Economics: HSN-01

Why to Study Economics?

To learn how to avoid being deceived by
economists
Economics as a discipline exists because
resources are limited

Economics and Choice

Economics is the study of how individuals and
society manages its scarce resources.
Economics is the study of how people and
society choose to employ scarce resources
that could have alternative uses in order to
produce various commodities and to distribute
them for consumption , now and/or in the
future among various persons and groups in
by Samuelson and Nordhaous
the society

How Economists Think

The first step in this process is to identify the
fundamental economic problem: scarcity.

What goods and services will be

produced and in what quantities?

How will they be produced?

Who will consume them?

Decision Makers
Households are groups of people that live
together.
Firms are organizations that use resources
to produce goods and services.

Government is an organization that sets laws

and rules, taxes, spends, and provides public
services.

How Economy Works

What Economists Do
Uses abstract models to help explain how a complex,
real world operates.
Develops theories, collects, and analyzes data to
evaluate the theories.
Economic questions can be divided into two big
groups: microeconomics and macroeconomics.
Microeconomics focuses on the individual parts of the
economy.
How households and firms make decisions and how
they interact in specific markets
Macroeconomics looks at the economy as a whole.
Economy-wide phenomena, including inflation,
unemployment, and economic growth

Economic Science and

Economic Policy
Economic science is the attempt to understand
the economic world. Science makes predictions.
Economic policy is the attempt to improve the
economic world. Policy makes prescriptions.
Policies made without science usually will not be
very good.

Economic Science is Young

Economics as a science is just over 200 years old.
Adam Smiths The Wealth of Nations (1776) marks the
beginning of our subject.
It began with Aristotle but got mixed up with ethics in
the Middle Ages. Adam Smith separated it from ethics,
and Walrus mathematized it. Alfred Marshall tried to
narrow it, and Keynes made is fashionable. Robbins
widened it, and Samuelson dynamized it, but modern
science made it statistical and tried to confine it again.
Compared to physics and chemistry, however, we are
newcomers.

Suggested Books
Koutsoyiannis, A., Modern Microeconomics, Second
Edition, Macmillon
Salvatore, D., Principles of Microeconomics, Fifth
Edition, Oxford University Press
Mankiw, N.G., Principles Of Microeconomics, Sixth
Edition, Cengage Learning India

Demand and Supply

Demand

Demand vs. Need

Effective Demand

Desire to have a good/commodity

Willingness to pay
Ability to pay

Factors Affecting Demand

Demand and Law of Demand

Demand is a multivariate concept

Qd = f(Px, I, PR, TC, PC, IF, PF, NC, DC)

Law of Demand

A relationship between price and quantity

demanded in a given time period, ceteris
paribus.

Demand Schedule

Demand Curve
QX = a - bPX

Law of Demand

An inverse relationship exists between the

price of a good and the quantity
demanded in a given time period, ceteris
paribus.
Mathematically: QX = a - bPX
Reasons:

substitution effect
income effect

Market Demand Curve

Market demand is the horizontal summation of

individual consumer demand curves

Change in Quantity Demanded vs.

Change in Demand
Change in quantity demanded

p1
p

Change in demand

b
a

q1 q
A movement along a demand
curve is referred to as a change
in the quantity demanded

b1

q1

Change in demand refers

to a shift in the whole
curve

Shifts in the demand curve

Such an increase in demand
can be caused by:

D1

A rise in
substitute

Price

D0

the

price

of

A fall in the
complement

price

of

A rise in income
A redistribution of income
towards those who favour the
commodity

Quantity

When the demand

curve shifts from D to
D1 more is demanded
at each price.

A change in tastes that favours

the commodity.

Shifts in the demand curve

D

Such a decrease in demand

can be caused by:

A fall in the price of a

substitute

Price

A rise in the price of a

complement, a fall in income
A redistribution of income
away from groups that favour
the commodity
Quantity
A change in tastes that dis When the demand curve favours the commodity.

shifts from D0 to D2 less is

demanded at each price.

Note

We are interested in developing a theory

of how products get priced.

How will the quantity of a product

demanded vary as its own price varies?

A basic economic hypothesis is that the lower

the price of a product, the larger the quantity
that will be demanded, other things being
equal.

Supply
We now look at the supply side of markets. The suppliers
are firms, which are in business to make the goods and
services that consumers want to buy.

Economic theory gives firms several attributes.

Firstly, each firm is assumed to make consistent decisions, as

though it was run by a single individual decision-maker.
Secondly, firms hire workers and invest capital and
entrepreneurial talent in order to produce goods and services
that consumers wish to buy.
Thirdly, firms are assumed to make their decisions with a
single goal in mind: to make as much profit as possible.

The nature and determinants of supply

The amount of a product that firms are able and willing

to offer for sale is called the quantity supplied.
Supply is a desired flow: how much firms are willing to
sell per period of time.
Three major determinants of the quantity supplied in a
particular market are:
The price of the product;
The prices of inputs to production;
The state of technology.
The expectations of producers,
The number of producers, and
The prices of related goods and services

Supply schedule

Supply

The relationship that exists between the price of

a good and the quantity supplied in a given time
period, ceteris paribus.
QX = a + bPX

Law of supply

A direct relationship exists between the price of a

good and the quantity supplied in a given time
period, ceteris paribus.
Mathematically: QX = a + bPX
The law of supply is the result of the law of
increasing cost.

As the quantity of a good produced rises, the marginal

cost rises.
Sellers will only produce and sell an additional unit of a
good if the price rises above the marginal cost of
producing the additional unit.

The market supply curve is the horizontal summation of the

supply curves of individual firms

Change in supply vs. change in

quantity supplied
Change in quantity supplied

p1
p

Change in supply

a
b1

q1

q1

Shifts in the Supply Curve

S0
S1

A shift in the supply

curve from S0 to S1
indicates
more
is
supplied at each price.

Quantity

Such an increase in supply can be caused by:

Improvements in the technology of producing the commodity

A fall in the price of inputs that are important in producing
the commodity

Shifts in the Supply Curve

S2

S0

A shift in the supply

curve from S0 to S2
indicates
less
is
supplied at each price.

Quantity

Such a decrease in supply can be caused by:

A rise in the price of inputs that are important in producing the

commodity.
Changes in technology that increase the costs of producing the
commodity (rare).

Price Determination

Price determination
How demand and supply interact to determine price
The concept of a market

A market may be defined as an area over which

buyers and sellers negotiate the exchange of
some product or related group of products.
It must be possible, therefore, for buyers and
sellers to communicate with each other and to
make meaningful transactions over the whole
market.

Market equilibrium
Determination of the Equilibrium Price

QX = a + bPX
E

QX = a - bPX

QdX = QsX

Equilibrium price is where the

demand and supply curves
intersect, point E in the figure.
At all prices above equilibrium
there is excess supply and
downward pressure on price.
At all prices below equilibrium
there is excess demand and
upward pressure on price.

a bPX = a + bPX

Market equilibrium
Price (Rs)

Demand

Supply

8.00

6,000

18,000

7.00

8,000

16,000

6.00

10,000

14,000

5.00

12,000

12,000

4.00

14,000

10,000

3.00

16,000

8,000

2.00

18,000

6,000

1.00

20,000

4,000

The equilibrium price in the market is 5.00 where demand and supply are
equal at 12,000 units
If the current market price was 3.00 there would be excess demand for
8,000 units, creating a shortage.
If the current market price was 8.00 there would be excess supply of 12,000
units.

Instability in Price

If the price exceeds the

equilibrium price, a
surplus occurs:

If the price is below

the equilibrium a
shortage occurs:

Excess Supply
p1
p

p1

Excess Demand

Rise and Fall in Demand

Demand rises

p1
p

E1
E

q1

An increase in demand
raises both price and
quantity

Demand falls

p
p1

E
E1

q1

A decrease in demand
lowers both price and
quantity

Rise and fall in Supply

Supply rises

p
p1

Supply falls

p1

E1

q q1
An increase in supply
raises quantity but
lowers price

E1
E

q1 q
A decrease in supply
lowers quantity but
raises price

Price ceiling
Price ceiling - legally
mandated maximum price
p
p1

Purpose: keep price below the

market equilibrium price
Examples:
Rent controls
Price controls during
wartime
Gas price rationing in 1970s

Price floor
Price floor - legally
mandated minimum price
p1

Designed to maintain a price

above the equilibrium level

Examples:

Agricultural price supports

Minimum wage laws

Elasticity of Demand

Elasticity of Demand
The demand and supply analysis helps us to
understand the direction in which price and quantity
would change in response to shifts in demand or
supply.
What economists would like to know is what will
happen to demand when price, income, price of the
related goods changes?
How the sensitivity of quantity demanded to a change in
price is measured by the elasticity of demand and what
factors influence it.
How elasticity is measured at a point or over a range.
How income elasticity is measured and how it varies with
different types of goods.

Defining & Measuring Price Elasticity of Demand

Demand elasticity is measured by a ratio: the
percentage change in quantity demanded divided by
the percentage change in price that brought it about.
Percentage change in quantity demanded
Price elasticity of demand =
Percentage change in price

GOOD A

Original

New

Quantity

100
(Q)

95
(Q1)

1
(P)

1.10
(P1)

Price

% Change
-5%
10%

Elasticity

-5%/10%
= -0.5%

Measuring Elasticity of Demand

Measuring Elasticity

Percentage
Method

=
ep

Q P

P Q

ARC
Method

Q( P1 + P2 )
ep =
P(Q1 + Q2 )

Point
Method

P Q
=
e p lim
P 0 Q
P

Q
P
e p = lim

P
0

P
Q
P dQ
e=

p
Q dP

Measuring Elasticity of Demand

=
ep
=
ep
=
ep

Q P

P Q
P
1

Slope Q
P
1

PD PR Q

PR OP

PD OQ
PR OP
=

ep
PD OQ
OQ OP
OP

ep =
PD OQ
PD
RD1
OP
=
=
ep
PD
RD

D1

=
ep

ep =

Quantity

Lower Segment
Upper Segment
This ratio is zero where the
curve intersects the quantity
axis and infinity where it
intersects the price axis.

Vertical axis formula PR is Parallel to OD1 in ODD1

Elasticity along a Linear Demand Curve

D

Perfectly inelastic
(Elasticity=0)
Inelastic (0<Elasticity<1)
D1

Quantity

Unit elastic (Elasticity=1)

Elastic (1<Elasticity<
Perfectly elastic
(Elasticity=
)

D1
Elasticity = 0

Price

Price

Elastic and Inelastic

12

12

Quantity

Perfectly Inelastic

Implies that quantity demanded

remains constant when price
changes occur.
Price elasticity of demand = 0

Elasticity =

D2

Quantity

Perfectly Elastic
Implies that if price changes by any
percentage quantity demanded will
fall to 0.
Price elasticity of demand =

12

D3

0<Elasticity<1

Price

Price

Elastic and Inelastic

12

1<Elasticity<
D4

Inelastic

Quantity

Implies the percentage change in

quantity demanded is less than
the percentage change in price.
Price elasticity of demand > 0
and < 1

Elastic

Quantity

Implies the percentage change in

quantity demanded is greater than
the percentage change in price.
Price elasticity of demand > 1
and <

Price

Elastic and Inelastic

Elasticity = 1

12

Unit Elasticity
6

Quantity

Implies that the

percentage change
in quantity
demanded equals
the percentage
change in price.
Price elasticity of
demand = 1

The Factors that Influence the Elasticity of Demand

Nature of the Goods
Essential goods are highly inelastic
Luxury goods are highly elastic

Availability of Substitutes
Higher the number of substitutes greater is the elasticity

Number of uses of a good

The demand for multi-used goods is more elastic

Distribution of Income
Demand for products is inelastic by the high income group

Level of Prices
Demand for high and low priced goods in inelastic

Proportion of Total Expenditure

Time factor
Longer the time period higher the elasticity

Complementary goods

Some Real-World Price Elasticities

of Demand
Good or Service
Elastic Demand
Metals
Electrical engineering products
Mechanical engineering products
Furniture
Motor vehicles
Instrument engineering products
Professional services
Transportation services
Inelastic Demand
Gas, electricity, and water
Oil
Chemicals
Beverages (all types)
Clothing
Tobacco
Banking and insurance services
Housing services
Agricultural and fish products
Books, magazines, and newspapers
Food

Elasticity
1.52
1.30
1.30
1.26
1.14
1.10
1.09
1.03
0.92
0.91
0.89
0.78
0.64
0.61
0.56
0.55
0.42
0.34
0.12

Significance of Elasticity of Demand

Useful for Business
Fixation of Prices

Significant for Government Economic Policies

Controlling business cycles, removing inflationary and deflationary gaps, price
stabilization
Goods with inelastic demand are taxed more
Fixation of wages
Incidence of taxes

International Trade
Import commodities with more elastic demand, Export commodities
less elastic demand

with

Market forms and Determination of Price of Public Utilities

Paradox of Poverty and Effects on Employment

Elasticity and Total Revenue

Total revenue = Price x Quantity

Marginal Revenue = TR/Q

Q P
ep

Price elasticity of demand: =

P Q

What happens to total revenue if the

price rises?

Elasticity and Total Revenue

Elasticity and Marginal Revenue

TR = P.Q

d ( P.Q )
MR =
dQ
dP Q

dP
1
MR = P + Q.
= P 1 +
= P 1 +
dQ
dQ P
Ep

Defining & Measuring Income Elasticity of Demand

The responsiveness of demand for a product to changes in
income is termed income elasticity of demand, and is defined as
Percentage change in quantity demanded
Income elasticity of demand =
Percentage change in Income

Q I
=
ei

I Q

I dQ

or e=
i
Q dI

A good is a normal good if income elasticity > 0.

A good is an inferior good if income elasticity < 0.
A good is a luxury good if income elasticity > 1.
A good is a necessity good if income elasticity < 1 and < 0.

Defining & Measuring Cross Elasticity of Demand

The responsiveness of quantity demanded of one product to
changes in the prices of other products is often of considerable
interest.

Cross elasticity of demand =

Percentage change in quantity demanded of X

Percentage change in Price of Y

Qx Py
=
exy

Py Qx

or

e=
xy

Py dQx

Qx dPy

Products are substitute if cross elasticity > 0.

Products are complimentary if cross elasticity < 0.

Summary
Price Elasticity of demand
Perfectly inelastic, Inelastic , Unit elastic,
Elastic , Perfectly elastic
Income Elasticity of demand
Normal , Inferior, Luxury, Necessity
Cross Elasticity of demand
Substitute , Complimentary

Examples
Q1. Find the elasticity if the demand function is
Q = 25 4P + P2 where Q is the demand for commodity at
price P. Find out elasticity at (i) P = 4, (ii) P = 8, (iii) P = 5
Ans: (i) P = 4, ep = 0.64 (inelastic)
(ii) P = 8, ep = 1.7 (elastic)
(iii) P = 5 ep = 1 (unitarily elastic)
Q2. The demand function is given X = 10 P at X = 4, P = 6.
If the price increased by 5% determine the percentage
decrease in demand and hence an approximation to the
elasticity of demand.
Ans: Decrease in demand is 7.5% and elasticity is 1.5

Examples
Q3. If the current demand for economics books is 10,000 per year
for a publishing house. The elasticity of demand is 0.75. The price
increased by Rs 50 per book, calculate the change in the quantity
of books demanded where price is Rs 150.
Ans: Q = 2500
Q4. Suppose demand for cars in a city as a function of income is
given by the following equations. Q = 20,000 + 5M, where Q is
quantity demanded and M is Per capita income. Find out income
elasticity of demand when per capita annual income is Rs 15,000.
Ans: ei= 0.8 (Normal)
Q5. Suppose the following demand function for coffee in terms of
price of tea is given Qc = 100 + 2.5Pt. Find out the cross elasticity
of demand when price of tea rises from Rs 50 per 250gm pack to
Rs 55 per 250gm pack.
Ans: ect= 0.51(Substitute)

Consumer Behavior

Consumer Behavior
Demand analysis starts with the behavior of
the consumer
Individual consumers demand is derived from
his utility function
Rational consumer tries to maximize his utility
Axiom of Utility Maximization
Cardinalist Approach
Ordinalist Approach

Cardinal Utility Theory

Concepts
Utility: level of happiness or satisfaction associated
with alternative choices
Total utility: the level of happiness derived from
consuming the good
Marginal utility: the additional utility that is received
when an additional unit of a good is consumed
MU=

Change in total utility

Change in quantity

Or

U
Qx

Cardinal Utility Theory

TUx

Concepts
Qx

TUx

MUx

....

10

10

16

20

22

22

20

-2

Quantity

MUx

Quantity

Diminishing Marginal Utility

As consumption of a good or service increases, the
incremental (or marginal) satisfaction we get from
consuming one more unit decreases.
This decrease is called the principle of diminishing
marginal utility.
Law of diminishing marginal utility - marginal utility
declines as more of a particular good is consumed in
a given time period, ceteris paribus
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

Equilibrium of the Consumer

Assumptions
Rationality : Consumer aims at the maximization of his utility
subject to constraint his income
Cardinal Utility : Utility is measured by monetary units that
the consumer is prepared to pay for another unit of the
commodity
Constant Marginal Utility of Money: Unit of measurement is
that it be constant
Diminishing Marginal Utility: The utility gained from a
successive units of a commodity diminishes.

=
U U1 ( x1 ) + U 2 ( x2 )........U n ( xn )
Total Utility is Additive:

Equilibrium of the Consumer

Single Commodity Model : The consumer can either buy
Commodity (x) or retain his money income (Y)
The Utility function is U = f (Qx )
If the consumer buys Qx his expenditure is PxQx
The consumer seeks to maximize the difference between his utility
and expenditure

U Px Qx
( Px Qx )
U

=
0
Qx
Qx

U
= Px
Qx

Or

MU x = Px

Derivation of the Demand Curve

Condition for the equilibrium

MU x = Px

MUx

Quantity

Quantity

Equilibrium of the Consumer

If there are more commodities, the condition for the
equilibrium of the consumer is the equality of the
ratios of the marginal utilities of the individual
commodities to their prices
MU x
=
Px

MU y
=
Py

MU n
.........
Pn

Equilibrium of the Consumer

Qx
0
1
2
3
4
5
6
7
8
9
10

Tux
0
50
88
121
150
175
196
214
229
241
250

Mux
50
38
33
29
25
21
18
15
12
9

Mux/Px
8.33
6.33
5.50
4.83
4.17
3.50
3.00
2.50
2.00
1.50

Qy
0
1
2
3
4
5
6
7
8
9
10

Tuy
0
75
117
153
181
206
225
243
260
276
291

Muy
75
42
36
28
25
19
18
17
16
15

Suppose the price of X is 6 and price of Y is 3

Muy/Py
25.00
14.00
12.00
9.33
8.30
6.33
6.00
5.67
5.33
5.00

Critique of the Cardinal Approach

Utility can not be measured objectively
Constant utility of money is unrealistic
Money can not be used as a measuring-rod since
its own utility changes

Ordinal Utility Theory

Assumptions
Rationality : Consumer aims at the maximization of
his utility subject to constraint his income
Ordinal Utility : Consumer can rank his preferences
Diminishing Marginal Rate of Substitution
Total Utility is Additive
Consistency and transitivity of choice
If A > B then B A

If A > B, and B > C, then A > C

Preferences: What the Consumer Wants

A consumers preference among consumption bundles

Case 1
A
B
C
D
E

Pizza (X) Pepsi (Y)

1
12
2
8
3
5
4
3
5
2

Case 2
A1
B1
C1
D1
E1

Pizza (X) Pepsi (Y)

2
24
4
16
6
10
8
6
10
4

A consumers preference among consumption bundles

may be illustrated with indifference curves.

Figure 1 The Consumers Preferences

Quantity
of Pepsi
A1

Indifference curve
B1

B
C1
D1

E1

I2

D
E
0

,I1
Quantity
of Pizza

Representing Preferences with Indifference Curves

The Consumers Preferences
The consumer is indifferent, or equally happy, with
the combinations shown at points A, B, and C
because they are all on the same curve.

The Marginal Rate of Substitution

The slope at any point on an indifference curve is
the marginal rate of substitution.
It is the rate at which a consumer is willing to trade one
good for another.
It is the amount of one good that a consumer requires as
compensation to give up one unit of the other good.

Properties of Indifference Curves

Higher indifference curves are preferred to
lower ones.
Indifference curves do not cross.
Indifference curves are downward sloping and
convex to the origin.

Properties of Indifference Curves

Property 1: Higher indifference curves are
preferred to lower ones.
Consumers usually prefer more of something to
less of it.
Higher indifference curves represent larger
quantities of goods than do lower indifference
curves.

Figure 2 The Consumers Preferences

Quantity
of Pepsi
A

B
C

D1
I2

D
E
0

Indifference
curve, I1
Quantity
of Pizza

Properties of Indifference Curves

Property 2: Indifference curves do not cross.
Points A and B should make the consumer equally
happy.
Points B and C should make the consumer equally
happy.
This implies that A and C would make the
consumer equally happy.
But C has more of both goods compared to A.

Figure 3 The Impossibility of Intersecting Indifference Curves

Quantity
of Pepsi
C
A

Quantity
of Pizza
Copyright2004 South-Western

Properties of Indifference Curves

Property 3: Indifference curves are down ward
sloping and convex to the origin.
People are more willing to trade away goods that
they have in abundance and less willing to trade
away goods of which they have little.
These differences in a consumers marginal
substitution rates cause his or her indifference
curve to bow inward.

Marginal Rate of Substitution

A
B
C
D
E

Pizza (X)
1
2
3
4
5

Pepsi (Y)
12
8
5
3
2

MRSxy
--4
3
2
1

Diminishing marginal rate of substitution: The rate of

substitution declines as consumption for X per unit
increases

Figure 4 Down ward sloping Indifference Curves

Quantity
of Pepsi
A

12

MRS = 4
B

1
D

3
2

MRS = 1
1

Indifference
curve
5

Quantity
of Pizza
Copyright2004 South-Western

Relationship between MRS and MU

U ( x, y ) = a
U
U
0
dx +
dy =
x
y
U
dy
U
=

y
dx
x
dy

= MUx
MUy

dx

MRS xy = MUx
MUy

Two Extreme Examples of Indifference Curves

Perfect substitutes
Perfect complements

Two Extreme Examples of Indifference Curves

Perfect Substitutes
Two goods with straight-line indifference curves are
perfect substitutes.
The marginal rate of substitution is a fixed number.

Figure 5 Perfect Substitutes and Perfect Complements

CD of brand X

(a) Perfect Substitutes

I1
0

I2
2

I3
3

CD of brand Y
Copyright2004 South-Western

Two Extreme Examples of Indifference Curves

Perfect Complements
Two goods with right-angle indifference curves are
perfect complements.

Figure 5 Perfect Substitutes and Perfect Complements

(b) Perfect Complements
Left
Shoes

I2

I1

Right Shoes
Copyright2004 South-Western

The Budget Constraint: What the

Consumer Can Afford
The budget constraint depicts the limit on the
consumption bundles that a consumer can
afford.
People consume less than they desire because their
spending is constrained, or limited, by their
income.
The budget constraint shows the various combinations
of goods the consumer can afford given his or her
income and the prices of the two goods.

The Consumers Budget Constraint

Assuming Per unit price of Pepsi 2 and Per unit Price of Pizza 10

The Budget Constraint: What the

Consumer Can Afford
The Consumers Budget Constraint
Any point on the budget constraint line indicates
the consumers combination or tradeoff between
two goods.
For example, if the consumer buys no pizzas, he
can afford 500 pints of Pepsi (point B). If he buys no
Pepsi, he can afford 100 pizzas (point L).
Alternately, the consumer can buy 50 pizzas and
250 pints of Pepsi.

Figure 6 The Consumers Budget Constraint

Quantity
of Pepsi
500

250

C
Consumers
budget constraint

L
0

50

100

Quantity
of Pizza

The Budget Constraint: What the

Consumer Can Afford
The slope of the budget constraint line equals
the relative price of the two goods, that is, the
price of one good compared to the price of the
other.
It measures the rate at which the consumer
can trade one good for the other.

Figure 7: Slope of the Budget Line

Quantity
of Pepsi
500

Px Qx + Py Qy =
M
Slope =

OB
OL

Slope =

M Py

Px Qx + Py Qy =
M

Consumers
budget constraint

M Px

Px
Slope =
Py

L
0

100

Quantity
of Pizza

Optimization: What The Consumer Chooses

Consumers want to get the combination of
goods on the highest possible indifference
curve.
However, the consumer must also end up on or
below his budget constraint.

Figure 8 The Consumers Equilibrium

Quantity
of Pepsi

=
E MRS
=
P=
MU x MU y
xy
x Py
Optimum
B

E
A
I3
I2
I1
Budget constraint

Quantity
of Pizza
Copyright2004 South-Western

The Consumers Optimal Choices

Combining the indifference curve and the
budget constraint determines the consumers
optimal choice.
Consumer optimum occurs at the point where
the highest indifference curve and the budget
constraint are tangent.
The consumer chooses consumption of the two
goods so that the marginal rate of substitution
equals the relative price.

Mathematical derivation of the Equilibrium

Given the market prices and his income, the consumer
aims at the maximization of his utility.
Maximize

U = f ( q1 , q2 ,........qn )
n

Subject to

q p
i =1

Rewrite the constraint

in the form

= q1 p1 + q2 p2 + ...... + qn pn = Y

( q1 p1 + q2 p2 + ...... + qn pn Y ) =
0

Multiply the constraint by a constant which is Lagrangian multiplier

( q1 p1 + q2 p2 + ...... + qn pn Y ) =
0

Mathematical derivation of the Equilibrium

Composite
function
Differentiating
the composite
function with
respect to q1,
q2.qn

=U (q1 p1 + q2 p2 + ...... + qn pn Y )
U
= ( P1 ) =0
q1 q1

U
= ( P2 ) =0
q2 q2

U
= ( Pn ) =0
qn qn

=
(q1 p1 + q2 p2 + ...... + qn pn Y ) =
0 ..4

Mathematical derivation of the Equilibrium

Solving
EQ1EQ2.
EQ3

U
U
U
= =
P1 ,
= Pn
P2 ,.......
q1
q2
qn

U
U
U
= MUq
=
MUq=
MUqn
1,
2 ,......
q1
q2
qn
MUqn
MUq1 MUq2
=
......
P1
P2
Pn
MUx MUy
=
Px
Py

Equilibrium
condition

MUx Px
= = MRS xy
MUy Py

Mathematical derivation of the Equilibrium

Utility function of an consumer is given by
3
1
4
=
U
f=
( x, y )
x y 4 . Find out the
optimal quantity of the two goods , if price of x
is Rs 6/- per unit and price of y is Rs 3/- per unit
and the income of the consumer is Rs 120/-

Example

Solution
Maximize
Subject to
Composite
function

U = x

6x + 3y =
120
3

x y
=
4

(6 x + 3 y 120)
Ans: x = 15 and y = 10

How Changes in Income Affect the Consumers

Choices
How a consumers purchases react to changes in
income with relative prices held constant

An increase in income shifts the budget constraint

outward.

The consumer is able to choose a better

combination of goods on a higher indifference
curve.

Quantity of Y

An Income-consumption Line
Income-consumption line

E3
E2
E1
I3
I2
I1
0

Quantity of X

Income-consumption Line
This line shows how a consumers purchases react to
changes in income with relative prices held constant.
Increases in income shift the budget line out parallel to
itself, moving the equilibrium from E1 to E2 to E3.
The income-consumption line joins all these points of
equilibrium.
If a consumer buys more of a good when his or her
income rises, the good is called a normal good.
If a consumer buys less of a good when his or her
income rises, the good is called an inferior good.

Figure 9 An Inferior Good

Quantity
of Pepsi

3. . . . but
Pepsi
consumption
falls, making
Pepsi an
inferior good.

New budget constraint

Initial
optimum

1. When an increase in income shifts the

budget constraint outward . . .

New optimum

Initial
budget
constraint

I1

I2

0
2. . . . pizza consumption rises, making pizza a normal good . . .

Quantity
of Pizza

How Changes in Price of a Commodity Affect

the Consumers Choices
The Price-consumption Line

a
Quantity of Y

Price-consumption
line

E1
E2

E3

I3
I2
I1
o

Q1

b Q2

Q3

d
Quantity of X

The Price-consumption Line

This line shows how a consumers purchases react to a
change in one price, with money income and other
prices held constant.
Decreases in the price of food (with money income and
the price of clothing constant) pivot the budget line
from ab to ac to ad.
The equilibrium position moves from E1, to E2 to E3.
The price-consumption line joins all such equilibrium
points.

Derivation of an Individuals Demand Curve

A price-consumption line provide the information needed to draw a
demand curve

Price

BL

IC

Equilibrium

Qx

P1

ab

IC1

E1

OQ1

P2

ac

IC2

E2

OQ2

P3

ad

IC3

E3

OQ3

Derivation of an Individuals Demand Curve

Quantity of Y

Derivation of an Individuals Demand Curve

a

E1

Price-consumption line

E2

E0
I0
b

Price of X

I1

I2

Q1 Q2 Q3

d
Quantity of X

P1

P2

Demand curve
z

P3
0

Q1 Q2 Q3
Quantity of X

Price Effect = Income Effect + Substitution Effect

A Change in Price: Substitution Effect

A price change first causes the consumer to move
from one point on an indifference curve to another
on the same curve.
Illustrated by movement from point A to point B.

A Change in Price: Income Effect

After moving from one point to another on the
same curve, the consumer will move to another
indifference curve.
Illustrated by movement from point B to point C.

Changes in a Goods Price

Suppose the consumer is maximizing
utility at point A.

Quantity of y

If the price of good x falls, the consumer

will maximize utility at point B.
B
A
U2
U1

Quantity of x
Total increase in x
52

Changes in a Goods Price

Quantity of y

To isolate the substitution effect, we hold

real income constant but allow the
relative price of good x to change
The substitution effect is the movement
from point A to point C

U1

The individual substitutes

good x for good y
because it is now
relatively cheaper
Quantity of x

Substitution effect
53

Changes in a Goods Price

Quantity of y

The income effect occurs because the

individuals real income changes when
the price of good x changes
The income effect is the movement
from point C to point B
B

C
U2
U1

If x is a normal good,
the individual will buy
more because real
income increased
Quantity of x

Income effect
54

Changes in a Goods Price

Quantity of y
An increase in the price of good x means that
the budget constraint gets steeper
The substitution effect is the
movement from point A to point C

C
A
B

U1

The income effect is the

movement from point C
to point B

U2

Quantity of x
Substitution effect
Income effect
55

Price Effect = Income Effect + Substitution Effect

Normal good
The substitution effect is always negative
The income effect is negative for normal goods
PE(-) = IE (-) + SE (-)
If a good is normal, substitution and income effects
reinforce one another
when price falls, both effects lead to a rise in quantity
demanded
when price rises, both effects lead to a drop in quantity
demanded

Price Effect = Income Effect + Substitution Effect

Inferior goods
The substitution effect is always negative,
The income effect is positive for inferior goods
PE(-) = IE (+) + SE (-) but (IE<SE)

If a good is inferior, substitution and income effects move

in opposite directions
The combined effect is indeterminate
when price rises, the substitution effect leads to a drop
in quantity demanded, but the income effect is opposite
when price falls, the substitution effect leads to a rise in
quantity demanded, but the income effect is opposite

Price Effect = Income Effect + Substitution Effect

Price Effect = Income Effect + Substitution Effect

Giffen goods
The substitution effect is always negative,
The income effect is positive for inferior goods
PE(+) = IE (+) + SE (-) but (IE > SE)
If the income effect of a price change is strong enough, there could be
a positive relationship between price and quantity demanded
an increase in price leads to a drop in real income
since the good is inferior, a drop in income causes quantity
demanded to rise
The most commonly cited example of a Giffen good is that of the Irish potato famine in the
19th century. During the famine, as the price of potatoes rose, impoverished consumers had little
money left for more nutritious but expensive food items like meat (the income effect). So even
though they would have preferred to buy more meat and fewer potatoes (the substitution effect),
the lack of money led them to buy more potatoes and less meat. In this case, the income
effect dominated the substitution effect, a characteristic of a Giffen good.

Price Effect = Income Effect + Substitution Effect

Consumer Surplus and Tax

Incidence

Revisiting the Market Equilibrium

Does the equilibrium price and quantity maximize the total
welfare of buyers and sellers?
Market equilibrium reflects the way markets allocate scarce
resources.
Whether the market allocation is desirable can be addressed
by welfare economics.
Welfare economics is the study of how the allocation of
resources affects economic well-being.
Buyers and sellers receive benefits from taking part in the
market.
The equilibrium in a market maximizes the total welfare of
buyers and sellers.

Producer and Consumer Surplus

Consumer surplus is the value the consumer gets from buying a
product, less its price

It is the area below the demand curve and above the price
Willingness to pay is the maximum amount that a buyer
will pay for a good.
It measures how much the buyer values the good or
service.

Producer and Consumer Surplus

Producer surplus is the value the producer sells a product for
less the cost of producing it

It is the area above the supply curve but below the

price the producer receives
Producer surplus is the amount a seller is paid for a
good minus the sellers cost.
It measures the benefit to sellers participating in a
market.

Producer and Consumer Surplus

Consumer surplus =
area of red triangle =
($5)(5) = $12.5

P
$10
9
8
7
6
5
4
3
2
1

Producer surplus =
area of green triangle =
($5)(5) = $12.5

CS
PS
D
0 1 2 3 4 5 6 7 8

The combination of
producer and consumer
surplus is maximized at
market equilibrium

Market Efficiency
Consumer surplus and producer surplus may be used
to address the following question:
Is the allocation of resources determined by free markets in
any way desirable?

Consumer Surplus
= Value to buyers Amount paid by buyers

Producer Surplus
= Amount received by sellers Cost to sellers
Efficiency is the property of a resource allocation of maximizing
the total surplus received by all members of society.

Government Intervention
The Role of Government in the Market Economy
Up to this point, we have examined how free markets work.

A free market is one without any government control or intervention. The price and output
is determined by the interactions of buyers and sellers
However, not all markets are completely free. Governments tend to intervene often to
influence several variables in markets for particular goods, such as:
Taxing the good to discourage consumption or raise revenues: Indirect taxes
Paying producers of the good to reduce costs or encourage the goods production:
Subsidies
Reducing the price of the good below its free market equilibrium to benefit consumers:
Price Ceilings
Raising the price of a good above its free market equilibrium to benefit producers: Price
Floors

When governments intervene in the free market, the level of output and price that
results is may NOT be the allocatively efficient level. In other words, government
intervention may lead to a misallocation of societys resources.

A Free Market
P

If there is no tax, market

equilibrium is reached and
consumer and producer surplus
is maximized

D
Q

8-8

Government Intervention : Tax

A tax paid by the supplier shifts

the supply curve up by the
amount of the tax (=t)

S1
S0

Both producer and

consumer surplus decrease
Positive government revenue
Deadweight loss exists

P1
P0
P1-t

D
Q1

Q0

8-9

The Costs of Taxation

Consumer Surplus Before Tax: A + B + C
Consumer Surplus After Tax: A

Producer Surplus Before Tax: D + E + F

Producer Surplus After Tax: F

Deadweight Loss: C + E

Price

Consumer
surplus

S1
S0

P1
P0
P1t

tax

Deadweight
loss

Producer
surplus
Q1

Demand
Q0

Quantity

Application: The Costs of Taxation

How do taxes affect the economic well-being of
market participants?
A tax places a wedge between the price, buyers pay
and the price, sellers receive.
Because of this tax wedge, the quantity sold falls
below the level that would be sold without a tax.
The size of the market for that good shrinks.

The Burden of Taxation

The tax burden is independent of who pays the tax

Supplier pays the tax,

supply shifts

Consumer pays the tax,

demand shifts

S1

S0

P1

P1+t

P0

P0

P1-t

P1

Q0

Q1

D0
D1

Q0

Q1

Q
8-12

The Burden of Taxation

Sales Tax
Sales taxes are paid by retailers
on the basis of their sales
revenue
Since sales taxes are broadly
defined to include most goods
and services, consumers find it
hard to substitute to avoid the
tax
Demand is inelastic so consumers
bear the greater burden of the
tax
As consumers increase purchases
on the Internet where sales are
not taxed, retail stores will bear a
greater burden of the sales tax

Social Security Taxes

Both employer and employee
contribute the same percentage
of before-tax wages to the Social
Security fund
Although the employer and
employee contribute the same
percentage, they do not share
the burden equally
On average, labor supply tends to
be less elastic than labor
demand, so the Social Security
tax burden is primarily on
employees

What Goods should be Taxed and who bears the Tax?

The Effects of an Indirect Tax and PED

Good A

S+tax

Observations:

The $ 1 tax on Good A (highly elastic demand):

Rs 0.80 is paid by produces, and only $ 0.20 by consumers

Quantity falls dramatically.
The loss of welfare (gray triangle) is large
Revenue raised is small due to the large decrease in Q

$1

2.20
2.00
1.20

The $ 1 tax on Good B (highly inelastic demand):

$ 0.90 is paid by consumers, and only $. 0.10 by producers

Quantity does not fall by much
The loss of welfare (gray triangle) is small
Revenue raised is greater than Good A because the quantity
does not fall by much

Qtax

Qe

Good B

S+tax

2.90

Taxing goods with relatively inelastic demand will raise

more revenue and lead to a smaller loss of total welfare,
2.00
while taxing goods with elastic demand will lead to a larger 1.90
decrease in quantity and a greater loss of total welfare.

$1

D
Qtax Qe

What Goods should be Taxed and who bears the Tax?

If demand is relatively elastic: Producers will bear the larger burden of the
tax. Firms will not be able to raise the price by much out of fear of losing all
their customers, therefore price will not increase by much, but producers
will get to keep less of what consumers pay.
If demand is relatively inelastic: Consumes will bear the larger burden of
the tax. Firms will be able to pass most of the tax onto consumers, who are
not very responsive to the higher price, thus will continue to consume close
to what they were before the tax.
Elasticity and government revenue: The implication for government of the
above analysis is that if a tax is meant to raise revenue, it is better placed on
an inelastic good rather than an elastic good. Taxing elastic goods will
reduce the quantity sold and thus not raise much revenue.

What Goods Should Be Taxed and who bears the Tax?

Goal of Government

Most effective when

Raise revenue, limit deadweight loss

Demand or supply is inelastic

Change behavior

Demand or supply is elastic

Elasticity

Who bears the burden?

Demand inelastic and supply elastic

Consumers

Supply inelastic and demand elastic

Producers

Both supply and demand elastic

Shared, but the group whose S or D is

more inelastic pays more

8-16

Incidence of Tax

Incidence of Tax

Before the
tax:

After the
tax:

Incidence of Subsidy

Incidence of Subsidy

Before the
subsidy:

After the
subsidy:

The Effects of Taxes and Subsidies on Consumers and Producers

The Effects of Taxes and Subsidies on Consumers and Producers
We can determine how much of the tax burden was born by consumers and producers:
Effect of the tax
The price increased from $4.00 to $4.75, meaning consumers paid $0.75 of the $1.00 tax.
Producers got to keep just $3.75, meaning they paid just $0.25 of the $1.00 tax
Effect of the subsidy:
Price went down from $4.00 to $3.25, meaning consumers received $0.75 of the $1.00
subsidy.
Producers received $4.25, meaning they enjoyed $0.25 of the $1.00 subsidy.

Before the
tax and the
subsidy:

After the
tax:

After the
subsidy:

Price Controls
Price Controls: Another form government intervention might take in a market is price
controls.

Price Ceiling: This is a maximum price, set

below the equilibrium price, meant to help
consumers of a product by keeping the
price low.
P

Gasoline
Market

Price Floor: This is a minimum price, set below

the equilibrium price, meant to help producers
of a product by keeping the price high.
S

Corn
Market

Pf

Pe

Pe

Pc

D
QS

Qe

QD

D
QD

Qe

QS

The Effects of a Price Ceiling

When a government lowers the price of a good to help consumers, there are several
effects that we can observe in the market. Assume the government has intervened in the
market for gasoline to make transportation more affordable for the nations households
On consumers:
Quantity demanded increases (Qd)
P
The lower price leads to an increase in consumer
surplus, which is now the blue area
The lower quantity means some consumers who want to
will not be able to buy the good
On Producers:
The lower price means less producer surplus (red
Pe
triangle)
The lower quantity means some producers will have to
leave the market and output will decline (Qs)
Pc
On the market:
Overall, not enough gasoline is produced, and is the
market is allocatively inefficient. The gray triangle
represents the loss of total welfare resulting from the
price ceiling.

Gasoline
Market

Shortage
D
QS

Qe

QD

The Effects of a Price Ceiling

The Effects of a Price Floor

When a government raises the price of a good to help producers, there are several effects
that we can observe in the market. Assume the government has intervened in the market
for corn to help farmers sell their crop at a price that allows them to earn a small profit.
On consumers:

Quantity demanded decreases (Qd)

The higher price means there is less consumer
surplus (blue area)

On Producers:

Quantity supplied increases (Qs)

The higher price means there is more producer
surplus, but since consumers only demand Qd,
there is an excess supply of unsold corn (Qd-Qs)
On the market:
Overall, the market produces too much corn and is
thus allocatively inefficient. The increase in
producer surplus is smaller than the decrease in
consumer surplus. The total loss of welfare is
represented by the gray triangle.

Corn Market
P

Pf

Pe

Surplus
D
QD

Qe

QS

The Effects of a Price Floor