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KEY TERMS 1) NEED OR DESIRE : The items we need in our daily lives. Needs are unlimited. 2) UTILITY : the satisfaction received when some need is fulfilled. It is a state of mind. The items which provide satisfaction are called utilities. 3) COMMODITY : It includes goods and services, which will satisfy needs. 4) DEMAND : Need becomes demand when the following conditions are satisfied a) willingness to purchase b) ability to purchase. The most important factor of economics and determinant of all economic activities. It is inversely proportional to price of commodities. 5) SUPPLY : Providing commodities for satisfying demand. It is directly proportional to price of commodities.

6) PRODUCTION : The act of creation of commodities, or conversion of natural resources to usable commodities capable of satisfying demand . it is called creation of utility. Factors of production the resources required for production are LAND, LABOUR, CAPITAL, ENTREPRENEUR 7) CONSUMPTION : The act of utilization of commodities to derive satisfaction is consumption. It is called destruction of utility. 8) INCOME : Any earning out of productive service is income. Earning is always as factor of production. Land Rent Labour Wages/salary Capital Interest Entrepreneur - Profit 9) SAVINGS : Part of the income not used for consumption is savings 10) INVESTMENT :Part of the savings used for income generating assets for future is investments. BASIC Problems of an Economic System An economic system has to search answers to three basic problems

What to produce ? How to produce ? For whom to produce ? In a free market economy, these problems can be solved by operation of a invisible hand. But in a command economy these problems are solved by planning undertaken by a central planning authority.


Household Generates demand Buyer of goods and services Supplier of factors Firms Generates supply Seller of goods and services Buyer of factors






Purchase of goods Taxes & subsidy governm ent taxes compensation &social security &subsidy househol ds Financial markets firm s



Cardinal utility analysis

Proposed by Prof. A. Marshall Main presumption : utility is measurable in terms of money. 1 unit of utility from a commodity = Re 1 spend on it Total utility (TU) : total satisfaction received from all the units consumed Marginal utility (MU) :utility received from consumption of one additional unit of a good MU = TU / x = TUn TU n-1
Where x the good being purchased

Law of diminishing Marginal Utility

The law states that when a person consumes successive units of a commodity, the marginal utility from each successive unit gradually diminishes and finally becomes negative. The total utility first increases and then falls.

Assumptions of the law

1) The consumer is rational. 2) The commodity is a normal good and the consumers need for the good is not satiated. 3) The commodity is finely divisible. 4) The consumer purchases all units successively ,i.e. there is no time gap between successive consumption. 5) The price of the commodity and the money income of the buyer remains constant during analysis. 6) There is no improvement in the quality of the product.

No. of units 1 2 3 4 5 6

TU 8 15 20 22 22 20

MU 7 5 2 0 -2 Table showing diminishing MU



Figure showing relation between TU and MU


Up to what level would a consumer consume a particular commodity ?

A consumer is willing to purchase a unit as long as the utility from that unit is greater than or equal to the [price paid for it. If price is fixed or falls for every successive unit, he will purchase up to that unit when MU = P units 1 2 3 4 5 P 8 8 8 8 8 MU 12 11 9 8 6


Ordinal utility analysis Proposed by Prof. J. R. Hicks

Main presumption : utility cannot be measured, consumers can rank commodities according to their utilities. Types of ordering of utility Strong preference:- A>B or A P B When good A provides much more utility than good B and if good A is not available, buyer will not buy good B. Weak preference :- A B or A R B Both good A and good B gives more or less equal utility but if both are available buyer will chose good A. Indifference :- A B or A I B good A and good B gives exactly same utility and the buyer chooses any one randomly.


RATIONALITY : The buyer is rational. He seeks to maximize utility. COMPLETENESS : the buyer will express any one the above preferences. CONSISTENCY : If between any two goods at any time A > B , then for any time B will not be preferred to A. TRANSITIVITY : If A > B and B > C, then A > C. If A = B and B = C, then A = C. NON-SATIETY : the consumer is not fully satisfied with the two commodities. He still needs more units of at least one of the good.

DIMINISHING MARGINAL RATE OF SUBSTITUTION : As quantity of A increases, the quantity of B the consumer is ready to sacrifice gradually diminishes. MRS = - B / A = - MUx/MUy

Marginal rate of substitution is the units of any good B which the buyer is ready to sacrifice, to buy one additional unit of another good A. Concept of DMRS can be explained from this table. It is assumed that the buyers income is fixed and he is buying two goods A & B.
Units of A
Units of B


8 9 10 11

10 6 4 3

4 2 1




Indifference curve analysis

The choice or preference pattern in the ordinal utility analysis is explained with the help of an indifference curve. The demand and buying pattern of consumers can be shown with the help of this curve. If we assume that a buyer buys two goods, then the locus of the different combination of the two goods among which the consumer is indifferent , i.e. he gets the same level of utility, is known as indifference curve.

Assumptions of Indifference curve

1.The consumer buys only two goods X and Y. 2.There can be different combinations of the two goods that he buys. Each such combination is called a commodity bundle.

3.The consumer is rational, he seeks to maximize utility. 4.The consumer has a given fixed money income. 5.The prices of the two goods remain fixed.

Properties of Indifference curve

It is downward sloping It is convex to origin Two Indifference curves will never intersect Higher Indifference curves indicate higher level of utility.

Demand : the desire to get a commodity supported by two qualities :o Willingness to purchase it.

o Ability to purchase i.e. having the necessary purchasing power.

FACTORS AFFECTING DEMAND Factors affecting demand of an individual

The need of the buyer Price of the commodity In usual cases, price and demand are inversely related. In exceptional cases, positive relation may prevail. Income of the buyer Usually for normal goods, demand rises with increase in income. If demand falls with rise in income, it is an inferior good. Price of other related commodities Complementary goods Px and Dy are inversely related.

Substitute goods Px and Dy are directly related.

Taste and preference of the buyer Demonstration or publicity affect

Factors affecting demand for the entire market or country

Total population Age composition of population Availability of consumer credit Expectation regarding future changes in price


States the inverse relationship between demand and price. The law states other factors remaining constant, the demand will rise with a fall in price and will fall with a rise in price.

Demand schedule price 20 24 28 32 36 Qty. demanded 15 12 10 9 8

Explanation to the law of demand Or Explanation to the downward slope of the demand curve
There are two major explanations


Law of diminishing Marginal Utility As explained by Prof. Marshall, due to the principle of MU = P to make any purchase, as price falls, the buyer gets utility from purchasing some further units of the good 2) Price Effect As explained by Prof. Hicks, price effect is a combination of 2 effects:- income effect and substitution effect. Income effect: the increase in real income experienced by the buyer when the price of a good falls. This induces him to buy a few more units of that good. Substitution effect: after a fall in price, the good becomes cheaper compared to its substitutes. So the buyer purchases more units. P.E. = I.E. + S.E. 3) Increase in no. of consumers: As price falls, some more buyers are able to afford the good or the good is put to more use. Thus consumption increases.

Exceptions to the law of demand

Or Can the demand curve slope upwards ? Cases where the law of demand is not obeyed

Giffen goods /Giffen effect Bandwagon and Snob effect Veblen effect items of conspicuous consumption Share market Certain expectations of future price changes

Elasticity of demand The relative change in demand due to change in any of the factors affecting demand Different types of elasticity:

1) Price elasticity : percentage change in demand due to 1% change in the own price of the commodity. ep = ( q/ p)*(p/q) 2) Income elasticity : percentage change in demand due to 1% change in the income of the buyer. ei = ( q/ Y)*(Y/q)

3) Cross price elasticity : percentage change in demand due to 1% change in the price of related commodities like complements or substitutes. ec = ( qx/ py)*(py/qx)

4) Advertising / Promotional elasticity : percentage increase in sales of a good due to 1% increase in advertising expenses. EA = ( S/ A)* A/S


Perfectly Inelastic When there is no change in demand for some infinite change in price Ep = 0

Relatively Inelastic When proportional change in demand is less than proportional change in price. Ep < 1

Unit Elastic When proportional change in demand is equal to proportional change in price. Ep = 1

Relative elastic When proportional change in demand is more than proportional change in price. Ep > 1

Perfectly Elastic When there is no change in price but infinite change in demand. Ep =

Factors affecting price elasticity

Nature of the good Availability of substitutes

Use of the good Possibility of postponing consumption Time factor