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• QAZI MUHAMMAD TOUSEEF
• DEPARTMENT OF ECONOMICS
UNIVERSITY OF BALOCHISTAN QUETTA, PAKISTAN
MICRO ECONOMICS AND MACRO ECONOMCS
Adam smith is usually considered the founder of the field of microeconomics, the branch of economics which today is concerned with the behavior of Individual entities such as market, firms, and households • In the wealth of nations smith considered how individual price are set. • Studies the determination of price of FOP.
concerned with the overall performance of the economy. John Maynard Keynes (General Theory of Employment, interest and Money) 1935. He invented the idea of ME it did not even exist in its modern form until 1935. In his new theory Keynes developed;
What causes unemployment and economic
downturns. How I and C determined. How central Bank manage the money and interest rate. Why some nations thrive while others stagnate.
MACROECONOMICS which is
PE is related to the explanation of economic events as what they are It does not state whether the thing is right or wrong it only makes theories to explain the real situation and to establish cause and effect relationship existing b/w them. It gives no value judgment and does not explain the rightness or wrongness of the economic events. E.g. if a firm pays low wages to women worker, the PE simply tell us that it is done to reduce the cost. However it does not tell us whether low wages to women is justifiable or not .
NE evaluates the state of things as they ought to be it is related with value judgment it means that it gives judgment whether the thing is right or wrong. It evaluates the situation and prescribes solution for it. It means that ECONOMICS is not neutral & is not colorless, e.g. if there is poverty in an economy NE not only explain the situation and causes for it but also provide measure to overcome the problem. Overall economics is both N & P science,
Efficiency means that the economy’s resource are being used as effectively as possible to satisfy people’s needs and desires. One important aspect of overall economics efficiency is productive efficiency. Pro- eff. occurs when an economy can not produce more of one goods without producing less of another good. This implies that economy is on its PPF. e.g. when we are producing more guns, we are substituting guns for butter.
Countries are always being forced to decide how much of their limited resources goes to their military and how much goes into other activities such as agriculture, industry and social sector. Some countries like Japan allocate about 1% of their national output to their military. The USA spends 5% the North Korea spends up to 20%. The more output that goes for defense, the less there is available for
Economies Relevance to Business Organization.
Opportunity Cost : Life is full of choices because resources are scarce, we always consider how to spend our limited incomes or time, when you decide whether to study economics, buy a car or go to university, in each case you must consider how much the decision will cost in term of forgone opportunity. The cost of forgone alternatives is the opportunity cost of decision. In a world of scarcity, choosing one thing
THE PRODUCTON POSSIBILTY FRONTIER
PPC curve helps us to understand the problem of choice and scarcity of resources. PPC is based on the following assumptions ; 1. The economy is operating at full employment level. 2. Technology remains constant. 3. The supplies of FOP are fixed but they can be shift or reallocated within limits among alternative uses. Societies can not have every thing they want.
The PPC is of much importance in explaining some of the basic facts of human life: the problem of unemployment, technological progress, economic growth and economic efficiency. Relaxing the assumption of full employment of resources, constant production techniques, economic growth and economic efficiency. Three efficiencies : Efficient allocation of resources in production and efficient choice of method of production.
Alternatives Production Possibilities Possibilities Butter
Guns (thousand) (In million pound)
15 14 12 9
0 1 2 3 4
B C D E
Production Possibility Curve
16 14 12 10 8 6 4 2 0 0 2 4 6 Butter(million pounds) Guns(thousands)
ILLUSTRATION OF PPF
Production Possibilities ACommodity Y Commodity X
0 2 4 6
B C D E F 22 16
Factors Of Production
Another term for inputs is FOP, these can be classified into three broad categories. LAND LABOUR & CAPITAL Land- represent gift of nature to our productive processes. Labour- consist of human time spent in production. Capital- resources form the durable goods of an economy, produced in order to produce yet other goods. Stating the three economic problem in term of input and outputs a society must decide. 1- what output to produce and in what quantity;
INPUTS AND OUTPUTS
To answer three questions, every society must make choices about the economy’s inputs and outputs. INPUTS are commodities or services that are used to produce goods and services. OUTPUTS are the various useful goods or services that result from the production process
The Three Problems of Economics Organization
Fundamental questions of economic organization WHAT , HOW and FOR WHOM As crucial today as they were at the dawn of human civilization. Let’s look more closely at them. What commodities are produces & in What quantities? We will produce consumption goods or investment goods (either pizza or pizza
How are goods produces? Society must determine who will do production, with resources, and what production techniques, they will use. Who farm and who teaches. Is electricity generated from oil, from coal or from sun? with much air pollution or with little.
For Whom are goods produced ?
Who get to eat the fruit of economic activity ? How the national product divided among different households ? Are many people poor and a few rich? Do high incomes go to managers or athletes or workers or landlords ? Will society provide minimal consumption to the poor, or they work if they are to survive?
WHAT are the different ways that society can answer the question of WHAT, HOW and FOR WHOM ? Different societies are organized through alternate economics system and economics studies the various mechanisms that a society can use to allocate its scare resources. These systems are A market economy (USA) (Laissez – faire) Command Economy (Former USSR) No Contemporary society falls completely into either of these polar category. Rather all societies are Mixed Economies
MARKET, COMMAND AND MIXED ECONOMICS
Economics is a social science. Its development is related with the socio-economic and political development of society. Definition of economics have been changing through time and circumstances major definitions can be presented as; A- Economics : A science of wealth. B- Economics : A science of material welfare. C- Economics science of scarcity or science of .choices. D- Economics :A science of economic growth.
Economics: A science of wealth ( Classical) Adam Smith “ An Enquiry into the nature and causes of wealth of nations. Distinguish man into two group vise economic man and noneconomic man. Other Classical economists; J B Says- Eco is science which treats of wealth. F A Walker- Eco is body of knowledge which relates to wealth. J S Mill- “it is practical science of production and distribution of Wealth. Criticism - Too much emphasis on wealth. - Concept of Economic Man. - No mention of human welfare. - Narrow definition.
Economics : A science of material welfare. (Neo classical) Alfred Marshal- economics is the study of man's action in the ordinary business of life; it enquires How he gets his income and how he uses it. Thus, it is on one side study of wealth and on the other side study of man. Other neo-classical Economists. A C Pigou- Economics deals with the part of social welfare that can be bought directly or indirectly into relation with the measure rod of money. Edwin Cannan – it is the study of general methods by which man cooperate to meet their material needs. Criticism. - Classical rather than analytical in nature. - Difficult to separate material and no-material things. - Connection b/w economics and welfare. - Social science ( welfare) - Quantitative measurements of welfare.
Economics: A Science of Scarcity Science of Choice.
Lionel Robbins:” Economics studies human behavior as a relationship b/w ends and scarce means which have alternatives uses.” The nature and significance of economics science published in 1932 The Fundamental characteristics of definition; - Unlimited ends - Limited means - Alternative uses of means - Problem of choice. Criticism - It does not cover macroeconomics - Difficult to separate means and ends - It ignores development economics.
Economics : A Science of Economics growth
Paul A Samuleson : “ Economics is the study of how men and society choose, with or without the use of money, to employ scarce productive resources which could have alternative uses to produces various commodities over time and distribute them for consumption more and in future among various people and group of society” Economics Published in 1964. He considered economics as much more that the theory of value or resource allocation. He was widened the definition of economics based on the concept of Robbins. He considered economics as a dynamic science. He defined and explained the use of factors over different period of time. He is capable of including the nature of economics activities. Under capitalistic economy as well as socialistic economy. He also Covers welfare aspect.
The Demand Function
Demand : Desire back with purchasing power. Demand= wish + will + Purchasing power. Qd = f( p) , Qd = f ( P1, P2, Y, T, Pop, S) Demand is a function of rice of that commodity which is demanded, price of other commodities, average income of Consumer, taste of consumer population of that area and special influences. Amount of commodity people buy depends on its price. Law of Demand the higher the prices of commodity, the fewer units consumers are willing to buy. The lower its market price, the more units of it are bought. Ceteris paribus. There exists a definite relationship b/w the market price of a good and the quantity demanded of that good, other things held constant. The relationship b/w price and quantity bought is called Demand Schedule or the Demand Curve.
Demand Schedule 0.6 0.5 0.4 0.3 10 20 30 40
individual demand curve 70 60 50 Units 40 30 20 10 0 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 Prices ( Rs)
Causes of Downward sloping demand curve;
1- The law of demand is based on the law of diminishing marginal utility (MU), when a consumer buys more units of a commodity MU That commodity continues to decline. Therefore, the consumer will buy more units of that only when its price fall this this will prove that demand will be more at a lower price and it will be less at higher price that’s why demand curve is downward sloping. 2- Everyone commodity has certain consumers but when its prices falls, New consumer start consuming it as a result demand increases, on the contrary with increase in its prices many consumers either to reduce or stop its consumption and demand will be reduced thus due to price effect, when consumers consume more or less, the demand cure slopes downward. 3- When price of commodity falls, the real income of consumer increase because he has to spend less in order to buy the same quantity. On the contrary, with the rise in the price of a commodity the real income of consumer falls. This is called the income effect.
4- With the fall in the price of a commodity, the prices of its substitute remaining the same it is known as substitution effect, consumer will buy more of the same rather than the substitutes. On the contrary, with the rise in the price of commodity its demand will fall, given the prices of its substitute. 5- There are different income groups in every society, but the majority relates to low income group, the downward sloping demand curve depends upon this group. Ordinary people buy more when prices falls and less when prices rises. The rich do not have any effect, because they are capable to buy same quantity even at higher prices. 6- There are different uses of certain commodities and services that are responsible for negative slope, with the increase in the of such products, they will be used only for more important uses, and their demand will fall. On the contrary, with fall in prices, they will be put to various uses and their demand will rise .g. with increase in electricity charges, power will be used for domestic lighting, but if charges are reduced, people will use power for cooking, heating etc.
Exceptions of Law of Demand
- In certain cases the demand curve slopes up from left to right.
Many causes are attributed to an up ward D- curve. 1- War : If shortage is feared in anticipation of war, people may start buying for building stocks, even price rises. 2- Depression : during, prices of commodity very low, the demand for them is also less because of less purchasing power. 3- Giffen Paradox : if a commodity happens to be a necessary of life like wheat and prices goes up, consumer are forced to curtail the consumption of more expensive foods like meat and fish, and wheat being still the cheapest, they will consume more of it. 4- Demonstration Effect : If the consumer are affected by the principles of demonstration effect, they will like to buy more of those commodities which confer distinction on the possessor, when their prices rise. On the other hand, with the fall in the price of such commodities, their demand falls as the case with diamonds.
Do not Confuse movement along the curve with shift of curve (See the figures 3 E & F) Factors affecting demand curve; 1- Average income : As income increases, people purchasing more. 2- Population : As growth of population increases, purchases of goods increases. 3- Prices Of related Goods : Higher prices, reduces the demand for Goods. 4- Taste: Having distinct things become a status symbol. 5- Special Influences : Availability of alternates.
The supply side of market typically involves the terms on which business produced and sell their product. Quantity of commodity supplied in a market for sale at certain or prevailing prices is called supply Qs = f (P) Qs = f (P1, P2,…n, Tech, Input, GP, SI) Quantity Supplied is function of price of that commodity which is supplied, prices of related goods, technology, input, prices, government policies, Special Influences. The supply schedule or supply curve for a commodity shows the relationship b/w its market price and the amount of that commodity that producers are willing to produce and sell, other things held constant.
Supply Schedule Prices (Rs) : 1 2 3 Quantity (Units) : 2 4 6
Indivdual supply curve Quantity (units) 12 10 8 6 4 2 0 0 1 2 3 Prices ( Rs) 4 5 6
There is positive relationship b/w market price and quantity supplied so supply curve going up ward left to right. One important reason for the upward slope is the “ law of diminishing returns” Factors affecting the supply curve: Technology – Computerized manufacturing lowers production cost and increase supply. Input prices – a reduction in the wage paid to workers, lower production costs and increase supply. Prices of related goods - When oil prices increase sharply, increase production cost ad lower the supply. Government Polices – Improving quota and tariff and imported goods, domestic supply increases. Special Influences – If govt lowers the prices of gas kits, more environment friendly cars on the roads.
Equilibrium Of Supply and Demand
Equilibrium is a state of balance : when two opposite forces are interact at point. The market equilibrium comes at that price and quantity where the forces of supply and demand are in balance. At this point the amount buyers want to buy is just equal to the amount the seller want to sell. The reason we call this an equilibrium is that when the forces of supply and demand in balance there is no reason for price to rise or fall, As long as other things remains unchanged. Equilibrium with supply and demand curves (see figure A) Effect of shift in supply or demand ( See figures B and C )
Market Equlibrium FIGURE-A
6 5 4 P3 2 1 0 0 5 10
Surplus S>D shortage S<D Equilibrium
7 6 5 4 P 3 2 1 0 -1
15 20 Q
-Nature of Commodity -Substitute -Variety of Uses -Joint demand -Deferred Consumption -Habits -Income Group -Proportion of Spent -Level of Price -Time factor
Factors Affecting The Price Elasticity Of Demand :
Elasticity of demand and Supply
The law of demand does not solve the problem of degree of change in demand to a change in credit goes to Marshall who offered a solution by formulating the concept of elasticity of demand in these words,” The elasticity (or Responsiveness) of demand in a market is greater or smaller according as the amount demanded increases much on little for a given fall in price and diminish much or little for a given rise in price.” Modern economist define elasticity of demand in a mathematical manner. Lipsey’s word” is the ratio of percentage in demand to percentage change in price.” Robinson definition is more clear “ The elasticity of demand at any price or at any out put , is the Proportional change of amount purchased in response to a small change in price, divided by proportional change of price thus it is the ratio of percentage in amount demanded to a percentage change in price.
Its importance in Government Policies
The application of Ed in formulation of government polices in various fields. 2. While granting protection : G consider the Ed of the product of those industries which apply for grant of subsidy or protection. It is given to those industries whose product have an elastic demand. As a consequences they are unable to face foreign competition unless their prices are lowered through subsidy or by raising the prices of imported goods by imposing heavy duties on them 3. Whole deciding about public utilities: G decision to declare certain industries as public utility depends upon Ed for their product, these are taken over and run as public utility by the state. Demand for those product is inelastic the G in this way provide essential g/s to the public at reasonable rates thus eliminating monopolists exploitation. 4. In facing minimum price of farm products: G policies of guaranteeing minimum price for form products, price support programmed and creating the buffer stocks are meant for stabilizing the agriculture price. Paradox of Bumper Crop….?
It has paramount importance to FM. He has to find about how he can bring more revenue to exchequer? He must now the Ed of the product on which the tax has to be imposed. Let us illustrate with the Help of diagram whether a tax on a product which elastic demand or inelastic demand would bring larger revenue to the exchequer. Importance in the problem of the international trade: The Ed has great practical importance in analyzing complex problems of IT. 4. In Determination of the Gain from IT: The TOT refer to the rate which a country exchanges her exports for her imports from the other country. The exact rate at which exchange will take place, will be determined by the relative elasticity of demand of two countries for each other’s product, the gain from trade in turn depend , among others, on the Ed and the term of trade. We will gain from IT If we export goods with less Ed and import those goods for which or demand is elastic . In the first case, we will charge high price for our product and in later case, we will be paying less for the goods obtained from other country. Thus we gain both way and shall
Importance to Finance Minister :
1. In tariff Policy: tariff tend to raise the prices of the domestic
products , internal price rise depends on the Ed of protected goods in the demand of protected goods is elastic, their sales will be reduce with the rise in prices, conversely, if the demand is less elastic , people will have to bear the Burdon of higher prices as a result of tariff policy. 2. Basis of policy of devolution: The consideration of elastic of demand for M and X is Important of a country which is thinking of correcting her adverse BOPs By devolution, Devolution makes X cheaper and M dearer of the country adopting it. Suppose we resort the devolution, its first effect will be that the price of a M will rise and we will induce to reduce or M, But this depends on the Ed for M on the other hand, the fall in foreign price for X will induce us to X more, But its depends upon the Ed of Foreigner for our products thus the extend to which we are in a position to reduce the gap b/w receipts and expenditure of foreign exchange depends upon the elasticity of demand for X and M.
Cross Elasticity Or Complementry goods (Jointly Demanded)
=If two goods are jointly demanded the rise in the price of one (Cars) lead to a fall in the demand for other ( petrol) or vise versa. =if the change in quantity demanded B exactly in the same proportion as change in price of A. (Eba = 1)..i.e ▲Qb / ▲Pa = 1 =when the change in the demand for good B is more than proportionate to the change in the price of good A. (Eba>1). i.e. ▲Qb / ▲Pa>1 =when change in quantity of B is less in response to change in price of A. (Eba<1) i.e. ▲Qb/ ▲Pa<1. =when an infinestimal change in the price of A causes infinity large change in the purchase of B. (Eba=ά) i.e. ▲Qb / ▲Pa= ά = when the price of A Remains almost the same and demand of B increases. (Eba=0) i.e. ▲Qb / ▲Pa =0
Formula maybe written as: Ed= % change in amount demanded Or ▲q/q
% change in price ▲p/p If percentage for quantity rises are known the value of coefficient can be calculated, price elasticity may be unity, greater than unity, less than unity and 0 or infinity, these five cases are explain with help of diagram ( see A,B,C,D and E).
5. Method of measuring elasticity:
The percentage Method. The point Method (Geometrical Method). The Arc Method (Geometrical Method). The outlay Method.
Income Elasticity: The Ey Expresses the responsiveness of a consumer’s demand (expenditure or consumption) for any good X to change in his income, it may be defined as the percentage change in the quantity demanded of good X to the percentage change in income. EY= percentage change in quantity demanded of X Percentage change in income Or ▲q/q // ▲y/y = ▲q/q x y/ ▲y = ▲q/ ▲y x y/q = Ey Promotional Elasticity: It is the knowledge of concept of elasticity that prompts producer to spend large sums of money on advertising their products for they know that advertisement makes the demand for that product less elastic so that rising the price will not reduce its sales lead to the concept of promotional elasticity which measure the responsiveness of sales to change in the advertising and other promotional expenses the formula for this: Change in sales / sums of sales multiply by Sum of promotional expenses / change in promotional
The Point Method: Marshall devised a geometrical method for measuring elasticity at a point ion the demand curve this is now as point elasticity of demand Formula: Ed= Lower segment / Upper segment With the help of point method it is easy to point out the elasticity at any point along the demand curve. Suppose that the straight line demand curve DC in figure F (See Slide)
Arc elasticity: we have studied the measurement of the elasticity at a point on demand curve, but when elasticity is measured b/w two point on the same demand curve it is now as Arc Elasticity Arc elasticity is a measure of the average responsiveness to the price change exhibited by a demand curve over some finite stretch of the curve- Baumal Any two points on the demand curve make an arc. Formula: Ed=q1-q2/q1+q2//p1/p2/p1+p2 Where q1, q2 and p1, p2 are two prices respectively arc elasticity on figure G (see the Slide) where q=q1-q2 and p=p1-p2 therefore elasticity b/w point B and C is q/q1+q2//p/p1+p2 Difference in q/sum of q// difference in p/sum of p = Ed
The outlay Method: Marshall evolved the total outlay, Total revenue or total expenditure method as a measure of elasticity. By comparing the total expenditure of a purchaser both before and after the change in price can be now whether his demand for good is elastic, unity or less elastic. Total out lay= price x quantity demanded. Demand for goods is elastic, when a fall in its price lead to a larger expenditure on it other wise vice versa. It is unitary, when Total expenditure remains un changed with the fall and Rise in the price of goods. Demand is inelastic when total expenditure falls, with the fall in price and rise with the rises in the price.
The percentage Method
One of the most satisfactory method of measure ment is to record elasticity as ratio of percentage change in the amount demanded to the percentage change in price of commodity Formula Ed= ▲q / q // ▲p/p = ▲q/qx ▲p/-p =- ▲q/p x ▲p/q The coefficient of price elasticity of demand is always negative because when price change the demand moves in opposite direction. Let us measure Ed with the aid of formula, suppose that. Quantity demanded Price 5Kg 10Rs.(Initial price and quantity) 6Kg 6Rs. less elastic. 4kg 12 Rs. Unity 4Kg 11 Rs. More elastic
Cross Elasticity of demand: It is the duration between percentage change in quantity demanded of a good to percentage change in the price of related good. The cross Elasticity of demand b/w good A and B is Eba = %change in the quantity of B / % change in price of a i.e. Eba= ▲qb/qb// ▲pa/pa= ▲qb/qb x pa/qb It can also be measured with the formula of arc elasticity i.e. Eba= Diff in qb / sum of qb x sum of pa / diff pa. There are two types of related goods; substitute and Complementry. Cross elasticity of substitute; In case of substitutes, if a change in the price of good A leads to more than proportionate change in demand for good B , the cross E is +ve and large the higher the coefficient of cross E such goods are close substitute. (Eba>1) If change in the price of A causes the same change in the quantity of B. ( Eba=1) When he quantity demanded of good B changes less than proportionate change in the price of good A (Eba<1) The goods are poor substitute. En Change in price of good A has no effect on demand of good B than (Eba=0) Unrelated goods – in case two goods are perfectly substitute then (Eba= ά) It may be –ve if the PA falls, the DA being inelastic, than less of A will be purchased because it is cheaper, and more of B will be bought.
Income Demand: QD=f (Average income of consumer Y) The Income- demand relationship is usually direct, the demand for commodity increases with the rise in income backward sloping income demand curve (see fig-1) C. In case of normal goods. D. In case of inferior goods. Cross demand: Qd = f (prices of related goods P2…..n) How the change in price of one effect the demand of other. Related goods are of two type, substitute and complimentary. In case of subs a rise in price of one good A raises the demand for other good B, the price of B remaining the same, opposite holds in case of fall the price of A when demand for B falls so the cross demand curve for substitute is positively sloping .(See fig 2A) - In Case of Complementry goods, a rise in the price of one good A will bring a fall in the demand for B (see fig 2B). In case of Complementry goods cross demand curve is negatively sloping.
Elasticity of Demand
Cardinal Approach and Consumer equilibrium: The theory demand is based in the cardinal measurement of utility. Utility denotes satisfaction, if commodity or service satisfies and economics want it possesses utility if a market A has higher utility than market B, this ranking indicates that consumer prefer A over B. utility is subjective pleasure or usefulness that a person drives from consuming a good and services. Economist explain consumer demand by the concept of utility which denotes relative satisfaction that a consumer obtained from using different commodities. In the theory of demand, we say that people maximize their utility which means that they choose the bundle of consumption gods that they most preferred.
Ordinal Utility: Economist to day generally rejected the nation of a cardinal, measurable utility that is attached to consumption of ordinary goods like shoes or eggs. We can easily derive demand curve with out ever mentioning the nation of utility. What counts for modern demand theory is the principal of ordinal utility. Under this approach we examine only the preference ranking of bundle of commodities. Ordinal utility asks” is A preferred to B” which does not require that we know how much A is preferred to B --- is called Ordinal or Dimensionless. Ordinal variable are ones that we can rank in order, but for which there is no measure of quantity difference between situations. Equi-Marginal Principal: The fundamental condition of maximum satisfactory. It states that a consumer having a fixed income and facing given market prices of goods will achieve maximum satisfactiom when the marginal utility of last ripee spent on ech good is exactly the same as the marginal utility of last rupee spent on any other good. The common marginal utility per rupee of all commodities in consumer equilibrium is alled the narginal utility of income.
Assumptions: The method of measuring utility is based on a set of assumptions; Consumer must be rational Perfect knowledge of choice open to him There are no substitute. Utility are measurable in term of money. The theory of consumer demand is based on the cardinal measurement of utility. How does utility apply to theory of demand; e-g Consuming a unit of commodity as we consumes some additional unit of commodity, we will get some additional satisfaction or utility --- the increment to one unit is called Marginal Utility. The expression “marginal” is the key term in economics and always means extra. Marginal utility denotes additional unit arising from consumption of an additional unit of commodity. Marginal mean extra or incremental utility.
Law of diminishing marginal utility. A century ago, when economists thought about utility, they enunciated the law of diminishing marginal utility. This law states that the amount of extra or marginal utility declines as a person consume more and more of a goods. What is the reason for this law? Utility tends to increase as you consume more of a good. However, according to DMU as you consume more and more your total utility will grow at a slower and slower rate. Growth in total utility slows because, your marginal utility (the extra utility added by the last unit consumed of a good) diminishes as more of a good is consumed. The law of diminishing marginal utility states that, as the amount of a good consumed increases the marginal utility of that good tends to diminish.
Limitation of law of diminishing marginal utility. The law holds under certain conditions; A single commodity with homogenous units. No change in taste, habit, custom, fashion and income. Continuity in consumption. Unit of commodity, a suitable size. Prices of substitutes, remains the same. Indivisible commodity. Act rationally. Ordinary type commodity. The Marshallian demand analysis is based on the concept of cardinal utility assumes that utility is measurable and additive. It is expressed as a quantity measured in hypothetical unit which are called “utils”. If a consumer imagines that one mango has 8 utils and an apple 4 utils, it implies that the utility of one mango is twice than of an apple.
Equiv. – Marginal Utility: To use utility theory to explain consumer demand and to understand the nature of demand curves. For this purposes, we need to know the condition under which a consumer most satisfied with the market basket of consumption goods. We say that consumer attempts to maximize his utility which means that the consumer chooses the most preferred bundle of goods from what is available. Can we see what a rule for such an optimal decision would be? Certainly I would not expect that the last egg I am buying brings exactly the same marginal utility as the last pair of shoes I am buying , for shoes cost much more per unit than eggs. A more sensible rule would be; if goods A cost twice a much as good B, than buy goods A only when its marginal Utility is at least twice as grate as good B’s marginal utility. This leads to the Equi-marginal principal that I should arrange my consumption tit heat every single goods is ring me the same marginal utility per rupee of expenditure. So I am attaining maximum satisfaction from my purchases.
The Fundamental Condition of consumer equilibrium can be written in term of marginal utilities (MUs) and prices (Ps) of different goods in the following compact way;
MU goods / P1=MU goods2/P2=,…,MUN/PN=MU of income. per Rs.
e-g we have the example of Quetta market. Bolan Shop Rs.1000 (35 Essential Items) Qudusi Shop Rs.1250 (35 Essential Items) Shaibi Store Rs.1300 (35 Essential Items) Ahmed Store Rs.1500 (35 Essential Items) Utility StoreRs.990 (35 Essential Items) Consumer Income = Rs. 5000 / month
Equiv. Marginal Utility.
Equation Y=PA x A +PB x B+,………..PN x N Consumer’s income – 50 rupees Spent on A+B 40 P X 4 = 1.60 20 P X 4 UTILS = 0.8O Y= 2.40 maximum satisfaction Rearrangement – by purchasing one util of apple he gain 1 x 40 P= 40 util shown by the area aa,a2,a3 while he losses 40 util of bananas, loss shown by the area bb1 b2 b3 .
The loss of util
Equiv. – Marginal Utility
Apple MUA / PA B3 Gain A A3 B Loss
Banana MUB / PA
A1 Unit of A
Unit of B
Q of Good consumed
Total Utility Marginal Utility
Total Utility 12 10 Total Utility 8 6 4 2 0 0 1 2 3 4 5 6 Quantity consumed
0 1 2 3 4 5
0 4 7 9 10 10
0 4 3 2 1 0
Marginal Utility 6 Marginal Utility 5 4 3 2 1 0 0 1 2 3 Quantity 4 5 6
Utility rises with the consumption B. TU rises with consumption, but it rises at a decreasing rate, showing DMU. This observation led early economists to formulate the law of down ward sloping demand. C. Show the extra utility added by each unit of commodity.
Geometrical Analysis of Consumer’s equilibrium:
Pareto developed what are today called indifference curves: The modern theory of indifference curves analysis examines the consumer behavior with that new tool
Indifference curve and its properties. Indifference Map Consumer’s equilibrium.
Start by assuming that you are a consumer who buys different combinations of two commodities at a given set of prices. For each combination the two goods, assume that you prefer one to the other or are indifferent between the pairs then asked to choose b/w combination you might. 2. Prefer A to B 3. Prefer B to A 4. Be indifferent b/w A and B The curved contour of linking up. It is an INDIFFERENCE CURVE. The point of the curve represents consumption bundles among which the consumer is indifferent, all equally durable. The level of satisfaction same on all point at IC.
A Family of ICs which IC is most preferred by the consumer. Assumption of IC analysis: ii. Consumer act rationally. iii. There are two goods X and Y. iv. Consumer possesses complete information of prices of the goods. v. Prices of two goods are given. vi. The consumer’s taste, habit, custom & income remain the same. vii. ICs are convex to the origin. viii. He can arrange the two goods in a scale of preference which means that he has both preference and indifference. ix. Both preference and indifference are transitive. If A is preferable to B and B to C than A is preferable to C. x. We can order all possible combinations.
Budget line or Budget Constraint
Given consumer Y fixed. Rs60/ Day to spend and he is confronted with fixed prices for each Unit. It is clear that he could spend his money on any of the variety of alternative combination . At one extreme he could buy Good X no unit of good Y.
The Consumer’s Equilibrium
The Consumer’s Equilibrium
Consumer equilibrium is attained at the point where the budget line is tangent to the IC. At that point A, the consumer’s substitution ratio is Just equal to the slope of the budget line. At differently The substitution ratio or the slope of the IC is the ratio of the marginal utility of good X to the marginal utility of Good Y so our tangency condition is just another way of stating that ratio of price must be equal to the ratio of marginal utility. i.e. PY/PX = substitution ratio = MUY/MUX or In equilibrium, the consumer is getting the same marginal utility from the last coin spent on Good X on the last coin spent on Good Y
Law of Substitution
ICs are drawn as bowl-shaped or convex to the origin, how ever, as we move down ward and to the right…..a movement that implies increasing the QX and Decreasing QY. The curve drawn in a way to illustrate a property which we call “ Law of Substitution”. Find the slope of resulting line (neglecting its negative sign) has a values of substitution ratio or some called it MARGINAL RATE OF SUBSTITUTION. MRS = ▲Y/ ▲X between two goods. As the size of movement along the curve becomes very small, the chooser the substitution ratio comes to the actual slope of the IC. The slope of IC if the measure of the goods “relative marginal utilities” An IC that is convex to origin conforms to the law of substitution.
On the basis of method of compensating variation, the substitution effect measures the effect of the change in relative prices, with income (nominal) constant. It is assumed that when the price of food falls Y becomes relatively dearer. The increase in the real income of consumer, as a result of the fall in the prices of good X. There is no change in his nominal income, he is neither better off nor worse off. Key Points. 4. Nominal Income unchanged. 5. Price of commodity changes. 6. Real income changes. This is called Substitution effect.
The new optimum on I3 is at Ec. The movement from Ea to Ec is the substitution effect Ea Ec xa xc Eb I3 I2
Assume first that the consumer’s daily income (Nomianl income or money Income) is halved while prices of two commodities remain unchanged. We should find that new budget line occupies the positon. The line has made a parallel shift inward. The consumer now free to move along this new (and lower) budget line to maximize his satisfaction Key Points. 4. Nominal Income Changes. 5. Prices of commodities remain unchange. This is called “ Income effect”.
The remainder of the total price effect is the Income Effect. The movement from Ec to Eb. Ea Ec xc Eb I3 xb I2
Now again return of our consumer to his previous dally income. But assume that price of good X rises while the prices of good Y is unchanged. We must examine the budget line changes its position from one end. It has pivoted on point I and rotate from I to I’’ is called price effect. Key Points 4. Nominal Income remain unchanged. 5. Price of one commodity unchanged. 6. Price of other commodity changes. 7. Real income changes.
The new optimum is Eb on I2. The Total Price Effect is xa to xb Ea xa Eb I1 xb I2
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