Adam Smith

Definition:
Adam Smith (Father of Economics) in his book “An enquiry into the nature and
causes of wealth of nations” defined economics as the ‘Science of Wealth’.

• According to him, economics studies the nature of wealth and the laws which governs its
production, distribution and exchange.
• In short, it studies how wealth is produced and spent.

✓ He also said that Political economy has 2 aspects:

1. To provide plentiful income to the people
2. To supply the state with enough revenue for public services.
✓ These 2 aspects can enrich the people and sovereign.

✓ Many other classical economists like J.B. Say, John Stuart Mill, Walker, J.E. Cairnes also
described economics in terms of wealth aspect.

Criticism:
Many economists, philosophers & intellectuals like Ruskin, Carlyle, Russel,
Edgeworth and Jevons criticized the views of classical economists.

The following are some points of Criticism:

1. Makes Economics a dark and dismal science:

• Acquisition of wealth and how to get rich at whatever cost will become the subject
matter of economics.
• It rises selfishness, greediness and worship of goddess of wealth.
• Carlyle called it a ‘pig science’.
• Thus, the emphasis on wealth acquisition made economics a dark and dismal science.

2. Narrow view of wealth:

Classical economists thought that the economics is concerned with earning and
spending of money. But money is not only the wealth.
 3. It is incomplete:
• Wealth definition gives an impression that human wants are satisfied only by earning
and spending of money, but this is a mistaken view.
• Generally human wants can also be satisfied through dancing, singing etc.
• Therefore, it is an incomplete definition.

4. Wealth is not only the end of all activities:

Wealth is only a means to an end. It is not an end.

5. It can not explain the problem of scarcity, welfare and choice:

The wealth definition did not think about the problem of limited resources, welfare
and choice.

In the view of above defects, the wealth definition is criticized unscientific, incomplete and
unsatisfactory.
Although the wealth definition is defective, the need for study of wealth cannot be denied.
The ultimate object of economics is to fight against hunger, shortage and make the society
rich.

Alfred Marshall
Definition:
Alfred Marshall in his book “Principle of Economics” defined economics as the study
of wealth and on the other hand as the study of man.

• In short, Economics is to promote the welfare/wellbeing of human beings through the

study of wealth.
• While the classical economists emphasized on wealth, Marshall emphasizes on both
wealth and welfare. He gave importance to Man than to wealth.
• According to him, wealth is only a means to increase welfare. Thus, wealth is given only
secondary place.
• He made economics a normative science by prescribing ‘welfare goal’ which means that
welfare ought to be maximized.
• By shifting emphasis from wealth to welfare, he enlarged the realm of economics.
• He also elevated economics to the status of science by changing the word political
economy into economics. He made economics free from all political influences.
• It rejects the idea of ‘Economic Man’ whose only intention is to acquire wealth without
any other human considerations. Economics deals with ordinary man who have feelings
like love, affection etc.
Criticism: - (Mainly by Lionel Robbins)

The following are some points of criticism:

1. Misrepresents the science:

The material welfare definition includes only those activities which leads to
production and consumption of material goods only. But it is the scarcity and value that
makes anything economic.

2. Welfare cannot be defined:

Welfare differs from person to person and time to time. It is subjective for every
individual. Therefore, it cannot be defined.

3. Some material goods do not promote welfare:

Goods like wine, cigarettes etc., do not promote welfare but they have economic
value because of scarce.
“In economics we should not consider anything superior or inferior on the basis of
welfare or ill fare”.

4. It is classificatory but not analytical:

The material welfare definition classifies activities into economic and non-economic
activities and deals only with economic activities (neglected non-economic activities).
Robbins criticizes this classificatory aspect.

5. The material welfare definitions are self-contradictory:

While defining economics he ruled out non-material things from its scope. But,
while defining labour they have included non-material things like services of teachers,
lawyers etc. So, there is self-contradiction.

Lionel Robbins
Definition:
Robbins in his book “The Nature and Significance of Economic science” defined
economics as ‘study of human behaviour as relationship between ends and scarce means’ which
have alternative use.

• Unlimited wants and limited resources cause economic problems. Economics studies this
economic problem of scarcity and taking decisions how to use a scarce resource having
alternative uses in a best possible manner.
Major points of Lionel Robbins definition of Economics:
1. Ends (unlimited wants)
2. Means (scarce resources)
3. Alternative uses

1. Ends (Unlimited wants):

Man has unlimited wants/needs. It is impossible to satisfy all his
wants. One makes constant efforts to satisfy wants with limited resources. If one want is
satisfied another want arises. So, the struggle to produce more goods or get more income
continues for the whole life.

2. Means (Scarce resources):

Resources are of 2 types:
1. Economic resources: Things and services which are limited in supply
2. Non-Economic resources: Unlimited in supply and are free (air, sea…)

- According to Robbins, unlimited want and scarce resources provides a foundation for
the field of economics.
- Since the human wants are unlimited and the means to satisfy them are scarce,
therefore economic problem arises.
- If all the things are freely available to satisfy human wants, there would not have arisen
any scarcity. Then no economic problems.

3. Alternative uses:
The scarce resources available to satisfy human wants have alternative
uses.
Ex: Wood – a scarce resource and have alternative uses to satisfy human wants.

• Therefore, Man must choose the best way of utilizing the scarce resources which
have alternative uses i.e., we must make a choice between more important and less
important wants.
• The choices to be made are:

✓ What goods shall be produced and in what quantity?

✓ How the goods and services should be distributed?

Finally,
Robbins definition on Economics is based on satisfaction of human wants
with scarce resources which have alternative uses.
 Nature of Economic Laws

Economics is a science and like other sciences it also has its laws. Economic laws are
also known as principles, generalizations and uniformities.

Acc. to Marshall:
“Economic laws are social laws which are related to a branch of conduct in
which the strength of motives chiefly concerned can be measured by money price”.
By this Marshall means that economists have framed this laws & theories
which explains human conduct who tries to maximise things or seeks to fulfil his objectives, and
these things and objectives must be measurable in terms of money.

Acc. to Robbins:
“Economic laws are statement of tendencies which govern human behaviour
concerning the utilisation of scarce resources for the achievement of unlimited ends”.

Statement of tendencies:
Economic laws are statement of tendencies. They tell us what is likely
to happen under certain conditions.

Some important laws of economics:

1. Law of Demand
2. Law of Supply
3. Law of Diminishing Marginal Utility
4. Law of Equi-Marginal Utility
5. Law of Comparative Advantage

• Economic laws describe how a human behaves as a producer and consumer. They also
concern with how economic system works and operates.
• Economic laws also describe the growth of economy as well as international trade
between different countries in the world.
• Presently, Economic laws have been framed in all the fields of subject matter of economics
like production, distribution, consumption, price determination, foreign trade, growth and
stability of economy etc.

✓ Basically, laws of physical sciences are exact, precise and definite but the economic laws
are not like that, they are conditional and are associated with number of assumptions and
qualifications.

Assumptions & Qualifications = Other things remaining same = Ceteris Paribus

 ✓ In real world, these other things do not remain same because the economic world is
dynamic.
Example:
Acc.to law of demand when Price of commodity increases then the
quantity demanded by consumers decreases.

But if along with the rise in price of commodity, income of the consumer
increases, then the consumer may demand more commodity even at the higher
price.
Therefore, Economic laws are conditional.

Economic laws are hypothetical due to Human behaviour, Time factor and Influence of several
laws.

Economic laws also establish relationship between cause and effect about the economic
behaviour of man and economic phenomenon.
Example:
Acc.to law of demand when Price of commodity decreases then the
quantity demanded by consumers increases.

Here, the fall in price is the cause and the rise in quantity is the effect
 ECONOMICS ---- divided by Ragnar Frisch - 1933
MICRO – ECONOMICS
Definition • The branch of science that
studies the behaviour of an
individual consumer, firm,
family etc.
Deals with • Individual economic
variables.
Tools • Demand and supply.
Assumption • It assumes that macro-
economic variables are
constant.
Scope • It concerns with product
pricing, factor pricing,
economic welfare etc.
Importance • Helps in determining the
prices of the product along
with prices of factors of
production (land, labour,
capital) within the economy.
Limitations • It is based on unrealistic
assumptions i.e.; In micro-
economics it is assumed
that there is full
employment in the society
which is not at all possible.
• ‘Laissez fair policy’ no
longer exist i.e., the
assumption of a free market
economy and non-
interference of the
government in economic
affairs.
MACRO – ECONOMICS
• The branch of science that studies
the behaviour of whole economy
both national and international.
• Aggregate economic variables.
• Aggregate Demand and
Aggregate supply.
• It assumes that micro-economic
variables are constant.
• It concerns with national income,
general price level,
unemployment, money,
economic growth, distribution
etc.
• Maintains stability of general
pricing level and resolves major
problems of the economy like
inflation, deflation,
unemployment, poverty etc.
• ‘Fallacy of Composition’ involves,
i.e., what is true for aggregates
may not be true for individuals.
• Micro changes are more
important than macro changes
Ex: - General pricing level
may be constant, but the prices
of food grains may be falling.
• It ignores the individual, but the
main aim of economics is to
promote individual welfare.
Scope, Purpose and Importance of Micro-economics:

1. It studies how resources are allocated to the production of goods and services and their
distribution.
2. It studies product pricing i.e., how prices of the individual commodities are determined.
3. It studies factor pricing i.e., how wages, interests, profits and rents are allocated.
4. A study of efficiency in production, distribution and consumption is nothing but a study of
welfare economics.
5. Helpful in making business decisions by guiding the managers in optimal resource
utilization, demand analysis, cost analysis etc.
6. It also helps to understand the working of economics by explaining how millions of
consumers and producers take decisions in allocation of productive resources among
millions of goods and services.
7. Helps in designing price policy, taxation policy.
8. It also studies human behaviour with the help of Law of diminishing marginal utility, Equi-
marginal utility, Indifference curve analysis etc.

Scope, Purpose and Importance of Macro-economics:

1. Gives us a ‘bird’s eye view’ of the economy i.e., picture of working of the economy as a
whole.
2. It studies the aggregate sections of the society.
3. By studying the economy as a whole it is easy for the government to make policies which
effects total production, income and unemployment etc.
4. It deals with the study of economic growth.
5. It studies economy in a dynamic aspect i.e., changes in national income, employment etc.

Conclusion:

• The division of economics into micro & macro does not mean that they are separate
branches. Both Micro & Macro economics hand-on-hand solve the economic problems
and seek for the country’s welfare.

ECONOMIC EQUILIBRIUM
Definition:
• Economic equilibrium is a state in which economic forces i.e., market forces are in a
perfect equilibrium.

• Economists also defined economic equilibrium as a point at which the supply and demand
of a single commodity are identical.

• The equilibrium price exists where the supply and demand curves meet.

Examples:

1. A single individual consumer is in equilibrium when he gets maximum satisfaction and of

a given expenditure. The Law of Equi-marginal utility explains the consumers equilibrium.
2. An industry is in equilibrium when all the firms in the industry are earning profits and
when there is no tendency for leaving and entering industry simultaneously.
Note:

• In Micro-economics, economic equilibrium price is the price that equates demand and
supply.
• In Macro-economics, national income is in equilibrium when aggregate demand equals
aggregate supply.

- refers to whole economy where demand is equal to the

Geneal supply of every single good and service in every market
equlibrium
Economic - Walras developed the theory of general equilibrium
equilibrium it considers only a part of the market i.e., it treats only
Partial
one particular sector of the economy as functioning in
equilibrium
isolation from all the other sectors.

Importance of General Equilibrium:

 1. It gives a complete picture of equilibrium of the entire economy.
2. It helps us to understand complex problems of the every market.
Ex: - Disequilibrium & restoration of the equilibrium can be studied with the help of
this analysis.
3. It helps us to understand pricing process i.e., how individual decisions affected by price
change.
4. It helps us to understand how households and industries are related in an interdependent
system of inputs & outputs.
5. Can easily analyse the inter-relationship of various sectors of the national economy like
primary, secondary and tertiary.

Limitations:

1. It is totally based on unrealistic assumptions.

Ex: - All companies do business under the same cost conditions.
- Techniques of production do not change.
- Perfect competition exists in the goods and services.
2. It is only a static model but not dynamic i.e., the assumptions in the analysis are
continuously changing.
Ex: - Consumers’ decision regarding each product and Producers’ decision for the
production of each item operate in a state of total harmony.

Importance of Partial Equilibrium:

3. It is very simple and effective to tackle the problems. We cannot solve all the problems at
the same. Therefore, it is best to solve particular problem at a particular time for best
analysis.
4. It helps us to analyse the cause of a change in the behaviour of a particular variable.
5. By considering particular sector/market it is easy to understand the economic problems.
6. It also helps in analysing the general equilibrium.

Limitations:
• It assumes that other things that effect the variable under analysis remain the same.
• It does not throw light on the economy as a whole i.e.; it did not study the inter relations
of all parts of the economy.

ECONOMICS – POSITIVE SCIENCE or NORMATIVE SCIENCE

POSITIVE SCIENCE NORMATIVE SCIENCE

 • Deals with all real things/activities
• It gives the solution What is? What
was? What will be?
• It explains causes and effects by making
value judgements whether it is right or
wrong.
• It is also called as ‘Pure science’.
• It is concerned only with theoretical
aspects.
Example:
• Poverty and Unemployment are the
major problems in India.
• The life expectancy of birth in India is
gradually rising
• Deals with What ought to be? What
ought to have happened?
• It discusses whether a thing is good or
bad and lays certain rules and policies
to achieve what is considered to be
good.
• It is also called as ‘Applied science’.
• It offers suggestions to the problems
Example:
• Literacy is a curse for Indian economy.
• The backwardness of Indian economy is
due to population explosion.

Support View to Economics as a positive science:

✓ Many economists like J.B. Say, J.S. Mill, Walker declared economics should only be
concerned with ‘What it is?’
✓ Senior thought that the ‘Economists should not add even one word of advice’.
Ex: - Economists should simply say ‘Car satisfies human wants and it has utility. But,
he should not say it increases pollution.
✓ Acc. to Robbins, ‘the function of economist is merely to explore and explain but not to
advocate or condemn’.

Support View to Economics as a Normative science:

✓ This is an age of planning. Economics must concern with practical problems.

✓ If economics do not help us to solve the practical problems, it loses its significance.
✓ The backward and underdeveloped countries are more in need of applied economics.
✓ The economists are today expected to give guidance in selecting the objectives.
✓ The knowledge of economics should help us to solve economic problems. It should give
mankind some benefits by suggesting solutions for these problems.

Arguments:
 • If economics remained purely as a theoretician – poverty, misery and class conflicts would
not have been abolished.
• If economics is made Normative, it may give much scope to disagreement i.e., economists
may differ in their opinion. Disagreement hampers the progress of economics.
• Economics will be misunderstood if ethical judgments are passed i.e., the economist has
to pass moral judgments every time which leads to problems.

Conclusion:
Economics is both a positive and normative science. It is both pure science and
applied science. Economic problems are solved by studying facts, causes and effect along with
practical solutions.

UTILITY
Meaning:
• Utility is the want satisfying power of a particular commodity.
• It is basically a satisfaction we receive from consuming a particular commodity.
• The more it satisfies a person; the more is utility.

✓ It is subjective in nature i.e., it changes from individual to individual, time to time, place to
place.
 Examples:
• (Individual to Individual)
The utility of a tea will be more for the person who likes tea and the utility will
be less for the person who likes coffees.
• (Time to Time)
The utility of heaters in summer is very less compared to the utility of heaters
in winter.
• (Place to Place)
The utility of blanket in hilly station is much more than the utility of that
blanket in coastal areas where the temperature is high.

Total Utility:
Sum total of utility derived from the consumption of all units of a
commodity.
Ex:
▪ 1st chocolate = 5 utils of utility
▪ 2nd chocolate = 6 utils of utility

Total utility (TU): 5+6 = 11 utils

Marginal Utility:
Change in total utility due to consumption of one additional unit of a
commodity.
Ex:
▪ 10 chocolates = 100 utils of utility
▪ 11 chocolates = 120 utils of utility

Marginal utility = Utility derived from the last commodity – the rest of the commodities

i.e., MU = Tn – Tn-1

Therefore,
Marginal utility (MU): 120-100 = 20 utils

Relation between Total Utility and Marginal Utility:

Total utility refers to the utilities of all the commodities whereas marginal utility refers to
the utility of each commodity.
 Example 1: Suppose a consumer purchases a packet of biscuits and consumes them.

Then,
Total utility = utilities of all the biscuits in the packet.
Marginal utility = utility of each biscuit.
Tabular form:

Units Marginal Utility Total Utility

1 10 10
2 5 15
3 3 18
4 0 18
5 -2 16

➢ As long as marginal utility is positive, Total utility keeps on increasing.

➢ Total utility is maximum when Marginal utility is ‘0’.

➢ Total utility starts decreasing when marginal utility is negative.

➢ Decreasing marginal utility implies that, Total utility increases at a diminishing

rate.

Graph which explains relationship between Total utility and Marginal Utility:
 ➢ Till the time that Marginal utility is positive, the Total utility increasing at an increasing
rate.

➢ As soon as the marginal utility reaches ‘0’, the Total utility reaches its maximum point.

➢ As soon as the marginal utility starts becoming negative, the Total utility keeps on falling
(it starts decreasing).

Relation between Marginal utility and Supply:

▪ If the supply of commodity increases, then marginal utility decreases.

▪ If the supply of commodity decreases, then marginal utility increases.

▪ If the supply is unlimited, then marginal utility is zero.

Relation between Marginal utility and Goods:

▪ If two goods are substitutes like tea and coffee, if the quantity of one good increase then
the marginal utility of other goods decreases.
 ▪ If two goods are complementary goods like pen and ink, marginal utility increases when
the quantity of goods with the consumer increases.

Relation between Marginal utility and Price:

The price of a commodity is determined by marginal utility and not total utility.

Example:

No. of Chocolates Marginal utility of Chocolates Price

1 10 utils 3 rupees
2 6 utils 2 rupees
3 3 utils 1 rupee

▪ In the above table, first chocolate he pays 3 rupees and for second chocolate 2 rupees and
for third chocolate1 rupee.
▪ If all the three chocolates are available at a time, he will pay only 1 rupee per chocolate
but not 3,2,1 rupee.

Therefore, Price is determined by the marginal utility and not total utility.

Law of Diminishing Marginal Utility

The law of diminishing marginal utility was introduced by ‘Gossen’ and later developed by
Marshall.
Definition:
It states that as more and more units of commodity are consumed the marginal
utility derived from each additional unit goes on diminishing.

Example:
Assume that a consumer consumes 6 ice creams one after another. The first ice
cream gives him 20 utils of utility (units for measuring utility). When he consumes the
second and third ice cream, the marginal utility of each additional ice cream will be lesser.
This is because with an increase in the consumption of ice creams, his desire to consume
more ice creams falls.

Schedule for Law of Diminishing Marginal Utility:

Units Marginal utility Total utility

1 20 20
2 15 35
3 10 45
4 5 50
5 0 50
6 -5 45

In the above table, the total utility obtained from the first ice cream is 20 utils,
which keep on increasing until we reach our saturation point at 5th ice cream.

On the other hand, marginal utility keeps on diminishing with every additional ice
cream consumed. When we consumed the 6th ice cream, we have gone over the limit.
Hence, the marginal utility is negative and the total utility falls.

Graph:
 ➢ As long as marginal utility is positive, Total utility keeps on increasing.

➢ Total utility is maximum when Marginal utility is ‘0’.

➢ Total utility starts decreasing when marginal utility is negative.

➢ Decreasing marginal utility implies that, Total utility increases at a diminishing

rate.

Disutility:
If you still consume the product after the saturation point, the total utility starts to
fall. This is known as disutility.

Assumptions/Limitations:

Following are the assumptions in the law of diminishing marginal utility:

1. The quality of successive units of goods should remain the same. If the quality of the
goods increases or decrease, the law of diminishing marginal utility may not be proven
true.

2. Consumption of goods should be continuous. If there is break in the consumption of

goods, the actual concept of diminishing marginal utility will be altered.

3. Consumer’s mental outlook should not change.

 4. Unit of good should not be very few or small. In such a case, the utility may not be
measured accurately.

Exceptions:
Following are the exceptions for this law:

1. Does not apply to money.

2. Does not apply to knowledge.

3. Does not apply to liquor or music

4. Does not apply to Collection of rare objects.

Practical importance:
• It is the basis of several laws of consumption such as:
(a) Equi-Marginal utility
(b) Principle of Consumer surplus
(c) Law of Demand
(d) Elasticity of demand

• It explains the paradox of value:

Although water has great use-value its price or exchange value is very low or
sometimes nil. But the price of diamond is very high though their use-value is very little. This
is known as water-diamond paradox.
Price depends on marginal utility. Marginal utility depends on supply. The greater
the supply the lower will be the marginal utility and therefore the price will be low.
Diamond has high price because the supply is very limited. Water has no price
because its supply is unlimited.

• Redistribution of wealth:
Wealth should be redistributed from the rich to the poor is justified on the basis of
this law. As the utility of money to the poor is greater than its utility to rich, redistribution of
income from rich to poor increases total welfare of the society.

Criticism:
1. Utility is a mental feeling and it cannot be measured.
2. The law assumes constant utility of money.
 3. In real life very few commodities are consumed in quick succession one unit after
another.

Conclusion:
This clearly explains that utility derived from each additional unit goes on
diminishing in which the consumer is ready to consume single good.

Law of Equi-Marginal Utility

This law was introduced by Gossen and later Alfred Marshall developed this law with the
help of cardinal utility. This is mainly based on the law of diminishing marginal utility.

This law is also called as Law of Substitution or Law of Maximum Satisfaction Theory.

Definition:
The principle of Equi-marginal utility explains how the consumer distributes his
limited income over different wants to get maximum satisfaction through expenditure.

Acc. to Marshall, “if a person has a thing which can be put to several uses, he will
distribute it in such a way that it has marginal utility in all”.

Explanation:
Let’s suppose two commodities: ‘X’ and ‘Y’

Acc. to this law, both commodities/goods marginal satisfaction(utility) should be equal.

i.e.,

𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑢𝑡𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑿 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑢𝑡𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝒀

=
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑿 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝒀

𝑀𝑈𝑥 𝑀𝑈𝑦
➢ =
𝑃𝑥 𝑃𝑦

Consumer has to spend money on 2 commodities X and Y. He will compare the

price of these commodities and the marginal utilities he gets. He will spend in such a way that
both commodities marginal utility should be equal.
 When a consumer follows this principle of substitution, it means that the last unit
of money spent on commodity X is giving him the same marginal utility as the last unit of money
spent on Y.

Imaginary Example:
Suppose a consumer monthly income is 20/- and he wants to spend it on
PEN and Chocolate. The cost of Pen is 3 rupees and the cost of Chocolate is 4 rupees. The
marginal utilities of Pen and Chocolate are given in the table.

Commodities Units Marginal Utility of Pen Marginal Utility of Chocolate

1 33 36
PEN 2 30 32
& 3 27 28
CHOCOLATE 4 24 24
5 21 20

Equate the both commodities Marginal utility.

Commodities Units Marginal Utility of Pen Marginal Utility of Chocolate

1 33/4 = 11 36/4 = 9
PEN 2 30/3 = 10 32/4 = 8
& 3 27/3 = 9 28/4 = 7
CHOCOLATE 4 24/4 = 6
24/3 = 8
5 21/3 = 7 20/4 = 5

From the above table,

The consumer got max satisfaction after consuming 4 units of Pen and 2
units of chocolates. The satisfaction derived is also equal for Pen and coffee i.e., 8=8 (for the
income of 20/-).

➢ Out of 20/- he gets 4 units of Pen and 2 units of chocolate.

i.e.,
Units of Pen = 4; Price = 3/-
Q×P = 4×3 = 12/-

Units of Chocolate = 2; Price

Q×P = 2×4 = 8/-

Therefore, total expenditure of his income = 20/- completed.

 ➢ Moreover, the last unit of commodity giving the satisfaction should be the same.
MUPEN = MUCHOCOLATE
8 = 8
➢ Pen marginal utility: 33+30+27+24 = 114
Perfume marginal utility: 36+32 = 68
Total: = 182

Therefore, 182 utils is the maximum satisfaction received by expenditure of 20/-

Graph:
Y
Chocolate PEN

A B
8 MU

X
0 1 2 3 4 5 6

➢ In the graph, same satisfaction for the goods PEN and CHOCOLATE at point A and point B
on the same line of MU.

Assumptions:
To prove this law of Equi-marginal utility, we have to make assumptions:

1. According to Marshall, utility can be measured in terms of numerical values.

2. Consumer is rational, he wants to get maximum satisfaction, he always tries to consume

different goods.

3. Price of commodity = constant; Income of consumer = constant, then only this law is
applicable.

Limitations:
1. Calculation and weighing of utilities impossible.
 2. Indivisible goods equalization of utilities not possible. (We cannot but 2 ½ radio sets or
fans).
3. Durable goods utility cannot be equalized.
4. The law does not operate in the case of unlimited or free goods of nature.
5. Advertisement makes us buy less useful goods
6. Scarcity of goods make us by less useful goods.

Consumer’s Surplus
Definition:
Consumer surplus is defined as the difference between the total amount that
consumers are willing and able to pay and the total amount that they actually pay (i.e. the
market price) for a good or service.
In short, if the price we actually pay for a commodity is less than what we are willing
to pay for it, we get an excess or surplus satisfaction. This surplus satisfaction is called consumer
surplus.
Example:
I want to buy a chocolate and I thought it would cost Rs.15. But after
going to shop I got the chocolate only for Rs.10(market price). Therefore, the remaining Rs.5 is
consumer surplus which gave excess satisfaction to me.

• Consumer surplus is indicated by the area under the demand curve and above the
market price.

Consumer surplus based on diminishing marginal utility:

Acc. to Law of Diminishing Marginal utility, each additional unit of a
commodity gives less and less satisfaction. Therefore, the price the consumer willing to pay for
the additional units will be lower than the earlier units.

Apples Marginal Utility Price willing to pay

1 10 utils Rs. 1.00
2 5 utils Rs. 0.50
 3 2 utils Rs. 0.25

For the first apple the consumer is willing to pay Rs.1 because its utility is high.
For the second apple, he is willing to pay only 50paise.
For the third apple, he paid only 25paise only. This is because the marginal utility for each extra
apple is falling.

Price is determined by the utility of last unit. According to market price, all the three apples cost
75paise only but the consumer is willing to pay 1.75 rupees

Therefore, 1.75-0.75 = 1 rupee (is the consumer surplus)

Thus, consumer surplus arises because market prices are determined by marginal utility (utility
of the last unit) and not by total utility.

Market Consumer Surplus:

It is the sum total of individual consumer’s surplus.

Assumptions of consumer’s surplus:

• Expected and realized utility are same.
• Tastes and preferences of the consumer remains same.
• Marginal utility of money remains same.
• While considering market consumer’s surplus, the differences between consumers
are ignored.
Importance:
1. To compare economic welfare i.e., it helps us to compare economic condition of
people living at different places. Economic welfare is greater in countries where
consumer’s surplus is greater. Consumer’s surplus will be high in places where
prices are low.
2. International Trade:
▪ A country imports goods because they are cheaper. If we produce in our
country, they cost more. Therefore, the difference between the price of
imports and the price we would have to pay if produced within the country
is the consumer’s surplus.
3. In public Finance:
▪ The Finance Minister should carefully select commodities on which the
consumers enjoy more consumer’s surplus.
4. Consumer’s surplus and elasticity of demand:
 ▪ If the consumer’s surplus on a commodity is very high, the demand for that
commodity will be inelastic because people do not mind paying a higher
price.

Law of Demand
Demand:
Consumer desire to purchase goods or services and willingness to pay a price for
specific good/service. It also includes the ability of a consumer to pay.

3 Major Determinants of Demand:

1. Price of other commodities
2. Income
3. Tastes and Preferences
Law of Demand:
The law of demand expresses a relationship between the quantity
demanded and its price.

Acc. to Marshall, “the amount demanded increases with a fall in price, and diminishes
with a rise in price”
Thus, it expresses an inverse relationship with price and demand.
Examples:
1. Price rises, Demand falls:
Shortage of Kiwi causes prices to rise from 25/piece to 100/piece. Then
demand falls from 5000 Kiwi a month to 1000 Kiwi a month as consumer can find
substitute products such as other fruits.
2. Demand rises, Prices falls:
A mobile manufacturer company reduces the cost of mobile phone from
10,000 rupees/unit to 9,000 rupees/unit resulted in increase in demand of that
particular phone.

Assumptions:
Demand not only depends on price but also on other factors. These
other factors are assumed to be constant.
1. There should be no change in the taste and preferences of the
consumer.
2. The income of the consumer should be constant.
3. Prices of other goods do not change.
4. There should not be any substitutes of the commodity.
 5. There should not be any change in quality of the product.
6. Commodity should not be a prestige good.

Demand Schedule:
Demand schedule is a table/schedule showing how much of a
commodity is purchased in a market at different prices.

Price of (Orange) Quantity Demanded

5/- 100 units
4/- 200 units
3/- 300 units
2/- 400 units
1/- 600 units

From the table, when the price of an orange is Rs.5/unit, the quantity
demanded is 100 units. If the price falls to Rs.4/unit, the quantity demanded
increases to 200 units. Similarly, when the price declines to Rs.1/unit, the demand
increases to 600 units.
In the same way, when the price rises from Rs.1/unit to Rs.5/unit, the
demand also decreases from 600 units to 100 units.

Demand Curve:
It explains various quantities of a commodity that the consumer is
willing to buy at varying prices of the same commodity.
 From the graph, Point P of the demand curve DD1 shows demand for 100 units at Rs.5.
Similarly, it is clear from (Q, R, S, T) as the price falls from Rs.4 to Rs.1, the demand rises from
200 units to 600 units.
Thus, the demand curve DD1 shows increase in demand of oranges when its price falls.
This indicates the inverse relationship between price and demand.
Reasons why demand curve slopes down:
The demand curve slopes down from left to right because demand increases at a
lower price.
1. Income Effect:
When the price of the commodity falls, the amount of money that the
consumer pays will be less than before i.e., he can buy more units of the commodity at the
same price.
Ex: If the price of the orange is Rs.1 and later the price of the orange
reduces to 50paise, the consumer will get 2 oranges at the same price of Rs.1 i.e., a fall in
price means saving in the money or increase in real income.

2. Substitution Effect:
When the price of a good falls, the consumer will shift to the less cost
good, if the less cost good is the alternative of the high cost good
Ex: If the tea price falls than coffee, consumers will prefer to consume tea
instead of coffee. Therefore, the demand for tea increases when the price falls.

3. New buyers:
People who could not afford when the price is high begin to buy the good
when the price falls. Thus, the demand will be more at a lower price.

4. Different uses:
There are certain goods that can be used for different purposes.
Ex: Wheat can be used as food, for cattle feed and for making alcohol. If the price of
the wheat increases, it will be used only in food. If the price falls, it can be used
for different purposes. Therefore, demand increases as its price falls.

5. Diminishing marginal utility and the law of demand:

Here, consumer compare price and utility. He will pay a lesser price for
additional units as their utility is less. Therefore, consumer buys more only at lower price.
 6. Consumer equilibrium:
Consumer purchases different commodities equalizing the ratio
of their marginal utilities and prices. If the price of commodity falls, the equilibrium is
disturbed. Therefore, to equalise the marginal utility price ratio, he has to buy more
commodities whose price has fallen.

Exceptions to the Law of Demand:

1. Giffen goods:
These goods constitute very inferior goods which are essential for a
minimum living. Law of Demand does not hold well in case of Giffen goods.

Ex: If a poor person’s staple food is Rice (Giffen good) and other superior
food is Meat. If the price of the rice increases, the person spends more amount on rice
instead of meat because rice is a staple food whereas Meat is a superior food. Here the
increase in price of rice and increase in demand of rice takes place.

2. Prestigious goods:
There are certain goods having prestige value. These goods are mainly
consumed by the richer sections of the society for the gain of pride and social distinction.
The consumption of prestigious goods is known as conspicuous consumption.
Ex: Diamond – The greater the price, the more is utility because of its
higher value.

3. Speculation:
The fear of price rise in future makes a consumer to buy more at a higher
price. On the other hand, he buys less at fewer prices with a hope of further fall in future.
Thus, this expectation or speculation constitutes another exception to the Law of Demand.

4. Ignorance about quality:

Usually consumers judge the quality of a commodity from its price. A high-
priced commodity is thought to have higher value than that of a low-priced commodity.

Elasticity
The term ‘elasticity’ means the change in one variable in comparison to
another variable. In Economics, elasticity is used specially to compare the effect of change of
one variable on another.
Price elasticity of demand:
Price Elasticity of Demand is the responsiveness of quantity demanded to
change in price. In other words, it is the percentage change in quantity demanded in
comparison to the percentage change in price of a product.

Ed = Percentage change in quantity demanded / Percentage change in price = %∆Qd/%∆P.

Example:

If quantity demanded goes up from 100 to 150 as a result of a change in price from
4 to 3, then we can calculate the price elasticity of demand as follows:

• Percentage change in quantity demanded = ((150-100)/100) x 100 = 50%

• Percentage change in price = ((4-3)/4) x 100 = 25%
• Price elasticity of demand = 50%/25% = 2.

This means, at this point on demand curve, the percentage change in quantity
demanded is 2 times of percentage change in price.

Elastic Demand:

If the percentage change in quantity demanded is higher than the percentage change in price,
the calculated elasticity demanded is greater than 1. In this case we say the demand is elastic.

Inelastic Demand:

If the percentage change in quantity demanded is less than the percentage change in price, the
calculated elasticity demanded is less than 1. In this case we say the demand is inelastic.

Unit Elastic Demand:

If the percentage change in quantity demanded is equal to the percentage

change in price, the demand will be unit elastic. The calculated price elasticity of demand is
equal to 1.
Methods of Measurement of Elasticity of Demand:

1. Geometric method:

This method is used to find the elasticity of demand at a point on the demand curve.

In a demand curve graph, on any point of the demand curve we can find the
elasticity of demand
i.e.,
𝐿𝑜𝑤𝑒𝑟 𝑠𝑒𝑔𝑚𝑒𝑛𝑡
(Ed)𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝐷𝑒𝑚𝑎𝑛𝑑 =
𝑈𝑝𝑝𝑒𝑟 𝑠𝑒𝑔𝑚𝑒𝑛𝑡

From the graph, CB is the demand curve;

Point A is the middle point; therefore, AB and AC are equal.

Lower segment of Demand curve is AB

Upper segment of Demand curve is AC

According to formula,

𝐴𝐵
• Ed at point A = = 1 (AB and AC are equal because A is the midpoint).
𝐴𝐶

𝐷𝐵
• Ed at point D = = ˂1 (DB is shorter as compared to DC).
𝐷𝐶

𝐸𝐵
• Ed at point E = = >1 (BE is greater as compared to BC).
𝐸𝐶

0
• Ed at point B = = 0 (there is no lower segment)
𝐵𝐶

𝐵𝐶
• Ed at point C = = 1 (Upper segment is zero).
0
Cross Elasticity of Demand:

Cross Elasticity of Demand measures the responsiveness in the quantity

demanded of one good to a change in price of another good. It is calculated by dividing the
percentage change in the quantity demanded of one good by the percentage change in the price
of another good.

Cross elasticity is used to determine whether two goods are substitutes or

complements or whether they fall into any of the two categories at all.

• If cross price-elasticity of two goods is positive = substitutes.

• If the cross-price elasticity is negative = complements.

Examples:

❖ In case of substitute goods:

If the price of train increases, the demand for bus may increase as it
becomes cheaper. Therefore, the demand curve goes upward from left to right.

In case of complementary goods:

If the price of Potato increases, the demand for Samosa may decrease as it
becomes costly. Therefore, the demand curve goes downward from left to right.
Income Elasticity of Demand:

This measures responsiveness of quantity demanded to a change in income. It

is calculated by dividing the percentage change in quantity demanded by the percentage change
in income.

Increases in income does not always lead to increase in consumption of all

types of goods. People often stop the usage of certain goods when they become richer.

❖ Income elasticity of demand is positive = Normal good

❖ Income elasticity is negative = Inferior good

Example:

• In case of Normal goods:

The income of consumer increases, they consume more of superior
(luxurious) goods. On the contrary, as the income of consumer decreases, they consume
less of luxurious goods.

• In case of inferior goods:

If the income of consumer (poor people) increases, they begin to buy
superior goods instead of inferior goods. Therefore, the demand for inferior goods will
decrease as the income rise.
 Demand Schedule

A demand schedule is a table that shows the quantity demanded of a good or

service at different price levels.
A ‘Demand Schedule’ states the relationship between two variables: price and
quantity. It shows that more is demanded at lower prices than at higher prices
Individual demand schedule:
Individual demand schedule refers to a tabular statement showing various
quantities of a commodity that a consumer is willing to buy at various price levels.

Price. (in Rs.) Quantity Demanded of

commodity x (in units)
5 1
4 2
3 3
2 4
1 5
As seen in the schedule, quantity demanded of ‘x’ increases with decrease in its
price. The consumer is willing to buy 1 unit at Rs. 5. When price falls to Rs. 4, demand rises to 2
units.

Market demand schedule:

 Market demand schedule refers to a tabular statement showing various
quantities of a commodity that all the consumers in the market are willing to buy at various
price levels. It is the sum of all individual demand schedules at every price.
Construction of Market Demand Schedule:
Market demand schedule can be constructed in two ways.
1. Addition method:
Market demand schedule can be constructed by adding up the demand
schedules of individual consumers. If there are A, B, C, D consumers in a market, the
market demand schedule can be constructed by A+B+C+D.

Example:
If at a price of Rs.5.
• A buys = 100
• B buys = 200
• C buys = 250
• D buys = 300
Total = 850
2. Representative method:
In this method, a representative consumer is considered. Then the quantity
demanded by this representative consumer is multiplied by the number of consumers in
the market.
Example:
If ‘x’ is considered as a representative consumer and he purchases 100
units at a price of Rs.5 and the total no. of consumers in the market are 5,000.

Market Demand = 100 × 5000 = 5,00,000 at the price of Rs.5

Individual Demand Schedule Market Demand Schedule

May be discontinuous
Does not influence the market price
Regular and continuous
Influence the market price
• Market demand increases, price
increase
• Market demand decreases, price
decreases
 Individual demand influences market Market demand influences individual
demand demand.

Importance:
1. Businessmen need demand schedule to take output and price decisions.
2. Government need demand schedule for taxing of goods.
Assumptions:
1. It is related to a given time.
2. The other factors that determine demand schedule like population, income, tastes and
preferences etc., are supposed to be constant.

Demand Determinants (context of business enterprise)

In addition to the price of the commodity, there are several general factors
that determine the demand like income, population, price of other commodities, weather
conditions, changes in money supply, tastes and preferences etc. The importance of these
factors differs from product to product.
The demand determinants of some particular types of goods like consumer
non-durable goods, consumer durable goods and capital goods.
Consumer Non-Durable Goods:
The following are the important factors that influence the demand for Non-durable consumer
goods:
1. Purchasing power:
Purchasing power is determined by discretionary income.

Discretionary income = Disposable income – Unavoidable cost of living

2. Price:
Normally price is an important factor. Along with price of that commodity we should
also consider prices of substitutes and complimentary goods.
Changes in the prices of substitutes and compliments also influence the demand for
a product.
3. Demography:
 The size of the population also influence demand. Male and Female ratio, Urban and
Rural population ratio, Education levels, geographic location etc., determines the demand.

Formula:
D = F (I, D, P)
Where, D = Demand; I = Discretionary income; D = Demography; P = Price; F = Function
Consumer Durable Goods:
The following are the factors that influence the demand for consumer durable goods:
1. Choice:
Decision to buy a new one increases the demand.

2. Facilities for use:

For using these goods special facilities are necessary. For example: petrol/diesel for
car, battery for mobile phones. The existence of facilities influences the demand.
3. Households:
The increase in the number of households increases the demand for them. Demand
increases when population increases.
4. Family characteristics:
Size of the family, age distribution, price income etc also influence demand.

Capital Goods:
The following are the factors influence the demand for capital goods:

1. Price of capital goods

2. Price of other factors of production
3. Profit levels
4. Corporation tax
5. Income
6. Interest rates
7. Confidence levels and Advances in technology.
 Indifference Curve Analysis
Definition:
Indifference curve analysis represents or shows the combination of two goods which
gives equal satisfaction to the consumer.

Example:
Let’s assume two commodities like Food and Cloth in four combinations (ABCD)

Combinations Food Cloth

A 1 12
B 2 6
C 3 4
D 4 3

When the consumer consumes 1 unit of food and 12 units of cloth in combination A
gives the equal satisfaction when he consumes 2 units of food and 6 units of cloth in
Combination B.

Combination A = Combination B

Similarly, all combinations A, B, C, D gives equal satisfaction to the consumer.

“Quantity varies but equal satisfaction”

When we made this plot on the graph, we can make the indifference curve

Curve:

• From the Indifference curve graph, the quantity of food consumed in point A gives the equal
satisfaction to the cloth also. In the same way, all other points B, C, D gives equal satisfaction
to the consumer for both commodities (Food and Cloth).

• Indifference curve generally measures utility.

Marginal Rate of Substitution:
The consumer is ready to exchange the goods in between, to get the same utility i.e.,
when the consumer consumes additional unit of one commodity, he gives up the quantity in other
commodity to equalize the satisfaction.

Combinations Food Cloth Marginal rate

of
substitution
A 1 12 -
B 2 6 6
C 3 4 2
D 4 3 1
From the table, when the consumer consumes the additional unit of food, he gives up the quantity
of cloth to equalize the satisfaction.

Suppose,
• 1 unit of Food = 12 units of cloth
• 2 units of Food (consumes 1 additional unit of food) = 6 units of cloth (he gives up 6 units
of cloth)
• 3 units of Food (consumes 2 additional unit of food) = 4 units of cloth (he gives up 2 units
of cloth)
• 4 units of Food (consumes 3 additional unit of food) = 3 units of cloth (he gives up 1 unit of
cloth)

Properties:
1. Indifference curve slopes downwards.
2. Indifference curve always convex to the origin because of Marginal Rate of Substitution.
3. Higher Indifference curve gives higher satisfaction.

When the consumer increases Food Quantity, its utility ‘decreases’ but at the same
time he gives up the Cloth quantity, its utility ‘increases’. That is the reason why Indifference curve
always convex to the origin.

When the consumer consumes more quantity of commodities, he is ready to make

more combinations of commodities which results in more satisfaction. This is the reason why
higher Indifference gives higher satisfaction.
IC1 – 5 combinations
IC2 – 4 combinations
IC3 – 3 combinations
IC4 – 2 combinations

Satisfaction: IC1 > IC2 > IC3 > IC4

Assumptions:
1. No change in the price of the commodities

2. No change in the taste of consumer preference

3. Consistency in the choice of the consumer i.e., if the consumer prefers Comb. A
than Comb. B then he should never change his preference (never prefer B over A)

4. Diminishing Marginal rate of Substitution.