income tax should be cut
because the burden is currently very high.
19
Rationality
Each individuals select the choices that make them

happiest, given the information available at the time
of a decision.
Every economic decisions have been made by
rationality.
We assume that people act in their own rational self

interest. People make the choices they believe leave
them best off.
20
Three Basic Questions of Economics
All Economic systems must have some way of

answering 3 basic questions:
1.
What goods and services are produced and in what

quantities?
2.
How are the goods and services produced and who

produces them?
3.
Who gets
produced?
the
goods
and
services
that
are
21

What goods and services are produced and in what
quantities?
o
o
o
A society must determine how much of each of the

many possible goods and services it will make, and
when they will be produced? Will we produce pizzas
and or shirts today?
A few high quality shirts or many cheap shirts?
Will we use scarce resources to produce many
consumption goods( like pizzas)?
22

How are the goods and services produced and who
produces them?
o
A society must determine who will do the

production, with what resources, and what
production techniques they will use.
Whether we will apply the Labour Intensive
Technology or Capital Intensive Technology?
23

Who gets
produced?
o
o
the
goods
and
services
that
are
Who gets to eat the fruit of economic activity?

How is the national product divided among different
households?
24

There are two extreme systems for answering these
questions.
In
a
Command
Economy,
the
Government decides all the answers. In a Market
Economy, the questions get answered through the
interaction of buyers and sellers in the market
25
Market Economy
o
A Market Economy is one in which individuals

and private firms make the major decisions about
production and consumption.
A system of prices, of markets, of profits and

losses, of incentives and rewards determine what,
how and for whom.
Firms produce the commodities that yield the
highest profits ( the what) by the techniques of
production that are least costly(the how).
Consumption is determined by individuals
decisions about how to spend the wages and
property incomes generated by their labour and
property ownership( the for whom)
26
Market Economy
A free-market economy is an economy where agents

decide for themselves which product to produce or
to buy. Another way to say the same thing: a freemarket economy is an economy where property
rights are voluntarily exchanged at a price arranged
completely by the mutual consent of sellers a
buyers.
The extreme case of a market economy, in which
the government keeps it hands off economic
decisions is called a laissez-faire economy.
27
Command Economy
By contrast, a command economy is one in which

the government makes all important decisions about
production and distribution through its ownership of
resources and its power to enforce decisions.
A typical example of such an economy was the
Soviet Union before the 1989, or nowadays, Cuba
and North Korea.
28
Command Economy
In a Planned economy all the relevant economic

decisions are made centrally, by an individual or a
small number of individuals on behalf of a larger
group of people. In general a central planner or
government would establish the production target
for the countrys factories, would develop master
plan for how to achieve those targets and would set
up guidelines for the distribution and use of the
goods and services produced (in the ancient Soviet
Union those targets were set up on a 5 year base.
All the productive sectors are nationalized (under
the direct control of the government) and so
individuals are not free to start their own businesses
as they do in free-market economy.
29
Mixed Economies
The free market and the planned economies

represent two extremes of how to organize
economic activity in a given economy. In reality,
most of the economies we see can be called mixed
economies.
A mixed economy is an economy where not all the

economic decisions are left to the private individuals
but governments intervene as well.
There has never been a 100 percent market
economy ( although nineteenth-century England
came close).
30
Economic Resources
Economists divide resources into four broad categories:
1.
Land
2.
Labour
3.
Capital and
4.
Entrepreneurship
Sometimes Resources are referred to as inputs or
factors of production
31
Economic Resources
Land Includes natural resources, such as minerals,
forests, water, and unimproved land. For example,
oil, wood and animals fall into this category.
Labour consists of the physical and mental talents

people contribute to the production process. For
example, a person building a house is using his or
her own labor.
Capital consists of produced goods that can be used as
inputs for further production. Factories, machinery,
tools, computers and buildings are examples of
capital.
Entrepreneurship refers to the particular talent that soe
32
Economic Resources
Entrepreneurship refers to the particular talent that
some people have for organizing the resources of
land, labor, and capital to produce goods, seek new
business opportunities, and develop new ways of
doing things.
33
Economic Resources
Economic Resource
Resource payment
land
rent
labor
wages
capital
interest
entrepreneurial ability
profit
34
Market Mechanism
The main mechanism for the allocation of resources

is the market. We study the way in which markets
work and the outcomes that the market mechanism
produces.
A Market is defined as any place where the sellers of
a particular good or service can meet with the
buyers of that goods and service.
35
Market Mechanism
The main economic actors (or agents) are:
Households, who consume goods and supply labour and

capital.
Firms, which employ workers and capital to produce

goods.
There is also an important role for the government in:
Creating and enforcing the conditions for markets to work.
Intervening to correct situations where markets fail.
Redistributing income and wealth in the interest of equity.
Stabilizing economy wide fluctuations.
36
Logical Fallacies
The following are some of the common fallacies
encountered in Economics reasoning:
1.
The Post hoc Fallacy
2.
Failure to hold other things constant
3.
The Fallacy of Composition
37
Logical Fallacies
The post hoc fallacy occurs when we assume that,

because one event occurred before another event,
the first event caused the second event.
A Post Hoc is a fallacy with the following form:

1.A occurs before B
2. Therefore A is the cause of B
Remember to hold other things constant when you

are analyzing the impact of a variable on the
economic system.
When you assume that what is true for the part is
also true for the whole, you are committing the
fallacy of composition.
38
Logical Fallacies
Some popular
economists:
fallacies
about
economics
and
Economists always disagree

Economics is mainly about predicting the future
Economic models are too simple to capture reality.
Economics views individuals as caring only about
money
39
Opportunity Cost
Opportunity cost of any action: is the best or next

highest ranked alternative foregone because of
choosing the given action.
Another way to say the same thing: an opportunity

cost is the cost of any activity measured in terms of
the best alternative foregone.
Opportunity Costs arise because time and resources
are scarce. Nearly all decisions involve Teade-offs.
40
Opportunity Cost
For example, the opportunity cost for a student that

buys the textbook for Eco 101 may be a new pair of
jeans that he could have bought instead. Obviously
we should consider only the best alternative in
evaluating the opportunity cost.
For example, if the best alternative was to go to a

restaurant and buy a dinner with the money spent
for the book, then the opportunity cost I
represented by the dinner and NOT by the pair of
jeans.
41
Marginalism
In weighing the costs and benefits of a decision, it is

important to weigh only the costs and benefits that
arise from the decision.
For example, when deciding whether to produce

additional output, a firm considers only the
additional cost (or marginal cost) with the
additional benefit.
42
Marginalism
Marginal benefit = additional benefit resulting from a

one-unit increase in the level of an activity
Marginal cost = additional cost associated with oneunit increase in the level of an activity
According to Economists, when individual make
decisions by comparing marginal benefits to
marginal costs, they are making decisions at the
margin.
MB > MC expand the activity
MB < MC contract the activity
43
Efficiency
Optimal level of activity: MB = MC

(Net benefit is
maximized at this point).This is the Efficient amount
of output.
Suppose we are studying for an economist test:

If MB Studying first hour> MC studying first hour;
Keep Studying.
If MB Studying second hour> MC studying second
hour; Keep Studying.
You should stop reading when MB=MC. This is where

Efficiency is achieved.
44
Figure: Efficiency
MB,
MC
MC of Studying
MB=MC
MB>
MC
MC>MB
MB of Studying
3 Hrs
Time Spent
Studying (Hrs)
45
Working with Diagrams and Slope:

Positive and Negative Relationships
An upward-sloping
line describes a
positive relationship
between X and Y
A downward sloping
line describes a
negative relationship
between X and Y
46
The Component of a Line

The algebraic expression of this
line is as follows:
Y = a + bX
where:
Y = dependent variable
X = independent variable
a = Y-intercept, or value of
Y when X = 0.
Y
Y1 Y0
b=
X X1 X 0
+ = positive relationship
between X and Y
b = slope of the line, or the

rate of change in Y
given a change in X.
47

Strength of the Relationship Between
X and Y
This line is relatively flat.
Changes in the value of X have
only a small influence on the
value of Y.
This line is relatively steep.

Changes in the value of X have a
greater influence on the value of
Y.
48

Different Slope Values
5
b
0.5
10
0
0
10
7
0.7
10
10
49
The Market Forces of Supply and

Demand
50
Demand
Demand refers to how much (quantity) 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.
Economists have a very precise definition of
demand. For them demand is the relationship
between the quantity of a good or service
consumers will purchase and the price charged for
that good.
51
Demand
Demand refers to the willingness and ability of

buyers to purchase different quantities of a good at
different prices during a specific time period.
A relationship between price and quantity demanded

in a given time period, ceteris paribus.
Ceteris paribus is a Latin phrase that means all
variables other than the ones being studied are
assumed to be constant. Literally, ceteris paribus
means other things being equal.
52
Demand
A households decision about what quantity of a

particular output, or product to demand depends on
a number of factors including:
The Price of the product in question.
The Income available to the Household (HH).
The Households amount of accumulated wealth.
The prices of other products available to the HH.
The Households Tastes and Preferences.
The Households Expectations about Future Income,

Wealth and Prices.
53
Demand schedule
54
Demand curve
55
Law of Downward-Sloping Demand
When the price of a commodity is raised ( and other

things are held constant), buyers tend to buy less of
the commodity and vice versa.
Why does quantity demanded tend to fall as price

increases?
Substitution Effect: When the price of a good rises,
we will substitute other similar goods for it.
Income Effect: The depressing effect of price

increases on purchases. When a price goes up, We
find ourselves somewhat poorer than we were
before. Example: When Gasoline prices double, we
have to curb our consumptions.
56
Market Demand
Market demand refers to the sum of all

individual demands for a particular good or
service.
Graphically, individual demand curves are
summed horizontally to obtain the market
demand curve.
Market demand is the horizontal summation of
individual consumer demand curves.
57
Market demand curve
58
Two Simple Rules for Movements vs. Shifts
Rule One
When an independent variable changes and

that variable does not appear on the graph,
the curve on the graph will shift.
Rule Two
When an independent variable does appear

on the graph, the curve on the graph will
not shift, instead a movement along the
existing curve will occur.
59
Change in Quantity Demanded versus Change in

Demand
Change in Quantity Demanded
Movement along the demand curve.

Caused by a change in the price of
the product.
60
Changes in Quantity Demanded

Price of
Cigarettes
per Pack
$4.00
A tax that raises the

price of cigarettes
results in a movement
along the demand
curve.
2.00
D1
12
20
Number of Cigarettes
61
Smoked per Day
Change in Quantity Demanded versus Change in

Demand
Change in Demand
A shift in the demand curve, either

left or right.
to the
Caused by a change in a
determinant other than the price.
62
Shift in Demand Curve
63
Determinants of Demand
Market price
Consumer income
Prices of related goods
Tastes
Expectations of Future Price and Income
64
Consumer Income
Price of
Ice-Cream
Cone
Normal Good
An increase
in income...
$3.00
2.50
Increase
in demand
2.00
1.50
1.00
0.50
D2
D1
0 1
2 3 4 5 6 7 8 9 10 11 12
Quantity of
Ice-Cream
65
Cones
Consumer Income
Price of
Ice-Cream
Cone
Inferior Good
$3.00
2.50
An increase
in income...
2.00
Decrease
in demand
1.50
1.00
0.50
D2
0 1
D1
2 3 4 5 6 7 8 9 10 11 12
Quantity of
Ice-Cream
66
Cones
Prices of Related Goods

Substitutes & Complements
When a fall in the price of one good reduces the demand

for another good, the two goods are called substitutes.
On the other hands an increase in the price of one results
in an increase in the demand for the other.
When a fall in the price of one good increases the demand
for another good, the two goods are called complements.
an increase in the price of one results in a decrease in the
demand for the other.
67
Change in the price of a substitute good
Price of coffee rises:
68
Change in the price of a

complementary good
Price of DVDs rises:
69
Demand and the # of buyers
An increase in the number of buyers

results in an increase in demand.
70
Expectations
A higher expected future price will increase

current demand.
A lower expected future price will decrease
current demand.
A higher expected future income will
increase the demand for all normal goods.
A lower expected future income will reduce
the demand for all normal goods.
71
Change in Quantity Demanded

versus Change in Demand
Variables that
Affect Quantity
Demanded
A Change in
This Variable . . .
Price
Represents a movement
along the demand curve
Income
Shifts the demand curve
Prices of related
goods
Tastes
Expectations
Number of
buyers

72
Supply
the relationship that exists between the price

of a good and the quantity supplied in a given
time period, ceteris paribus.
73
Supply
Quantity supplied is the amount

of a good that sellers are
willing and able to sell.
74
Supply schedule
75
Law of Supply
The law of supply states that
there is a direct (positive)
relationship between price and
quantity supplied.
76
Change in Quantity Supplied

Price of
Ice-Cream
Cone
$3.00
A rise in the
price of ice
cream cones
results in a
movement along
the supply
curve.
1.00
Quantity of
Ice-Cream
77
Cones
Change in Supply
S3
Price of
Ice-Cream
Cone
S1
S2
Decrease in
Supply
Increase in
Supply
Quantity of
Ice-Cream
78
Cones
Market Supply
Market supply refers to the sum of all

individual supplies for all sellers of a
particular good or service.
Graphically, individual supply curves are
summed horizontally to obtain the
market supply curve.
79
Determinants of Supply
Market price
Input prices
Technology
Expectations
Number of producers
80
Change in Quantity Supplied

versus Change in Supply
Variables that
Affect Quantity Supplied
A Change in This Variable . . .
Price
Represents a movement along

the supply curve
Input prices
Shifts the supply curve
Technology
Expectations
Number of sellers

81
Price of inputs
As the price of a inputs rises, profitability

declines, leading to a reduction in the quantity
supplied at any price.
82
Technological improvements
Technological improvements (and any changes

that raise the productivity of labor) lower
production costs and increase profitability.
83
Expectations and supply
An increase in the expected future price of

a good or service results in a reduction in
current supply.
84
Increase in # of sellers
85
Equilibrium of
Supply and Demand
Price of
Ice-Cream
Cone
Supply
$3.00
Equilibrium
2.50
2.00
1.50
1.00
Demand
0.50
0
1 2 3 4 5 6 7 8 9 10 11 12
Quantity of
Ice-Cream
86
Cones
Excess Supply
Price of
Ice-Cream
Cone
Supply
Surplus
$3.00
2.50
If the price exceeds the

equilibrium price,
a surplus occurs:
2.00
1.50
1.00
Demand
0.50
0
1 2 3 4 5 6 7 8 9 10 11 12
Quantity of
Ice-Cream
87
Cones
Excess Demand
Price of
Ice-Cream
Cone
If the price is below the

equilibrium a shortage
occurs:
Supply
$2.00
$1.50
Shortage
5 6
Demand
8 9 10 11 12 13
Quantity of
Ice-Cream Cones 88
Three Steps To Analyzing

Changes in Equilibrium
Decide whether the event shifts the supply or demand

curve (or both).
Decide whether the curve(s) shift(s) to the left or to the

right.
Examine how the shift affects equilibrium price and
quantity.
89
Demand rises
90
Demand falls
91
Supply rises
92
Supply falls
93
Harcourt, Inc. items and derived items copyright 2001 by Harcourt
How an Increase in Demand Affects the

Equilibrium
Price of
Ice-Cream
Cone
1. Hot weather increases

the demand for ice cream...
Supply
$2.50
New equilibrium
2.00
2. ...resulting
in a higher
price...
Initial
equilibrium
D2
D1
0
3. ...and a higher
quantity sold.
10
Quantity of
Ice-Cream Cones
94
How a Decrease in Supply Affects

the Equilibrium
Price of
Ice-Cream
Cone
S2
1. An earthquake reduces
the supply of ice cream...
S1
New
equilibrium
$2.50
2.00
Initial equilibrium
2. ...resulting
in a higher
price...
Demand
1 2 3 4
7 8 9 10 11 12 13
3. ...and a lower
quantity sold.
Quantity of
Ice-Cream Cones
95
Price ceiling
Price ceiling - legally mandated maximum price

Purpose: keep price below the market equilibrium
price
Examples:
rent controls
price controls during wartime
gas price rationing in 1970s
96
Price ceiling (continued)
97
Price floor
price floor - legally mandated minimum price

designed to maintain a price above the equilibrium
level
examples:
agricultural price supports
minimum wage laws
98
Price floor (continued)
99
Elasticity and its Application
What is an Elasticity?
Measurement of the percentage change in one

variable that results from a 1% change in another
variable.
When the price rises by 1%, quantity demanded

might fall by 5%.
The price elasticity of demand is -5 in this example.
Types of Elasticity
1.Elasticity of Demand
i) Price Elasticity of Demand
ii) Income Elasticity of Demand
iii) Cross Price Elasticity of Demand
2.Elasticity of Supply
Price Elasticity of Demand
Price elasticity of demand is the percentage change

in quantity demanded given a percent change in the
price.
It is a measure of how much the quantity demanded
of a good responds to a change in the price of that
good.
Q / Q
Q P
P / P
P Q
The price elasticity of demand is always
negative.
Economists usually refer to the price elasticity
of demand by its absolute value (ignore the
negative sign).
Computing the Price Elasticity

of Demand
Price elasticity of demand
Percentage change in quatity demanded

Percentage change in price
Example: If the price of an ice cream cone increases from $2.00 to

$2.20 and the amount you buy falls from 10 to 8 cones then your
elasticity of demand would be calculated as:
(10 8 )
100
20 percent
10
2
( 2.20 2.00 )
10
percent
100
2.00
Example:
P0 = 8
P1 = 7
Q0 = 40
Q1 = 48
Step 1: Q = 48 - 40 = 8
P
= 7 - 8 = -1
Step 2: Use the formula for Ed.
Example:
Step 3:
Ed = (Qd / P) * P0 / Q0
= (8 /-1) * (8/40) = - 1.6
Step 4:
This means that for every 1 % change in price that there is a 1.6
% change in quantity demanded in the opposite direction.

Unit elastic
Elastic
Inelastic
0
Demand is said to be:

elastic when Ed > 1,
unit elastic when Ed = 1, and
inelastic when Ed < 1.
Inelastic Demand
Inelastic demand
The percentage change in quantity is less than the

percentage change in price.
<1
Inelastic Demand
- Elasticity is less than 1
Price
1. A 25% $5
increase
in price... 4
Demand
Quantity
90 100
2. ...leads to a 10% decrease in quantity.
Elastic Demand
Elastic demand
The percentage change in quantity is greater than the

Price elasticity of demand > 1
Elastic Demand
- Elasticity is greater than 1
Price
1. A 25% $5
increase
in price...
4
Demand
Quantity
50
100
Unit Elastic Demand
Unit elasticity
The percentage change in quantity equals the percentage change in

price.
Price elasticity of demand = 1
Unit Elastic Demand

- Elasticity equals 1
Price
1. A 25% $5
increase
in price... 4
Demand
Quantity
75
100
The flatter the demand curve, the more price elastic is the
demand.
steeper
flatter
Qd
The flatter the demand

curve, the more room
there is for the quantity
to adjustment.
Qd
Hence, the flatter the

demand curve, the more
responsive is the quantity
to a price change.
Perfectly Elastic Demand

- Elasticity equals infinity
Price
1. At any price
above $4, quantity
demanded is zero.
Demand
$4
2. At exactly $4,
consumers will
buy any quantity.
3. At a price below $4,
quantity demanded is infinite.
Quantity
Perfectly Inelastic Demand

- Elasticity equals 0
Price
Demand
$5
1. An
increase
in price... 4
Quantity
100
2. ...leaves the quantity demanded unchanged.
Examples of Demand Elasticity
When the price of gasoline rises by

1% the quantity demanded falls by
0.2%, so gasoline demand is not
very price sensitive.
Price elasticity of demand is -0.2 .
When the price of gold jewelry rises

by 1% the quantity demanded falls
by 2.6%, so jewelry demand is very
price sensitive.
Price elasticity of demand is -2.6 .
Determinants of
Necessities versus
Luxuries
Availability of Close
Substitutes
Time Horizon
Factors That Influence Elasticity
The Closeness of Substitutes.
The closer the substitutes, the more elastic the demand

more elastic means a higher price elasticity (but not
necessarily > 1)
Proportion of Income Spent on the Good
The greater the proportion of income spent on food,

the more elastic the demand
Because of Income Effect of a price change
Time Elapsed Since Price Change
The longer the time, the more elastic the demand

Short-run demand
Long-run demand
Determinants of
Demand tends to be more
elastic :
if the good is a luxury.
the longer the time period.
the larger the number of close substitutes.
Determinants of Price Elasticity of

Demand
Demand tends to be more inelastic
If the good is a necessity.
If the time period is shorter.
The smaller the number of close substitutes.
Elasticity along a linear

demand curve
Computing the Price Elasticity of

Demand Using the Midpoint Formula
The midpoint formula is preferable when calculating the
price elasticity of demand because it gives the same answer
regardless of the direction of the change.
(Q2 Q1 )/[(Q 2 Q1 )/2]

Price Elasticity of Demand =
(P2 P1 )/[(P2 P1 )/2]
Computing the Price Elasticity

of Demand
(Q2 Q1 )/[(Q 2 Q1 )/2]
Price Elasticity of Demand =
(P2 P1 )/[(P2 P1 )/2]
Example: If the price of an ice cream cone increases from $2.00 to
$2.20 and the amount you buy falls from 10 to 8 cones the your
elasticity of demand, using the midpoint formula, would be
calculated as:
(10 8)
22 percent
(10 8) / 2
2.32
(2.20 2.00)
9.5 percent
(2.00 2.20) / 2
Arc elasticity measure
where
:
Example
Suppose that quantity demanded falls

from 60 to 40 when the price rises from
$3 to $5. The arc elasticity measure is
given by:
In this interval, demand is inelastic (since elasticity < 1).
Slope Compared to Elasticity
The slope measures the rate of change

of one variable (P, say) in terms of
another (Q, say).
The elasticity measures the percentage
change of one variable (Q, say) in
terms of another (P, say).
Because the price elasticity of demand
measures
how
much
quantity
demanded responds to the price, it is
closely related to the slope of the
demand curve.
Elasticity: Mathematical Definition

P
slope
Q
1
Q
slope P
P 1
elasticity
Q slope
Exercise -- Linear Demand
Compute the elasticity

at the point indicated in
red on the table
(Q=18,P=24).
Slope = -2
1/Slope = -1/2
P/Q = 24/18 = 4/3
Elasticity = -2/3
Quantity
10
11
12
13
14
15
16
17
18
19
20
Price
40
38
36
34
32
30
28
26
24
22
20
Elasticity and Total Revenue
Total revenue is the amount paid by buyers and

received by sellers of a good.
Computed as the price of the good times the

quantity sold.
TR = P x Q
Price
$4
P x Q = $400
(total revenue)
Demand
100
Quantity
If demand is elastic in the relevant range of

prices, price and total revenue vary
inversely.
That is, a price increase will decrease total

revenue.
An elastic demand means that the percentage
change in quantity demanded is greater than the
Elastic:
Hence, an increase in price will result in a more
than offsetting percentage decrease in quantity
taken.
TR
If demand is inelastic in the relevant range of

prices, price and total revenue vary directly.
That is, a price increase will increase total revenue.
An inelastic demand means that the percentage

change in quantity demanded is less than the
Hence, an increase in price will result in a less than

offsetting percentage decrease in quantity taken.
Inelastic:
TR
If demand is unitary in the relevant range of

prices, total revenue does not change in
response to price changes.
A unitary own-price elasticity of demand means that

the percentage change in quantity demanded is equal
to the percentage change in price.
Hence, an increase in price will result in an offsetting
percentage decrease in quantity taken.
Unitary:
TR
STAYS
The Total Revenue Test for Elasticity
Increase in
Price
Increase in
Total
Revenue
INELASTIC
DEMAND
Decrease in
Total
Revenue
ELASTIC
DEMAND
Decrease in
Price
ELASTIC
DEMAND
INELASTIC
DEMAND
Expenditure = Price x Quantity

Price
P1 x Q1 = A + B
P2 x Q2 = A + C
(P2 x Q2) - (P1 x Q1) =
(A + C) - (A + B) =
C-B
P2
P1
Q2
Q1
Quantity
Price
P
2
Inelastic Demand: Area C > Area B
P1
D
Q2
Q1
Quantity
Price
Elastic Demand: Area B > Area C
P
2
P1
C
D
Q1
Quantity
Income Elasticity of Demand
Income elasticity of demand measures how much

the quantity demanded of a good responds to a
change in consumers income.
It is computed as the percentage change in the

quantity demanded divided by the percentage
change in income.
Computing Income Elasticity

Income Elasticity =
of Demand
Percentage Change
in Quantity Demanded
Percentage Change
in Income
Income Elasticity
- Types of Goods
Normal Goods
Inferior Goods
Income Elasticity is positive.
Income Elasticity is negative.
Higher income raises the quantity

demanded for normal goods but
lowers the quantity demanded for
inferior goods.
Income elasticity of demand
A good is a luxury good if income elasticity > 1.

A good is a necessity good if income elasticity < 1.
A good is a normal good if income elasticity > 0.
A good is an inferior good if income elasticity < 0.
Cross Price Elasticity of Demand
Elasticity measure that looks at the impact a change

in the price of one good has on the demand of
another good.
% change in demand Q1/% change in price of Q2.
Positive-Substitutes
Negative-Complements.
Cross-Price elasticity of demand

The cross-price elasticity of demand between two
goods j and k is defined as:
Cross-Price elasticity (cont.)
Cross-price elasticity is positive if and only if the goods are

substitutes
Cross-price elasticity is negative if and only if the goods are
complements.
THE THEORY OF CONSUMER CHOICE
Utility
There are many goods and the consumer chooses a

bundle (or combination) of quantities. Here we
simplify to two goods, good X and good Y.
Goods yield satisfaction to the consumer; we shall

call it utility.
Utility is the benefit or satisfaction that a person
gets from the consumption of a good or service.
Sakib-Bin-Amin, Lecturer, Department of Economics, NSU.
Cardinal vs. Ordinal Utility
In economics utility can Cardinal or Ordinal.

Utility is a subjective quantity that can not be
measured in an obvious way. People usually attempt
to maximize welfare or utility, the enjoyment or
satisfaction that they derive from the consumption
of a commodity or service.
A utility is a cardinal measure if we can give

numbers to different levels of utility AND if we can
make absolute comparisons between those different
numbers.
For example, if the utility you get from a bundle is

100 while the utility you get from another bundle is
50, you can say that the first bundle gives you more
utility than the second AND you can also say that
the first bundle gives you double utility compared to
the second.
A utility is an ordinal measure if only the ranking

between different bundle matters. We cannot make
absolute comparisons. From previous example, we
can only say that the first bundle is preferred to the
second because the utility associated with the first
bundle is higher than the utility associated with the
second bundle. And thats all. The differences in
utilities (100 50) has no other meaning.
We normally consider utility to be ordinal. The main

reason is that to have a cardinal utility we must
have a unit of measure that we can use to measure
utility. However, as you may guess is not very easy
to find such a unit of measure (for example, how do
we measure happiness? We can say if we are
happier in some cases than in others, but we cannot
really say more than that).
According to
measured- if
with cardinal
This cardinal
as UTIL.
Bentham and Marshall, utility can be

not in practice, at least in principlenumbers ( such as 1,2,3 and so on).
measure of utility is commonly known
Utility Function
The Important concept is that any

consumer can
rationally compare and rank different combinations in
terms of utility. (This is what we mean by preference).
Utility function can be written as: U(x, y)
Consider two different bundles (x1, y1) and (x2, y2), and
assume that our consumer prefers (x2, y2) to (x1, y1)
then we must have that: U(x1, y1) U(x2, y2)
Total Utility
Total utility is the total benefit that a person gets

from the consumption of a good or service.
Total utility generally increases as the quantity

consumed of a good increases.
Total Utility Increases at a decreasing rate.
Marginal Utility
Marginal utility is the change in total utility
that results from a one-unit increase in the

quantity of a good consumed.
To calculate marginal utility, we use the total

utility numbers in Table.
Suppose that you can consume 30 units of good
A and 20 units of good B. You get some utility in
doing that. Now assume that you can consume
31 units of good A and 20 units of good B. Your
utility will probably change. This change in utility
is the marginal utility of good A.
Total and Marginal Utility
Total and Marginal Utility
The marginal utility of

the 3rd bottle of water
= 36 units 27 units =
9 units.
Part (b) shows how Tinas

marginal utility from bottled
water diminishes by placing
the bars shown in part (a)
side by side as a series of
declining steps.
The downward sloping blue
line is Tinas marginal utility
curve.
Diminishing Marginal Utility
The law of diminishing Marginal Utility states that for

a given time period, the marginal utility gained by
consuming equal successive units of a good will
decline as the amount consumed increases.
Even though marginal utility declines, total utility
still increases as long as marginal utility is positive.
Total utility will decline only if marginal utility is
negative.
Diamond-water paradox
As noted by Adam Smith, water is

essential for life and has a low market price
(often a price of zero) while diamonds are
not as essential yet have a very high
market price.
Smiths observation came to be known
as the Diamond- Water Paradox.
If a product is very useful then Total Utility of the
product is very high compared to a less useful
product. That Means value in use is related to total
utility.
The total utility of water is high because water is
extremely useful but we would expect its marginal
utility to be low because water is relatively plentiful.
Water is immensely useful, but there is so much of it

that individuals place relatively little value on
another unit of it.
In contrast, diamonds are not as useful as water.

We would expect the total utility of diamonds to be
lower than the total utility of water. However, we
would expect the marginal utility of diamonds to be
high because there are relatively few diamonds in
the world. So the consumption of diamonds takes
place at relatively high marginal utility.
Generally, Value in exchange is related to marginal
utility that means Market price is based on the
Marginal Utility concept.
If Marginal Utility is high, the Market Price is also

high and vice versa.
TU of water and diamonds
MU of water and diamonds
Equimarginal Principle
Equimarginal principle states that a consumer having a

fixed income and facing given market prices of goods
will achieve maximum satisfaction or utility when the
marginal Utility of the last dollar spent on each good is
exactly the same as the Marginal Utility of the last
dollar spent on any other good.
MU Good1/P1 = MU Good2/P2= MU Good3/P3=
In other words,
MUX/PX=MUY/PY
If any one good gave more MU/Dollar, utility would be

increased by taking more money away from other
goods and spending more on that good- until the law of
diminishing MU/Dollar down to equality with that of
other goods.
Equimarginal Principle
Case 1: MUX/PX>MUY/PY
In this case equilibrium will be
increasing the amount of Product X.
achieved
by
Case 2: MUX/PX<MUY/PY
In this case equilibrium will be restored
decreasing the amount of Product X.
by
Why Demand Curves Slope Downward?

Using the fundamental rule for consumer behaviour,
we can easily see why demand curves slope
downward.
Let us assume, The price of X falls. The situation

now becomes: MUX/PX>MUY/PY
The consumer will attempt to restore equilibrium by
buying more X. This behaviour- buying more X when
the price of X falls- is consistent with the law of
demand.
Indifference Curve
Indifference Curve is a curve which shows the
different combinations of two commodities that
gives the consumer same level of utility.
Features:
1.
Utility is same on each point of indifference curve.
2.
Indifference curve shows consumers preference.
Indifference Curve
INDIFFERENCE SCHEDULE
Combinations
Apples
Mangoes
15
11
Indifference Curve
In the above schedule, the consumer obtains as
much total satisfaction from 11 apples and 2
mangoes as from 8 apples and 3 mangoes as well as
from other combinations.
In other words, consumer feels indifferent whether
he gets the 1st
combination (15A+1M), 2nd
combination (11A+2M), the 3rd combination
(8A+3M), the 4th combination (6A+4M), or the 5th
combination (5A+5M)
Indifference Curve
Indifference Map
A set of indifference curve is called an indifference
map.
A higher indifference curve give higher utility but we

cant say how much more utility the higher
indifference curve represents.
Aggregate Utilities
measurable.
are
remarkable
but
not
Indifference Map
Marginal Rate of Substitution
The Marginal rate of substitution shows how much of one

commodity is substituted for how much of another or at
what rate a consumer is willing to substitute one
commodity for another in his consumption pattern to
maintain the same level of utility.
The concept of MRS is a tool of Indifference Curve

technique and MRS is the slope of Indifference Curve.
In the previous example, we have noticed that when a
consumer has 15 Apples and 1 mango, he will be
prepared to forgo 4 apples for 1 mango and yet remain at
the same level of utility.
Here the MRS of Mango for apple is 4:1
MRS=Y/ X= Slope of Indifference Curve
Consumer Equilibrium
A consumer attempts to allocate its limited income among

available goods and services so that he can maximize his
satisfaction or utility.
Consumer equilibrium comes at the point where consumer
utility is maximum. This occurs at a point where the
budget line is tangent to the indifference curve. At this
point of tangency:
Slope of Indifference Curve = Slope of Budget Line
MRSXY=PX/PY
MUX/MUY=PX/PY
MUX/PX=MUY/PY
This is the Consumer Equilibrium Condition

If MUX/PX>MUY/PY, it indicates that we have to

purchase more X commodity. It will cause the MU to
fall and over time equilibrium condition will be
restored.
If MUX/PX<MUY/PY. It indicates to consume less.

EC0 511 - Lecture Notes On Basic Microeconomics

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ECO 511: Microeconomics Analysis

Dr. Sakib B. Amin

Economics is the Social Science that studies the

Economics deal with a central problem faced by

Our wants far exceed our resources. So, scarcity

Our inability to satisfy all our wants is called

The problem of scarcity means that every time we

Scarcity arises because some resources that are

The amount of Labour is limited both in number and

The worlds land area is limited and so are raw

Furthermore, scarcity arises from other resources,

Given the limited amount of resources we con only

Why is scarcity a problem?

If we know that we have limited resources we could

the excess of human needs over what can actually

Scarcity implies that we cannot choose whatever we

Adam Smith is usually considered the founder of the

In The Wealth of Nations, Smith considered how

Microeconomics studies the behaviour of individual

A Micro economist might be interested in answering

How does a Market work?

What level of output does a firm produce?

What price does a firm charge for the good it

Generally Microeconomics looks at the production,

The Key word is individual: Microeconomics deals

Macroeconomics is the study of the entire economy

Rather than worrying about why the price of

How does the Economy work?

What might cause interest rates to be low one year

Micro vs. Macro

Macroeconomics and Microeconomics are obviously

Positive economics involves ifthen statements:

Essentially Positive Economics deal with cause-effect

Normative economics makes recommendations

Normative Economics deals with value judgments

Positive and Normative Economics

Many topics in Economics can be discussed within

An economist practicing normative economics would

Each individuals select the choices that make them

We assume that people act in their own rational self

Three Basic Questions of Economics

All Economic systems must have some way of

What goods and services are produced and in what

How are the goods and services produced and who

Three Basic Questions of Economics

A society must determine how much of each of the

Three Basic Questions of Economics

A society must determine who will do the

Three Basic Questions of Economics

Who gets to eat the fruit of economic activity?

Three Basic Questions of Economics

A Market Economy is one in which individuals

A system of prices, of markets, of profits and

A free-market economy is an economy where agents

By contrast, a command economy is one in which

In a Planned economy all the relevant economic

The free market and the planned economies

A mixed economy is an economy where not all the

Labour consists of the physical and mental talents

The main mechanism for the allocation of resources

Households, who consume goods and supply labour and

Firms, which employ workers and capital to produce

There is also an important role for the government in: