Economics.

The study of economies and the factors affecting economies is called economics.

The discipline of economics can be broken into two major areas of focus, microeconomics
and macroeconomics.

Microeconomics:

Microeconomics is the branch of economics that analyzes market behavior of individuals and firms in
order to understand their decision-making processes

Microeconomics studies why various goods have different values and how individuals coordinate and
cooperate with each other.

Microeconomics tends to focus on economic tendencies, such as how individual choices and actions
impact changes in production.

Microeconomics in simple words

Microeconomics is the science of how people make decisions at the small scale. It is different from
macroeconomics which looks at how the economy works as a whole "on aggregate". Some parts
of microeconomics include Consumer Theory and Theory of the Firm, which study how people and
businesses make decisions.

What is the purpose of microeconomics?

It studies an individual consumer, producer, manager or a firm, price of a particular commodity or a
household. Microeconomics investigates how individual, rational economic agents (consumers, firms, or
really any entity facing a problem that involves economic quantities) take decisions and tries to derive
mathematical models to describe such decision processes. One goal of microeconomics is to analyze the
market mechanisms that establish relative prices among goods and services and allocate limited
resources among alternative uses. Microeconomics shows conditions under which free markets lead to
desirable allocations. It generally applies to markets of goods and services and deals with
individual and economic issues.

The Use, Importance, Advantage, Limitation or Disadvantage of the Microeconomics which is

very useful for the all economics people or general people also.

Use / Importance or Advantages of Microeconomics.

Micro-economics has many theoretical and practical niches. Due to this even the Neo-classical
economists had concentrated on micro-economics.

 Understand the working of the economy.

 Efficient allocation of resources. ...
 Useful in business decision-making. ...
 Study of human behavior. ...
 Examine conditions of economic welfare. ...
 Formulation of public policies. ...
 Solution of contemporary microeconomic problems.
Limitations / Disadvantages of Microeconomics:
Micro-economics has following Limitations/Disadvantage:
 May not be true in aggregates
 Assumption of full employment unrealistic
 Concentration on small parts

Analyzing Economic Problems:

Economists have sometimes characterized "how" to produce as a "technological problem" of efficiency
whereas the allocation of what is produced is an "economic problem".[1] In a free market, the "how" of
production and allocation of resources is distributed among economic agents. In a centrally planned
economy, a principal decides how and what to produce on behalf of agents. Modern economies are
often welfare capitalist with various regulations, which makes the economic system more equitable
while retaining the distributed free market system.

The economic problem can be divided into three different parts, which are given below.

• What goods and services will be produced, and in what quantities?

• Who will produce the goods and services, and how?

• Who will receive the goods and services?

Microeconomic analysis attempts to answer these questions by studying the behavior of individual
economic units.

By answering questions about how consumers and producers behave, microeconomics helps us
understand the pieces that collectively make up a model of an entire economy. Microeconomic analysis
also provides the foundation for examining the role of the government in the economy and the effects
of government actions. Microeconomic tools are commonly used to address some of the most
important issues in contemporary society. These include (but are not limited to) pollution, rent controls,
minimum wage laws, import tariffs and quotas, taxes and subsidies, food stamps, government housing
and educational assistance programs, government health care programs, workplace safety, and the
regulation of private firms.

What goods and services will be produced, and in what quantities?

The problem of allocation of resources arises due to the scarcity of resources, what to produce and how
much to produce. More production of a good implies more resources required for the production of that
good, and resources are scarce. These two facts together mean that, more production of a desired
commodity can be made possible only by reducing the quantity of resources used in the production of other
goods.
The problem of allocation deals with If the community decides to produce capital goods, resources must be
withdrawn from the production of consumer goods. In the long run, however in capital goods augments the
production of consumer goods. Thus, both capital and consumer goods are important. The problem is
determining the optimal production ratio between the two.
This problem can also be explained with the help of the production possibility curve shown as below

Suppose the economy produces capital goods and consumer goods. In deciding the total output of the
economy, the society has to choose that combination of capital goods and consumer goods which is in
keeping with its resources.
It cannot choose the combination R which is inside the production possibility curve PP1 because it reflects
economic inefficiency of the system in the form of unemployment of resources. Nor can it choose the
combination R which is outside the current production possibilities of the society. The society lacks the
resources to produce this combination of capital goods and consumer goods.
It will, therefore, have to choose among the combinations В or D which give the highest level of satisfaction.
If the society decides to have more capital goods, it will choose combination B; and if it wants more
consumer goods, it will choose combination D.
Who will produce the goods and services, and how?

The allocation of basic consumer goods or necessities and luxuries comforts and among the household
takes place on the basis of among the distribution of national income. Whosoever possesses the means
to buy the goods may have then. A rich person may have a large share of the luxuries goods, and a poor
person may have more quantities of the basic consumer goods he needs. This problem is illustrated in
below graph where the production possibility curve PP shows the combinations of luxuries and
necessaries.
At point В on the PP curve, the economy is producing more of luxuries ОС for the rich and less of
necessaries ОС for the at whereas at point D more of necessaries OH are being produced for the poor
and less of luxuries OF for the rich.

The basic problem of an economy is to decide about the techniques or methods to be used in order to
produce the required goods. This problem is primarily dependent upon the availability of resources
within the economy. If land is available in abundance, it may have extensive cultivation. If land is scarce,
intensive methods of cultivation may be used. If labour is in abundance, it may use labour-intensive
techniques; while in the case of labour shortage, capital-intensive techniques may be used.

The technique to be used also depends upon the type and quantity of goods to be produced. For
producing capital goods and large outputs, complicated and expensive machines and techniques are
required. On the other hand, simple consumer goods and small outputs require small and less expensive
machines and comparatively simple techniques. Further, it has to be decided what goods and services
are to be produced in the public sector and what goods and services in the private sector. But in
choosing between different methods of production, those methods should be adopted which bring
about an efficient allocation of resources and increase the overall productivity in the economy.

Suppose the economy is producing certain quantities of consumer and capital goods at point A on PP
curve . у adopting new techniques of production, given the supplies of factors, the productive efficiency
of the economy increases. As a result, the PP0 curve shifts outwards to P1P1.
It leads to the production of more quantities of consumer and capital gods from point A on PP0 curve to
point С of PP with be the new production possibility curve and the economy will move from point A to В
where more of both the goods are produced.

Who will receive the goods and services?

The last and the most important problem is to find out whether the economy is growing through time or
is it stagnant. If the economy is stagnant at any point inside the production possibility curve, says in
Figure 5, it has to be moved on to the production possibility curve PP whereby the economy now
produces larger quantities of consumer goods and capital goods. Economic growth takes place through a
higher rate of capital formation which con-sists of replacing existing capital goods with new and more
productive ones by adopting more efficient production techniques or through innovations. This leads to
the outward shifting of the production possibility curve from PP to P1P1.
 The economy moves, say after 5 years, from point A to В or С or D on the P1P1 curve. Point С
represents the situation where larger quantities of both consumer and capital goods are produced in the
economy. Economic growth enables the economy to have more of both the goods.

Conclusion
All these central problems of an economy are interrelated and interdependent. They arise from the
fundamental economic problems of scarcity of means and multiplicity of ends which lead to the problem
of choice or economizing of resources.

Analytical tools for economic problems.

Economic theories are formulated to explain different phenomenon. They try to explain the relationship
between two or more variables. While formulating theories a number of tools are used by experts in this
field.

The tools of economic analysis are found in the realm of Mathematics. Mathematics is being profusely
used in modern economic analysis. Mathematics is regarded as the second language for the students of
economics.

Geometry is being increasingly resorted to in order to provide pictorial presentation of economic

behavior. Diagrams and Graphs provide visual impact and help to grasp and learn economics with
interest and ease. A Chinese proverb says “A picture is worth a thousand words”.

In brief, get acquainted with the terms such as Variables, Ceteris Paribus, Functions, Equations,
Identities, Graphs and Diagrams, Lines and Curves, Slopes, Limits and Derivatives, Time Series and so on.
These are the basic tools of economic analysis.

VARIABLES

Variables play an important role in economic theories and models. A variable is a magnitude of interest
can be defined and measured. In other words a variable is something whose magnitude can change. It
assumes different values at different times or places. Variables that are used in economics are income,
expenditure, saving, interest, profit, investment, consumption, imports, exports, cost and so on. It is
represented by a symbol.
CETERIS PARIBUS

Ceteris paribus is a Latin phrase meanings, “all other things remaining the same” or all relevant factors
being equal. In Economics the term “Ceteris Paribus” is used quite often to assume all other factors to
remain the same, while analyzing the relationship between any two variables.
Ceteris Paribus is an assumption which we are compelled to make due to complexities in the reality. It is
necessary for the sake of convenience. The limitations of human intelligence and capacity compel us to
make this assumption. Besides, without the assumption we cannot reach on economic relations,
sequences and conclusions. In fact, there are large numbers of variables interacting simultaneously at a
given time. If our analysis has to be accurate we may have to examine two variables at a time which
makes it inevitable to assume other variables to remain unchanged.
For instance, if we try to establish the relationship between demand and price, there may be other
variables which may also influence demand besides price. The influence of other factors may invalidate
the hypothesis that quantity demanded of a commodity is inversely related to its price. If rise in price
takes place along with an increasing in income or a change technology, then the effect of price change
may not be the same. However, we try to eliminate the interrupting influences of other variables by
assuming them to remain unchanged.
The assumption of Ceteris Paribus thus eliminates the influence of other factors which may get in the
way of establishing a scientific statement regarding the behavior of economic variables.

FUNCTION
A 'function' explains the relationship between two or more economic variables. A simple technical term
is used to analyze and symbolizes a relationship between variables. It is called a function. It indicates
how the value of dependent variable depends on the value of independent or other variables. It also
explains how the value of one variable can be found by specifying the value of other variable.
For instance, economist generally links demand for good depends upon its price.
It is expressed as D = f (P). Where D = Demand, P = Price and f = Functional relationship.
Functions are classifieds into two type namely explicit function and implicit function. Explicit function is
one in which the value of one variable depends on the other in a definite form. For instance, the
relationships between demand and price Implicit function is one in which the variables are
interdependent.

EQUATIONS
Economic theory is a verbal expression of the functional relationships between economic variables.
When the verbal expressions are transformed into algebraic form we get Equations. The term equation
is a statement of equality of two expressions or variables. The two expressions of an equation are called
the sides of the equation. Equations are used to calculate the value of an unknown variable. An equation
specifies the relationship between the dependent and independent variables. Each equation is a concise
statement of a particular relation.
For example, the functional relationship between consumption (C) and income (Y) can take different
forms. The most simple equation; C = a (Y) states that consumption (C) is related to income (Y). It says
nothing about the form that this relation takes.
Here ‘a’ is constant and it has a value greater than zero but less than one (0<a<1). Thus the equation
shows that C is a constant proportion of income. For instance, if ‘a’ is 1/2then the consumer would
always spend 50% of the income on consumption. The equation shows that if income is zero,
consumption will also be zero.

IDENTITIES
An identity explains an equilibrium condition or a definitional condition. A definitional identity explains
that two alternative expressions have exactly the same meaning. For example, total profit is defined
as the excess of total revenue over total cost, and we can denote as:
π ≡ TR - TC
Where π is total profit, TR is total revenue and TC is total cost.
Similarly, saving is defined as the difference between income and consumption expenditure and we
can say;
S≡ Y-C
You are required to note that an identity is denoted by a three - bar sign (≡).
The distinction between an identity and an equation is very subtle and important. An identity is a
relation that is true for all values of the variables; no values can be found that will contradict it. For
instance, (x + y)2 = x2 + 2xy + y2 is an expression which is true for any numerical value of x and y.
Identities are statements that are compatible with any state of the universe. In case of National
Income accounting we have an important identity between National Income (Y) ≡ National Output
(O) ≡ National Expenditure (E)
Hence; Y ≡ O ≡ E
Identities are mere “truisms”, they cannot form the basis of any theory.

GRAPHS AND DIAGRAMS

A graph or a diagram presents the relationship between two or more sets of data or variables
that are related to one another. Graph is most commonly used tool in modern economics. Graph
depicts the functional relationship between two or more economic variables. The use of graph
provides a better understanding of the economic generalizations. Graph presents a visual picture of
an abstract idea. Also it is useful for accuracy and precision.
Graph can be drawn only two dimensional figures on a plain paper. It represents the values of only
two variables at a time. The common method of constructing a graph or a diagram is
described below:
A graph has a horizontal line termed as X axis and a vertical line termed as Y axis. The point of
intersection between X and Y axis is termed as 'origin' point.
The surface is divided into four parts; each part is called a quadrant. The four quadrants are
numbered in anticlockwise direction as depicts in following diagram.
The first quadrant depicts the positive values of both X and Y. It is called positive quadrant.
Generally, economic theories are deals with the positive quadrants.
At times the terms “Graph” and “Diagram” are used interchangeably. Diagrams, like graphs, are
pictorial presentations. Diagrams may be in the form of figures such as explaining the circular flow of
national income. Graphs are quite meticulous whereas diagrams can be based on abstraction. For
instance, Pie diagram is a best example of a diagram that indicates through slicing the percentage-
wise composition of a phenomenon, such as how much percentage of national income is generated
from which sector of the economy.

LINES AND CURVES

The functional relationship between the variables may be linear or non-linear. A line or a curve is
nothing but the locus of various points. A line depicts the relationship between the variables. For
example, the relationship between consumption and income as shown in the following diagram:

Line CC1 is a straight line and has a positive slope. It depicts that aggregate consumption is positively
related to aggregate disposable income. It explains that, an increase in disposable income will promote
to an increase in consumption. Many economists try to set up the relationship between economic
variables in different ways. One of the most popular and easy method is through curves. A nonlinear
function of graph is depicted in terms of curve. Let us consider the following curves.
In the following diagram,DD1 is a smooth downward sloping nonlinear demand curve. It explains the
relationship between quantity demanded of good X at various prices. Moreover, SS1 is an upward
sloping supply curve. It is also a non-linear curve and shows relationship between quantity supplied of
good X at various prices.

SLOPE
Slope is an important term in modern economic analysis. The slope indicates change in one variable due
to a change in other variable. Slope is defined as the amount of change in the variable measured on the
vertical or Y axis per unit change in the variable measured on the horizontal or X axis. It is expressed
as ∆Y/∆X, where delta (∆) stands for a change in the variable. The slope of a curve is an exact numerical
measure of the relationship between the change in the variable Y to change the variable X.
Slope is also popularly termed as ‘the rise over the run’. Here rise is the vertical distance while run is the
horizontal distance. The measurement of slope can be shown as follows:

In both the diagrams (A) and (B) slope = vertical distance/horizontal distance. i. e. CD / BC. However, in
diagram (A), slope is negative as the relationship between X and Y is inverse. Here units of Y decrease
with increase in the units of X. In Diagram (B) the curve is slopping upwards, indicating a positive
relationship between X and Y. Here units of Y increase with increase in the units of X.
If the curve is non-linear, then its slope changes at various points. Slope on a non-linear curve is
measured at a given point by drawing a tangent at the given point and is then measured as the vertical
distance/horizontal distance. This is shown in the following diagram with a non-linear curve. We
measure slope at point 'a' by drawing a tangent at point 'a'. Y1X1 is the tangent drawn at point 'a'. Slope
of the curve at point 'a' is given as 0Y1/0X1

The main properties of slope are:

i) It can be numerically measured.
ii) In case of a straight line, the slope is constant throughout the curve.
iii) In case of a non-linear curve, the slope changes throughout the curve.
iv)The nature of the relationship between two variables can be indicated with the help of slope. If the
slope is negative then it indicates inverse relationship between the two variables and if the slope is
positive, it indicates direct relationship.

Demand and Supply Analysis

Demand and supply analysis is the study of how buyers and sellers interact to determine transaction
prices and quantities. Prices simultaneously reflect both the value to the buyer of the next (or marginal)
unit and the cost to the seller of that unit. In private enterprise market economies, which are the chief
concern of investment analysts, demand and supply analysis encompasses the most basic set of
microeconomic tools.

Microeconomics classifies private economic units into two groups: consumers (or households) and firms.
These two groups give rise, respectively, to the theory of the consumer and theory of the firm as two
branches of study. The theory of the consumer deals with consumption (the demand for goods and
services) by utility-maximizing individuals (i.e., individuals who make decisions that maximize the
satisfaction received from present and future consumption). The theory of the firm deals with the
supply of goods and services by profit-maximizing firms. The theory of the consumer and the theory of
the firm are important because they help us understand the foundations of demand and supply.
Subsequent readings will focus on the theory of the consumer and the theory of the firm.

Demand
In economics, demand is the quantity of a good that consumers are willing and able to purchase at
various prices during a given period of time

Law of Demand
The law of demand states that, if all other factors remain equal, the higher the price of a good, the less
people will demand that good. In other words, the higher the price, the lower the quantity demanded.
The amount of a good that buyers purchase at a higher price is less because as the price of a good goes
up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a
product that will force them to forgo the consumption of something else they value more.

A good’s own price is important in determining consumers’ willingness to purchase it, other variables
also have influence on that decision, such as consumers’ incomes, their tastes and preferences, the
prices of other goods that serve as substitutes or complements, and so on. Economists attempt to
capture all of these influences in a relationship called the demand function. In general, a function is a
relationship that assigns a unique value to a dependent variable for any given set of values of a group of
independent variables.

Demand Curve
The demand curve is a representation of the correlation between the price of a good or service and the
amount demanded for a period of time

In economics, a demand curve is a graph depicting the relationship between the price of a certain
commodity (the y-axis) and the quantity of that commodity that is demanded at that price (the x-axis).
Demand curves may be used to model the price-quantity relationship for an individual consumer (an
individual demand curve), or more commonly for all consumers in a particular market (a market demand
curve).

It is generally assumed that demand curves are downward-sloping, as shown in the below

This is because of the law of demand: for most goods, the quantity demanded will decrease in response to an
increase in price, and will increase in response to a decrease in price.

MOVEMENT IN DEMAND CURVE

Movement in the demand curve is when the commodity experience change in both the quantity
demanded and price, causing the curve to move in a specific direction.

Movement in Demand Curve

Shift in Demand Curve

The shift in the demand curve is when, the price of the commodity remains constant, but there is a
change in quantity demanded due to some other factors, causing the curve to shift to a particular side
Shift in Demand Curve

SUPPLY

Supply is a fundamental economic concept that describes the total amount of a specific good or
service that is available to consumers

Law Of Supply

The law of supply is the microeconomic law that states that, all other factors being equal, as the price of
a good or service increases, the quantity of goods or services that suppliers offer will increase, and vice
versa. The law of supply says that as the price of an item goes up, suppliers will attempt to maximize
their profits by increasing the quantity offered for sale.

The law of supply says that a higher price will induce producers to supply a higher quantity to the
market. Supply in a market can be depicted as an upward sloping supply curve that shows how the
quantity supplied will respond to various prices over a period of time. Because businesses seek to
increase revenue, when they expect to receive a higher price, they will produce more.

The law of supply using a supply curve, which is upward sloping. A, B and C are points on the supply
curve. Each point on the curve reflects a direct correlation between quantity supplied (Q) and price (P).
So, at point A, the quantity supplied will be Q1 and the price will be P1, and so on.

The supply curve is upward sloping because, over time, suppliers can choose how much of their goods to
produce and later bring to market. At any given point in time however, the supply that sellers bring to
market is fixed, and sellers simply face a decision to either sell or withhold their stock from a sale;
consumer demand sets the price and sellers can only charge what the market will bear. If consumer
demand rises over time, the price will rise, and suppliers can choose devoted new resources to
production (or new suppliers can enter the market) which increases the quantity supplied. Demand
ultimately sets the price in a competitive market, supplier response to the price they can expect to
receive sets the quantity supplied.

Consumer Preference And The Concept Of Utility

Consumer preferences are defined as the subjective (individual) tastes, as measured by utility, of various
bundles of goods. They permit the consumer to rank these bundles of goods according to the levels of
utility they give the consumer. Ability to purchase goods does not determine a consumer's likes or
dislikes.

Consumer preference is crucial to Microeconomics. Concepts such as utility, budget line, indifference
curve

Concept Of Utility

Utility refers to the degree of removed discomfort or perceived satisfaction that an individual receives
from an economic act for example; a consumer purchases a hamburger to alleviate hunger pangs and to
enjoy a tasty meal.

All economists would agree that the consumer has gained utility by eating the hamburger. Most
economists would agree that human beings are, by nature, utility-maximizing agents; human beings
choose between one act or another based on each act's expected utility. The controversial part comes in
the application and measurement of utility.

The development of utility theory begins with a logical deduction. Voluntary transactions only occur
because the trading parties anticipate a benefit (ex-ante); the transaction wouldn't happen otherwise. In
economics, "benefit" means receiving more utility.

Economists also say that human beings rank their activities based on utility. A laborer chooses to go to
work rather than skip it because he anticipates his long-run utility to be greater as a result. A consumer
who chooses to eat an apple rather than an orange must value the apple more highly, and thus
anticipates more utility from it.

Ordinal Utility and Cardinal Utility

The ranking of utility is known as an ordinal utility. It is not a controversial topic; however, most
microeconomic models also use cardinal utility, which refers to measurable, directly comparable levels
of utility. The ordinal utility might say that, ex-ante, the consumer prefers the apple to the orange.

Cardinal utility is measured in utils to transform the logical to the empirical. Cardinal utility might say
that the apple provides 80 utils while the orange only provides 40 utils.
Even though no economist truly believes that utility can be measured this way, some still consider utility
a useful tool in microeconomics. Cardinal utility places individuals on utility curves and can track
declines in marginal utility across time. Microeconomics also performs interpersonal comparisons with
cardinal utility.

How to Measure Utility?

According to classical economists, utility can be measured, in the same way, as weight or height is
measured. For this, economists assumed that utility can be measured in cardinal (numerical) terms. By
using cardinal measure of utility, it is possible to numerically estimate utility, which a person derives
from consumption of goods and services. But, there was no standard unit for measuring utility. So, the
economists derived an imaginary measure, known as ‘Util’.

Utils are imaginary and psychological units which are used to measure satisfaction (utility) obtained
from consumption of a certain quantity of a commodity.

Total Utility (TU):

Total utility refers to the total satisfaction obtained from the consumption of all possible units
of a commodity. It measures the total satisfaction obtained from consumption of all the units of
that good. For example, if the 1st ice-cream gives you a satisfaction of 20 utils and 2nd one
gives 16 utils, then TU from 2 ice-creams is 20 + 16 = 36 utils. If the 3rd ice-cream generates
satisfaction of 10 utils, then TU from 3 ice-creams will be 20+ 16 + 10 = 46 utils.

TU can be calculated as: TUn = U1 + U2 + U3 +……………………. + Un

Where:

TUn = Total utility from n units of a given commodity

U1, U2, U3,……………. Un = Utility from the 1st, 2nd, 3rd nth unit

n = Number of units consumed

Marginal Utility (MU):

Marginal utility is the additional utility derived from the consumption of one more unit of the given
commodity. It is the utility derived from the last unit of a commodity purchased. As per given example,
when 3rd ice-cream is consumed, TU increases from 36 utils to 46 utils. The additional 10 utils from the
3rd ice-cream is the MU.

In the words of Chapman, “Marginal utility is addition made to total utility by consuming one more
unit of a commodity”.
MU can be calculated as: MUn = TUn – TUn-1

Where: MUn = Marginal utility from nth unit; TUn = Total utility from n units;

TUn-1 = Total utility from n – 1 units; n = Number of units of consumption

MU of 3rd ice-cream will be: MU3 = TU3 – TU2 = 46 – 36 = 10 utils One More way to Calculate MU

MU is the change in TU when one more unit is consumed. However, when change in units consumed is
more than one, then MU can also be calculated as:

ATU

MU = Change in Total Utility/ Change in number of units = ∆TU/∆QPerfect

Substitutes

In some cases of consumption, a two-good (X and Y) consumer may prefer to substitute one of the
goods, say, X, for the other good Y at a constant rate, to keep his level of utility constant, i.e., MRSX,Y =
constant. For example, he may always want to substitute one red pencil for one blue pencil, to keep
him-self on the same indifference curve (IC).

In this case, naturally, his level of utility would depend on the total number of pencils, not on how many
of the pencils are red and how many of them are blue, provided the consumer has no fascination for any
particular colour. Therefore, his utility function may be written as: U = x + y

where x and y are, respectively, the number of red and blue pencils.

Perfect complements
Perfect complements are goods which only provide utility or happiness when they are consumed
together. They are an extreme case of complementary goods, which are goods which complement other
goods (fries and ketchup are an example of complements). Perfect complements are different from
normal complementary goods in that they only provide utility if consumed together whereas you can
consume complements individually. The best way to think of perfect complement is "has to be
consumed together, otherwise, they provide you with no happiness".

Examples of perfect complements

Left and right shoes , Portable gaming devices and batteries , Computers and operating systems

Consider our left and right shoe example. We typically want to consume shoes in a 1:1 ratio.
 In the above case, we see that U = min(Good 1, Good 2) which says "our utility equals whichever value
is smaller between good 1 or good 2". The blue curve represents the indifference curve and is an "L"
shape. It takes on the "L" shape because given we consume only one unit of good 2, it does not matter
how many units of good 1, we will still only receive one unit of utility. We can see that from the diagram.
If we consume 1 unit of both, U = min(1,1) and the minimum value of 1 and 1 is 1. Now suppose that we
increase our consumption of good 1 to 2 units whilst leaving consumption of good 2 at 1 unit. The utility
now equals min(1,2) and the minimum value of 1 or 2 is still 1, so our utility does not change and
remains at 1.

Consumer choice
The theory of consumer choice is the branch of microeconomics that relates preferences to
consumption expenditures and to consumer demand curves. It analyzes how consumers maximize the
desirability of their consumption as measured by their preferences subject to limitations on their
expenditures, by maximizing utility subject to a consumer budget constraint

When economists talk about consumer choice, what they are referring to is the combination of goods
and services a consumer purchases. To understand how a household will make its choices, economists
look at what consumers can afford, as shown in a budget constraint (or budget line), and the total utility
or satisfaction derived from those choices. When we graph a budget constraint, the quantity of one
good is on the horizontal axis and the quantity of the other good on the vertical axis. The budget
constraint line shows the various combinations of two goods that are affordable given a specific budget
(or level of consumer income).

Consider José’s situation. José likes to collect T-shirts and watch movies. In Figure 1 we show the
quantity of T-shirts on the horizontal axis while we show the quantity of movies on the vertical axis. If
José had unlimited income or goods were free, then he could consume without limit. However, José, like
all of us, faces a budget constraint. José has a total of $56 to spend. The price of T-shirts is $14 and the
price of movies is $7. Notice that the vertical intercept of the budget constraint line is at eight movies
and zero T-shirts ($56/$7=8). The horizontal intercept of the budget constraint is four, where José
spends of all of his money on T-shirts and no movies ($56/14=4). The slope of the budget constraint line
is rise/run or –8/4=–2. The specific choices along the budget constraint line show the combinations of
affordable T-shirts and movies.
Advantages of Consumer Choice Theory
Building a better understanding of individuals' tastes and incomes is important because it has a big
bearing on the demand curve, the relationship between the price of a good or service and the quantity
demanded for a given period of time, and the shape of the overall economy.

Consumer spending drives a significantly large chunk of gross domestic product (GDP) in the U.S. and
other nations. If people cut down on purchases, demand for goods and services will fall, squeezing
company profits, the labor market, investment, and many other things that make the economy tick.

Consumer choice theory is taken very seriously, influencing everything from government policy to
corporate advertising.

Limitations of Consumer Theory

Challenges to developing a practical formula for this situation are numerous. For instance, as behavioral
economics points out, people are not always rational and are occasionally indifferent to the choices
available. Some decisions are particularly difficult to make because consumers are not familiar with the
products. There could also be an emotional component involved in the decision-making process that
isn't able to be captured in an economic function.

The many assumptions that consumer theory makes means it has come under heavy criticism. While its
observations may be valid in a perfect world, in reality there are numerous variables that can expose the
process of simplifying spending habits as flawed.

Going back to the example of Kyle, figuring out how he will spend his $200 is not as clear-cut as it might
at first seem. Economics assumes he understands his preferences for pizza and video games and can
decide how much of each he wants to purchase. It also presumes there are enough video games and
pizzas available for Kyle to choose the quantity of each he desires.

Consumer Choice: Budget Constraints

Preferences do not explain all of consumer behavior. There are probably a lot of other factors as well.
Budget constraints also limit an individual’s ability to consume in light of the prices they must pay for
various goods and services. In other words, a consumer needs to select the best possible goods or
market basket in the limited income that it has.

By the title Budget Constraint, mean “the constraints that consumers face as a result of limited
Income”

Budget Line:
A budget line is all the possible combinations of of goods for which the total amount of money spent is
equal to income.

Let us explain the definition by an example: Let F equal the amount of food purchased, and C is the
amount of clothing:

Price of food = Pf

Price of clothing = PC

Then PfF is the amount of money spent on food, and PCC is the amount of money spent on clothing.

The Budget line than can be written:

All income is allocated to food (F) and/or clothing (C) . If we look at the definition it says in the last
phrase as “TOTAL AMOUNT OF MONEY SPENT IS EQUAL TO INCOME” which we can see in the above
equation of the budget line after the combination of Food and clothing.

Example: Assume income of $80/week

PF = $1

PC = $2

Using the above data in graphical Analysis we have:

Interpretation of the Graph:
The vertical intercept, I/PC, illustrates the higher amount of C that can be bought with income I. The
horizontal intercept, I/PF, illustrates the high amount of F that can be bought with income I.
As consumption moves along with the budget line from the level intercept, the consumer spends less on
one item and more on the other.(Obviously you wont prefer being naked for the sake of food. You
would certainly forgo less and less of clothing to acquire the additional unit of Food).
Additionally, the slope of the line measures the relative cost of food and clothing. Furthermore, the
slope is the negative of the ratio of the prices of two goods.The slope indicates the rate at which the
two goods can be substituted without changing the amount of money spent on both of them.

Understanding Demand Theory

Demand is simply the quantity of a good or service that consumers are willing and able to buy at a given
price in a given time period. People demand goods and services in an economy to satisfy their wants,
such as food, healthcare, clothing, entertainment, shelter, etc. The demand for a product at a certain
price reflects the satisfaction that an individual expects from consuming the product. This level of
satisfaction is referred to as utility and it differs from consumer to consumer. The demand for a good or
service depends on two factors: (1) its utility to satisfy a want or need, and (2) the consumer’s ability to
pay for the good or service. In effect, real demand is when the readiness to satisfy a want is backed up
by the individual’s ability and willingness to pay.

Demand theory is one of the core theories of microeconomics. It aims to answer basic questions about
how badly people want things, and how demand is impacted by income levels and satisfaction (utility).
Based on the perceived utility of goods and services by consumers, companies adjust the supply
available and the prices charged.

The demand curve has a negative slope as it charts downward from left to right to reflect the inverse
relationship between the price of an item and the quantity demanded over a period of time. An
expansion or contraction of demand occurs as a result of the income effect or substitution effect. When
the price of a commodity falls, an individual can get the same level of satisfaction for less expenditure,
provided it’s a normal good. In this case, the consumer can purchase more of the goods on a given
budget. This is the income effect. The substitution effect is observed when consumers switch from more
costly goods to substitutes that have fallen in price. As more people buy the good with the lower price,
demand increases.
Sometimes, consumers buy more or less of a good or service due to factors other than price. This is
referred to as a change in demand. A change in demand refers to a shift in the demand curve to the
right or left following a change in consumers’ preferences, taste, income, etc. For example, a consumer
who receives an income raise at work will have more disposable income to spend on goods in the
markets, regardless of whether prices fall, leading to a shift to the right of the demand curve.

The law of demand is violated when dealing with Giffen or inferior goods. Giffen goods are inferior
goods that people consume more of as prices rise, and vice versa. Since a Giffen good does not have
easily available substitutes, the income effect dominates the substitution effect.

Income Effect
The income effect is the change in consumption patterns due to a change in purchasing power. This
occurs with income increases, price changes, and even currency fluctuations. Since income is not a good
in and of itself (it can only be exchanged for goods and services), price decreases increase purchasing
power.
In microeconomics, the income effect is the change in demand for a good or service caused by a change
in a consumer's purchasing power resulting from a change in real income. This change can be the result
of a rise in wages etc., or because existing income is freed up by a decrease or increase in the price of a
good that money is being spent on.

The income effect is a part of consumer choice theory—which relates preferences to consumption
expenditures and consumer demand curves—that expresses how changes in relative market prices and
incomes impact consumption patterns for consumer goods and services. For normal economic goods,
when real consumer income rises, consumers will demand a greater quantity of goods for purchase.

The income effect and substitution effect are related economic concepts in consumer choice theory. The
income effect expresses the impact of changes in purchasing power on consumption, while the
substitution effect describes how a change in relative prices can change the pattern of consumption of
related goods that can substitute for one another.

The Income Effect and Changes in Demand

Changes in real income can result from nominal income changes, price changes, or currency
fluctuations. When nominal income increases without any change to prices, this makes consumers able
to purchase more goods at the same price, and for most goods consumers will demand more.

If all prices fall, known as deflation and nominal income remains the same, then consumer’s nominal
income can purchase more goods, and they will generally do so. These are both relatively
straightforward cases. However in addition, when the relative prices of different goods change, then the
purchasing power of consumer’s income relative to each good changes and the income effect really
comes into play. The characteristics of the good will impact whether income effect results in a rise or fall
in demand for the good

When the price of a good increases relative to other similar goods, consumers will tend to demand less
of that good and increase their demand for the similar goods to substitute.

Normal goods are those whose demand increases as people's incomes and purchasing power rise. A
normal good is defined as having an income elasticity of demand coefficient that is positive, but less
than one. For normal goods, the income effect and the substitution effect both work in the same
direction; a decrease in the relative price of the good will result in an increase in quantity demanded
both because the good is now cheaper than substitute goods, and because the lower price means that
consumers have a greater total purchasing power and can increase their overall consumption.

Inferior goods are goods for which demand declines as consumers real incomes rise, or rises as incomes
fall. This occurs when a good has more costly substitutes that see an increase in demand as the society's
economy improves. For inferior goods, income elasticity of demand is negative, and the income and
substitution effects work in opposite directions.

An increase in the inferior good’s price means that consumers will want to purchase other substitute
goods instead but will also want to consume less of any other substitute normal goods because of their
lower real income

Inferior goods tend to be goods that are viewed as lower quality, but can get the job done for those on a
tight budget, for example, generic bologna or coarse, scratchy toilet paper. Consumers prefer a higher
quality good, but need a greater income to allow them to pay the premium price.

Example of Income Effect

For example, consider a consumer who on an average day buys a cheap cheese sandwich to eat for
lunch at work, but occasionally splurges on a luxurious hot dog. If the price of a cheese sandwich
increases relative to hotdogs, it may make them feel like they cannot afford to splurge on a hotdog as
often because the higher price of their everyday cheese sandwich decreases their real income.

In this situation, the income effect dominates the substitution effect, and the price increase raises
demand for the cheese sandwich and reduces demand for a substitute normal good, a hotdog, even if
the hotdog's price remains the same.

Substitution Effect

The substitution effect is the decrease in sales for a product that can be attributed to consumers
switching to cheaper alternatives when its price rises.

A product may lose market share for many reasons, but the substitution effect is purely a reflection of
frugality. If a brand raises its price, some consumers will select a cheaper alternative. If beef prices rise,
many consumers will eat more chicken.

The substitution effect is not seen only in consumer behavior. A manufacturer faced with a
price hike for an essential component may switch to a cheaper version produced by a foreign
competitor. In general, when the price of a product or service increases but the buyer's income
stays the same, the substitution effect kicks in.
When Prices Decrease
As noted, when a product price increases consumers tend to drop it for a cheaper alternative. The can
turn into an endless game of supply and demand. Steak prices rise, so consumers substitute pork.
Demand for steak declines, so its price drops. Consumers return to buying steak. This does not mean
only that consumers chase a bargain. Consumers make their choices based on their overall spending
power and make constant adjustments based on price changes. They strive to maintain their living
standards despite price fluctuations.

The Substitution Effect and Inferior Goods

As illogical as it seems, the substitution effect may not be seen when the products that increase in price
are inferior in quality. In fact, an inferior product that rises in price may actually enjoy a sales increase.
Products that display this phenomenon are called Giffen goods, after a Victorian economist who first
observed it. Sir Robert Giffen noted that cheap staples such as potatoes will be purchased in greater
quantities if their prices rise. He concluded that people on extremely limited budgets are forced to buy
even more potatoes because their increasing price places other higher-quality staples altogether out of
their reach. Substitute goods may be adequate replacements or inferior goods. Demand for an inferior
good will increase when overall consumer spending power falls.

Income Effect vs. Substitution Effect:

The income effect expresses the impact of increased purchasing power on consumption, while
the substitution effect describes how consumption is impacted by changing relative income and prices.
These economics concepts express changes in the market and how they impact consumption patterns
for consumer goods and services.

Different goods and services experience these changes in different ways. Some products, called inferior
goods, generally decrease in consumption whenever incomes increase. Consumer spending and
consumption of normal goods typically increases with higher purchasing power, which is in contrast with
inferior goods.

Consumer surplus
Consumer surplus is an economic measurement of consumer benefits. Consumer surplus happens when
the price that consumers pay for a product or service is less than the price they're willing to pay. A
consumer surplus occurs when the consumer is willing to pay more for a given product than the current
market price.

Many producers are influenced by consumer surplus when they set their prices.

The Basics of a Consumer Surplus

The concept of consumer surplus was developed in 1844 to measure the social benefits of public
goods such as national highways, canals, and bridges. It has been an important tool in the field
of welfare economics and the formulation of tax policies by governments.
Consumer surplus is based on the economic theory of marginal utility, which is the additional
satisfaction a consumer gains from one more unit of a good or service. The utility a good or service
provides varies from individual to individual based on their personal preference. Typically, the more of a
good or service that consumers have, the less they're willing to spend for more of it, due to the
diminishing marginal utility or additional benefit they receive.

Economic welfare is also called community surplus, or the total of consumer and producer surplus.

Measuring Consumer Surplus With a Demand Curve

The demand curve is a graphic representation used to calculate consumer surplus. It shows the
relationship between the price of a product and the quantity of the product demanded at that price,
with price drawn on the y-axis of the graph and quantity demanded, drawn on the x-axis. Because of the
law of diminishing marginal utility, the demand curve is downward sloping.

Consumer surplus is measured as the area below the downward-sloping demand curve, or the amount a
consumer is willing to spend for given quantities of a good, and above the actual market price of the
good, depicted with a horizontal linedrawn between the y-axis and demand curve.

Consumer surplus can be calculated on either an individual or aggregate basis, depending on if the
demand curve is individual or aggregated. Consumer surplus always increases as the price of a good falls
and decreases as the price of a good rises.

For example, suppose consumers are willing to pay $50 for the first unit of product A and $20 for the
50th unit. If 50 of the units are sold at $20 each, then 49 of the units were sold at a consumer surplus,
assuming the demand curve is constant.

Consumer surplus is zero when the demand for a good is perfectly elastic. But demand is perfectly
inelastic when consumer surplus is infinite.

Real World Example of a Consumer Surplus

Consumer surplus is the benefit or good feeling of getting a good deal. For example, let's say that you
bought an airline ticket for a flight to Disney during school vacation week for $100, but you were
expecting and willing to pay $300 for one ticket. The $200 represents your consumer surplus.

However, businesses know how to turn consumer surplus into producer surplus or for their gain. In our
example, let's say the airline realizes your surplus and as the calendar draws near to school vacation
week, they raise their ticket prices to $300 each.

The airline knows there'll be a spike in demand for travel to Disney during school vacation week and that
consumers will be willing to pay higher prices. So by raising the ticket prices, the airlines are taking
consumer surplus and turning into producer surplus or additional profits.