I SEMESTER- MICRO-ECONOMICS- BCOM

MODULE 1- Demand and consumer behaviour

Total revenue- the whole income received by the seller from selling a given amount of a product is
called total revenue. Total revenue can be obtained by multiplying the quantity of output sold by the
market price of the product. Thus,

Total Revenue= PxQ

Where P= price and Q= quantity

Average revenue- it is the revenue earned per unit of output. It is obtained by dividing the total revenue
by the number of units sold. Thus,

total revenue TR
Average revenue= =
total output sold Q
Where AR=average revenue, TR=total revenue and Q=quantity

Marginal revenue-it is the addition made to the total revenue by selling one more unit of the
commodity.

Average and marginal revenue under perfect competition:

Under perfect competition, the demand curve is perfectly elastic. Since the price is given or a firm does
not have any control over the price, the average revenue is constant even when more units of a product
are sold. Moreover, since price does not change, the additional revenue made by selling an additional
unit of the product also remains constant.

Fig.1- Revenue curves under perfect competition

Horizontal straight line AR indicates that price or average revenue remains the same at OP level when
quantity sold is increased. So, under perfect competition the MR curve coincides with the AR curve.

Average and marginal revenue under imperfect competition:

Under imperfect competition (monopoly, monopolistic completion and oligopoly), the demand curve of
a firm is downward sloping. The monopolist is a price searcher; it searches the market demand curve for
the profit maximizing price. As a firm under imperfect competition increases production and sale of its
products, its price falls. Marginal revenue can be obtained from total revenue from the following table.
The table all shows the relation between AR and MR.
So, under imperfect competition, the AR curve is falling downwards and the MR curve lies below it.

Elasticity of demand:

It is price elasticity of demand which is generally referred to as elasticity of demand.

Definition: Price elasticity of demand measures how much the quantity demanded of a good changes
when the price changes. It is the percentage change in the quantity demanded divided by the
percentage change in price. Thus,

Percentage change∈quantity demanded

ep=
percentage change∈ price
Classification/types of price elasticity of demand:

1. Elastic demand: When 1 percent change in price call for more than 1 percent change in quantity
demanded, the good has price-elastic demand. For example, 1 percent increase in price yields a
5 percent decrease in quantity demanded, the commodity has highly price elastic demand.

Fig. 2- Elastic demand

2. Unit-elastic demand- When the percentage change in quantity demanded is exactly equal to the
percentage change in price, the good is said to have unit- elastic demand. For example, a 1
percent rise (fall) in price results in a 1 percent fall (rise) in quantity demanded.

Fig. 3- Unit-elastic demand

3. Inelastic demand- When 1 percent change in price produces less than a 1 percent change in
quantity demanded, the good is said to have inelastic demand. For example, when a 1 percent
increase in price results in only a 0.2 (say) percent decrease in demand.

Fig. 4- Inelastic demand

4. Perfectly elastic demand- When a tiny change in price results in an indefinitely large change in
quantity demanded, the good is said to have perfectly elastic demand. Here, the demand curve
is horizontal.

Fig. 5- Perfectly elastic demand

5. Perfectly inelastic demand- When a change in price does not result in any change in quantity
demanded, the good is said to have perfectly inelastic demand. Here the demand curve is
vertical.

Fig. 6- Perfectly inelastic demand

Measurement of elasticity of demand-

Percentage change∈quantity demanded

Price elasticity= ep=
percentage change∈ price
Symbolically,

∆q
X 100
q ∆q ∆ p
ep= = +
∆p q p
X 100
p
∆q p
= X
q ∆p
∆q p
= X
∆p q
Where ep=price elasticity, q= original quantity, p= original price and ∆=¿ small change.

Cross elasticity of demand-

Definition- It is defined as how much the quantity demanded of one good changes when the price of
another good changes.

Percentage change∈quantity demanded of X

Co-efficient of cross-elasticity of demand of X for Y= ec=
percentage change ∈ price of Y
Symbolically,

∆ qx
X 100
qx ∆ qx ∆ py
ep= = x
∆ py qx py
X 100
py
∆ qx py
= X
qx ∆ py
∆ qx py
= X
∆ py qx
ec= cross elasticity of demand of good X for Y

qx=original quantity demanded of X

∆q= change in quantity demanded of good X

Py= original price of good X

∆Py= small change in the price of good Y

Income elasticity of demand-

Definition: it can be defined as the ratio of the percentage change in purchases of a good to a
percentage change in income of the consumer.

Thus,

Percentage change∈ purchases of a good

Income elasticity= ei=
Percentage change∈income
Income elasticity, normal good and inferior good:

Goods having positive income elasticity are known as normal goods. E.g.  Organic foods, wheat, rice.

Goods having negative income elasticity are known as inferior goods. E.g. Inter-city bus service.

Income elasticity, luxuries and necessities:

Goods having income elasticity more than one and which occupies more place in a consumer’s budget
as he becomes richer is called a luxury.

Goods having income elasticity less than one and which occupies less place in a consumer’s budget as he
becomes richer is called a necessity.

Indifference curve (IC) approach:

An alternative and more advanced approach to deriving demand curves uses the approach called
indifference curves.
Definition: The indifference curve represents all those combinations of goods which give same
satisfaction to the consumer. Since all the combinations on the indifference curve give equal
satisfaction to the consumer, he will be indifferent between them, that is, it does not matter to
him which combination he gets.
Indifference schedule: Let us illustrate the indifference schedule.
Table 2
Two Indifference Schedules
I II
Good X Good Y Good X Good Y
1 12 2 14
2 8 3 10
3 5 4 7
4 3 5 5
5 2 6 4

In indifference schedule I, the consumer starts with 1 unit of good X and 12 units of good Y.
Now the consumer is asked how much of good Y he will be willing to give up for the gain of an
additional unit of good X so that his level of satisfaction is the same. If the gain of 1 unit of X
com0pensates fully for the loss of 4 units of good Y, then the next combination of 2 units of X
and 8 units of good Y i.e. (2X + 8Y) will give him the same level of satisfaction as the previous
combination of (1X + 12Y). Similarly, each of the other combinations (3x+5Y), (4X+3Y) and
(5X + 2Y) will give him the same level of satisfaction.
In indifference schedule II, the initial combination the consumer choose is (2X + 14Y). Now the
consumer consumes 1 additional unit of X which fully compensates him for the loss of 4 units of
Y so that the new combination is (3X + 10Y) his level of satisfaction remains the same.
Similarly, the combinations (4X + 7Y), (5X + 5Y) and (6X + 4Y) give the consumer the same
level of satisfaction as the initial combination (2X + 14Y).
But the consumer will prefer any combination in schedule II to any combination in schedule I
since it is assumed that more of a commodity is preferable to less of it.

Fig. 4- Indifference Curve Fig. 5- Indifference Map

Now, we can convert the indifference schedules into IC by plotting the various combinations of
the indifference schedule I. In Fig. 4, quantity of good X is measured in X axis and quantity of
good Y is measured in Y-axis. By plotting the quantities of good X and good Y in the X-axis and
Y-axis respectively, we get the IC.
Indifference map: it consists of a set of indifference curves. Any combination on a higher IC
will be preferred to any combination on a lower IC. Thus, an IC lying above or to the right of
another IC will imply higher level of satisfaction to the consumer. Thus, in fig 5, the higher
indifference curves, II, II, IV and V represent progressively higher levels of satisfaction. Higher
and higher IC can be denoted by any ascending series, 1, 2, 3, ….; or I, II, III,….. as in fig. 5.
Marginal rate of Substitutions (MRS):
Definition: The marginal rate of substitution of X for Y is the amount of good Y which the
consumer has to give up for the gain of one additional unit of good X so that the level of
satisfaction remains the same. It can be written as
 change∈Y
MRSxy=
change∈ X
Illustration:
Table 3
Indifference Schedule
Combination Good X Good Y MRSxy
A 1 12 4
B 2 8 3
C 3 5 2
D 4 3 1
E 5 2
In table 3, when the consumer moves from combination A to B, he gives up or sacrifices 4 units
of good Y to get 1 additional unit of good X. So, the MRSxy is 4. Similarly, when he moves
from combination B to C, his MRSxy is 3. At points D and E, the MRSxy is 2 and 1 respectively.
Assumptions of indifference curves:
1. Non-satiety
2. Transitivity
3. Diminishing marginal rate of substitution
Properties:
I. Indifference curves slope downward to the right- this property implies that an IC has
a negative slope. This property follows from assumption I. it means that when the
amount of one good in the combination is increased, the amount of the other good is
decreased.
II. Indifference curves are convex to the origin- This property follows from the
assumption that the marginal rate of substitution of X for Y diminishes as more and
more of X is substituted for Y.
III. Indifference curves cannot intersect each other- This property follows from
assumptions 1 and 2. This can be shown with the help of an illustration.
 IV. A higher IC represents a higher level of satisfaction than the lower IC- this property
states that the combination which lie on a higher indifference curve will be preferred
to the combination which lie on a lower indifference curve.
Price line or Budget Line:
Definition: it shows all those combinations of two goods which the consumer can buy by
spending his given money income on the two goods whose prices are given.
Illustration:
There are 2 assumptions:
(i). prices of the two goods are given
(ii). Limited income

Consumer’s equilibrium: maximising satisfaction-

Definition: Consumer equilibrium is at a point where the price line is tangent to the indifference
curve and where the MRSx y is equal to the ratio of the prices of the two goods X and Y.
Illustration:
 Fig. 10
In fig. 10 the indifference curve map and the price line PL is shown. Good X is measured in the
X axis and good Y is measured in the Y axis. Every combination of goods on the price line costs
him the same money.the consumer will try tio maximise his satisfaction by reaching the highest
possible indifference curve. This is the indifference curve which is tangent to the price line PL.
so, in the fig. the consumer will be on the indifference curve IC3 and be at point Q where the IC3
is tangent to the price line PL and will consume OM of good X and ON of good Y. Any other
point on the PL will give him lower satisfaction or it will be unattainable for him with his given
income. Point R, S, T anh H lie on the PL but they belong to lower indifference curves. Any
combination on IC4 and IC5 will give him higher satisfaction but the consumer cannot afford to
buy those combinations as they are outside the price line PL. it is therefore concluded that with
his given money income and the given prices of goodX and good Y, the consumer will be in
equilibrium at point Q where the indifference curve IC3 is tangent to the price line PL.
Second order condition for consumer’s equilibrium:
The tangency between the gi9ven budget line and an indifference curve is a necessary but not a
sufficient condition of consumer’s equilibrium. The second order condition also needs to be
fulfilled. The second order condition is that at the point of equilibrium the indifference curve
must be convex to the origin, i.e., the MRSxy must be falling at the point of equilibrium. In
fig.10 both the conditions are fulfilled.
But it may happen that the budget line is tangent to the indifference curve but the indifference
curve is concave to the origin.
In the figure above, the budget line BL is tangent to IC1 at point J but IC1 is concave to the
origin at that point. So, J cannot be the point of equilibrium because consumer’s satisfaction is
not maximum there. There are some points on the budget line BL such as U and T which will lie
on a higher indifference curve.
So the two conditions to be fulfilled for consumer equilibrium are-
1. A given budget line must be tangent to an indifference curve, or MRSxy=Px/Py
2. Indifference curve must be convex to the origin at the point of tangency.
Income effect: it is the change in the consumer’s purchase of goods due to a change in his
money income.
Illustration:
Substitution effect:
Definition- it means the change in the purchase of a good as a result of a change in relative
prices alone, real income remaining constant.
Price effect:
Definition- It measures the effect of the change in the price of a good on the quantity purchased.
Price consumption curve:
Illustration:

Fig 12
Given the prices of goods X and Y and given his money income represented by the price line
PL1, the consumer is in equilibrium at Q on the indifference curve IC1. At Q he buys OM1 of X
and ON1 of Y. Now let price of good X fall, price of Y and money income remaining the same.
So, the price line shifts to PL2 and the new equilibrium point is R on a higher indifference curve
IC2 where the consumer buys OM2 of X and ON2 of Y. He is better off as he is on a higher
indifference curve. The exercise can be repeated further as that the new equilibrium points are S
and T on successively higher indifference curves IC3 and IC4 respectively. When all the points
are joined, the price consumption curve is derived which traces the price effect. It shows
how the changes in price of good X affects the consumer’s purchase of good X, given the
price of good X and his money income (this is the definition).
Breaking price effect into income and substitution effect:

Fig 13

In Fig 13, the consumer is in original equilibrium at Q on indifference curve IC 1 from which it
shifts to a new equilibrium R on higher indifference curve IC 2 when the price of good X falls.
The price line twists from PL1 to PL2. The movement from Q to R is the price effect. Price effect
can be broken down into substitution effect and income effect.
With a given money income and prices of the goods also given as represented by the price line
PL1, the consumer is in equilibrium at point Q on the indifference curve IC where he consumes
OM of good X. Suppose the price of good X falls so that the price line shifts to PL 2. With the fall
in the price of X, the consumer’s real income has increased. But in order to see the substitution
effect, this gain in real income should be wiped out. This can be done by reducing the money
income of the consumer in such a way that he remains on the same indifference curve as he was
before the change in price of X. Since money income has been taken away from him, PL2 will
shift downward to AB which is parallel to PL 2. Consumer’s income has been reduced by PA in
terms of Y and BL2 in terms of X so as to keep him on the same indifference curve IC. Now
considering the new price line AB, in comparison to PL 1, keeping in mind the fall in price of
good X, it is relatively cheaper and Y expensive. So, now the consumer will substitute X for Y.
The consumer’s new equilibrium point is D where it consumes OK of X. This movement from Q
to D is the substitution effect since it occurs due to change in relative price alone. If the amount
of money income which was taken from him is given back to him, he would move from D on
indifference curve IC1 to R on higher indifference curve IC 2 and buy ON of good X. This
movement from D to R is the income effect.
Thus,
Price effect= MN; Substitution effect= MK; Income effect= KN
Price effect=Substitution effect + Income effect
MN= MK + KN
Income consumption curve and Engel curve-
Indifference curve as an analytical tool:

Cash subsidy vs kind subsidy-

In cash subsidy, the government gives lump-sum cash grant to consumer. In in-kind subsidy, the
government may give food-subsidy to the consumers. In this case, the consumer may be given food
stamps, etc with which he can buy food and only food.

Cash subsidy can give higher level of satisfaction to a consumer as compared to in-kind subsidy as a
consumer is free to spend the money on whatever goods he likes. But if the purpose of the government
is to increase consumption of food and improve their diet, then food subsidy is better. These situations
can be shown with the help of indifference curve analysis.

Revealed preference theory of demand:

Prof. Samuelson put forward this theory.

According to this theory, when a consumer is observed to choose a combination A out of various
alternative combinations open to him, then he reveals his preference for A over all other alternative
combinations which he could have purchased.

So, according to this theory, choice reveals preference.

Graphical explanation:

Fig. 15

Choice Reveals Preference

Suppose in the figure above, the prices of good X and good Y and the consumer’s income are given so
that the budget line is PL. The consumer can buy or choose any combination of good X and good Y lying
on the line PL such as A, B and C and lying below the line PL such as D, E, F and G. If the consumer
chooses combination A out of all the others, it means that he reveals his preference for A over all other
combinations. In the figure, at point A, the consumer is buying OM quantity of good X and ON quantity
of good Y.

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