Season 5

(1) Useful for Government
It is a basic function of government to undertake public utility works like

construction of roads, bridges, schools, etc; water supply; public transport; and so
on. WPI can be of great use in determining future costs of these activities.
Some other functions of governments are controlling fluctuation in prices,
announce dearness allowance for its employees. CPI is of great help in this regard.
(2) Useful for businesses
Index numbers reveal trends in prices, production, exports, imports, etc.
Businesses can use this information for future expansion plans.
(3) Useful for planners
Index numbers provide to the planners the basis of allocation of funds to different
sectors of the economy. These can also be used for determining rate of growth of economy
which in turn will indicate success of failure of planning.
12.3 BASIC ELEMENTS OF AN INDEX NUMBER
12.3.1 Introduction
There are many types of index numbers. Of what type an index number is depends on
what it measures. In economics and business, index numbers are normally classified into
(i) price, (ii) quantity, (iii) value and (iv) special purpose. In India, Index Numbers of
Wholesale Prices, Consumer Price Index, etc., are the examples of price index. Index of
Industrial Production, Index Numbers of Agricultural Production, etc., are the examples of
quantity indices. Index numbers of national income, capital formation, etc., are the value
indices. Index Numbers of Human Development is an example of special purpose index
(you will study this index in class XII). Normally, a special purpose index is a composite
index in the sense that it combines many indices. It is 'many in one' type of index.
12.3.2 Basic Elements
Basic elements in the construction of each index are the same. We will explain
these elements in brief with reference to price index. The basic elements are : (i)
base year, (ii) price relative, and (iii) weights.
(i) Base year
Base year is a reference year. We require a base year to make comparisons between
prices referring to several time periods or several places. The prices of the base year
are taken as the standard and to them is assigned the value of 100%. Problems arise
in choosing a base year. Two important things are kept in mind in choosing a base
year. First, it should be a normal year with least cyclical fluctuations. Second, it
should not be too far away from the year of comparison.
(ii) Price Relative
A "price relative" is obtained by expressing the price of each commodity in a
given year as a percent of the price of the commodity in the base year. If p is the
price of base year and p the price of the nth year, then price relative (P), equals
Pn
P=
P0
In the Index Number of Wholesale Prices the base year is 2004—05. Suppose we want to find
the price relative of 2009—2010. It will be:
P p2009−10
2009−10
p2004−05
Price relative of each commodity or each group of commodities is calculated first and we take
the average in the following way
P=
∑ ( )
pn
p0
N
where, P = Price relative
N = Number of items (i.e., commodities)
(iii) Weights
By 'weights' we mean 'importance' assigned to different commodities included in the index.
In an index number prepared just on the basis of price relatives, equal importance is assigned to
all commodities. This is why it is usually referred to as simple price index number. But in
reality, all commodities do not have equal importance. In markets quantity bought and sold of
different goods differ. Quantity sold of salt is much less than the quantity sold of wheat, etc. This
reduces the usefulness of an index number.
To recognise differences in importance of different items instead of taking simple price relatives,
we take weighted price relatives. In this the price of a commodity is weighted by the quantity
sold. In other words, instead of taking p 0 we take p0q, i.e., price multiplied by quantity sold.
Instead of taking pn , we take pnq. The formula of price relative now becomes:
pn q
P=
p0 q
In weighting there are two variations. We can take base year quantities (qo) as base or we can
take current year (qn) as weights. We will not go into discussion about the merit and demerit of
each weights. However, if we choose qo as weights
pn q 0
P=
p0 q 0
and if we choose qn as the weights,
pn q n
P=
p0 q n
The index number prepared by applying weights is called Weighted Price Index Number.
Generally, most index numbers are weighted index numbers. These are more meaningful than
simple price index numbers.
12.4 METHODS OF WEIGHTED INDEX NUMBERS
12.4.1 Methods
There are many methods of preparing a weighted index number. Weights are assigned to take
care of the relative importance of the variable whose index number is to be prepared. In
preparing index number of commodities the basic weights used are quantity weights and value
weights. In case of price index, quantity weights are used. But quantities of which time period?
The choice is between the base year quantity (q 0) and the current year quantity (q n). This leads to
be distinction between the Laspeyre's method, the Paashe's method and the Fisher's method.
(1) The Laspeyre's Method
The Laspeyre's method uses base year quantities weights (q0). The formula is:
pn q0
P L= ×100
p0 q0
In this method a base year is selected first for determining weights. Suppose the
base year is 2008. The weights determined for the year are then used for the
subsequent years 2009, 2010 and so on.
(2) The Paasche's Method
The Paasche's method uses current year quantities as weights (q1). The formula is:
pn q1
P p= × 100
p0 q1
In this method current year's weights are determined first and then applied to all the
previous years.
(3) The Fisher's Ideal Index
Since the Laspeyre's index and the Passhe's method use different weights the numerical values
of the two indexes are bound to differ. Theoretically, both the values are correct. Since there is
no unique value, the Fisher's method strikes a compromise to arrive at a unique result.
If we write the Laspeyre's index as L and the Paashe's index as P, the Fisher's Ideal Index (F) is:
F=√ L P ×100
¿
√ ∑ p n q 0 × ∑ pn q n ×100
∑ p 0 q 0 ∑ p0 q n
Fisher takes the geometric mean of the two index numbers. Therefore, the value of the Fisher's
Ideal Index must be somewhere between the values of the Laspeyre's and the Paashe's index
numbers.
12.4.2 Steps in Construction
The main steps are .
(a) Determine weights
(b) Multiply prices by their respective weights
(c) Take the sum of these multiplications for each year.
(d) (d) Apply the formula.
Example
Suppose we have to prepare a price index number constituting three goods A, B and C.
For the year 2008 and 2009. We are given the following information :
Prices (in O for the years 2008 and 2009
Commodities Prices (₹) Weights (Percentage)
2016 2017 2016 2017
A 5 4 50 40
B 3 6 30 50
C 2 3 20 10
100 100
Solution
Commodities Prices Weight Price x Weights
2016 2017 2016 2017 2016 2017 2016 2017
p0 p1 q0 q 1 P0 q 0 P1 q 0 P0 q 1 P1 q 1
5 4 50 40 250 200 200 160

3 6 30 50 90 180 150 300
C 2 3 20 10 40 60 20 30
380 440 370 490
∑ p0q0 ∑ p1 q 0 ∑ p0q1 ∑ p1 q 1
p1 q0 440
L=∑ ×100= ×100=116≈.
p0 q 0 380
p1 q1 490
P=∑ ×100= × 100=1 32≈.
p0 q 1 37 0
F=√ L P=√116 ×132=124≈.
12.5 INDIA'S WHOLESALE PRICE INDEX

12.5.1 Introduction
By 'wholesale price' we mean the price at which a commodity is sold in bulk. It is distinguished
from retail price at which the commodity is sold in small amounts. The Wholesale Price Index
(WPI) is prepared in India by the Office of the Economic Advisor, Ministry of Commerce and
Industry, Government of India. The purpose is to study the movement in wholesale prices of
various goods produced. The rate of change in WPI is also treated as the rate of inflation in the
country. This forms a basis of many a short and long-term policies of government of India.
Since the rate of inflation concerns the common man the people also like to keep a watch on the
movement of prices. The rate of inflation is regularly announced in news bulletin on TV, Radio
and in newspapers, magazines, etc. Therefore, a detailed study of WPI is of great importance.
We will study mainly three aspects of WPI in India : base year, the type of goods
included and the weights assigned to each category of good.
12.5.2 Base Year
The base year of WPI in India at present is year 2011—12. Before this year 2004— 05
was the base year. Why is the change in base year? The need arises on account of three
reasons : (a) change in the relative importance of different goods, i.e., change in weights ;
(b) entry of new goods in the market and (c) some old products no longer produced. A
change in base year is required to make these adjustments.
12.5.3 Goods included in WPI
The goods included in WPI are classified into three categories : (a) primary articles, (b)
fuels, power, light and lubricants and (c) manufactured products.
Primary articles include (i) food articles like cereals, fruits, eggs, spices, etc. (ii) non-
food articles like raw cotton, raw jute, oilseeds, sugarcane, etc. and (iii) minerals.
The detailed classification is given in Table 12.3.
Fuel, power, light and lubricants group includes coal mining, mineral oils and
electricity.
Manufactured products include sugar, edible oils, textiles, paper, leather, chemicals,
machinery, etc. A comprehensive list of the products included in WPI in India is given in table
12- 3.
12.5.4 Weights Assigned to Goods

Weights are expressed in percentages. The weights assigned to different categories are
(a) Primary articles 22.6

(b) Fuels, power, light and lubricants 13.2
(c) Manufactured products 64.2
All commodities 100. 00
It means that manufactured products have nearly two-third importance in WPI. The remaining
one-third importance is assigned to other two categories. A list of weights assigned to selected
products is given in table 12- 3.
TABLE 12.3
Weight (percent) of selected commodities in Wholesale Price Index
Commodity group/ Weight Commodity group/ sub- Weight
sub-group (percent) group (percent)
Fuels, Power, Light and Lubricants 14.91

All Commodities 100.00
Coal Mining 2.14
Primary Articles 22.6
Mineral oils 7.95
Food articles 15.3
Foodgrains 3.5
64.2
Manufactured products
9.1
Rice 1.43 Food products
Sugar, khandsari and gur 1.16
Wheat 1.03
Pulses 0.64
2.64
Edible oils
4.9
Textiles
Tea 0.12
4.1 6.5
Non-food articles Chemicals and Chemical products
Cotton Yarn I .34 Fertilizers
Raw Cotton 0.66
Cotton fabric 0.95
Raw Jute 0.05 Cement
1.64
Groundnut seed 0.27 Basic metals, alloys and metal products 9.6
Iron, steel, and Ferrous Alloys 6.55
Minerals 0.8 Machinery and Machine tools 4.8
Source: Economic Survey 2016-17
TABLE 12.4
Index Numbers of Wholesale Prices (Base: 2004-05 = 100)
Year Primary Fuel and power, Manufactured All
articles products commodities
2011-12 100 100 100 100.0

2012-13 111 107 105 111
2013-14 125 115 109 122
2014-15 132 108 111 125
2015-16 135 87 109 125
2016-17 140 86 111 129
Source: Economic Survey : 2016—2017
12.5.5 What Does WPI Show?
WPI shows the change in price level over the period from base year to the year in question.
For example, suppose the year in question is 2016—17. Then the WPI of 2016—17 shows the
percentage change in price between 2011—12 (base year) and 2016—17. Consider the table
12.4.
In table 12-4, the WPI of 2016—2017 is 129. It shows that between 2011—12 (base year)
wholesale price level in India has increased by 29% (= 129-100). Similarly, price level in case
of manufactured products has increased by 11%, and so on.
To find out year to year change, we have to make some additional calculation. Suppose we
want to find out change in WPI during the year 2016—17. The general method is:
( WPI
WPI of the given year
of the previous year
×100 )=100
Therefore, price change during 2016-17 is.
( 129
125
× 100)−100=3.2 %
It means that rise in price level during 2016-17 was 3.2% (in case of all commodities).
12.5.6 Uses of WPI
WPI can be put to many uses. By traders, manufacturers, government, planners, etc. WPI is
one of the most important price index for a government in all countries of the world. Some of
the important uses of WPI are
(1) Basis for calculating rate of inflation
Annual rate of inflation is nothing but percentage increase in WPI during the year. For
example, wholesale price level during 2009—10 increased by 3-6%. This is the annual rate of
inflation.
The rate of inflation is used by government to revise the annual cost of projects undertaken by
it. The general public can also know the real value of their income, savings, wealth, etc. from
this.
(2) Basis for calculating real national income
Technically, real national income is called 'national income at constant prices'. WPI is used for
calculating real national income. A change in real national income indicates the change in
physical output in the country. The growth rate of the country is nothing but the rate of growth
of national income at constant prices.
(3) Indicator of general business conditions in the country
Movement in WPI indicates relative movements in aggregate demand and supply in the
country. Such an information can be conveniently used by the business class for planning their
production activities. It is also helpful in determining their future production costs, pricing,
marketing and sales policies.
(4) Useful for planning
Government launches long range economic and other programmes now and then. It has to
make provision for these programmes in its annual budget every year. The provision cannot be
the same every year because costs do rise every year. Government can use WPI for
determining allocation of funds for various schemes and sectors of the economy.
12.6 CONSUMER PRICE INDEX
12.6.1 Introduction
Consumer price index is a statistical measure of changes in prices of goods and services
bought by a well defined group of families. It is an index of prices paid by the consumers
for a well defined basket of goods and services. This basket varies for different groups of
consumer. For this purpose consumers are classified into three groups : (a) industrial workers,
(b) urban non-manual employees and (c) agricultural labourers. Separate CPI is prepared for
each group.
So, there is no one single CPI for all consumers but three CPIs for three categories of
consumers. The method of construction of each index is nearly the same as that WPI.
CPI serves as indicator of movement in retail prices. In India, there are three distinct series of
CPI for (i) industrial workers (CPI — IW) ; (ii) for agricultural labourers (CPI AL) and (iii)
for rural labourers (CPI—RL). Out of these CPI—IW is the most popular. It is calculated on
monthly basis.
12.6.2 Base Year
At present the base year of CPI - IW is 2012. (In case CPI - AL it is 1986—87 and in case of
CPI - RL it is 1986-87).
12.6.3 Major Commodity Groups and their Weights
The two major groups and their respective weights are given in Table 12-5.
TABLE 12.5
Commodity Groups and Their Weights in CPI - IW (Base: 2010 ---100)
Major group Weight ( % )

Food 46
Non-food 54
All commodities 100.00
Source: Economic Survey 2016-17
It is clear that food occupies an important place in CPI - IW.
12.6.4 What does CPI - IW Show?
It shows the percentage change in prices of goods and services bought by the families of
industrial workers in comparison to the base. Consider CPI - IW given in table 12.6.
TABLE 12.6
All India Consumer Price Index Numbers
For Industrial Workers (Base : 2012 = 100)
Year Rural Urban Combined
2012 100
2011 - 2012 111.9
100 100
2012 - 123.3
2013 113.1 110.4 112.2
2013 - 124.5 121.8 118.9
2014 112.6 111.8 124.7
2014 - 119.5 118.1 130.3
2015 126.1 123.0
2015 - 132.4 127.9
2016
2016 -
2017
(Source : Economic Survey 2016-17).
For example, rural price index of 2016-2017 shows that between 2012 and 2016-2017 the
prices rose by 30.3%. For year to year changes we have to make additional calculations
like the one we did in case of WPI. For example, annual increase in food prices during
the year 2016—2017 is 4-5% (¿ 130.3124.7×100 −100)
12.6.5 Uses of CPI
(1) Used for determining dearness allowance (DA) to Central government employees.
The Central government grants additional DA to its employees every six month on the basis of
increase in CPI - IW. It is also used for revising salaries every 10 years.
(2) Indicator of movement of retail prices of most of essential commodities of daily use.
Government closely monitors the movement in CPI - IW. On this basis, government follows its
supply management policies to ensure stability and moderation in prices of sensitive essential
commodities. When government finds that these prices have risen too high it can take effective
price stability measures.
(3) Useful for measuring real wages.
A rupee is not the same rupee year after year. Its value changes inversely with change in prices.
When prices rise the value of rupee falls and the real wages of workers decline. To compensate
the workers for this decline, workers demand higher money wages. Employers use CPI index to
raise money wages accordingly.
(4) Helpful in forecasting demand.
Price indexes of the previous years serve an indicator of likely price in the current and future
years. Price of a good is an important determinant of demand for that good. Producers can
design their output plans on the basis of such forecasts.
12.7 INDEX OF INDUSTRIAL PRODUCTION
12.7.1 Introduction
Index of Industrial Production (IIP) is basically a quantity index. It measures the average
change in physical volume of output of industries in the country.
12.7.2 Base Year
The present base year of IIP is 2011—12. Previous to this it was 2004—05.
12.7.3 Main Industry Groups and their Weights
There are three industry groups: (a) mining (b) manufacturing and (c) electricity. The
weights assigned to each group are:
Industry groups % weight
Mining 14.37
Manufacturing 77.63
Electricity 7.99
All groups 100.000

12.7.4 What does an IIP show ?
It shows percentage change in physical volume of output of commodities in the different
industries. Consider the following table (12.7):
TABLE 12.7
Index of Industrial Production (Base : 2011—12)
Year Index
2011-2012 100.0
2012-2013 103.3
2013-2014 106.8
2014-2015 111.1
2015-2016 114.9
2016-2017 120.7
Source: Economic Survey 2016—2017.
To find out year to year change additional calculation is to be made. For example, during
(
120.7 ×100
the year 2016-2017, output increased by 5% ¿ 114.9 −100 )
Inflation and Index Numbers
Inflation is a sustained increase in the general price level of goods and services in an
economy over a period of time. Thus, an occasional or periodic rise in prices or in
general price level cannot be called inflation. The rise in general price level has to be
persistent over time to be categorized as inflation. Besides this, inflation is associated
with rising prices and not the high prices. It is measured by changes in general price
index and is expressed as percentage rise in prices over the previous period i.e., the past
year, month or week.
Often, inflation is measured in terms of wholesale price index. For example, if
wholesale price index rises from 100 in 2011-12 (base year) to 150 in 2017, and if the
increase in price has almost been consistent over time, (an increase of 4% to 6%) it
would be considered the situation of inflation. In subsequent years, percentage increases
push the index number above 100, and percentage decreases push the figure below 100.
An index number of 102 means a 2% rise from the base year, and an index number of
98 means a 2% fall. Increase in price level decreases the value of money or purchasing
power of money. It reduces to half if the wholesale price index rises by 100%. Thus we
can say, double the price level, half the purchasing power of money. Similarly, a 10%
increase in the price level implies a 10% decrease in the purchasing power of people, if
money income of the people remains constant. Thus, inflation leads to erosion of
purchasing power of people. That is why during inflation, workers are demanding rise
in dearness allowance (DA), so that they can compensate the rise in prices.
Distinction between Inflation and Rate of Inflation
Inflation is measured as a percentage increase in the general price level, during the period of one
year. Whereas, rate of inflation is the relative change in the price index from week to week
(remember prices may not be rising at the same pace).
A 2− A1
Rate of Inflation = A1
× 100
Here, A1 = Wholesale price index for week l, and A 2 = Wholesale price index for week 2. This
means that within the year price may increase or decrease. For example, in week 1 the rate of
inflation may be 7%, whereas, in week 2 the rate of inflation may be 8%. Here, an increase from 7%
to 8% should not be treated as a rise in the price level, It only implies a rise in the speed at which
prices tend to rise or rate of inflation.
POINTS TO REMEMBER
 An index number is a specialized statistical average measuring changes in one or a group
of related variables with reference to time or place.
 There are many types of index numbers : (i) price, (ii) quantity (iii) value and (iv) special
purpose.
 The basic elements in a price index number are : (i) base year, (ii) price relative and (iii)
weights.
 Base year is a reference year. The index in all other years is with reference to base year.
 Price relative equals price in the current year divided by price in the base year (= pn/p0)
 Weights mean relative importance assigned to different items included in an index.
 Index number without applying weights is called simple index number.
 Index number prepared by applying weights is called weighted index number.
 Wholesale Price Index (WPI) shows relative movements in wholesale prices over different
years.
 The base year of WPI in India is 2011 - 12.
 The goods included in WPI are: (a) primary articles, (b) fuels, power, light and lubricants
and (c) manufactured products.
 The weights assigned to the three categories are 22-6, 13-2 and 64-2 per cent.
 Some uses of WPI are: (1) basis for calculating rate of inflation, (2) basis for calculating
real national income (3) indication of general business conditions in the country and (4)
useful for planning.
 Consumer Price Index (CPI) is a statistical measure of changes in prices of goods and
services bought by a well defined group of families.
 There are three distinct series of CPI for (i) industrial workers, (ii) for urban nonmanual
employees and (iii) for agricultural labourers.
 The base year of CPI for industrial workers (CPI - IW) is 2012.
 There are six major commodity groups in CPI - IW.
 Some uses of CPI -WI are
(1) Used for grant of dearness allowance to central government employees.
(2) Indicator of movement of retail prices of most of the essential commodities of daily use.
(3) Useful for measuring real wages.
(4) Helpful in forecasting demand.
 Index of Industrial Production (IIP) measures the average change in physical volume of
output of industries.
 Base year of IIP is 2011-12.
 The main groups of industries (with their weights) covered by IIP are : mining (14- 37),
manufacturing (77- 63) and electricity (7- 99).
EXERCISES
MULTIPLE CHOICE QUESTIONS [1 Markl
(Answers at the end of exercises)
Choose the correct alternative in the following questions :
1. An index number does the following to the variables
(a) Measures changes (b) Averages out changes
(c) Uses 'base' to measure changes (d) All the above
2. An index number is useful for
(a) For making government policies (b) For future plans by the businessmen
(c) For measuring success of planning (d) All the above
3. Base year in an index number should be an year in which these are .
(a) No cyclical fluctuations (b) Minimum cyclical fluctuations
(c) Average cyclical fluctuations (d) Maximum cyclical fluctuations
SHORT ANSWER QUESTIONS-I [3 Marks]
Answer the following questions in about 60 words.
1. Name the categories in which index numbers are classified in economics.
2. Distinguish between simple and weighted price indexes.
3. State any three uses of Wholesale Price Index in India.
4. State any three uses of Consumer Price Index.
5. Name the three Weighted Price Index Numbers.
SHORT ANSWER QUESTIONS-II [4 Marks]
1. State the tasks an index number performs.
2. Explain 'price relative' in a price index number.
3. Explain the term 'weights' in the construction of an index number.
4. Explain why the need for change of base year arises.
5. State the commodity groups and their respective weights in the Wholesale Price Index in India.
6. Explain any two uses of Wholesale Price Index.
7. State the major commodity groups in the Consumer Price Index for Industrial Workers in India.
8. Explain any two uses of Consumer Price Index for Industrial Workers in India.
9. State the industry groups and their respective weights in the Index of Industrial Production in India.
LONG ANSWER QUESTIONS [6 Marks]
1. Explain the basic elements of a price index number.
2. Explain the steps taken in the construction of an index number.
3. Explain the significance of index numbers.
4. Explain the uses of CPI.
Answer to the Multiple Choice Questions
1. (d) 2. (d) 3. (b)
PART B
INTRODUCTORY MICROECONOMICS
UNIT 1
INTRODUCTION
Chapter 1: SCOPE OF ECONOMICS
Chapter 2: ECONOMY AND ECONOMIC PROBLEM
Chapter 3: CENTRAL PROBLEMS OF AN ECONOMY
Chapter 4: CONCEPTS OF OPPORTUNITY COST AND PRODUCTION
POSSIBILITIES FRONTIER
CHAPTER: 1 SCOPE OF ECONOMICS

Study of economic behaviour of individual units, the economic system comprises is
microeconomics study. Study of economic behaviour of the economic system as a whole is
macroeconomics study.
1.1 INTRODUCTION
Economics is a social science which studies the way the society chooses to use its limited
resources to produce goods and services and distribute them among people. It is a science that
analyses the choice-making economic behaviour. What is the scope of study of economics in this
regard?
Is the analysis limited to the behaviour of an individual or is it extended to the society as a whole?
Economics studies both. It analyses the behaviour of an individual under the branch of economics
called "microeconomics". The behaviour of the society as a whole is analysed under the branch
"macroeconomics".
1.2 MICROECONOMICS AND MACROECONOMICS

Study of economics is traditionally divided into microeconomics and macroeconomics. The terms
"micro" and "macro" come from Greek words, meaning "small" and "large".
1.2.1 Microeconomics
Microeconomics studies the behaviour of individual economic units, or parts, that make up
economic system. These individual economic units are individual firms, households and industries. It
is concerned with how individual units make decisions, i.e. make choices. It also studies how these
individual units interact. The studies like relation between price and demand of good, price and
supply of a good, price determination, are all examples of microeconomic studies.
Microeconomics is a study of how individual economic units, firms, households and
industries make economic decisions, that is, make choices.
1.2.2 Macroeconomics
Macroeconomics studies the behaviour of the economy as a whole. It studies national
aggregates like aggregate demand and aggregate supply. It also studies national economic problems
like inflation, unemployment, poverty and the issues connected with economic growth and economic
development.
1.2.3 Relation Between Microeconomics and Macroeconomics
Both microeconomics and macroeconomics are simply two ways of looking at the same thing. It is
because the behaviour of the economy as a whole is dependent on the behaviour of the units that
make it up. For example, aggregate demand of the economy is the sum total of demand of all
individual units that make the economy. Similarly, national income is the sum total of income of all
the residents of the economy. An economist has beautifully summed up the relation between the two
with this expression : Microeconomics sees and examines the "trees", while macroeconomics sees
and analyses the "forests".
1.3 POSITIVE ECONOMICS AND NORMATIVE ECONOMICS

1.3.1 Introduction
Consider the following two statements:
(1) Higher tax on cigarettes causes people to smoke less because smoking becomes costly.
(2) People should not smoke.
What is the difference between the two statements?
The first statement simply describes what happens if a tax is imposed on cigarettes and how it
happens. No opinion is expressed on smoking whether it is good or bad.
The second statement implies that smoking is bad. Therefore, people should not smoke. This is
based on the value judgement that smoking is bad for health.
The first statement is an example of positive economics. The second statement is an example of
normative economics. These aspects are explained below.
1.3.2 Positive Economics
Analysing economic behaviour without making any value judgement whether the outcome
is good or bad is positive economics. It concerns 'what is' or 'what will be'. What will happen
when price rises is a positive statement. "Demand falls when price rises" is also a positive
statement. Whether this statement is true or false can be verified from the facts for example,
by conducting market survey. People normally do buy less when price rises. Positive
economics can be defined as follows .
Positive economics analyses 'what is' without making any value judgement with
outcome verifiable from the facts.
1.33 Normative Economics
Analysing behaviour and at the same time passing judgement on the outcome whether it is
good or bad and whether it can be made better is normative economics. It is based upon value
judgements. Value judgements are something which are based on personal opinion. Different
persons have different ideas about what is good and what is bad. Therefore, there can always
be a disagreement about normative statements. Such statements concern 'what ought to be'.
People should spend less and save more is a normative statement. 'Senior citizens should be
given free medical facilities' is also a normative statement. Normative economics can be
defined in the following way.
Normative economics deals with 'what ought to be' and based on value judgement not
verifiable from the facts.
1.3.4 Comparison
Positive Economics Normative Economics
1. Deals with 'what is'. l. Deals with 'what ought to be'.
2. No value judgement made on the outcome. 2. Value judgement made on the outcome.
3. Verifiable from the facts. 3. Not verifiable from the facts.
POINTS TO REMEMBER
 Economics can be looked at as a study of economic behaviour of an individual or of the
society as a whole. Accordingly, distinction is made between (1) microeconomics and (2)
macroeconomics.
 Microeconomics is the study of behaviour of individual economic units of the economic
system.
 Macroeconomics is a study of the behaviour of the economic system as a whole. Positive
economics analyses 'what is' without making any value judgement with outcome verifiable
from the facts.
 Normative economics deals with 'what ought to be' and based on value judgement not
verifiable from the facts.
EXERCISES
Answers at the end of exercises)
Choose the correct alternative in the following questions.
. Microeconomics deals with economic behaviour of :
(a) Economic System (b) Economic entities that make up the system
(c) Country (d) Regions of a country
2. Macroeconomics deals with economic functions of :
(a) Central bank (b) Government (c) NITI Ayog (d) All the above
3. Microeconomics is study of :
(a) A producer (b) Production of a good (c) An industry (d) All the above
4. Macroeconomics is study of :
(b) Consumption behaviour of all members of a family.
(c) Sum of all consumers of a good.
(d) Sum of all consumers of all goods.
(e) All the above
5. Which is macroeconomic variable?
(a) Unemployment (b) Inflation
(c) Income inequalities (d) All the above
6. Macroeconomics generalises :
(a) How economic decisions are taken?
(b) How economic decisions are taken by people?
(c) How economic decisions are taken by the industry?
(d) How economic decisions are taken by government?
7. Which one is microeconomic variable?
(a) Foreign exchange
(b) Balance of payments
(c) Exports and imports of a country
(d) None of the above
8. Macroeconomic delas with:
(a) Pricing of as product
(b) Pricing of a factor of production
(c) General price level
(d) None of the above
SHORT ANSWER QUESTIONS
1. Distinguish between microeconomics and macroeconomics with an example of each.
2. Explain the relation between microeconomics and macroeconomics.
3. Giving reason identify which of the following are the subject matter of microeconomics or of
macroeconomics : (HOTS)
(i) National income (ii) Supply by an industry
(iii) Government budget (iv) Supply by a firm
4. Give one example each of positive economics and normative economics.
SOME IMPORTANT QUESTIONS
1. Define micro-economics.
2. Define macro-economics.
3. Give two examples of microeconomics.
4. Give two examples of macroeconomics.
VALUE BASED QUESTIONS
1. Which branch of economics studies aspects concerning people of the country as a whole?
2. Inflation hits the common man the most. Which branch of economics tries to find solution of
this problem?
3. Which branch of economics deals with the problem of unemployment, a curse for the society?

1. (b) 2. (d) 3. (d) 4. (c) 5. (d) 6. (b) 7. (c) 8. (c)
APPENDIX
WHAT WE STUDY IN MICROECONOMICS
Basically, microeconomics is concerned with the study of market forces of demand and
supply. The interaction between these forces leads to determination of 'price' in the market.
The prices may be of 'outputs' and of 'inputs' (i.e., the four factors of production : land, labour,
capital and entrepreneur). This book is concerned with prices of 'outputs'. The coverage
(Chapters 1 - 15) is summed up in the flow chart given below
CHAPTER: 2 ECONOMY AND ECONOMIC PROBLEM
Economic aspects of an area/region is economy of that area/region. Limited resources
2.1 WHAT IS AN ECONOMY?
2.1.1 Meaning of an Economy
In economics, the word 'economy' refers to production activities of a well defined area or a region.
It may be a village, a district, a city, a country or the whole world. For example, when we refer to
the Indian economy, we actually refer to the whole collection of farms, factories, shops, offices,
banks, schools, colleges, theatres, TV channels, internet, police, courts, military, roads or for that
matter any activity concerning production of goods and services. Production activities are carried
out by the people to earn livelihood. The earnings are in the form of wages, rent, interest and
profits. On the basis of the above description, economy can be defined as follows :
Economy means the whole collection of production units operating in a defined area or region
by which people of that area earn their living.
2.1.2 Functioning of an Economy
An individual needs a large number of goods and services to survive and enjoy life. No individual
can ever produce on his own all what he needs. He can produce one or just a few things he needs
but for most of the other requirements he has no option but to depend on others. A farmer
producing wheat may be self-sufficient in wheat but has to depend on other producers for other
food items, clothes, utensils, education, seeds, fertilisers, tractors, etc.
An individual produces one or a few products from the resources he has. Normally, he attempts to
produce more than what he actually needs for his own consumption. This is because he wants other
things which he can obtain for the surplus production he has. A farmer may produce 100 quintals of
wheat but may need just 2 quintals to meet the needs of his family. The surplus of 98 quintals he
sells in the market and uses the money so received to obtain the other goods and services he needs.
The system of selling goods for money and then using money to obtain other goods is called
'exchange', and the economy is called the exchange economy.
Money and exchange are thus two vital aspects of the functioning of today's economy. Money
facilitates exchange and exchange facilitates to obtain goods and services one does not produce.
Obtaining goods and services for satisfying wants is called 'consumption'. Obtaining goods needed
to undertake production is called 'investment'.
2.1.3 The Basic Problem of an Economy
The goods and services usable to carry out production are called 'resources'. These are classified
into natural resources, human resources, man-made resources and organisation. These are also
called land, labour, capital and entrepreneurship respectively. Resources are also referred to as
factors of production. The resources are not enough to satisfy the never ending wants. This is what
is meant when it is said that resources are scarce. The scarcity is in relation to the quantum of
wants.
Since the resources are scarce, the people have to be choosy in using the available resources. They
have to find ways and means to economize i.e. use resources in the best possible manner. How to
make the efficient use of the available resources, is the basic problem of an economy.
'Efficient use' means efficient allocation of resources. Efficiency has three parameters . maximum
output, minimum cost and maximising welfare of the people. The first two aspects refer to the
efficient use of the resources. The third aspect refers to the efficient use of the output produced
from these resources.
2.2 THE ECONOMIC PROBLEM AND WHY DOES IT ARISE?
2.2.1 Meaning of Economic Problem
Economic problem is essentially the problem of which alternative to choose from amongst the
available economic alternatives. The problem is that if one alternative is chosen, the other
alternative cannot be availed. For example, given income, if a person decides to buy more of
one good, he must at the same time decide to buy less of some other good. You cannot watch
TV and study at the same time. One has to make choice between available alternatives.
"Which alternative to choose" is the economic problem.
2.2.2 Why does an Economic Problem Arise?
The root cause
The root cause is scarcity. Scarcity is a relative term. It cannot be defined in isolation. There
is scarcity of resources in every economy. Scarcity here implies that the society cannot get all
what it wants from the available resources. It means that wants of people are much more than
the available resources can satisfy. Therefore, one has to make a choice as to which one to
satisfy. Scarcity gives rise to the act of choice. The problem is that which alternative to
choose. Causes of an economic problem
Why does an economic problem arise? Scarcity of resources is the root cause but that is not
all. In fact, there are three causes : (i) Wants are unlimited, (ii) Resources to satisfy the wants
are limited and (iii) the resources have alternative uses. Let us explain each cause.
(i) Unlimited wants
Wants of human beings are unlimited. This is the basic fact of life and human nature. We
are never satisfied. Some wants are everlasting, like the needs of food, clothing and
housing. Some wants grow as income rises. There is never ending cycle of rise in income
and rise of wants. Wants keep growing.
(ii) Limited resources
There is limited amount of resources available in a society, or in every society. Resources
are land, labour, capital and entrepreneurial expertise. All the four are required to produce
goods and services. No society has enough of all the four. A society may have at a time more
of one but not more of all. India has more of labour but less of capital. USA has more of land
and capital but less of labour. No country has enough resources to satisfy all their people
want. People everywhere want more goods and services than there are means to produce
them.
(iii) Alternative uses of resources
Alternative uses means that a resource can be used for many purposes. But a resource
can be used only for one purpose at a time. A piece of land can be used, at a time, either for
growing crops, or for erecting a building, or for using as a garden, and so on. Time is a
resource. You cannot simultaneously watch a movie and attend the school. The same
resources cannot be used for more than one purpose at a time.
POINTS TO REMEMBER
• Economy means the whole collection of production units operating in a defined area or region
by which people of that area get their living.
• Money and exchange are the two vital aspects of functioning of an economy.
• How to make efficient use of the available resources is the basic problem of an economy.
• Economic Problem is the problem of choice making from amongst the available
alternatives.
• The root cause of economic problems is 'scarcity'.
• Scarcity means that the society does not have enough resources to satisfy all that people want.
• Economic problem arises due to : unlimited wants, scarcity of resources and alternative uses
of resources.
• Unlimited wants implies everlasting existing wants and evergrowing new wants.
• Scarcity of resources means not enough resources to meet the unlimited wants.
• Alternative uses of resources mean more than one uses to which a resource can be put and
imply that resource can be used only for one purpose at a time.
EXERCISE
1. The word "economy" stands for:
(a) Government institutions (b) People
(c) Income earning activities of the people (d) All the above
2. The area of an economy is confined to:
(a) A region of a country (b) Country as a whole
(c) World as a whole (d) Any of the above (HOTS)
3. Economic problem, in the context of a country, is using resources :
(a) Fully (b) Efficiently
(c) Both fully and efficiently (d) None of the above
4. Economic problem arises because of :
(a) Unlimited wants (b) Unlimited resources (c) Both a and b (d) Neither a nor b
5. Economic problem arises because .
(a) Resources are limited (b) Most resources have alternative uses (c) Wants are unlimited
(d) All the above
SHORT ANSWER QUESTIONS-I [3 Mar
1. Describe an economy.
2. Explain vital aspects of functioning of an economy.
3. Explain the basic problem of an economy.
4. What is an economic problem? What is its root cause? Explain.
5. Give reason why an economic problem arises.
SHORT ANSWER QUESTIONS-II 14 Ma

Answer the following question in about 70 words.
1. Explain the meaning and functioning of an economy.
1. Why does the problem of choice arise?
2. State any two causes of an economic problem.
3. State two characteristics of resources which give rise to an economic problem.
1. (c) 2. (d) 3. (c) 4. (a) 5. (d)
CHAPTER: 3 CENTRAL PROBLEMS OF AN ECONOMY
The problems faced by the economy are: how much to produce, which technique of production to
use, and how to allocate the goods so produced among people.
3.1 MEANING OF CENTRAL PROBLEM
Economics deals with the way society chooses to use its limited resources, which have alternative
uses, to produce goods and services and distribute them among different groups. The compulsion of
making choices before societies is referred to as 'central problems'. The word 'central', in this
context, means common to all societies. The choice problem is common to all societies of all types.
3.2 THE THREE ASPECTS
The way society chooses to use its limited resources to produce goods and services has three
aspects. The society has to make a choice as to what goods and services are to be produced in what
quantities. The problem is briefly described as 'what to produce'.
The society has also to make a choice as to by what method, or technique, should be adopted in
producing goods and services. It involves choice of inputs. The problem is briefly described as 'how
to produce'.
The way the society chooses to distribute the produced goods and services among different groups is
another problem. Who should get the produced goods and services is the problem? It is referred to
'for whom to produce' problem.
The three problems, viz., what, how and for whom, are the central problems of an economy. These
problems are basic and common to all economies, of all types.
Central Problems
1. What and how much to produce?
2. How to produce?
3. For whom to produce?
3.3 CENTRAL PROBLEMS OF AN ECONOMY
(1) What goods and service to be produced and in what quantities?
The problem arises because resources are scarce and have alternative uses. Should resources be used
for producing goods and services for civilians or for military? Should they be used for producing
more cars or for producing more cycles? Should land be used for producing more wheat or for
producing more rice? The problem, in fact, is that what combination of goods and services be
produced?
For example
The problem before the Finance Minister is: Out of given resources how much to allocate to
defense and how much to civilian goods?
(2) How to produce?
This means that what technique of production should be employed to produce a good? By
technique is meant the particular combination of inputs like labour and capital. A given quantity of a
d can be produced by many techniques. Generally, the techniques are classified into capital
nsive and labour intensive.
ital intensive technique uses more of capital than labour. Capital intensive technique is
entially a machine intensive technique.
Labour intensive technique uses more of labour than capital. The problem then virtually
amounts to that should more capital (machines) be used or more labour in producing a good or
a service.
For example
The problem before the businessmen and the NITI Ayog is to employ more capital in
production activities.
(3) For whom to produce? (How to distribute goods and services?)
Goods and services are produced for those who have the capacity to buy them. Capacity to
buy depends on income. More income means more capacity to buy. So, the problem 'for
whom to produce' amounts to the problem of distribution of income among income earners.
Incomes are distributed in the form of wages, rent, interest and profits. Who should get how
much is thus the problem?
The problem is:
What should be:
 the wage rate
 the rental
 the interest rate
 the profit rate
POINTS TO REMEMBER
 There are three basic economic problems common to all societies; what, how and for
whom to produce. Being common, these are called central problems.
 What to produce means what goods and services to be produced and in what
quantities.
 How to produce means that what technique should be employed in producing goods
and services.
 For whom to produce means how should the goods and services so produced be
distributed to people.
EXERCISES
1. The central problems are called central because these are faced by:
(a) All the consumers (b) All the producers (c) All the investors (d)
All the countries 2. Economic problem is basically the problem of choice
making :
(a) Between inputs (b) Between outputs
(c) About distribution of output (d) All the above (HOTS)
3. The central problems of "what, how and for whom" are :
(a) Interdependent (b) Independent
(c) All problems may not be present at one time (d) May vary from country to country
4. The central problem of 'how to produce' is basically the problem of deciding to undertake
production with the help of :
(a) Capital only (b) Labour only
(c) Both capital and labour (d) How much of capital and labour each
5. The central problem of 'for whom' refers to distribution of goods between :
(a) Rich and the poor (b) Users
(c) Different sections of society (d) Between public sector and private sectors
SHORT ANSWER QUESTIONS-I [13 Marks]
1. State the central problems of an economy.
2. Explain the problem of 'what to produce'.
3. Explain the problem 'how to produce'.
4. Explain the problem 'for whom to produce'.
1. Explain the basic problem of distribution of income. (HOTS)
2. Explain the central problem of 'what to produce' by giving examples.
3. Giving examples, explain the central problem of 'how to produce'.
4. Explain, giving examples, the problem of 'for whom to produce'.
I. What does the problem 'for whom to produce' refer to?
2. What are the three central problems of an economy? Why do they arise?
3, Why does an economic problem arise? Explain the problem of 'how to produce'.
4. Explain the central problem of 'for whom to produce'.
5. Explain the central problem of 'choice of technique'.
1. (d) 2. (d) 3. (a) 4. (d) 5. (b)
CHAPTER: 4 CONCEPT OF OPPORTUNITY COST AND PRODUCTION
POSSIBILITIES FRONTIER
The economy has to choose from amongst the available alternatives. In an attempt to
choose the best, the economy has to forgo the next best alternative. Foregoing the next
best alternative is the opportunity cost of choosing the best.
4.1 CONCEPT OF OPPORTUNITY COST

Economics is the study of making choices from the available alternatives. The available
alternatives mean available opportunities. The opportunities before the consumer are whether
to buy good X, or good Y, or any other good. The opportunities before a producer are whether
to produce good X or produce good Y, or some other good. The society has to make a
selection from the various opportunities (i.e. alternatives) available. The selection (i.e. choice)
becomes necessary because resources are limited.
The same quantity of a resource cannot be engaged in producing two goods simultaneously. A
plot of land cannot be used simultaneously for growing crops, and for running a factory. A
worker cannot be engaged for working on a farm and in a factory at the same time.
Now, if you use the plot of land for growing crops, you have to forgo its use for running a
factory. It means that if you avail one opportunity, you have no option but to forgo the other
opportunity. This forgoing of one alternative (i.e. running a factory) is the opportunity cost of
availing another alternative (i.e. growing crops). What is the cost here? The cost is that the
society has forgone the benefit it could derive by running a factory on that piece of land. This
loss of benefit from the alternative forgone is the cost society has to bear in choosing an
alternative.
Opportunity cost is a basic concept in Economics. It can be defined as follows .
Opportunity cost is defined as the value of the benefit that is forgone by choosing the
best alternative rather than the next best.
We take into account, nearly always, the opportunity cost of doing an activity. Suppose an
individual, who is in search of employment, finds that he has three possible opportunities. In
one case, he is offered ₹10,000 a month; in another case ₹8,000 a month; and in the third case
₹6,000 a month. Surely, if working conditions in all the three cases are the same, he will avail
₹10,000 a month job. The next best alternative before him was ₹8,000 a month job. He
forgoes this alternative to avail ₹10,000 a month alternative. To him, this is the opportunity
cost of availing an alternative. This leads us to another way of defining opportunity cost.
The opportunity cost of using a resource is defined as the value of the next best use to
which that resource could be put.
You can think of many other examples. The opportunity cost of investing money in one
project is the earning forgone by not investing money in the next best project, and so on.
4.2 PRODUCTION POSSIBILITIES FRONTIER

The compulsion of making choices and the opportunity cost of choosing an alternative can
be explained with the aid of a graphical technique 'Production Possibilities Frontier' — (PP
Frontier). It is also called PP curve. Let us explain this technique.
4.2.1 Assumptions
The concept of PP frontier is based on these assumptions. First, the amount of resources in the
economy is fixed. Second, the technology is given and unchanged. Third, the resources are
efficiently and fully employed. Fourth, no resource is equally emcient in production of all goods.
4.2.2 PP Schedule
Before drawing a PP frontier let us first explain the concept of a PP schedule on the basis of
which a PP curve is drawn. For this, we assume that only two goods X and Y are produced in
an economy. Given this, a PP schedule records the various combinations of the two goods
that can be produced with the fixed resources assuming that resources are fully and
efficiently employed. Suppose, the combinations that can be produced are as follows.
PP-Schedu1e
Combination Good X Good Y Marginal Rate of Transformation
(units) (units) (MRT) or Marginal Opportunity Cost
A 0 + 10 --
B 1 + 9 1Y : 1X
2 + 7 2Y : 1X
C
3 + 4 3Y : 1X
D
4 + 0 4Y : 1X
E
There are five combinations in the above schedule. These combinations are based on the
assumption that no resource is equally efficient in production of all goods. In combination A,
nothing of X is produced and all resources are used to produce Y. In combination B, one unit
of X is produced and for this one unit of Y is sacrificed. In C, one more unit of X is produced,
but now 2 units of Y are sacrificed. It is because now less effcient resources are transferred to
produce X. In this way, in combinations D and E, the rate of sacrifice of Y is respectively 3Y
and 4Y. This rate of sacrifice is called Marginal Rate of Transformation.
4.2.3 PP Frontier (Curve)
This increasing rate of sacrifice of Y gives the concave shape to the PP frontier. When we
represent all the above combinations in a diagram PP curve AE emerges. Note that this curve
(Figure 4.1) is of concave shape (and not a straight line) sloping downward from left to
right. (For more understanding, see Appendix.)
Definition of a PP Frontier: A PP frontier is the locus of the various combinations of
the two goods that can be produced in a two goods economy with fixed resources,
assuming full and efficient utilisation of these resources.
The economy can produce some combination on PP frontier only if resources are fully and
efficiently employed. It will produce somewhere below PP curve if some resources are
unemployed or inefficiently employed. For example, there may be unused land and
unemployment in the country. Also remember that it cannot produce at any point above the
PP frontier because fixed resources do not permit to do so. However, if resources increase,
the PP frontier itself shifts above.
4.3 RATE OF SACRIFICE FURTHER EXPLAINED
4.3.1 Rate of Sacrifice Increases. Why?
In our PP schedule we find that the rate of sacrifice of production of Y to produce an
additional unit of X increases as more and more of X is produced. Why is this rate increasing
(and not remaining constant or falling)? The answer is found in our fourth assumption which
states that 'no resource is equally efficient in production of all goods'. It means that resources
which are efficient in production of Y are comparatively less efficient in production of X.
In the beginning, we may find some resources which are equally efficient, but as we go on
producing more and more of X, it may be difficult to find equally efficient resources. Then,
there is no option but to transfer only the less and less efficient or less and less productive
resources. It means that to produce each additional unit of X, we have to sacrifice the
resources engaged in production of Y at an increasing rate.
There is a famous example of choice between producing guns and producing butter. (Guns
and butter are symbolic of defence goods and civilian goods.) Let us assume that resources
engaged in production of guns are less efficient in production of butter, and those engaged in
production of butter are also less efficient in production of guns. The assumption is quite
realistic. Suppose, a country is at war and needs production of more guns. There is no option
but to transfer resources from production of butter to production of guns. Since the resources,
say workers, engaged in production of butter are less efficient in production of guns, more and
more workers have to be transferred to produce each additional unit of gun. You can think of
another example like that of transferring resources from production of consumer goods to
capital goods, and so on.
4.3.2 Marginal Rate of Transformation
The technical term used for 'rate of sacrifice' is Marginal Rate of Transformation, in brief
MRT. The word 'transformation' here signifies transfer of resources. MRT can be defined as
the ratio of number of units of a good sacrificed to produce one more unit of the other
good, in a two-goods economy. For example, if production of two units of Y is sacrificed to
obtain the production of one more unit of X, MRT equals 2Y : I X. The production possibility
schedule is based on the assumption that 'MRT is increasing'
4.3.3 Marginal Opportunity Cost
The rate of sacrifice, i.e. MRT, can also be interpreted in another way. Suppose the production
of 2Y is sacrificed to produce 1 X. Then 2Y can be said to represent opportunity cost of
producing 1 X. Recollect the definition of opportunity cost. It is the value of benefit forgone
by choosing one alternative rather than another. The society loses the benefit it could derive
from 2Y by producing one more unit of X. In more exact terms, it should be called 'marginal
opportunity cost'.
The word 'marginal' signifies one more unit. In the present context, it signifies addition to the
cost on producing one more unit of output.
Marginal Opportunity Cost is defined as the addition to the cost in terms of a number of
units of a good sacrificed to produce one more unit of the other good.
To sum up, the rate of sacrifice, MRT and Marginal Opportunity Cost convey the same
meaning in the context of PP schedule and PP curve. What do these signify in case of a PP
curve?
The behaviour of MRT (or Marginal Opportunity Cost) determines the shape of PP frontier. A
typical PP frontier is a concave curve. It derives its concave shape from 'increasing MRT'.
4.4 PROPERTIES OF THE PP CURVE
A typical PP curve has two characteristics :
(1) Sloping downwards from left to right
It is so because to produce more quantity of one good the society has to sacrifice some
quantity of the other good. The reason is that resources are limited.
(2) Concave from the origin
The PP curve is concave because marginal rate of transformation, which is also its slope,
increases continuously as more and more of one good is produced by reducing the quantity
of the other good. It means that to produce more and more units of one good each time the
quantity of the other good is sacrificed at an increasing rate. MRT increases because no
resource is equally efficient in production of all goods. Therefore, each time one more unit
of the other good is to be produced, more and more units of the resources producing given
good are to be transferred because they are less efficient in producing the other good.
4.5 THE SHAPE OF PP FRONTIER IF MRT IS CONSTANT
If MRT is constant, it means that every time the society requires to produce one more unit of a
good, the number of units of the other good to be sacrificed is the same. It also means that
each resource equally efficient in production of all the goods.
PP-Schedu1e
Good X Good Y MRT = ∆Y/∆V
(units) (units)
0 10 --
1 8 2Y : 1X
2 6 2Y : 1X
3 4 2Y : 1X
4 2 2Y : 1X
5 0 2Y : 1X
In the above PP schedule, we find that MRT is constant. In this case PP frontier would be
a downward sloping straight line (Figure 4.2).
4.6 WHAT HAPPENS IF RESOURCES ARE NOT

FULLY AND EFFICIENTLY EMPLOYED?
A PP frontier is drawn on the assumption that resources are fully and efficiently employed. If
it is so,
actual production must take place at some point on PP frontier only, say at A, or at B, or at
any other
point. However, if resources are not fully employed, or not efficiently employed, actual
production
will take place at some point below the PP frontier, say at U (Figure 4.3). It means that the
economy
is not producing goods and services to its full potential.
4.7 SHIFT OF THE PP FRONTIER

Under what circumstances a PP curve shifts?
It can be due to the following reasons:
(1) When Resources Increase?
Every economy tries to increase its resources so that more can be produced. PP curve is based
on the assumption that Good X resources are fixed. When resources are fixed more of one
good can be produced only by sacrificing some quantity of the Shift of PP Frontier Resources
Increase other good. We cannot produce more of both the goods. However, when resources
increase we can produce more of both the goods. Graphically, when resources increase, PP
frontier shifts upwards (Figure 4.4).
(2) When Technology Changes?
Generally, the change in technology is for the better. Better technology means that more can
be produced of either one or of both the goods. In this situation also PP frontier shifts
upwards.
(3) When Resources Decrease?
Resources with the society may decrease due to unusual happenings like war, natural
calamities like floods, earthquakes, epidemics, large-scale migration of population to other
countries etc. In such situations the production potential of the country decreases, and the PP
frontier shifts O Good X downwards. (Figure 4.5).
POINTS TO REMEMBER
 Opportunity cost is defined as the value of the benefit that is forgone by choosing
one alternative rather than the other.
 Opportunity cost of using a given resource can also be defined as the value of
next best use to which that resource could be put.
 A PP curve or a PP frontier is the locus of various combinations of the two goods
that can be produced with fixed resources, assuming full and efficient utilisation of
these resources.
 A PP frontier is based on these assumptions
1. Amount of resources in the economy is fixed.
2. Technology is given and unchanged.
3. Resources are efficiently and fully employed.
4. No resource is equally efficient in the production of all goods.
 Marginal Rate of Transformation (MRT) is defined as the ratio of number of units
of a good sacrificed to produce one additional unit of the other good.
 MRT can also be called Marginal Opportunity Cost. Marginal Opportunity Cost is
defined as the additional cost in terms of number of units of a good sacrificed to
produce an additional unit of the other good.
 The assumption of increasing MRT, or Marginal Opportunity Cost, gives PP a
downward sloping concave shape.
 If MRT is constant, a PP frontier is a downward sloping straight line.
 If resources are fully and efficiently employed, production takes place only on some
point of the PP frontier.
 If resources are unemployed, or inefficiently employed, production takes place
below the pp frontier.
 If resources increase, PP frontier shifts upwards.
 If technology changes, PP frontier shifts upwards.
 If resources decrease, PP frontier shifts downwards.
EXERCISES
MULTIPLE CHOICE QUESTIONS [l Markl
1. A person has four job offers of ₹20,000, ₹23,000, ₹25,000, ₹28,000 respectively. Assuming
that working conditions in all the four are the same and the person is rational. The opportunity
cost of the offer chosen is :
(a) 20,000 (b) 23,000 (c) 25,000 (d) 28,000
2. You have four alternatives to spend your spare time. The alternatives in order of preference are
take rest, play, watch television, and study. What is the opportunity cost of choosing the best
alternative?
(a) Play (b) Watch television
(c) Study (d) Any of the above
3. The nation has two alternatives of producing IOOX + 200Y or 102X + 196Y from its given
resources. The nation chooses the second. What is the marginal opportunity cost of producing
X:
(a) 4Y (b) 3Y (c) 2Y (d) 1Y
(HOTS)
4. Opportunity cost refers to the value of the opportunity:
(a) to be available in future (b) available in the past
(c) actually availed at present (d) could be availed at present as a second alternative
5. A typical PP frontier shows :
(a) The actual output the nation is producing.
(b) The minimum output the nation must produce.
(c) The maximum output the nation can produce for all times to come.
(d) The potential output of the nation from the given resources at present.
6. A typical PP curve is downward sloping concave curve because: to produce more of one good,
output of the other good must be reduced,
(a) at increasing rate (b) at decreasing rate
(c) at constant rate (d) Initially at decreasing rate and then at increasing rate.
7. As one moves along a PP curve, Marginal Rate of Transformation :
(a) Decreases continuously (b) Remains unchanged
(c) Increases continuously (d) Decreases upto a point, remains constant and then increases.
A typical PP curve is :
onvex (c) downward sloping convex
oncave (d) downward sloping concave
Marginal Rate of Transformation increases as we move along a typical PP curve due to :
(a) Resources being fully employed.
(b) Resources being effciently employed.
(c) No resource is equally efficient in production of every good.
(d) All the above
A PP curve :
(a) Cannot shift at all (b) Can shift upwards only
(c) Can shift downward only (d) Can shift both upwards and downwards
ORT ANSWER QUESTIONS-I

swer the following questions in about 60 words.
1. Explain briefly the concept of opportunity cost.
2. State any three assumptions on which a typical PP frontier is based.
3. Explain the concept of Marginal Opportunity Cost by giving a numerical example. (HOTS)
4. Draw PP frontiers when Marginal Opportunity Cost is (i) increasing, and (ii) constant.
5. Explain what happens to a PP frontier when resources increase. Use diagram.
6. Explain how the central problem of 'what to produce' is represented on a PP frontier. Use diagram.
7. How is unemployment of resources represented with the help of PP frontier. Use diagram.
8. How is inefficient use of resources represented on a diagram showing PP frontier? Explain.
(HOTS)
ORT ANSWER QUESTIONS-II [4 Marks]

swer the following questions in about 70 words.
1. Explain the concept of opportunity cost by giving a suitable illustration.
2. Calculate Marginal Rate of Transformation of good X :
Production of Production of Marginal Rate of
Good X (Units) Good Y (Units) Transformation
0 15
1 14
2 12
3 9
4 5
5 0
3. What is a PP schedule? Prepare a typical PP schedule.
4. Prepare a PP schedule assuming that the Marginal Opportunity Cost is constant. Also, comment on the
shape of the PP curve.(HOTS)
5. Explain the concept of PP frontier. Use diagram.
6. Explain briefly what happens to PP frontier when (a) resources increase, and (b) resources decrease.
Use diagram.
LONG ANSWER QUESTION [6 Marks]
1. State the assumptions on which a PP curve is based. Also explain its properties. Use diagram.
1. Give meaning of opportunity cost.
2. What does a production possibility frontier show? When will it shift to the right?
3. Draw and define production possibility frontier. Why is it downward sloping from left to right?
4. Draw a production possibility frontier. What does a point below this curve indicate? Explain.
5. Why is PP curve concave?
6. Unemployment is reduced due to measures taken by government. State economic value in the context
of production possibilities frontier. (Value based)
7. Government has started promoting foreign capital. What is its economic value in the context of
production possibilities frontier. (Value based)
8. Large number of technical training institutions have been started by government. State its economic
value in the context of production possibilities frontier. (Value based)
9. Name the economic value achieved through the spread of education in the context of production
potential. (Value based)

1. There is unemployment in the country. The government launches employment guarantee schemes.
Explain the effect of this action of the government using the Production Possibilities Curve.
2. People of a country are becoming more and more aware of the importance of education. Explain its
effect on the production potential of the country using the Production Possibilities Frontier.
3. The country lacks capital needed to raise national income of the country. Government initiates policies
favouring globalisation to attract foreign capital. Explain the effect of these policies using Production
Possibilities Curve.
4. Explain the effect of upgradation of technologies on the production potential of the country. Use
diagram.
5. What is the likely effect of environmental degradation on the production potential of the country.
Explain. Use diagram.
6. The economy has reached the production capacity it has at present. There is, however, good scope for
increasing the efficiency levels through promotion of education and training. Explain its effects. Use
diagram.
7. What is likely to be the impact of "Make in India" appeal to the foreign investors by the Prime
Minister of India on the production possibilities frontier of India? Explain. (CBSE)
. (c) 2. (a) 3. (c) 4. (d) 5. (b) 6. (a) 7. (c) 8. (d) 9. (c) 10. (d)
APPENDIX
CONCAVE CURVE AND INCREASING MRT
e can show that if MRT increases as the society produces more of one good, the PP curve must be
ncave. We continue to assume full and emcient employment of resources. As we move downwards along
e PP curve, from A to C, from C to E and so on the MRTs are:
Movements from MRT AY/AX)
A to C AB/BC
C to E CD/DE
E to G EF/FG
G to I GH/HI
that denominators BC, DE, FG and HI are constant, all equal to l. Also note that the numerators AB,
EF and GH, the dark vertical lines, are continuously increasingx as we move downwards. Since the
erators are increasing 0 1 2 3 4Good X and the denominators are constant, it is proved that MRT
eases as more of X is produced. Remember that MRT is also the slope of the PP curve.
Understanding Based Questions from CBSE Examination Papers (Alongwith Answer)
Based on unit 1 — Introduction
hat is opportunity cost? Explain with the help of a numerical example.
Opportunity cost is the next best alternative foregone in choosing the best one. Suppose an economy produces
two goods X and Y. Further suppose that by employing all resources fully and efficiently, the economy can
uce IX + 10Y. If the economy decides to produce 2X, it has to cut down production of Y by 2 units because
urces are limited. In this case opportunity cost of producing one more unit of X is 2Y.
oduction in an economy is below its potential due to unemployment. Government starts employment
ration schemes. Explain its effect using Production Possibility Curve.
Production below the potential means that total production in the economy is somewhere below the
uction possibility curve PP', for example at point U, in the diagram.x
n government starts employment generation schemes, and Good X since the production is below potential
due to unemployment, the economy moves forward in its attempt to remove unemployment and reach the
ntial. The movement forward is towards the PP' curve.
xplain the central problem 'for whom to produce'.
'For whom' means who will buy the goods and services produced. Clearly, only those who have purchasing
er or income will be able to buy. As such the problem amounts to that how should the national income be
buted among people in the economy.
hy is Production Possibilities Curve concave? Explain.
A typical downward sloping PP curve is concave, i.e., its slope is increasing as we move from left to right. It
means that Marginal Rate of Transformation (MRT) increases as we move downwards along the curve. The
e is based on the assumption that no resource is equally effcient in production of all goods. MRT increases
use in order to produce more and more units of one good each time the quantity of the other good is sacrificed
increasing rate.
hat will likely be the impact of large scale outflow of foreign capital on Production Possibilities Curve of the
omy and why?
Ans. The outflow of foreign capital from the economy will reduce resources and thus production potential
of the country. This, in turn, will shift the PP curve downwards.
6. What is likely to be the impact of "Make in India" appeal to the foreign investors by the Prime Minister
of India, on the production possibilities frontier of India? Explain.
Ans. "Make in India" appeal signifies invitation to foreign investors to produce in India. This will bring in
foreign capital into India and thus it will lead to increase in resources, raising production potential of
the country. It will shift the PP curve upwards.
UNIT 2
CONSUMER’S EQUILIBRIUM AND DEMAND

Chapter 5 : CONSUMER’S EQULIBRIUM : UTILITY ANALYSIS
Chapter 6 : CONSUMER’S EQUILIBRIUM : NDIFFERENCE CURVE ANALYSIS
Chapter 7 : DEMAND
Chapter 8 : PRICE ELASTICITY OF DEMAND

CHAPTER: 5 CONSUMER’S EQULIBRIUM : UTILITY ANALYSIS
The best state achievable under the given constraints is termed as the equilibrium state.
Getting maximum satisfaction by spending the given income is the Consumer's equilibrium
state. Utility Analysis is one explanation of this state.
5.1 CONSUMER
5.1.1 Who is a Consumer?
The act of using up goods and services to satisfy wants is called 'consumption'. The one who
consumes is called a consumer. If we look at the consumer in this way, then fundamentally all
human beings are consumers. But what interests economists is not 'who consumes' but 'who takes
decisions about what to consume and how much to consume'. The economist also takes interest in
the logic behind a consumption decision.
In microeconomics, the one who takes decision about buying goods and services for satisfaction of
wants is a 'consumer'. Note that, generally, such a decision is the joint decision of a family. An
individual may take some decisions totally on his own but most of the decisions he takes as a
member of the family. A family unit in economics is called a 'household'.
A household consists of all the people who live under one roof and who take joint decisions as to
what to buy for satisfaction of wants. In microeconomics, an individual consumer is the same as
household. It can be defined as :
The one who takes decisions about what to buy for satisfaction of wants, both as an
individual and as a member of household, is called a consumer.
5.1.2 A Rational Consumer

It is a fundamental fact that wants of human beings are unlimited. It is also a fact that the income a
consumer has is limited. One cannot fulfil all of one's desires. There is no alternative but to make a
choice as to what to buy. Since the income is limited one has to make the most in making choice.
Making the most means maximisation of satisfaction from the purchases one chooses to make.
In microeconomics, a consumer who seeks to maximise utility or satisfaction in spending his
income is called a rational consumer. The study of consumer behaviour is the study of rational
consumer.
5.1.3 Aspects of Consumer's Behaviour
A consumer takes decisions on the basis of his preferences, his income and the prices prevailing in
the market. Accordingly, the economists study two aspects of consumer behaviour.
First, on what basis a rational consumer allocates the limited income between different goods and
services desired. Of course, the objective behind the allocation is maximisation of satisfaction.
Technically, it is called consumer's equilibrium.
Second, what is the reaction of a consumer to change in price of a good or a service he intends to
buy? How does he usually react? Does he buy more? Does he buy less? Does he buy the same
quantity? The generalisation of behaviour in this respect is called the law of demand.
The two aspects are studied under three analyses (l) Marginal Utility analysis of Alfred Marshall
(1891); (2) The Indifference Curve Analysis of J.R. Hicks (1937); and (3) The Revealed Preference
Hypothesis of Paul Samuelson (1947). The scope of this book is confined to the first
only. Marginal utility analysis is studied in this chapter. The indifference curve analysis is studied in the
t chapter.
MEANING OF EQUILIBRIU
uilibrium is a general term. It is not associated with consumer only. We talk of equilibrium of a producer,
ilibrium price, equilibrium wage rate, equilibrium level of national income, and so on. It is necessary,
refore, to know the meaning of equilibrium first, before we apply it to a consumer.
ere are two ways in which we can define equilibrium. Equilibrium is a state of rest. This is one way. It
state when actions of an entity come to rest when the given objective of that entity is achieved. Let this
ty be the consumer. What are the actions of a consumer? The act of allocation of income is the action.
at is his objective? Maximum satisfaction from this allocation is his objective. When do his actions
me to rest? When he achieves his objective. So, consumer's equilibrium means that allocation of his
ome on goods and services which gives him maximum satisfaction. In brief, consumer's equilibrium is
sumer's maximum satisfaction level. When applied to a producer, it means maximum profit position.
equilibrium is a state of balance due to equal action of opposite forces. This is another way of
ining equilibrium. Take, for example, price determination process. It is determined at that level at which
sumers are willing to demand the same quantity of a good which producers are willing to supply.
umers and producers have opposite interests, and so these are opposite forces as far as price
mination in a market is concerned. The price is determined when these two opposite forces have equal
n, i.e. the same quantity of demand and supply. The price so determined is called the equilibrium price.
consumer tries to achieve 'equilibrium'. He tries to plan his expenditures in such a way that he gets
mum satisfaction out of this. Economists in studying consumer's equilibrium, try to interpret actions of
onsumer. What exactly lies behind these actions? How does a consumer make choices as to how much
end on each good? Studying choices is what Economics is all about. There are many theories which
in these choices. In this chapter we will study marginal utility analysis.
ONCEPT OF UTILITY
Meaning
y is the satisfaction, actual or expected, derived from the consumption of a good. Normally, it is
pected satisfaction, because we generally purchase first and consume later.
y is a psychological phenomena. It is a feeling which differs from consumer to consumer. There cannot
standard measure of a feeling. To analyse the concept, economists use an imaginary measure called
". They express utility in terms of number of utils derived from the consumption of a good. But the
em remains, because there is no ruler measuring utils. So, economists found it convenient to express
n money units, say in rupees. It is assumed that utility can be measured in terms of money. Let one util
ual to one rupee. It is only an assumed value, and not a standard value. It may dif fer from consumer
nsumer. The assumption is made for the sake of making analysis of utilitypossible. ' 1 util — 1 Rupee'
mption means that, if a consumer gets 5 utils of satisfaction from consumption of a good, the utility is
as ₹5 worth. Now, we can conveniently proceed to another concept related to utility called 'marginal
'.
Marginal Utility
inal utility means addition to the total utility from the consumption of one more unit of a good.
xample, if a consumer gets a total utility of 5 utils from one unit, and 9 utils from two units, he gets 4
rom consumption of the second unit. So, marginal utility of 2 units of a good is 4 utils, or ₹4 (because
ve assumed that I util = I Rupee). If total utility from 3 units is 12 utils, then marginal utility of 3 units
tils, i.e. utility derived from the third unit. It can also be defined as utility of the last unit consumed. In
xample, the third unit, is the last unit and utility from this unit is 3 utils. If we are given information on
utility from different levels of consumption we can find marginal utility at each level. Consider the
wing table :
Table 5.1
Utility Schedule of a Consumer from Consumption of a Good
1 2 3 4
Consumption Total Marginal Marginal
(units) Utility Utility Utility (₹)
(utils) (utils) (1 util = 1 Rupee)
0 0 -- --
1 4 4 4
2 7 3 3
3 9 2 2
4 10 1 1
5 10 0 0
6 9 -1 -1
Table 5.1, column 2 records total utility. Column 3 records marginal utility which is derived from total
ility in the following way.
TUn – TUn_= MUn
here TU is total utility, MU is marginal utility and n is the number of units of a good consumed. It mean
at TUn is the total utility of n units consumed.
uppose n is equal to 5 units. Then TU N is 10 utils. (n - l) units is equal to 4 and TU N-1 is 10 utils. MUN
en equals
MUn = TUn – TUn-1
10 – 10 = 0 utils.
here is an alternative way to find marginal utility. The way is .
∆ Total utility ∆ U
MU = =
∆ Consumption ∆ C
his method has an advantage. MUn = TUn – TUn-1 can be applied only when change in total utility due to
ery new unit consumed is given. ∆U/∆C can be applied even when more than one unit change is given.
uppose total utility of 2 units consumed is 10 utils and of 4 units consumed is 18 utils. In this case MU n =
Un – TUn-1 cannot be applied. ∆U/∆C can be applied. By applying this method
∆U 8
MU of 4 units = ∆ C = 2 =¿ 4 utils.
.3 Law of Diminishing Marginal Utility
e law examines the relation between increase in consumption of a good and the consequent change in
rginal utility from that good. The law states .
w of diminishing marginal utility states that as the consumer consumes more and more units of a
od, the addition to total utility from each new unit consumed obtained goes on decreasing.
A stage comes when marginal utility becomes zero. At this point total utility is maximum. Check this
from Table 5.1. If the consumer goes beyond this stage, marginal utility becomes negative and total
utility starts falling. It means that instead of utility the consumer starts getting disutility. The good
begins to harm the consumer. To avoid the marginal disutility stage, economists make the assumption
that consumer is rational, i.e. he wants to maximise satisfaction. So, a rational consumer will not go
beyond the zero marginal utility stage. It means that, given an option, he will consume at the most 5
units in our example.
e law states that marginal utility continuously declines. This is generally true. But there may be a
uation in the beginning of consumption when marginal utility may initially increase. It all depends on
circumstances. Economists, in their studies, normally assume a situation of continuously falling
rginal utility.
e concepts of utility, marginal utility, and the law of diminishing marginal utility are helpful in
derstanding consumer's equilibrium.
.4 Relation between Total Utility and Marginal Utility
hen consumption of a good by a consumer increases, total utility derived from it changes. The law of
minishing marginal utility is the basis of change. According to the law, as consumption is increased,
rginal utility falls. During the fall, marginal utility is positive in the beginning, becomes zero after
me consumption level and ultimately becomes negative. As consumption increases the relation between
al utility and marginal utility which emerges from this is as follows (refer to Table 5.1). becomes
gative. As consumption increases the relation between total utility and marginal utility which emerges
m this is as follows (refer to Table 5.1).
 Initially, total utility increases but at a decreasing rate. Marginal utility is falling but
positive. In the table, this phase is upto 4 units of consumption.
 After some consumption level, total utility is maximum and neither increases nor
decreases. In the table, total utility is maximum at 4 units and remains so at 5 units.
Marginal utility is zero at 5 units.
 Ultimately total utility starts falling and marginal utility becomes negative. In the table
this change is from 6th unit onwards.
5.4 CONSUMER'S EQUILIBRIUM
5.4.1 Meaning
Consumer's equilibrium means that allocation of income by a consumer on goods and services he buys
which gives him maximum gain of satisfaction. A consumer spends on many goods and services. He is
said to be in equilibrium when the sum of utilities obtained from the consumption of all goods and services
expressed in monetary units less the amount paid for obtaining these is maximum. It means the allocation
of income is done in such a way that he gets maximum gain or satisfaction. It also means that any
alternative allocation is going to give him only less gain or satisfaction.
5.4.2 How does consumer decide as to how much to buy of a good?
Before we explain consumer's equilibrium, let us see how does a consumer decide as to how much
to buy of a good. It will all depend on the price he pays for each unit and the utility he receives.
When purchasing a unit of a commodity, consumer compares its price with the expected utility from
it. Utility obtained is the benefit, and the price payable is the cost. The consumer compares benefit
and the cost. He will buy the unit of a commodity only if the benefit is greater than, or at least equal
to the cost. In other words, a consumer will buy a unit of a commodity only when utility from that
unit exceeds, or at least equals the price paid. Exactly, how many units he will buy, will depend on
this rule.
Illustration Table 5.2
Consumption T.U. M.U. Price Market Expenditur Total
(units) (₹) (₹) willing price e Gain
to pay (₹) (₹) (₹)
(₹)
(= MU)
1 2 3 4 5 6 7
0 0 0 -- -- -- --
1 15 15 15 10 10 5
2 28 13 13 10 20 8
3 38 10 10 10 30 8
4 44 6 6 10 40 4
Refer to Table 5.2. The price of commodity X in the market is 10 per unit. It means he has to pay 10
per unit for all the units he buys. The utility obtained from the first unit is 15 utils (= 15). The
consumer will buy this unit because the utility of this unit is greater than the price.
Will he buy the second unit? It will depend on the utility obtained from the second unit. It is 13 utils (= 13).
He will buy the second unit also.
Will he buy the third unit? The utility of the third unit is 10 utils (= 10). The price paid is also 10.
Since the utility equals price, he will buy the third unit also.
Now, will he buy the fourth unit? Utility of this unit is 6 utils (= 6). He will not buy the 4th unit
because utility is less than the price. It is not worth buying the fourth unit. The consumer will restrict
his purchase to only 3 units.
The difference between utility and price of a unit of a commodity represents the gain to the
consumer from that unit. For example, utility of first unit of X is 15 and price paid is 10. The gain is
₹5 (= 15 — 10). Similarly, gain from the second unit is 3 and from the third unit is zero. The total
gain from the three units is ₹8 (= 5 + 3 + 0). If he also buys the fourth unit, the total gain would be
less. Gain from the 4th unit is negative, i.e., ₹4 (= 6 — 10). Total gain from 4 units is ₹4 (= 5 + 3 +
0 — 4). The consumer maximises gain when he buys only 3 units. The conclusion is that in a single
commodity case, a consumer makes purchases only upto the point where utility of the last unit
is equal to the price of that unit.
The above conclusion can now be restated in the technical language of microeconomics. You are
familiar with the term 'marginal utility'. It is addition to total utility from the consumption of one
more unit of a commodity. When a consumer buys the first unit, he moves from a position of zero
unit to one unit. The utility of the first unit ₹15) is the marginal utility of one unit. When he buys
one more unit, the utility obtained from the second unit ₹ 13) is the marginal utility of 2 units. Like
this, the marginal utility of the three units is ₹10. (The sum total of marginal utilities of the 3 units is
the total utility of these three units.) We have seen above that the consumer maximises gains when
he buys just 3 units. Note that the marginal utility of 3 units is 10 and the price paid for the third unit
is also ₹10. It means that a consumer maximises gains when the marginal utility equals the
price. Clearly, he does not maximise gains if marginal utility is less than the price.
What applies to one good applies to all the goods the consumer consumes. Suppose the consumer
consumes only two goods X and Y. The consumer will then maximize satisfaction
or gain when :
MUx = Px
And MUy = Py
MU x
Or =1 …………. (i)
Px
MU y
=1 ………… (ii)
Py
From (i) and (ii) we get.

MU X MU y
=
Px Py
The above equation forms the basis of study of consumer's equilibrium.
5.4.3 Conditions of Consumer's Equilibrium
Let us now assume that a consumer consumes only two goods. Given the income of the consumer
and the prices of the two goods in the market, on what basis should that consumer allocate the given
income on each good to obtain maximum satisfaction? We can restate the same in another way. To
achieve maximum satisfaction, on what basis the consumer should allocate his income so that no
increase in utility gain is possible by transferring expenditure from one good to the other good? If
this criterion is satisfied the consumer is said to be in equilibrium. The question now is that what are
the conditions that must be fulfilled to achieve this end.
Conditions
The following two conditions must be fulfilled to achieve the consumer's equilibrium :
1. Marginal utility (MU) of the last rupee of expenditure on each good is the same.
2. Marginal utility of a good falls as more of it is consumed.
Let us now explain each condition.
1. MU of last unit of money spent on each good is same (Law of Equi-Marginal Utility).
What is the meaning of the 'MU of last rupee spent on each good'? A consumer does not spend rupee
by rupee but purchases a good unit by unit. Suppose, he purchases 5 units of a good at a price of ₹4
per unit. Further, suppose that MU of these units, i.e. addition to total utility from the last unit, is 8
utils. It means that MU, of the last four rupees spent on a good is 8 utils. Since there is no way of
finding rupee by rupee MU, we take an average, which comes out to be 2 utils per rupee. This is
then taken as MU of the last rupee spent on a good.
Let the two goods be X and Y, their prices PX and Py, and their MUS MUx and MU The
equilibrium condition then is .
MU X MU y
= MU of last rupee spent on each good.
Px Py
The above equality condition is given a name : The Law of Equi-Marginal Utility. The term
'equi-MU' does not refer to the equality of MUS of goods, but MUS of the last rupee spent on each
good.
What happens when equality condition is not satisfied?
Suppose, MUy/Px is greater than MUy/Py. This means that MU from the last rupee spent on X is
greater than the MU of the last rupee spent on Y. This induces the consumer
to transfer expenditure from Y to X. The consumption of X rises while that of Y falls. As a

consequence, MUx falls and MUy rises. The act of transfer of expenditure continues till MU x/Px and
MUy/Py are equal. When they are equal, the consumer gets the same MU per rupee, and he has no
reason to further reallocate his income on the two goods he consumes.
2. MU of a good falls as more of it is consumed (The Law of Diminishing Marginal Utility).
This condition is nothing but the assumption that the Law of Diminishing Marginal Utility is in
operation. Why is this a condition? It is a condition because if the Law is not operating, the Law of
Equi-MU may also not be realised.
Suppose, as consumption increases, MU remains unchanged. Now if MU x/ PX is greater than MU /P
the consumer will continue transferring expenditure from Y to X till expenditure on Y is reduced to
zero, and the entire income is spent on X. It means that consumer consumes only one good. This is
highly unrealistic. A consumer does spend on many goods. Therefore, for fulfillment of the first
condition, a necessary condition for equilibrium, it is also necessary that the Law of diminishing
marginal utility is in operation.
5.4.4 Many goods case (Non-evaluative)
So far we have assumed that a consumer consumes only two commodities. The realistic situation is
that consumer consumes many commodities. The condition applicable in two commodities case can
be extended to cover more than two commodities. Suppose, the consumer consumes 'n' number of
goods. The equilibrium condition is :
MU 1 MU 2 MU N
P1
=
P2
=… … … .
PN
= MU of last rupee spent on each.
The condition implies that the ratio of MU to price in case of each commodity is the same and equal
to the marginal utility of the last rupee spent on each good.
POINTS TO REMEMBER
 Equilibrium is defined as a state of rest.
 Equilibrium is also defined as a state of balance due to equal action of opposite forces.
 Consumer's equilibrium is defined as that allocation of a consumer's income on goods
and services he buys, which gives him maximum satisfaction gain.
 Utility is the satisfaction, actual or expected, derived from the consumption of a good.
 Marginal utility is the addition to total utility from the consumption of one more unit of a
good.
 Law of diminishing marginal utility states that as a consumer consumes more and more
units of a good, the additional utility obtained from each additional unit goes on falling.
 A consumer purchases any good upto when marginal utility equals price.
 A consumer is in equilibrium when the ratio of marginal utility to price in case of each
good is same.
 The law of equi-marginal utility states that ratio of marginal utility to price is same in case
of all goods when the consumer is in equilibrium.
EXERCISES
1, In the study of consumer behaviour, we study decision making by a consumer with respect to :
(a) Spending of income (b) Adjusting purchases due to change in price
(c) Both (a) and (b) (d) Neither (a) nor (b)
2. A rational consumer is called 'rational' because he/she aims at :
(a) Maximizing purchases (b) Minimizing expenditure
(c) Maximizing utility (d) Minimizing wastage
3, On consuming some units of a good, the utility obtained is 10 utils. It is an example of :
(a) Ordinal utility (b) Cardinal utility
(c) Marginal utility (d) None of the above
4. There is a 'Law' in theory of consumer behaviour which states that as a consumer consumes more and
more units of a good, the utility from each new unit consumed
(a) Increases (b) Remains constant
(c) Decreases (d) Increases initially, remains constant and ultimately decreases.
5. Marginal utility refers to utility:
(a) From the last unit consumed (b) From one more unit consumed
(c) From one less unit consumed (d) All the above
6. Marginal utility of a good means utility on consuming:
(a) More units (b) Less units
(c) One more unit (d) All the above
7. When a consumer increases consumption of a good from 2 units to 4 units, total utility rises from 9 utils
to 14 utils. Marginal utility is: (HOTS)
(a) 5 utils (b) 2.5 utils (c) 3 utils (d) Can't calculate
8. According to the Law of Diminishing Marginal Utility, as the consumer reduces consumption of a
goods marginal utility of the remaining quantity of that good:
(a) Falls (b) Rises
(c) Remains unchanged (d) Cannot calculate
9. A consumer consumes only two goods X and Y. On planning to spend the whole of income on these
two goods he finds MUx = 6 utils and MU y = 4 utils. Px and Py are ₹4 and ₹6 per unit respectively. In
this situation the consumer will :
(a) Stick to his plan (b) Buy less of X
(c) Buy more of Y (d) Buy more of X and less of Y (HOTS)
10. A consumer consumes only two goods X and Y and plans to spend entire income on these. The prices
of X and Y are respectively ₹7 and ₹8 per unit respectively. In the plan marginal utilities of X and Y turn
out to be 8 utils and 7 utils respectively. Suppose marginal utility in case of each good remains unchanged
as more or less is consumed. In such a case consumer will:
(a) Buy only X (b) Buy only Y
(c) Buy both X and Y in equal quantities (d) Stick to his plan (HOTS)
11. Given total utility schedule of a good, how many units of the good the consumer will buy if the price
per unit is ₹4
Consumption (unit) Total utility (utils)

1 3
2 5
3 6
(a) 1 unit (b) 2 units (c) 3 units (d) 0 unit
12. A consumer consumes only two goods X and Y with prices 4 and 5 per unit respectively. On making a
plan of spending his whole of income he finds MUx = 12 utils and MUx = s15 utils. The consumer :
(a) Is in equilibrium.
(b) Is not in equilibrium nor can reach equilibrium.
(c) Can reach equilibrium by buying less of X and more of Y.
(d) Can reach equilibrium by buying more of X and less of Y.
13. A consumer consumes only two goods X and Y and is in equilibrium with MUx = MUy, then :
(a) Px = Py
(b) Px < Py
(c) Px > Py
(d) Any of the above (HOTS)
SHORT ANSWER QUESTIONS-I [3 Marksl
1. Explain the meaning of equilibrium.
2. Explain the concept of marginal utility by giving a numerical example.
3. Calculate marginal utility:
Consumption (units) Total utility (utils) Marginal utility (utils)
1 6
2 11
3 15
4 18
5 20
6 21
4. Calculate total utility:
Consumption (units) MU (utils) TU (utils)
1 7
2 6
3 5
4
4
5 3
6
2
5. State and explain the Law of Diminishing Marginal Utility.
1. Explain the two alternative meanings of equilibrium.
2. State and explain the Law of Diminishing Marginal Utility with the help of a numerical example.
3. . Explain why the price which a consumer is willing to pay for a good equals the marginal utility of
that good, when purchasing a good. (HOTS)
4. Explain the conditions of equilibrium assuming that consumer consumes only two goods.
247
1. Define marginal utility. State the Law of Diminishing Marginal Utility.
2. Define utility. Describe the Law of Diminishing Marginal Utility.
3. By planning to spend his entire income only on two goods the consumer finds that :
MU x MU y
>
Px Py
Explain how will the consumer react.
4. A consumer consumes only two goods. Explain his equilibrium with the help of utility analysis.
5. Given the market price of a good, how does a consumer decide as to how many units of that good to
buy? Explain. (HOTS)
6. A consumer consumes only two goods. What are the conditions of consumer's equilibrium in the
utility approach? Explain the changes that will take place if the consumer is not in equilibrium.
(HOTS)
7. A consumer consumes only two goods X and Y and is in equilibrium. Price of X falls. Explain the
reaction of the consumer through the Utility Analysis.
8. A consumer consumes only two goods and is in equilibrium. Show that price and demand for a good
are inversely related. Explain using Utility Analysis.
9. A consumer consumes only two goods X and Y whose prices are ₹5 and ₹4 respectively. If the
consumer chooses a combination of two goods with marginal utility of X equal to 4 and that of Y
equal to 5, is the consumer in equilibrium? Why or why not? What will a rational consumer do in this
situation? Use utility analysis.
I. A consumer consumes only two goods and is in equilibrium. Persistent campaign about consumer's
awareness enables the consumer to buy one of the goods at a lower price. Explain its effect on
consumer's equilibrium.
2. Consumer makes purchase of any good by comparing price and marginal utility. When he becomes
aware of his rights as a consumer, he is able to get the same product at the same price but with better
'after sale service'. Explain its effect on the purchase of good by the consumer.
1. (c) 2. (c) 3. (b) 4. (c) 5. (d) 6. (c) 7. (b) 8. (b) 9. (d) 10. (a) 11. (d) 12. (a) 13. (a)

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(1) Useful for Government

It is a basic function of government to undertake public utility works like

12.3 BASIC ELEMENTS OF AN INDEX NUMBER

5 4 50 40 250 200 200 160

F=√ L P=√116 ×132=124≈.

12.5 INDIA'S WHOLESALE PRICE INDEX

12.5.2 Base Year

12.5.3 Goods included in WPI

12.5.4 Weights Assigned to Goods

(a) Primary articles 22.6

All commodities 100. 00

Fuels, Power, Light and Lubricants 14.91

2011-12 100 100 100 100.0

Therefore, price change during 2016-17 is.

Major group Weight ( % )

Industry groups % weight

All groups 100.000

CHAPTER: 1 SCOPE OF ECONOMICS

1.2 MICROECONOMICS AND MACROECONOMICS

1.3 POSITIVE ECONOMICS AND NORMATIVE ECONOMICS

Answer to the Multiple Choice Questions

SHORT ANSWER QUESTIONS-II 14 Ma

3.1 MEANING OF CENTRAL PROBLEM

3.2 THE THREE ASPECTS

4.1 CONCEPT OF OPPORTUNITY COST

Opportunity cost is a basic concept in Economics. It can be defined as follows .

4.2 PRODUCTION POSSIBILITIES FRONTIER

4.6 WHAT HAPPENS IF RESOURCES ARE NOT

4.7 SHIFT OF THE PP FRONTIER

ORT ANSWER QUESTIONS-I

ORT ANSWER QUESTIONS-II [4 Marks]

VALUE BASED QUESTIONS

CONSUMER’S EQUILIBRIUM AND DEMAND

Chapter 6 : CONSUMER’S EQUILIBRIUM : NDIFFERENCE CURVE ANALYSIS

Chapter 8 : PRICE ELASTICITY OF DEMAND

5.1.2 A Rational Consumer

From (i) and (ii) we get.

to transfer expenditure from Y to X. The consumption of X rises while that of Y falls. As a

Consumption (unit) Total utility (utils)

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