ECONOMIC BUSINESS

ANALYSIS
• QAZI MUHAMMAD TOUSEEF
AKHTAR

• DEPARTMENT OF ECONOMICS
UNIVERSITY OF BALOCHISTAN
QUETTA, PAKISTAN
 MICRO ECONOMICS AND MACRO
ECONOMCS
Adam smith is usually considered the
founder of the field of
microeconomics, the branch of
economics which today is concerned
with the behavior of Individual
entities such as market, firms, and
households
• In the wealth of nations smith
considered how individual price are
set.
• Studies the determination of price of
FOP.
 MACROECONOMICS which is
concerned with the overall performance
of the economy.
John Maynard Keynes
(General Theory of Employment, interest
and Money) 1935.
He invented the idea of ME it did not even
exist in its modern form until 1935.
In his new theory Keynes developed;
 What causes unemployment and economic
downturns.
 How I and C determined.
 How central Bank manage the money and
interest rate.
 Why some nations thrive while others stagnate.
 Positive Economics
PE is related to the explanation of economic events
as what they are
It does not state whether the thing is right or wrong
it only makes theories to explain the real situation
and to establish cause and effect relationship
existing b/w them. It gives no value judgment and
does not explain the rightness or wrongness of
the economic events. E.g. if a firm pays low
wages to women worker, the PE simply tell us
that it is done to reduce the cost. However it does
not tell us whether low wages to women is
justifiable or not .
 Normative Economics
NE evaluates the state of things as they
ought to be it is related with value
judgment
it means that it gives judgment whether
the thing is right or wrong. It evaluates
the situation and prescribes solution for
it. It means that ECONOMICS is not
neutral & is not colorless, e.g. if there is
poverty in an economy NE not only
explain the situation and causes for it but
also provide measure to overcome the
problem.
Overall economics is both N & P science,
Productive Efficiency
Efficiency means that the economy’s
resource are being used as effectively
as possible to satisfy people’s needs
and desires. One important aspect of
overall economics efficiency is
productive efficiency.
Pro- eff. occurs when an economy can not
produce more of one goods without
producing less of another good. This
implies that economy is on its PPF.
e.g. when we are producing more guns,
we are substituting guns for butter.
Countries are always being forced to
decide how much of their limited
resources goes to their military and
how much goes into other activities
such as agriculture, industry and social
sector.
Some countries like Japan allocate about
1% of their national output to their
military. The USA spends 5% the North
Korea spends up to 20%.
The more output that goes for defense,
the less there is available for
Economies Relevance to Business
Organization.
Opportunity Cost : Life is full of choices
because resources are scarce, we always
consider how to spend our limited incomes
or time, when you decide whether to study
economics, buy a car or go to university,
in each case you must consider how much
the decision will cost in term of forgone
opportunity.
The cost of forgone alternatives is the
opportunity cost of decision.
In a world of scarcity, choosing one thing
 THE PRODUCTON POSSIBILTY
FRONTIER
PPC curve helps us to understand the problem
of choice and scarcity of resources.
PPC is based on the following assumptions ;
1. The economy is operating at full employment
level.
2. Technology remains constant.
3. The supplies of FOP are fixed but they can be
shift or reallocated within limits among
alternative uses.
Societies can not have every thing they want.
The PPC is of much importance in explaining
some of the basic facts of human life: the
problem of unemployment, technological
progress, economic growth and economic
efficiency.
Relaxing the assumption of full employment
of resources, constant production
techniques, economic growth and
economic efficiency.
Three efficiencies :
Efficient allocation of resources in production
and efficient choice of method of
production.
 Alternatives Production
Possibilities Possibilities
Butter
Guns (In million pound)
(thousand)
A 0
15
B 1
14
C 2
12
D 3
9
E 4
 Production Possibility Curve

16
Guns(thousands)

14
12
10
8
6
4
2
0
0 2 4 6
Butter(million pounds)
 ILLUSTRATION OF PPF
Production Possibilities Commodity X
ACommodity Y 0
28
B 2
26
C 4
22
D 6
16
E 8
9
F 10
0
 Factors Of Production
Another term for inputs is FOP, these can be classified
into three broad categories.
LAND LABOUR & CAPITAL
Land- represent gift of nature to our productive
processes.
Labour- consist of human time spent in production.
Capital- resources form the durable goods of an
economy, produced in order to produce yet other
goods.
Stating the three economic problem in term of input
and outputs a society must decide.
1- what output to produce and in what quantity;
 INPUTS AND OUTPUTS
To answer three questions,
every society must make
choices about the economy’s
inputs and outputs.
INPUTS are commodities or
services that are used to
produce goods and services.
OUTPUTS are the various useful
goods or services that result
from the production process
 The Three Problems of
Economics Organization
Fundamental questions of economic
organization
WHAT , HOW and FOR WHOM
As crucial today as they were at the dawn
of human civilization. Let’s look more
closely at them.
What commodities are produces & in
What quantities?
We will produce consumption goods or
investment goods (either pizza or pizza
 How are goods produces?
Society must determine who will do
production, with resources, and
what production techniques, they
will use.
Who farm and who teaches.
Is electricity generated from oil,
from coal or from sun? with much
air pollution or with little.
For Whom are goods produced ?
Who get to eat the fruit of economic activity ?
How the national product divided among
different households ?
Are many people poor and a few rich?
Do high incomes go to managers or athletes
or workers or landlords ?
Will society provide minimal consumption to
the poor, or they work if they are to
survive?
 MARKET, COMMAND AND MIXED
ECONOMICS
WHAT are the different ways that society can answer the
question of WHAT, HOW and FOR WHOM ?
Different societies are organized through alternate
economics system and economics studies the various
mechanisms that a society can use to allocate its
scare resources.
These systems are A market economy (USA)
(Laissez – faire)
Command Economy (Former USSR)
No Contemporary society falls completely into either of
these polar category. Rather all societies are Mixed
Economies
Economics is a social science. Its development is
related with the socio-economic and political
development of society.
Definition of economics have been changing
through time and circumstances major
definitions can be presented as;

A- Economics : A science of wealth.

B- Economics : A science of material welfare.
C- Economics science of scarcity or science of
.choices.
D- Economics :A science of economic growth.
Economics: A science of wealth ( Classical)
Adam Smith - “ An Enquiry into the nature and
causes of wealth of nations.
Distinguish man into two group vise economic man and non-
economic man.

Other Classical economists;

J B Says- Eco is science which treats of wealth.
F A Walker- Eco is body of knowledge which relates to wealth.
J S Mill- “it is practical science of production and distribution of
Wealth.
Criticism
- Too much emphasis on wealth.
- Concept of Economic Man.
- No mention of human welfare.
- Narrow definition.
Economics : A science of material welfare.
(Neo classical)

Alfred Marshal- economics is the study of man's action in the

ordinary business of life; it enquires
How he gets his income and how he uses it. Thus, it is on one
side study of wealth and on the other side study of man.
Other neo-classical Economists.
A C Pigou- Economics deals with the part of social welfare that
can be bought directly or indirectly into relation with the
measure rod of money.
Edwin Cannan – it is the study of general methods by which man
cooperate to meet their material needs.
Criticism.
- Classical rather than analytical in nature.
- Difficult to separate material and no-material things.
- Connection b/w economics and welfare.
- Social science ( welfare)
- Quantitative measurements of welfare.
 Economics: A Science of Scarcity or
Science of Choice.
Lionel Robbins:” Economics studies human behavior as a
relationship b/w ends and scarce means which have
alternatives uses.”
The nature and significance of economics science published
in 1932
The Fundamental characteristics of definition;
- Unlimited ends
- Limited means
- Alternative uses of means
- Problem of choice.
Criticism
- It does not cover macroeconomics
- Difficult to separate means and ends
- It ignores development economics.
Economics : A Science of Economics growth
Paul A Samuleson : “ Economics is the study of how men and
society choose, with or without the use of money, to employ
scarce productive resources which could have alternative uses
to produces various commodities over time and distribute them
for consumption more and in future among various people and
group of society” Economics Published in 1964.
He considered economics as much more that the theory of value
or resource allocation.
He was widened the definition of economics based on the concept
of Robbins.
He considered economics as a dynamic science.
He defined and explained the use of factors over different period
of time.
He is capable of including the nature of economics activities.
Under capitalistic economy as well as socialistic economy.
He also Covers welfare aspect.
 The Demand Function
Demand : Desire back with purchasing power.
Demand= wish + will + Purchasing power.
Qd = f( p) , Qd = f ( P1, P2, Y, T, Pop, S)
Demand is a function of rice of that commodity which is
demanded, price of other commodities, average
income of Consumer, taste of consumer population of
that area and special influences. Amount of
commodity people buy depends on its price. Law of
Demand the higher the prices of commodity, the fewer
units consumers are willing to buy. The lower its
market price, the more units of it are bought. Ceteris
paribus.
There exists a definite relationship b/w the market price
of a good and the quantity demanded of that good,
other things held constant. The relationship b/w price
and quantity bought is called
Demand Schedule or the Demand Curve.
 Demand Schedule
Prices: 0.6 0.5 0.4 0.3 0.2 0.1
Quantity: 10 20 30 40 50 60

individual demand curve

70
60
50
Units

40
30
20
10
0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7
Prices ( Rs)
Causes of Downward sloping demand curve;
1- The law of demand is based on the law of diminishing marginal
utility (MU), when a consumer buys more units of a commodity
MU That commodity continues to decline. Therefore, the
consumer will buy more units of that only when its price fall this
this will prove that demand will be more at a lower price and it
will be less at higher price that’s why demand curve is
downward sloping.
2- Everyone commodity has certain consumers but when its
prices falls, New consumer start consuming it as a result
demand increases, on the contrary with increase in its prices
many consumers either to reduce or stop its consumption and
demand will be reduced thus due to price effect, when
consumers consume more or less, the demand cure slopes
downward.
3- When price of commodity falls, the real income of consumer
increase because he has to spend less in order to buy the
same quantity. On the contrary, with the rise in the price of a
commodity the real income of consumer falls. This is called the
income effect.
4- With the fall in the price of a commodity, the prices of its
substitute remaining the same it is known as substitution effect,
consumer will buy more of the same rather than the substitutes.
On the contrary, with the rise in the price of commodity its
demand will fall, given the prices of its substitute.
5- There are different income groups in every society, but the
majority relates to low income group, the downward sloping
demand curve depends upon this group. Ordinary people buy
more when prices falls and less when prices rises. The rich do
not have any effect, because they are capable to buy same
quantity even at higher prices.
6- There are different uses of certain commodities and services
that are responsible for negative slope, with the increase in the
of such products, they will be used only for more important
uses, and their demand will fall. On the contrary, with fall in
prices, they will be put to various uses and their demand will
rise .g. with increase in electricity charges, power will be used
for domestic lighting, but if charges are reduced, people will use
power for cooking, heating etc.
 Exceptions of Law of Demand
- In certain cases the demand curve slopes up from left to right.
Many causes are attributed to an up ward D- curve.
1- War : If shortage is feared in anticipation of war, people may
start buying for building stocks, even price rises.
2- Depression : during, prices of commodity very low, the demand
for them is also less because of less purchasing power.
3- Giffen Paradox : if a commodity happens to be a necessary of
life like wheat and prices goes up, consumer are forced to
curtail the consumption of more expensive foods like meat and
fish, and wheat being still the cheapest, they will consume more
of it.
4- Demonstration Effect : If the consumer are affected by the
principles of demonstration effect, they will like to buy more of
those commodities which confer distinction on the possessor,
when their prices rise. On the other hand, with the fall in the
price of such commodities, their demand falls as the case with
diamonds.
 Do not Confuse movement along the curve with
shift of curve
(See the figures 3 E & F)
Factors affecting demand curve;
1- Average income : As income increases,
people purchasing more.
2- Population : As growth of population
increases, purchases of goods increases.
3- Prices Of related Goods : Higher prices,
reduces the demand for Goods.
4- Taste: Having distinct things become a status
symbol.
5- Special Influences : Availability of alternates.
 Supply
The supply side of market typically involves the terms on
which business produced and sell their product.
Quantity of commodity supplied in a market for sale at
certain or prevailing prices is called supply
Qs = f (P)
Qs = f (P1, P2,…n, Tech, Input, GP, SI)
Quantity Supplied is function of price of that commodity
which is supplied, prices of related goods, technology,
input, prices, government policies, Special Influences.
The supply schedule or supply curve for a commodity
shows the relationship b/w its market price and the
amount of that commodity that producers are willing to
produce and sell, other things held constant.
 Supply Schedule
Prices (Rs) : 1 2 3 4 5
Quantity (Units) : 2 4 6 8 10
Indivdual supply curve

12
Quantity (units)

10
8
6
4
2
0
0 1 2 3 4 5 6
Prices ( Rs)
There is positive relationship b/w market price and
quantity supplied so supply curve going up ward left to
right.
One important reason for the upward slope is the “ law
of diminishing returns”
Factors affecting the supply curve:
Technology – Computerized manufacturing lowers
production cost and increase supply.
Input prices – a reduction in the wage paid to workers,
lower production costs and increase supply.
Prices of related goods - When oil prices increase
sharply, increase production cost ad lower the supply.
Government Polices – Improving quota and tariff and
imported goods, domestic supply increases.
Special Influences – If govt lowers the prices of gas kits,
more environment friendly cars on the roads.
Equilibrium Of Supply and Demand
Equilibrium is a state of balance : when two opposite
forces are interact at point. The market equilibrium
comes at that price and quantity where the forces of
supply and demand are in balance. At this point the
amount buyers want to buy is just equal to the amount
the seller want to sell.
The reason we call this an equilibrium is that when the
forces of supply and demand in balance there is no
reason for price to rise or fall,
As long as other things remains unchanged.
Equilibrium with supply and demand curves
(see figure A)
Effect of shift in supply or demand
( See figures B and C )
 Market Equlibrium
FIGURE-A
6
5 Surplus
4 S>D
P3 Equilibrium
2 shortage
1 S<D
0
0 5 10 15 20 25 30
Q

7
6
5
4
P 3
2
1
0
-1
0 5 10 15 20 25 30
Q
 Factors Affecting The Price Elasticity Of
Demand :
-Nature of Commodity
-Substitute
-Variety of Uses
-Joint demand
-Deferred Consumption
-Habits
-Income Group
-Proportion of Spent
-Level of Price
-Time factor
 Elasticity of demand and Supply
The law of demand does not solve the problem of degree of
change in demand to a change in credit goes to Marshall
who offered a solution by formulating the concept of
elasticity of demand in these words,” The elasticity (or
Responsiveness) of demand in a market is greater or
smaller according as the amount demanded increases
much on little for a given fall in price and diminish much or
little for a given rise in price.” Modern economist define
elasticity of demand in a mathematical manner. Lipsey’s
word” is the ratio of percentage in demand to percentage
change in price.” Robinson definition is more clear “ The
elasticity of demand at any price or at any out put , is the
Proportional change of amount purchased in response to a
small change in price, divided by proportional change of
price thus it is the ratio of percentage in amount
demanded to a percentage change in price.
 Its importance in Government Policies
The application of Ed in formulation of government polices in various
fields.
2. While granting protection : G consider the Ed of the product of
those industries which apply for grant of subsidy or protection. It
is given to those industries whose product have an elastic
demand. As a consequences they are unable to face foreign
competition unless their prices are lowered through subsidy or
by raising the prices of imported goods by imposing heavy
duties on them
3. Whole deciding about public utilities: G decision to declare
certain industries as public utility depends upon Ed for their
product, these are taken over and run as public utility by the
state. Demand for those product is inelastic the G in this way
provide essential g/s to the public at reasonable rates thus
eliminating monopolists exploitation.
4. In facing minimum price of farm products: G policies of
guaranteeing minimum price for form products, price support
programmed and creating the buffer stocks are meant for
stabilizing the agriculture price.
Paradox of Bumper Crop….?
 Importance to Finance Minister :
It has paramount importance to FM. He has to find about how he
can bring more revenue to exchequer? He must now the Ed
of the product on which the tax has to be imposed. Let us
illustrate with the Help of diagram whether a tax on a product
which elastic demand or inelastic demand would bring larger
revenue to the exchequer.
Importance in the problem of the international trade:
The Ed has great practical importance in analyzing complex
problems of IT.
4. In Determination of the Gain from IT: The TOT refer to the
rate which a country exchanges her exports for her imports
from the other country. The exact rate at which exchange will
take place, will be determined by the relative elasticity of
demand of two countries for each other’s product, the gain
from trade in turn depend , among others, on the Ed and the
term of trade. We will gain from IT If we export goods with
less Ed and import those goods for which or demand is
elastic . In the first case, we will charge high price for our
product and in later case, we will be paying less for the goods
obtained from other country. Thus we gain both way and shall
1. In tariff Policy: tariff tend to raise the prices of the domestic
products , internal price rise depends on the Ed of
protected goods in the demand of protected goods is
elastic, their sales will be reduce with the rise in prices,
conversely, if the demand is less elastic , people will have
to bear the Burdon of higher prices as a result of tariff
policy.
2. Basis of policy of devolution: The consideration of elastic of
demand for M and X is Important of a country which is
thinking of correcting her adverse BOPs By devolution,
Devolution makes X cheaper and M dearer of the country
adopting it. Suppose we resort the devolution, its first effect
will be that the price of a M will rise and we will induce to
reduce or M, But this depends on the Ed for M on the other
hand, the fall in foreign price for X will induce us to X more,
But its depends upon the Ed of Foreigner for our products
thus the extend to which we are in a position to reduce the
gap b/w receipts and expenditure of foreign exchange
depends upon the elasticity of demand for X and M.
Cross Elasticity Or Complementry goods (Jointly Demanded)
=If two goods are jointly demanded the rise in the price of one
(Cars) lead to a fall in the demand for other ( petrol) or vise
versa.
=if the change in quantity demanded B exactly in the same
proportion as change in price of A.
(Eba = 1)..i.e ▲Qb / ▲Pa = 1
=when the change in the demand for good B is more than
proportionate to the change in the price of good A.
(Eba>1). i.e. ▲Qb / ▲Pa>1
=when change in quantity of B is less in response to change in
price of A.
(Eba<1) i.e. ▲Qb/ ▲Pa<1.
=when an infinestimal change in the price of A causes infinity
large change in the purchase of B.
(Eba=ά) i.e. ▲Qb / ▲Pa= ά
= when the price of A Remains almost the same and demand of B
increases.
(Eba=0) i.e. ▲Qb / ▲Pa =0
Formula maybe written as:
Ed= % change in amount demanded Or ▲q/q
% change in price ▲p/p
If percentage for quantity rises are known the
value of coefficient can be calculated, price
elasticity may be unity, greater than unity, less
than unity and 0 or infinity, these five cases
are explain with help of diagram ( see A,B,C,D
and E).
5. Method of measuring elasticity:
 The percentage Method.
 The point Method (Geometrical Method).
 The Arc Method (Geometrical Method).
 The outlay Method.
Income Elasticity: The Ey Expresses the responsiveness of a
consumer’s demand (expenditure or consumption) for any
good X to change in his income, it may be defined as the
percentage change in the quantity demanded of good X to
the percentage change in income.
EY= percentage change in quantity demanded of X
Percentage change in income
Or
▲q/q // ▲y/y = ▲q/q x y/ ▲y = ▲q/ ▲y x y/q = Ey
Promotional Elasticity: It is the knowledge of concept of
elasticity that prompts producer to spend large sums of
money on advertising their products for they know that
advertisement makes the demand for that product less
elastic so that rising the price will not reduce its sales lead
to the concept of promotional elasticity which measure the
responsiveness of sales to change in the advertising and
other promotional expenses the formula for this:
Change in sales / sums of sales multiply by
Sum of promotional expenses / change in promotional
The Point Method: Marshall devised a
geometrical method for measuring elasticity at
a point ion the demand curve this is now as
point elasticity of demand
Formula: Ed= Lower segment / Upper segment
With the help of point method it is easy to point
out the elasticity at any point along the demand
curve.
Suppose that the straight line demand curve DC
in figure F
(See Slide)
Arc elasticity: we have studied the measurement of the
elasticity at a point on demand curve, but when
elasticity is measured b/w two point on the same
demand curve it is now as Arc Elasticity Arc elasticity
is a measure of the average responsiveness to the
price change exhibited by a demand curve over some
finite stretch of the curve- Baumal
Any two points on the demand curve make an arc.
Formula: Ed=q1-q2/q1+q2//p1/p2/p1+p2
Where q1, q2 and p1, p2 are two prices respectively arc
elasticity on figure G (see the Slide) where q=q1-q2
and p=p1-p2 therefore elasticity b/w point B and C is
q/q1+q2//p/p1+p2
Difference in q/sum of q// difference in p/sum of p = Ed
The outlay Method: Marshall evolved the total outlay,
Total revenue or total expenditure method as a
measure of elasticity. By comparing the total
expenditure of a purchaser both before and after the
change in price can be now whether his demand for
good is elastic, unity or less elastic.
Total out lay= price x quantity demanded.
Demand for goods is elastic, when a fall in its price lead
to a larger expenditure on it other wise vice versa.
It is unitary, when
Total expenditure remains un changed with the fall and
Rise in the price of goods.
Demand is inelastic when total expenditure falls, with the
fall in price and rise with the rises in the price.
 The percentage Method
One of the most satisfactory method of measure ment is
to record elasticity as ratio of percentage change in
the amount demanded to the percentage change in
price of commodity
Formula Ed= ▲q / q // ▲p/p = ▲q/qx ▲p/-p =- ▲q/p x
▲p/q
The coefficient of price elasticity of demand is always
negative because when price change the demand
moves in opposite direction. Let us measure Ed with
the aid of formula, suppose that.
Quantity demanded Price
5Kg 10Rs.(Initial price and quantity)
6Kg 6Rs. less elastic.
4kg 12 Rs. Unity
4Kg 11 Rs. More elastic
Cross Elasticity of demand: It is the duration between percentage change in
quantity demanded of a good to percentage change in the price of
related good. The cross
Elasticity of demand b/w good A and B is
Eba = %change in the quantity of B / % change in price of a
i.e. Eba= ▲qb/qb// ▲pa/pa= ▲qb/qb x pa/qb
It can also be measured with the formula of arc elasticity
i.e. Eba= Diff in qb / sum of qb x sum of pa / diff pa.
There are two types of related goods; substitute and Complementry.
Cross elasticity of substitute;
In case of substitutes, if a change in the price of good A leads to more than
proportionate change in demand for good B , the cross E is +ve and
large the higher the coefficient of cross E such goods are close
substitute. (Eba>1)
If change in the price of A causes the same change in the quantity of B.
( Eba=1)
When he quantity demanded of good B changes less than proportionate
change in the price of good A (Eba<1) The goods are poor substitute.
En Change in price of good A has no effect on demand of good B than
(Eba=0)
Unrelated goods – in case two goods are perfectly substitute then (Eba= ά)
It may be –ve if the PA falls, the DA being inelastic, than less of A will be
purchased because it is cheaper, and more of B will be bought.
Income Demand: QD=f (Average income of consumer Y)
The Income- demand relationship is usually direct, the
demand for commodity increases with the rise in income
backward sloping income demand curve (see fig-1)
C. In case of normal goods.
D. In case of inferior goods.
Cross demand: Qd = f (prices of related goods P2…..n)
How the change in price of one effect the demand of other.
Related goods are of two type, substitute and
complimentary.
In case of subs a rise in price of one good A raises the
demand for other good B, the price of B remaining the
same, opposite holds in case of fall the price of A when
demand for B falls so the cross demand curve for
substitute is positively sloping .(See fig 2A)
- In Case of Complementry goods, a rise in the price of one
good A will bring a fall in the demand for B (see fig 2B).
In case of Complementry goods cross demand curve is
negatively sloping.
Elasticity of Demand
Cardinal Approach and Consumer equilibrium:
The theory demand is based in the cardinal
measurement of utility. Utility denotes satisfaction, if
commodity or service satisfies and economics want it
possesses utility if a market A has higher utility than
market B, this ranking indicates that consumer prefer
A over B. utility is subjective pleasure or usefulness
that a person drives from consuming a good and
services.
Economist explain consumer demand by the concept of
utility which denotes relative satisfaction that a
consumer obtained from using different commodities.
In the theory of demand, we say that people maximize
their utility which means that they choose the bundle
of consumption gods that they most preferred.
Ordinal Utility:
Economist to day generally rejected the nation of a cardinal,
measurable utility that is attached to consumption of ordinary
goods like shoes or eggs. We can easily derive demand curve
with out ever mentioning the nation of utility. What counts for
modern demand theory is the principal of ordinal utility.
Under this approach we examine only the preference ranking of
bundle of commodities. Ordinal utility asks” is A preferred to
B” which does not require that we know how much A is
preferred to B --- is called Ordinal or Dimensionless. Ordinal
variable are ones that we can rank in order, but for which
there is no measure of quantity difference between situations.
Equi-Marginal Principal: The fundamental condition of
maximum satisfactory. It states that a consumer having a
fixed income and facing given market prices of goods will
achieve maximum satisfactiom when the marginal utility of last
ripee spent on ech good is exactly the same as the marginal
utility of last rupee spent on any other good. The common
marginal utility per rupee of all commodities in consumer
equilibrium is alled the narginal utility of income.
Assumptions:
 The method of measuring utility is based on a set of
assumptions;
 Consumer must be rational
 Perfect knowledge of choice open to him
 There are no substitute.
 Utility are measurable in term of money.
The theory of consumer demand is based on the cardinal
measurement of utility. How does utility apply to theory of
demand;
e-g Consuming a unit of commodity
as we consumes some additional unit of commodity, we will get
some additional satisfaction or utility --- the increment to one
unit is called Marginal Utility. The expression “marginal” is the
key term in economics and always means extra.
Marginal utility denotes additional unit arising from consumption
of an additional unit of commodity.
Marginal mean extra or incremental utility.
Law of diminishing marginal utility.
A century ago, when economists thought about utility, they
enunciated the law of diminishing marginal utility.
This law states that the amount of extra or marginal utility
declines as a person consume more and more of a
goods.
What is the reason for this law? Utility tends to increase as
you consume more of a good. However, according to
DMU as you consume more and more your total utility
will grow at a slower and slower rate. Growth in total
utility slows because, your marginal utility (the extra
utility added by the last unit consumed of a good)
diminishes as more of a good is consumed.
The law of diminishing marginal utility states that, as the
amount of a good consumed increases the marginal
utility of that good tends to diminish.
 Limitation of law of diminishing marginal utility.
 The law holds under certain conditions;
 A single commodity with homogenous units.
 No change in taste, habit, custom, fashion and income.
 Continuity in consumption.
 Unit of commodity, a suitable size.
 Prices of substitutes, remains the same.
 Indivisible commodity.
 Act rationally.
 Ordinary type commodity.
 The Marshallian demand analysis is based on the
concept of cardinal utility assumes that utility is
measurable and additive.
 It is expressed as a quantity measured in hypothetical
unit which are called “utils”. If a consumer imagines that
one mango has 8 utils and an apple 4 utils, it implies that
the utility of one mango is twice than of an apple.
Equiv. – Marginal Utility:
To use utility theory to explain consumer demand and to
understand the nature of demand curves. For this
purposes, we need to know the condition under which a
consumer most satisfied with the market basket of
consumption goods. We say that consumer attempts to
maximize his utility which means that the consumer
chooses the most preferred bundle of goods from what is
available. Can we see what a rule for such an optimal
decision would be?
Certainly I would not expect that the last egg I am buying
brings exactly the same marginal utility as the last pair of
shoes I am buying , for shoes cost much more per unit
than eggs. A more sensible rule would be; if goods A
cost twice a much as good B, than buy goods A only
when its marginal Utility is at least twice as grate as
good B’s marginal utility. This leads to the Equi-marginal
principal that I should arrange my consumption tit heat
every single goods is ring me the same marginal utility
per rupee of expenditure. So I am attaining maximum
satisfaction from my purchases.
 The Fundamental Condition of consumer
equilibrium can be written in term of marginal
utilities (MUs) and prices (Ps) of different goods
in the following compact way;
MU goods / P1=MU goods2/P2=,…,MUN/PN=MU per Rs.
of income.
e-g we have the example of Quetta market.
Bolan Shop Rs.1000 (35 Essential Items)
Qudusi Shop Rs.1250 (35 Essential Items)
Shaibi Store Rs.1300 (35 Essential Items)
Ahmed Store Rs.1500 (35 Essential Items)
Utility StoreRs.990 (35 Essential Items)
Consumer Income = Rs. 5000 /
month
Equiv. Marginal Utility.
Equation Y=PA x A +PB x B+,………..PN x N
Consumer’s income – 50 rupees
Spent on A+B
40 P X 4 = 1.60
20 P X 4 UTILS = 0.8O
Y= 2.40 maximum satisfaction
Rearrangement – by purchasing one util of apple
he gain 1 x 40 P= 40 util shown by the area
aa,a2,a3 while he losses 40 util of bananas, loss
shown by the area bb1 b2 b3 .
The loss of util
 Equiv. – Marginal Utility

Apple
y Banana

MUA / PA MUB / PA
B3

Gain Loss

A B
A3

B2 B1
A2 A1
X
Unit of A Unit of B
 Q of Good Total Utility Marginal Total Utility
consumed
Utility
12
0 0 0 10

Total Utility
1 4 4 8

2 7 3 4

2
3 9 2 0

4 10 1 0 1 2 3
Quantity consumed
4 5 6

5 10 0 Marginal Utility

6
Utility rises with the consumption
5
Marginal Utility
B. TU rises with consumption, but it rises 4
at a decreasing rate, showing DMU. 3
This observation led early economists 2
to formulate the law of down ward 1
sloping demand. 0
0 1 2 3 4 5 6
C. Show the extra utility added by each Quantity
unit of commodity.
 Geometrical Analysis of
Consumer’s equilibrium:
Pareto developed what are today called indifference
curves:
The modern theory of indifference curves analysis
examines the consumer behavior with that new tool
Indifference curve and its properties.
Indifference Map
Consumer’s equilibrium.
Indifference Curve
 Indifference curve
Start by assuming that you are a consumer who buys
different combinations of two commodities at a given
set of prices. For each combination the two goods,
assume that you prefer one to the other or are
indifferent between the pairs then asked to choose
b/w combination you might.
2. Prefer A to B
3. Prefer B to A
4. Be indifferent b/w A and B
The curved contour of linking up. It is an
INDIFFERENCE CURVE.
The point of the curve represents consumption bundles
among which the consumer is indifferent, all equally
durable.
The level of satisfaction same on all point at IC.
 A Family of ICs which IC is most preferred by the
consumer.
Assumption of IC analysis:
ii. Consumer act rationally.
iii. There are two goods X and Y.
iv. Consumer possesses complete information of prices of
the goods.
v. Prices of two goods are given.
vi. The consumer’s taste, habit, custom & income remain the
same.
vii. ICs are convex to the origin.
viii. He can arrange the two goods in a scale of preference
which means that he has both preference and
indifference.
ix. Both preference and indifference are transitive. If A is
preferable to B and B to C than A is preferable to C.
x. We can order all possible combinations.
Indifference Map
 Budget line or Budget Constraint
Given consumer Y fixed. Rs60/ Day to spend and
he is confronted with fixed prices for each Unit.
It is clear that he could spend his money on any
of the variety of alternative combination .
At one extreme he could buy Good X no unit of
good Y.
Budget Line
The Consumer’s Equilibrium
 The Consumer’s Equilibrium
Consumer equilibrium is attained at the point where the
budget line is tangent to the IC. At that point A, the
consumer’s substitution ratio is Just equal to the slope
of the budget line.
At differently
The substitution ratio or the slope of the IC is the ratio of
the marginal utility of good X to the marginal utility of
Good Y so our tangency condition is just another way
of stating that ratio of price must be equal to the ratio
of marginal utility. i.e.
PY/PX = substitution ratio = MUY/MUX or
In equilibrium, the consumer is getting the same
marginal utility from the last coin spent on Good X on
the last coin spent on Good Y
 Law of Substitution
ICs are drawn as bowl-shaped or convex to the origin, how ever,
as we move down ward and to the right…..a movement that
implies increasing the QX and Decreasing QY.
The curve drawn in a way to illustrate a property which we call “
Law of Substitution”.
Find the slope of resulting line (neglecting its negative sign) has a
values of substitution ratio or some called it
MARGINAL RATE OF SUBSTITUTION.
MRS = ▲Y/ ▲X between two goods.
As the size of movement along the curve becomes very small, the
chooser the substitution ratio comes to the actual slope of the
IC.
The slope of IC if the measure of the goods “relative marginal
utilities”
An IC that is convex to origin conforms to the law of substitution.
 Substitution Effect
On the basis of method of compensating variation, the
substitution effect measures the effect of the change
in relative prices, with income (nominal) constant.
It is assumed that when the price of food falls Y
becomes relatively dearer. The increase in the real
income of consumer, as a result of the fall in the
prices of good X. There is no change in his nominal
income, he is neither better off nor worse off.
Key Points.
4. Nominal Income unchanged.
5. Price of commodity changes.
6. Real income changes.
This is called Substitution effect.
 Substitution Effect
The new optimum
X2 on I3 is at Ec. The
movement from Ea
to Ec is the
substitution effect

Eb
Ea I2
Ec
I3
xa xc X1
Substitution Effect
 Income Effect
Assume first that the consumer’s daily income (Nomianl
income or money Income) is halved while prices of two
commodities remain unchanged.
We should find that new budget line occupies the positon.
The line has made a parallel shift inward. The
consumer now free to move along this new (and lower)
budget line to maximize his satisfaction
Key Points.
4. Nominal Income Changes.
5. Prices of commodities remain unchange.
This is called “ Income effect”.
 Income Effect
The remainder of
X2 the total price effect
is the Income Effect.
The movement from
Ec to Eb.
Eb
Ea I2
Ec
I3
xc xb X1
Income Effect
 Price Effect
Now again return of our consumer to his previous
dally income. But assume that price of good X
rises while the prices of good Y is unchanged.
We must examine the budget line changes its
position from one end. It has pivoted on point I
and rotate from I to I’’ is called price effect.
Key Points
4. Nominal Income remain unchanged.
5. Price of one commodity unchanged.
6. Price of other commodity changes.
7. Real income changes.
 Price Effect
The new optimum is
y
Eb on I2.
The Total Price
Effect is xa to xb

Eb
Ea I2
I1
xa xb X
Price Effect