Microeconomics:-

The purpose of this lesson is to reach an understanding of

how markets operate, how prices are set and transactions occur.
The two market forces of demand and supply are defined and
explained. The equilibrium point is studied. Conclusions and
applications are offered.

DEMAND

Demand is the expression of willingness and ability of a

potential buyer to acquire certain quantities of an item for
various possible prices the buyer can reasonably offer. Demand
can be thought of as a schedule of prices and quantities in the
mind of the buyer.

LAW OF DEMAND

The law of demand postulates that the relationship between price

and quantity in the mind of buyers is inverse. The law of demand
is represented graphically by a down sloping demand curve. The
law of demand is explained by the diminishing marginal utility,
the income effect, the substitution effect and with the help of
indifference curves analysis.

LAW OF DEMAND REASONS

The law of demand can be explained by
- price being an obstacle to consumption,
- diminishing marginal utility,
- price change income effect and substitution effect.
It can also be derived from the diminishing marginal rate of
substitution of indifference curves.
 SUPPLY

Supply is the willingness and ability of sellers or suppliers to

make available different possible quantities of a good at all
relevant prices.

LAW OF SUPPLY
The law of supply postulates that the relationship between
price and quantity in the mind of sellers or producers is
a direct one. When price increases so does quantity.

LAW OF SUPPLY REASONS

The law of supply is explained by
- price being an inducement for sellers or producers to sell
more, and
- cost of production increasing (because of the law of
diminishing returns).

Utility approach:-
The basic idea behind ordinal utility approach is that a consumer keeps number
of pairs of two commodities in his mind which give him equal level of satisfaction.
This means that the utility can be ranked qualitatively.

The ordinal utility approach differs from the cardinal utility approach (also called
classical theory) in the sense that the satisfaction derived from various
commodities cannot be measured objectively.

Ordinal theory is also known as neo-classical theory of consumer equilibrium,

Hicksian theory of consumer behavior, indifference curve theory, optimal choice
theory. This approach also explains the consumer's equilibrium who is confronted
with the multiplicity of objectives and scarcity of money income.
The important tools of ordinal utility are:

1. The concept of indifference curves.

2. The slop of I.C. i.e. marginal rate of substitution.

3. The budget line.

Indifference curves:-
In economics, an indifference curve connects points on a graph representing
different quantities of two goods, points between which a consumer is indifferent.
That is, the consumer has no preference for one combination or bundle of goods
over a different combination on the same curve. One can also refer to each point on
the indifference curve as rendering the same level of utility (satisfaction) for the
consumer. In other words, an indifference curve is the locus of various points
showing different combinations of two goods providing equal utility to the
consumer. Utility is then a device to represent preferences rather than something
from which preferences come. The main use of indifference curves is in the
representation of potentially observable demand patterns for individual consumers
over commodity bundles.

There are infinitely many indifference curves: one passes through each
combination. A collection of (selected) indifference curves, illustrated graphically,
is referred to as an indifference map.

An example of an indifference map with three indifference curves represented

Elasticity of demand and supply:-

The concept of elasticity is intended to measure the degree of

responsiveness of a buyer or seller to a change in a key
determinant, in particular price. The degree of responsiveness
of the quantity demanded to a price change is called the price
elasticity of demand. If the price change is that of another
good then the study deals with cross elasticity of demand.

ELASTIC DEMAND

If the demand is elastic, it means that a small price change

results in a large quantity change. This would generally take
place on the upper portion of the demand curve. If the demand is
perfectly elastic (which means that the smallest possible price
change results in a virtually infinite quantity change), the
demand curve is then horizontal.

DEMAND ELASTICITY DETERMINANTS

The determinants of demand elasticity are

- the time framework (market period, short run or long run),
- the availability of substitutes,
- the proportion the item represents in total income,
- the perception of the item as necessity or luxury.
SUPPLY ELASTICITY

Supply elasticity is the degree of responsiveness of the quantity

supplied to a change in price. It is calculated as

Es = % change in quantity / % change in price.

SUPPLY ELASTICITY DETERMINANTS

The major determinants of supply elasticity are
- the time framework (market period, short run or long run),
- the ability to shift resources.

Consumer surplus:-

Many times, the equilibrium price is lower than the highest price some folks are
willing to pay. For all consumers, this is called consumer surplus. Similarly, the
price might be higher than the minimum price at which some are willing to
produce. For all the producers, this is called producer surplus. This tutorial covers
them both with an emphasis on the visual.

Returns to Scale and Returns to Factor

Returns to a factor and returns to scale are two important laws of production. Both laws explain
the relation between inputs and output. Both laws have three stages of increasing, decreasing and
constant returns. Even then, there are fundamental differences between the two laws.

Returns to a factor relate to the short period production function when one factor is varied
keeping the other factor fixed in order to have more output, the marginal returns of the Variable
factor diminish. On the other hand, returns to scale relate to the long period production function
when a firm changes its scale of production by changing one or more of its factors.

Assumptions:

We discuss the relation between the returns to a factor (law of diminishing returns) and
returns to scale (law of returns to scale) on the assumptions that:

(1) There are only two factors of production, labour and capital.

(2) Labour is the variable factor and capital is the fixed factor.
(3) Both factors are variable in returns to scale.

(4) The production function is homogeneous.

Explanation:

Given these assumptions, we first explain the relation between constant return to scale and
returns to a variable factor in terms of Figure 14 where OS is the expansion path which shows
constant returns to scale because the difference between the two isoquants 100 and 200 on the
expansion path is equal i.e.,

OM = MN. To produce 100 units, the firm uses + OL quantities of capital and labour and to
double the output to 200 units, double the quantities of labour and capital are required so that
2 + OL2 lead to this output level at point N. Thus there are constant returns to scale because
OM = MN.

To prove that there are decreasing returns to the variable factor, labour, we take of capital as
the fixed factor, represented by the CC line which is parallel to the X-axis relating to labour.

This is called the proportional line. Keeping as constant, if the amount of labour is doubled by
LL2 we reach point Y which lies on a lower is quant 150 than the isoquant 200. By keeping
constant, if the output is to be doubled from 100 to 200 units, then OL3 units of labour will be
required. But OL3 > OL2. Thus by doubling the units of labour from OL to OL2 with constant C
the output less than doubles.

It is 150 units at point K instead of 200 units at point P. This shows that the marginal returns of
the variable factor, labour, have diminished when there are constant returns to scale.

The relation between diminishing returns to scale and returns to a variable factor is explained
with the help of Figure 15 where OS is the expansion path which depicts diminishing returns to
scale because the segment MN > OM. It means that in order to double the output from 100 to
200, more than double the amounts of both factors are required.

Alternatively, if both factors are doubled to 2 + OL2, they lead to the lower output level
isoquant 175 at point R than the isoquant 200 which shows diminishing returns to scale. If is
kept constant and the amount of variable factor, labour, is doubled by LL2, we reach point K
which lies on a still lower level of output represented by the isoquant 140. This proves that the
marginal returns of the variable factor, labour, and have diminished when there are diminishing
returns to scale.

Now we take the relation between increasing returns to scale and returns to a variable factor.
This is explained in terms of figure 16 (A) and (B) In Panel (A), the expansion path OS depicts
increasing returns to scale because the Segment > MN. It means that in older to double the
output from 100 to 200 less than double the amounts of both factors will be required.

If is kept constant and the amount of variable factor labour is doubled by LL2 the level of
output is reached at point K which shows diminishing marginal return as represented by the
lower isoquant 160 than the isoquant 200 when returns to scale are increasing.
In case the returns to scale are increasing strongly, that is, they are highly positive; they will
offset the diminishing marginal returns of the variable factor, labour. Such a situation leads to
increasing marginal returns. This is explained in Panel (B) of Figure 16 where on the expansion
path OS the segment OM > MN, thereby showing increasing returns to scale.

When the amount of the variable factor, labour, is doubled by LL while keeping as constant,
we reach the output level K represented by the isoquant 250 which is at a higher level than the
isoquant 200. This shows that the marginal returns of the variable factor, labour, have increased
even when there are increasing returns to scale.

Conclusion:

It can be concluded from the above analysis that under a homogeneous production function when
a fixed factor is combined with a variable factor, the marginal returns of the variable factor
diminish when there are constant, diminishing and increasing returns to scale. However, if there
are strong increasing returns to scale, the marginal returns of the variable factor increase instead
of diminishing.