Economics PPTs.pdf

Economics: HSN-01

Why to Study Economics? To learn how to avoid being deceived by

economists

Economics as a discipline exists because resources are limited

Economics and Choice Economics is the study of how individuals and

society manages its scarce resources.

Economics is the study of how people and society choose to employ scarce resources that could have alternative uses in order to produce various commodities and to distribute them for consumption , now and/or in the future among various persons and groups in the society by Samuelson and Nordhaous

How Economists Think The first step in this process is to identify the

fundamental economic problem: scarcity.

What goods and services will be produced and in what quantities?

How will they be produced? Who will consume them?

Decision Makers Households are groups of people that live

together.

Firms are organizations that use resources to produce goods and services.

Government is an organization that sets laws and rules, taxes, spends, and provides public services.

How Economy Works

What Economists Do Uses abstract models to help explain how a complex,

real world operates. Develops theories, collects, and analyzes data to

evaluate the theories. Economic questions can be divided into two big

groups: microeconomics and macroeconomics.Microeconomics focuses on the individual parts of the economy. How households and firms make decisions and how

they interact in specific marketsMacroeconomics looks at the economy as a whole. Economy-wide phenomena, including inflation,

unemployment, and economic growth

Economic Science and Economic Policy

Economic science is the attempt to understandthe economic world. Science makes predictions.

Economic policy is the attempt to improve the economic world. Policy makes prescriptions.

Policies made without science usually will not be very good.

Economic Science is Young Economics as a science is just over 200 years old.

Adam Smiths The Wealth of Nations (1776) marks the beginning of our subject.

It began with Aristotle but got mixed up with ethics in the Middle Ages. Adam Smith separated it from ethics, and Walrus mathematized it. Alfred Marshall tried to narrow it, and Keynes made is fashionable. Robbins widened it, and Samuelson dynamized it, but modern science made it statistical and tried to confine it again.

Compared to physics and chemistry, however, we are newcomers.

Suggested Books Koutsoyiannis, A., Modern Microeconomics, Second

Edition, Macmillon

Salvatore, D., Principles of Microeconomics, Fifth Edition, Oxford University Press

Mankiw, N.G., Principles Of Microeconomics, Sixth Edition, Cengage Learning India

Demand and Supply

Demand

Demand vs. Need

Effective Demand Desire to have a good/commodity Willingness to pay Ability to pay

Factors Affecting Demand

Demand and Law of Demand

Demand is a multivariate concept

Qd = f(Px, I, PR, TC, PC, IF, PF, NC, DC)

Law of Demand A relationship between price and quantity

demanded in a given time period, ceteris paribus.

Demand Schedule

Demand Curve

QX = a - bPX

Law of Demand

An inverse relationship exists between the price of a good and the quantity demanded in a given time period, ceteris paribus.

Mathematically: QX = a - bPX Reasons:

substitution effect income effect

Market Demand Curve Market demand is the horizontal summation of

individual consumer demand curves

p p p

q q q

a b m

Change in Quantity Demanded vs. Change in DemandChange in quantity demanded Change in demand

p

p1

qq1

a

bp

q q1

a b1

Change in demand refers to a shift in the whole curve

A movement along a demand curve is referred to as a change in the quantity demanded

D0 D1

Pric

e

Quantity

Shifts in the demand curve Such an increase in demand

can be caused by:

A rise in the price of asubstitute

A fall in the price of acomplement

A rise in income

A redistribution of incometowards those who favour thecommodity

A change in tastes that favoursthe commodity.

When the demandcurve shifts from D toD1 more is demandedat each price.

Shifts in the demand curve

D0

Quantity

Pric

e

D2

Such a decrease in demandcan be caused by:

A fall in the price of asubstitute

A rise in the price of acomplement, a fall in income

A redistribution of incomeaway from groups that favourthe commodity

A change in tastes that dis-favours the commodity.When the demand curve

shifts from D0 to D2 less isdemanded at each price.

Note We are interested in developing a theory

of how products get priced. How will the quantity of a product

demanded vary as its own price varies?

A basic economic hypothesis is that the lower the price of a product, the larger the quantity that will be demanded, other things being equal.

We now look at the supply side of markets. The suppliers are firms, which are in business to make the goods and services that consumers want to buy.

Supply

Economic theory gives firms several attributes.

Firstly, each firm is assumed to make consistent decisions, as though it was run by a single individual decision-maker.

Secondly, firms hire workers and invest capital and entrepreneurial talent in order to produce goods and services that consumers wish to buy.

Thirdly, firms are assumed to make their decisions with a single goal in mind: to make as much profit as possible.

The amount of a product that firms are able and willing to offer for sale is called the quantity supplied.

Supply is a desired flow: how much firms are willing to sell per period of time.

Three major determinants of the quantity supplied in a particular market are: The price of the product; The prices of inputs to production; The state of technology. The expectations of producers, The number of producers, and The prices of related goods and services

The nature and determinants of supply

Supply schedule

Supply The relationship that exists between the price of

a good and the quantity supplied in a given time period, ceteris paribus.

QX = a + bPX

Law of supply A direct relationship exists between the price of a

good and the quantity supplied in a given time period, ceteris paribus.

Mathematically: QX = a + bPX The law of supply is the result of the law of

increasing cost. As the quantity of a good produced rises, the marginal

cost rises. Sellers will only produce and sell an additional unit of a

good if the price rises above the marginal cost of producing the additional unit.

The market supply curve is the horizontal summation of the supply curves of individual firms

Change in supply vs. change in quantity suppliedChange in quantity supplied Change in supply

p

pp1

q qq1 q1

a

b b1

a

Quantity

S0

S1

Shifts in the Supply Curve

A shift in the supplycurve from S0 to S1indicates more issupplied at each price.

Such an increase in supply can be caused by: Improvements in the technology of producing the commodity A fall in the price of inputs that are important in producing

the commodity

Shifts in the Supply Curve

Quantity

S2 S0

A shift in the supplycurve from S0 to S2indicates less issupplied at each price.

Such a decrease in supply can be caused by: A rise in the price of inputs that are important in producing the

commodity. Changes in technology that increase the costs of producing the

commodity (rare).

Price Determination

Price determinationHow demand and supply interact to determine price

A market may be defined as an area over which buyers and sellers negotiate the exchange of some product or related group of products.

It must be possible, therefore, for buyers and sellers to communicate with each other and to make meaningful transactions over the whole market.

The concept of a market

Market equilibriumDetermination of the Equilibrium Price

Equilibrium price is where thedemand and supply curvesintersect, point E in the figure.

At all prices above equilibriumthere is excess supply anddownward pressure on price.

At all prices below equilibriumthere is excess demand andupward pressure on price.

Ep

q

QX = a + bPX

QX = a - bPX

QdX = QsX a bPX = a + bPX

o

Price (Rs) Demand Supply

8.00 6,000 18,000

7.00 8,000 16,000

6.00 10,000 14,000

5.00 12,000 12,000

4.00 14,000 10,000

3.00 16,000 8,000

2.00 18,000 6,000

1.00 20,000 4,000

Market equilibrium

The equilibrium price in the market is 5.00 where demand and supply are equal at 12,000 units

If the current market price was 3.00 there would be excess demand for 8,000 units, creating a shortage.

If the current market price was 8.00 there would be excess supply of 12,000 units.

Instability in Price If the price exceeds the

equilibrium price, a surplus occurs:

If the price is below the equilibrium a shortage occurs:

E

E

Excess Supply

Excess Demand

p pp1

p1

Rise and Fall in DemandDemand rises Demand falls

An increase in demand raises both price and quantity

A decrease in demand lowers both price and quantity

E

EE 1

E 1ppp1p1

q qq1 q1

Rise and fall in Supply Supply rises Supply falls

An increase in supply raises quantity but lowers price

A decrease in supply lowers quantity but raises price

E 1

E 1E

Ep

pp1

p1

q qq1 q1

Price ceiling

Price ceiling - legally mandated maximum price

Purpose: keep price below the market equilibrium price

Examples: Rent controls Price controls during wartime

Gas price rationing in 1970s

Ep

p1

Price floor Price floor - legally mandated minimum price

Designed to maintain a price above the equilibrium level

Examples:

Agricultural price supports

Minimum wage laws

E

p1

p

Elasticity of Demand

Elasticity of Demand The demand and supply analysis helps us to

understand the direction in which price and quantity would change in response to shifts in demand or supply.

What economists would like to know is what will happen to demand when price, income, price of the related goods changes?

How the sensitivity of quantity demanded to a change in price is measured by the elasticity of demand and what factors influence it.

How elasticity is measured at a point or over a range. How income elasticity is measured and how it varies with

different types of goods.

Defining & Measuring Price Elasticity of Demand

Demand elasticity is measured by a ratio: the percentage change in quantity demanded divided by the percentage change in price that brought it about.

Price elasticity of demand =Percentage change in quantity demanded

Percentage change in price

Original New % Change ElasticityGOOD A

Quantity

Price

100 (Q)

1 (P)

95(Q1)

1.10(P1)

-5%

10%-5%/10% = -0.5%

Measuring Elasticity of Demand

Measuring Elasticity

Percentage Method

ARCMethod

PointMethod

pQ PeP Q

=

1 2

1 2

( )( )p

Q P PeP Q Q +

= +

0

0

lim

lim

p P

p P

p

P QeQ P

P QeQ PP dQeQ dP

=

=

=

Measuring Elasticity of Demand

Q

P R

D

Quantity0

D1

1

1

1

p

p

p

p

p

p

p

Q PeP Q

PeSlope Q

PePD PR QPR OPePD OQPR OPePD OQOQ OP OPePD OQ PD

RDOPePD RD

=

=

=

=

=

=

= =

Vertical axis formula PR is Parallel to OD1 in ODD1

ep =Lower Segment

Upper SegmentThis ratio is zero where thecurve intersects the quantityaxis and infinity where itintersects the price axis.

Elasticity along a Linear Demand Curve

Perfectly inelastic (Elasticity=0)

Inelastic (0

612

Pric

e

Quantity

D1

Elasticity = 0

Perfectly Inelastic

Elastic and Inelastic

Implies that quantity demanded remains constant when price changes occur.

Price elasticity of demand = 0

6

12

Pric

e

Quantity

D2

Elasticity =

Perfectly Elastic

Implies that if price changes by any percentage quantity demanded will fall to 0.

Price elasticity of demand =

612

Pric

e

Quantity

D30

612

Pric

e

Quantity1 2 3

Elasticity = 1

Unit Elasticity

Elastic and Inelastic

Implies that the percentage change in quantity demanded equals the percentage change in price.

Price elasticity of demand = 1

Nature of the Goods Essential goods are highly inelastic Luxury goods are highly elastic

Availability of Substitutes Higher the number of substitutes greater is the elasticity

Number of uses of a good The demand for multi-used goods is more elastic

Distribution of Income Demand for products is inelastic by the high income group

Level of Prices Demand for high and low priced goods in inelastic

Proportion of Total Expenditure Time factor

Longer the time period higher the elasticity

Complementary goods

The Factors that Influence the Elasticity of Demand

Some Real-World Price Elasticitiesof Demand

Good or Service ElasticityElastic Demand

Metals 1.52Electrical engineering products 1.30Mechanical engineering products 1.30Furniture 1.26Motor vehicles 1.14Instrument engineering products 1.10Professional services 1.09Transportation services 1.03

Inelastic DemandGas, electricity, and water 0.92Oil 0.91Chemicals 0.89Beverages (all types) 0.78Clothing 0.64Tobacco 0.61Banking and insurance services 0.56Housing services 0.55Agricultural and fish products 0.42Books, magazines, and newspapers 0.34Food 0.12

Useful for Business Fixation of Prices

Significant for Government Economic Policies Controlling business cycles, removing inflationary and deflationary gaps, price

stabilization Goods with inelastic demand are taxed more Fixation of wages Incidence of taxes

International Trade Import commodities with more elastic demand, Export commodities with

less elastic demand

Market forms and Determination of Price of Public Utilities Paradox of Poverty and Effects on Employment

Significance of Elasticity of Demand

Elasticity and Total Revenue

Total revenue = Price x Quantity

Marginal Revenue = TR/Q

Price elasticity of demand:

What happens to total revenue if the price rises?

pQ PeP Q

=

Elasticity and Total Revenue

Elasticity and Marginal Revenue

.TR P Q=

( . )d P QMRdQ

=

1. 1 1dP dP QMR P Q P PdQ dQ P Ep

= + = + = +

Defining & Measuring Income Elasticity of Demand

The responsiveness of demand for a product to changes in income is termed income elasticity of demand, and is defined as

Income elasticity of demand =Percentage change in quantity demanded

Percentage change in Income

A good is a normal good if income elasticity > 0. A good is an inferior good if income elasticity < 0. A good is a luxury good if income elasticity > 1. A good is a necessity good if income elasticity < 1 and < 0.

iQ IeI Q

=

or iI dQeQ dI

=

Defining & Measuring Cross Elasticity of Demand

The responsiveness of quantity demanded of one product to changes in the prices of other products is often of considerable interest.

Cross elasticity of demand =Percentage change in quantity demanded of X

Percentage change in Price of Y

Products are substitute if cross elasticity > 0. Products are complimentary if cross elasticity < 0.

xyQx PyePy Qx

=

xyPy dQxeQx dPy

= or

Summary

Price Elasticity of demandPerfectly inelastic, Inelastic , Unit elastic, Elastic , Perfectly elastic

Income Elasticity of demandNormal , Inferior, Luxury, Necessity

Cross Elasticity of demandSubstitute , Complimentary

ExamplesQ1. Find the elasticity if the demand function isQ = 25 4P + P2 where Q is the demand for commodity at price P. Find out elasticity at (i) P = 4, (ii) P = 8, (iii) P = 5

Ans: (i) P = 4, ep = 0.64 (inelastic)(ii) P = 8, ep = 1.7 (elastic)

(iii) P = 5 ep = 1 (unitarily elastic)

Q2. The demand function is given X = 10 P at X = 4, P = 6. If the price increased by 5% determine the percentage decrease in demand and hence an approximation to the elasticity of demand.

Ans: Decrease in demand is 7.5% and elasticity is 1.5

ExamplesQ3. If the current demand for economics books is 10,000 per year for a publishing house. The elasticity of demand is 0.75. The price increased by Rs 50 per book, calculate the change in the quantity of books demanded where price is Rs 150.

Ans: Q = 2500Q4. Suppose demand for cars in a city as a function of income is given by the following equations. Q = 20,000 + 5M, where Q is quantity demanded and M is Per capita income. Find out income elasticity of demand when per capita annual income is Rs 15,000.

Ans: ei= 0.8 (Normal) Q5. Suppose the following demand function for coffee in terms of price of tea is given Qc = 100 + 2.5Pt. Find out the cross elasticity of demand when price of tea rises from Rs 50 per 250gm pack to Rs 55 per 250gm pack.

Ans: ect= 0.51(Substitute)

Consumer Behavior

Consumer Behavior Demand analysis starts with the behavior of

the consumer

Individual consumers demand is derived from his utility function

Rational consumer tries to maximize his utility

Axiom of Utility Maximization Cardinalist Approach Ordinalist Approach

Cardinal Utility Theory

Utility: level of happiness or satisfaction associated with alternative choices

Total utility: the level of happiness derived from consuming the good

Marginal utility: the additional utility that is received when an additional unit of a good is consumed

MU=Change in total utility

Change in quantityOr

x

UQ

Concepts

Cardinal Utility TheoryConcepts

Qx TUx MUx

0 0 ....

1 10 10

2 16 6

3 20 4

4 22 2

5 22 0

6 20 -2

Quantity

Quantity

TUx

MUx

Diminishing Marginal Utility As consumption of a good or service increases, the

incremental (or marginal) satisfaction we get from consuming one more unit decreases.

This decrease is called the principle of diminishing marginal utility.

Law of diminishing marginal utility - marginal utility declines as more of a particular good is consumed in a given time period, ceteris paribus

Even though marginal utility declines, total utility still increases as long as marginal utility is positive. Total utility will decline only if marginal utility is negative

Equilibrium of the Consumer Assumptions

Rationality : Consumer aims at the maximization of his utility subject to constraint his income

Cardinal Utility : Utility is measured by monetary units that the consumer is prepared to pay for another unit of the commodity

Constant Marginal Utility of Money: Unit of measurement is that it be constant

Diminishing Marginal Utility: The utility gained from a successive units of a commodity diminishes.

Total Utility is Additive: 1 1 2 2( ) ( )........ ( )n nU U x U x U x= +

Equilibrium of the ConsumerSingle Commodity Model : The consumer can either buy

Commodity (x) or retain his money income (Y)

( )xU f Q=The Utility function is

If the consumer buys Qx his expenditure is PxQx The consumer seeks to maximize the difference between his utility and expenditure

x xU P Q( ) 0x x

x x

P QUQ Q

=

xx

U PQ

= Or x xMU P=

Quantity Quantity

Derivation of the Demand Curve

x xMU P=Condition for the equilibrium

MUx

Equilibrium of the ConsumerIf there are more commodities, the condition for the

equilibrium of the consumer is the equality of the ratios of the marginal utilities of the individual commodities to their prices

.........yx nx y n

MUMU MUP P P

= =

Qx Tux Mux Mux/Px Qy Tuy Muy Muy/Py0 0 - - 0 0 - -1 50 50 8.33 1 75 75 25.002 88 38 6.33 2 117 42 14.003 121 33 5.50 3 153 36 12.004 150 29 4.83 4 181 28 9.335 175 25 4.17 5 206 25 8.306 196 21 3.50 6 225 19 6.337 214 18 3.00 7 243 18 6.008 229 15 2.50 8 260 17 5.679 241 12 2.00 9 276 16 5.33

10 250 9 1.50 10 291 15 5.00

Suppose the price of X is 6 and price of Y is 3

Equilibrium of the Consumer

Critique of the Cardinal Approach

Utility can not be measured objectively

Constant utility of money is unrealistic

Money can not be used as a measuring-rod since its own utility changes

Ordinal Utility TheoryAssumptions

Rationality : Consumer aims at the maximization of his utility subject to constraint his income

Ordinal Utility : Consumer can rank his preferences Diminishing Marginal Rate of Substitution Total Utility is Additive Consistency and transitivity of choice

If A > B then B A

If A > B, and B > C, then A > C

Preferences: What the Consumer Wants

A consumers preference among consumption bundles

A consumers preference among consumption bundles may be illustrated with indifference curves.

Case 1 Case 2

Pizza (X) Pepsi (Y) Pizza (X) Pepsi (Y)A 1 12 A1 2 24B 2 8 B1 4 16C 3 5 C1 6 10D 4 3 D1 8 6E 5 2 E1 10 4

Figure 1 The Consumers Preferences

Quantityof Pizza

Quantityof Pepsi

0

Indifference curve

, I1

I2

A

B

E

C

D

A1

B1

C1

D1E1

Representing Preferences with Indifference Curves

The Consumers Preferences The consumer is indifferent, or equally happy, with

the combinations shown at points A, B, and C because they are all on the same curve.

The Marginal Rate of Substitution The slope at any point on an indifference curve is

the marginal rate of substitution. It is the rate at which a consumer is willing to trade one

good for another. It is the amount of one good that a consumer requires as

compensation to give up one unit of the other good.

Properties of Indifference Curves

Higher indifference curves are preferred to lower ones.

Indifference curves do not cross. Indifference curves are downward sloping and

convex to the origin.

Property 1: Higher indifference curves are preferred to lower ones. Consumers usually prefer more of something to

less of it. Higher indifference curves represent larger

quantities of goods than do lower indifference curves.


Figure 2 The Consumers Preferences

Quantityof Pizza

Quantityof Pepsi

0

Indifferencecurve, I1

I2

A

B

E

DD 1C

D

Property 2: Indifference curves do not cross. Points A and B should make the consumer equally

happy. Points B and C should make the consumer equally

happy. This implies that A and C would make the

consumer equally happy. But C has more of both goods compared to A.


Figure 3 The Impossibility of Intersecting Indifference Curves

Quantityof Pizza

Quantityof Pepsi

0

C

A

B

Copyright2004 South-Western


Property 3: Indifference curves are down ward sloping and convex to the origin. People are more willing to trade away goods that

they have in abundance and less willing to trade away goods of which they have little.

These differences in a consumers marginal substitution rates cause his or her indifference curve to bow inward.

Pizza (X) Pepsi (Y) MRSxyA 1 12 ---B 2 8 4C 3 5 3D 4 3 2E 5 2 1

Marginal Rate of Substitution

Diminishing marginal rate of substitution: The rate of substitution declines as consumption for X per unit increases

Figure 4 Down ward sloping Indifference Curves

Quantityof Pizza

Quantityof Pepsi

0

Indifferencecurve

8

2

B

2

5

E

1

MRS = 4

1MRS = 13

4

12

1


A

D

Relationship between MRS and MU( , )

0

xy

U x y aU Udx dyx y

dy U Ux ydx

dy MUxMUydx

MUxMRS MUy

=

+ =

=

= =

Two Extreme Examples of Indifference Curves

Perfect substitutes Perfect complements


Perfect Substitutes Two goods with straight-line indifference curves are

perfect substitutes. The marginal rate of substitution is a fixed number.

Figure 5 Perfect Substitutes and Perfect Complements

CD of brand Y0

CD

of b

rand

X(a) Perfect Substitutes

I1 I2 I33

6

2

4

1

2



Perfect Complements Two goods with right-angle indifference curves are

perfect complements.

Figure 5 Perfect Substitutes and Perfect Complements

Right Shoes0

LeftShoes

(b) Perfect Complements

I1

I2

7

7

5

5


The Budget Constraint: What the Consumer Can Afford

The budget constraint depicts the limit on the consumption bundles that a consumer can afford. People consume less than they desire because their

spending is constrained, or limited, by their income.

The budget constraint shows the various combinations of goods the consumer can afford given his or her income and the prices of the two goods.

The Consumers Budget Constraint

Assuming Per unit price of Pepsi 2 and Per unit Price of Pizza 10

The Budget Constraint: What the Consumer Can Afford The Consumers Budget Constraint

Any point on the budget constraint line indicates the consumers combination or tradeoff between two goods.

For example, if the consumer buys no pizzas, he can afford 500 pints of Pepsi (point B). If he buys no Pepsi, he can afford 100 pizzas (point L).

Alternately, the consumer can buy 50 pizzas and 250 pints of Pepsi.

Figure 6 The Consumers Budget Constraint

Quantityof Pizza

Quantityof Pepsi

0

Consumersbudget constraint

500 B

250

50

C

100L

The Budget Constraint: What the Consumer Can Afford

The slope of the budget constraint line equals the relative price of the two goods, that is, the price of one good compared to the price of the other.

It measures the rate at which the consumer can trade one good for the other.

Figure 7: Slope of the Budget Line

Quantityof Pizza

Quantityof Pepsi

0

Consumersbudget constraint

500 B

100L

x x y yP Q P Q M+ =

OBSlopeOL

=

y

x

M PSlope

M P=

x

y

PSlopeP

=

x x y yP Q P Q M+ =

Optimization: What The Consumer Chooses

Consumers want to get the combination of goods on the highest possible indifference curve.

However, the consumer must also end up on or below his budget constraint.

Figure 8 The Consumers Equilibrium

Quantityof Pizza

Quantityof Pepsi

0

Budget constraint

I1I2

I3

Optimum

AB


E

X

Y

xy x y x yE MRS P P MU MU= = =

The Consumers Optimal Choices

Combining the indifference curve and the budget constraint determines the consumers optimal choice.

Consumer optimum occurs at the point where the highest indifference curve and the budget constraint are tangent.

The consumer chooses consumption of the two goods so that the marginal rate of substitution equals the relative price.

Mathematical derivation of the Equilibrium

Given the market prices and his income, the consumer aims at the maximization of his utility.

1 2( , ,........ )nU f q q q=Maximize

Subject to 1 1 2 21

......n

i i n ni

q p q p q p q p Y=

= + + + =

Rewrite the constraint in the form

1 1 2 2( ...... ) 0n nq p q p q p Y+ + + =

Multiply the constraint by a constant which is Lagrangian multiplier

1 1 2 2( ...... ) 0n nq p q p q p Y + + + =


Composite function 1 1 2 2( ...... )n nU q p q p q p Y = + + +

11 1

22 2

1 1 2 2

( ) 0

( ) 0

( ) 0

( ...... ) 0

nn n

n n

U Pq q

U Pq q

U Pq q

q p q p q p Y

= =

= =

= =

= + + + =

Differentiating the composite function with respect to q1, q2.qn

1

2

3

..4


1 21 2

1 21 2

1 2

1 2

, ,.......

, ,......

......

nn

nn

n

n

x y

xxy

y

U U UP P Pq q qU U UMUq MUq MUqq q q

MUqMUq MUqP P P

MUx MUyP P

PMUx MRSMUy P

= = =

= = =

=

=

= =

Solving EQ1EQ2.EQ3

Equilibrium condition

Mathematical derivation of the Equilibrium Example Utility function of an consumer is given by

. Find out the optimal quantity of the two goods , if price of x is Rs 6/- per unit and price of y is Rs 3/- per unit and the income of the consumer is Rs 120/-

3 14 4( , )U f x y x y= =

SolutionMaximize

Subject to

3 14 4U x y=

6 3 120x y+ =Composite function

3 14 4 (6 3 120)x y x y = +

Ans: x = 15 and y = 10

How Changes in Income Affect the Consumers Choices

How a consumers purchases react to changes in income with relative prices held constant

An increase in income shifts the budget constraint outward.

The consumer is able to choose a better combination of goods on a higher indifference curve.

I2

I3

I1

E2

An Income-consumption Line

Quantity of X

Qua

ntity

of Y

E3

E1

Income-consumption line

0

This line shows how a consumers purchases react tochanges in income with relative prices held constant.

Increases in income shift the budget line out parallel toitself, moving the equilibrium from E1 to E2 to E3.

The income-consumption line joins all these points ofequilibrium.

If a consumer buys more of a good when his or herincome rises, the good is called a normal good.

If a consumer buys less of a good when his or herincome rises, the good is called an inferior good.

Income-consumption Line

Figure 9 An Inferior Good

Quantityof Pizza

Quantityof Pepsi

0

Initialbudgetconstraint

New budget constraint

I1 I2

1. When an increase in income shifts thebudget constraint outward . . .3. . . . but

Pepsiconsumptionfalls, makingPepsi aninferior good.

2. . . . pizza consumption rises, making pizza a normal good . . .

Initialoptimum

New optimum

I2

I3

I1

E2

The Price-consumption Line

Quantity of X

Qua

ntity

of Y

E3

E1

Price-consumptionline

b c d

a

How Changes in Price of a Commodity Affect the Consumers Choices

Q1 Q2 Q3o

This line shows how a consumers purchases react to achange in one price, with money income and otherprices held constant.

Decreases in the price of food (with money income andthe price of clothing constant) pivot the budget linefrom ab to ac to ad.

The equilibrium position moves from E1, to E2 to E3.

The price-consumption line joins all such equilibriumpoints.

The Price-consumption Line

Derivation of an Individuals Demand CurveA price-consumption line provide the information needed to draw a demand curve

Price BL IC Equilibrium Qx

P1 ab IC1 E1 OQ1

P2 ac IC2 E2 OQ2

P3 ad IC3 E3 OQ3

Price-consumption line

Quantity of XQ3Q2Q10

I0I1

I2

E2

E0E1

Q1 Q2 Q30

P1

P2

P3

x

y

z

Demand curve

Derivation of an Individuals Demand Curve

a

b c d

Quantity of X

Qua

ntity

of Y

Pric

e of

X

Derivation of an Individuals Demand Curve

A Change in Price: Substitution Effect A price change first causes the consumer to move

from one point on an indifference curve to another on the same curve. Illustrated by movement from point A to point B.

A Change in Price: Income Effect After moving from one point to another on the

same curve, the consumer will move to another indifference curve. Illustrated by movement from point B to point C.

Price Effect = Income Effect + Substitution Effect

52

Changes in a Goods Price

Quantity of x

Quantity of y

U1

A

Suppose the consumer is maximizing utility at point A.

U2

B

If the price of good x falls, the consumer will maximize utility at point B.

Total increase in x

53

U1

Quantity of x

Quantity of y

A

To isolate the substitution effect, we holdreal income constant but allow the relative price of good x to change

Substitution effect

C

The substitution effect is the movementfrom point A to point C

The individual substitutes good x for good ybecause it is now relatively cheaper


54

U1

U2

Quantity of x

Quantity of y

A

The income effect occurs because theindividuals real income changes whenthe price of good x changes

C

Income effect

B

The income effect is the movementfrom point C to point B

If x is a normal good,the individual will buy more because realincome increased


55

U2

U1

Quantity of x

Quantity of y

B

A

An increase in the price of good x means thatthe budget constraint gets steeper

CThe substitution effect is the movement from point A to point C

Substitution effect

Income effect

The income effect is the movement from point Cto point B



Normal good The substitution effect is always negative The income effect is negative for normal goods

PE(-) = IE (-) + SE (-)

If a good is normal, substitution and income effects reinforce one another when price falls, both effects lead to a rise in quantity

demanded when price rises, both effects lead to a drop in quantity

demanded


Inferior goods The substitution effect is always negative, The income effect is positive for inferior goods

PE(-) = IE (+) + SE (-) but (IE


Giffen goods The substitution effect is always negative, The income effect is positive for inferior goods

PE(+) = IE (+) + SE (-) but (IE > SE)

If the income effect of a price change is strong enough, there could be a positive relationship between price and quantity demanded an increase in price leads to a drop in real income since the good is inferior, a drop in income causes quantity

demanded to riseThe most commonly cited example of a Giffen good is that of the Irish potato famine in the19th century. During the famine, as the price of potatoes rose, impoverished consumers had littlemoney left for more nutritious but expensive food items like meat (the income effect). So eventhough they would have preferred to buy more meat and fewer potatoes (the substitution effect),the lack of money led them to buy more potatoes and less meat. In this case, the incomeeffect dominated the substitution effect, a characteristic of a Giffen good.

Consumer Surplus and Tax Incidence

Revisiting the Market Equilibrium

Does the equilibrium price and quantity maximize the total welfare of buyers and sellers?

Market equilibrium reflects the way markets allocate scarce resources.

Whether the market allocation is desirable can be addressed by welfare economics.

Welfare economics is the study of how the allocation ofresources affects economic well-being.

Buyers and sellers receive benefits from taking part in the market.

The equilibrium in a market maximizes the total welfare of buyers and sellers.

Producer and Consumer Surplus

Consumer surplus is the value the consumer gets from buying a product, less its price

It is the area below the demand curve and above the price Willingness to pay is the maximum amount that a buyer

will pay for a good. It measures how much the buyer values the good or

service.


It is the area above the supply curve but below the price the producer receives

Producer surplus is the amount a seller is paid for a good minus the sellers cost.

It measures the benefit to sellers participating in a market.

Producer surplus is the value the producer sells a product for less the cost of producing it

SD

P

Q

Consumer surplus = area of red triangle =

($5)(5) = $12.5

Producer surplus = area of green triangle =

($5)(5) = $12.5

The combination of producer and consumer surplus is maximized at

market equilibrium

CS

PS

$10987654321

0 1 2 3 4 5 6 7 8


Market EfficiencyConsumer surplus and producer surplus may be used to address the following question: Is the allocation of resources determined by free markets in

any way desirable?

Consumer Surplus = Value to buyers Amount paid by buyers

Producer Surplus = Amount received by sellers Cost to sellers

Efficiency is the property of a resource allocation of maximizing the total surplus received by all members of society.

The Role of Government in the Market EconomyUp to this point, we have examined how free markets work.

A free market is one without any government control or intervention. The price and output is determined by the interactions of buyers and sellers

However, not all markets are completely free. Governments tend to intervene often to influence several variables in markets for particular goods, such as: Taxing the good to discourage consumption or raise revenues: Indirect taxes Paying producers of the good to reduce costs or encourage the goods production:

Subsidies Reducing the price of the good below its free market equilibrium to benefit consumers:

Price Ceilings Raising the price of a good above its free market equilibrium to benefit producers: Price

FloorsWhen governments intervene in the free market, the level of output and price that results is may NOT be the allocatively efficient level. In other words, government

intervention may lead to a misallocation of societys resources.

Government Intervention

SD

P

Q

A Free Market

P

Q

If there is no tax, market equilibrium is reached and

consumer and producer surplus is maximized

8-8

S0

D

P

Q

Both producer and consumer surplus decrease

A tax paid by the supplier shifts the supply curve up by the

amount of the tax (=t)

P1-t

P0

P1

Q0Q1

Positive government revenue

S1

t

Deadweight loss exists

8-9

Government Intervention : Tax

The Costs of Taxation

S1

P1t

Quantity

Price

P0

Q0

P1

Q1

Producer surplus

S0

Demand

Consumer surplus

Deadweight loss

taxA

B C

D E

F

Consumer Surplus Before Tax: A + B + CConsumer Surplus After Tax: A

Producer Surplus Before Tax: D + E + FProducer Surplus After Tax: F

Deadweight Loss: C + E

Application: The Costs of Taxation

How do taxes affect the economic well-being of market participants? A tax places a wedge between the price, buyers pay

and the price, sellers receive. Because of this tax wedge, the quantity sold falls

below the level that would be sold without a tax. The size of the market for that good shrinks.

The Burden of Taxation

S0

D

P

Q

S1

P0

P1

t

The tax burden is independent of who pays the tax

P1-t

Q0 Q1

S

D0

P

P0

P1 t

P1+t

Q0 Q1

D1 Q

Supplier pays the tax, supply shifts

Consumer pays the tax, demand shifts

8-12

Sales Tax Sales taxes are paid by retailers

on the basis of their sales revenue

Since sales taxes are broadly defined to include most goods and services, consumers find it hard to substitute to avoid the tax

Demand is inelastic so consumers bear the greater burden of the tax

As consumers increase purchases on the Internet where sales are not taxed, retail stores will bear a greater burden of the sales tax

Social Security Taxes Both employer and employee

contribute the same percentage of before-tax wages to the Social Security fund

Although the employer and employee contribute the same percentage, they do not share the burden equally

On average, labor supply tends to be less elastic than labordemand, so the Social Security tax burden is primarily on employees

The Burden of Taxation

The Effects of an Indirect Tax and PEDObservations:

Good A

S

D

Q

P

Qe

S+tax

2.00

Qtax

$ 12.20

1.20

Good BS

D

Q

P

Qe

S+tax

2.00

Qtax

$ 12.90

1.90

The $ 1 tax on Good A (highly elastic demand): Rs 0.80 is paid by produces, and only $ 0.20 by consumers Quantity falls dramatically. The loss of welfare (gray triangle) is large Revenue raised is small due to the large decrease in QThe $ 1 tax on Good B (highly inelastic demand): $ 0.90 is paid by consumers, and only $. 0.10 by producers Quantity does not fall by much The loss of welfare (gray triangle) is small Revenue raised is greater than Good A because the quantity

does not fall by much

Taxing goods with relatively inelastic demand will raise more revenue and lead to a smaller loss of total welfare,

while taxing goods with elastic demand will lead to a larger decrease in quantity and a greater loss of total welfare.

What Goods should be Taxed and who bears the Tax?

If demand is relatively elastic: Producers will bear the larger burden of the tax. Firms will not be able to raise the price by much out of fear of losing all their customers, therefore price will not increase by much, but producers will get to keep less of what consumers pay.

If demand is relatively inelastic: Consumes will bear the larger burden of the tax. Firms will be able to pass most of the tax onto consumers, who are not very responsive to the higher price, thus will continue to consume close to what they were before the tax.

Elasticity and government revenue: The implication for government of the above analysis is that if a tax is meant to raise revenue, it is better placed on an inelastic good rather than an elastic good. Taxing elastic goods will reduce the quantity sold and thus not raise much revenue.

What Goods should be Taxed and who bears the Tax?

What Goods Should Be Taxed and who bears the Tax?

Goal of Government Most effective when

Raise revenue, limit deadweight loss Demand or supply is inelastic

Change behavior Demand or supply is elastic

Elasticity Who bears the burden?

Demand inelastic and supply elastic Consumers

Supply inelastic and demand elastic Producers

Both supply and demand elastic Shared, but the group whose S or D is more inelastic pays more

8-16

Incidence of Tax

Before the tax:

After the tax:

Incidence of Tax

Incidence of Subsidy

Before the subsidy:

After the subsidy:

Incidence of Subsidy

The Effects of Taxes and Subsidies on Consumers and ProducersWe can determine how much of the tax burden was born by consumers and producers:Effect of the tax The price increased from $4.00 to $4.75, meaning consumers paid $0.75 of the $1.00 tax. Producers got to keep just $3.75, meaning they paid just $0.25 of the $1.00 taxEffect of the subsidy: Price went down from $4.00 to $3.25, meaning consumers received $0.75 of the $1.00

subsidy. Producers received $4.25, meaning they enjoyed $0.25 of the $1.00 subsidy.

Before the tax and the

subsidy:

After the tax:

After the subsidy:

The Effects of Taxes and Subsidies on Consumers and Producers

Price Controls: Another form government intervention might take in a market is price controls.

Price Ceiling: This is a maximum price, set below the equilibrium price, meant to help consumers of a product by keeping the price low.

P S

Pe

Qe

Pc

QS QD

Gasoline Market

D

Q

P S

Pe

Qe

Pf

QD QS

Corn Market

D

Q

Price Floor: This is a minimum price, set below the equilibrium price, meant to help producers of a product by keeping the price high.

Price Controls

When a government lowers the price of a good to help consumers, there are several effects that we can observe in the market. Assume the government has intervened in the market for gasoline to make transportation more affordable for the nations households

On consumers: Quantity demanded increases (Qd) The lower price leads to an increase in consumer

surplus, which is now the blue area The lower quantity means some consumers who want to

will not be able to buy the goodOn Producers: The lower price means less producer surplus (red

triangle) The lower quantity means some producers will have to

leave the market and output will decline (Qs)On the market: Overall, not enough gasoline is produced, and is the

market is allocatively inefficient. The gray triangle represents the loss of total welfare resulting from the price ceiling.

P S

Pe

Qe

Pc

QS QD

Gasoline Market

D

Q

Shortage

The Effects of a Price Ceiling

The Effects of a Price Ceiling

When a government raises the price of a good to help producers, there are several effects that we can observe in the market. Assume the government has intervened in the market for corn to help farmers sell their crop at a price that allows them to earn a small profit.

On consumers: Quantity demanded decreases (Qd) The higher price means there is less consumer

surplus (blue area)On Producers: Quantity supplied increases (Qs) The higher price means there is more producer

surplus, but since consumers only demand Qd, there is an excess supply of unsold corn (Qd-Qs)

On the market: Overall, the market produces too much corn and is

thus allocatively inefficient. The increase in producer surplus is smaller than the decrease in consumer surplus. The total loss of welfare is represented by the gray triangle.

P S

Pe

Qe

Pf

QD QS

Corn Market

D

Q

Surplus

The Effects of a Price Floor

The Effects of a Price Floor

1 IntroductionEconomics: HSN-01Why to Study Economics?Economics and ChoiceHow Economists ThinkDecision MakersHow Economy WorksWhat Economists DoEconomic Science and Economic PolicyEconomic Science is YoungSuggested Books

2 Demand and SupplyDemand and SupplyDemandFactors Affecting DemandDemand and Law of DemandDemand ScheduleDemand CurveLaw of DemandMarket Demand CurveChange in Quantity Demanded vs. Change in DemandShifts in the demand curveShifts in the demand curveNoteSupplySlide Number 14Supply scheduleSupplyLaw of supplyChange in supply vs. change in quantity suppliedSlide Number 19Slide Number 20Slide Number 21Slide Number 22Market equilibriumMarket equilibriumInstability in PriceRise and Fall in DemandRise and fall in Supply Price ceilingPrice floor

3 Elasticity of DemandElasticity of DemandElasticity of DemandDefining & Measuring Price Elasticity of DemandMeasuring Elasticity of DemandMeasuring Elasticity of DemandElasticity along a Linear Demand CurveElastic and InelasticElastic and InelasticElastic and InelasticThe Factors that Influence the Elasticity of DemandSome Real-World Price Elasticities of DemandSignificance of Elasticity of DemandElasticity and Total RevenueElasticity and Total RevenueSlide Number 15Elasticity and Marginal RevenueDefining & Measuring Income Elasticity of DemandDefining & Measuring Cross Elasticity of DemandSummaryExamplesExamples

4 Consumer BehaviorConsumer BehaviorConsumer BehaviorCardinal Utility TheoryCardinal Utility TheoryDiminishing Marginal UtilityEquilibrium of the Consumer Equilibrium of the ConsumerDerivation of the Demand Curve Equilibrium of the ConsumerEquilibrium of the ConsumerCritique of the Cardinal ApproachOrdinal Utility TheoryPreferences: What the Consumer WantsFigure 1 The Consumers PreferencesSlide Number 15Properties of Indifference CurvesProperties of Indifference CurvesFigure 2 The Consumers PreferencesProperties of Indifference CurvesFigure 3 The Impossibility of Intersecting Indifference CurvesProperties of Indifference CurvesSlide Number 22Figure 4 Down ward sloping Indifference CurvesRelationship between MRS and MUTwo Extreme Examples of Indifference CurvesTwo Extreme Examples of Indifference CurvesFigure 5 Perfect Substitutes and Perfect ComplementsTwo Extreme Examples of Indifference CurvesFigure 5 Perfect Substitutes and Perfect ComplementsThe Budget Constraint: What the Consumer Can AffordThe Consumers Budget ConstraintThe Budget Constraint: What the Consumer Can AffordFigure 6 The Consumers Budget ConstraintThe Budget Constraint: What the Consumer Can AffordFigure 7: Slope of the Budget LineOptimization: What The Consumer ChoosesFigure 8 The Consumers Equilibrium The Consumers Optimal ChoicesMathematical derivation of the Equilibrium Mathematical derivation of the Equilibrium Slide Number 41Slide Number 42How Changes in Income Affect the Consumers ChoicesSlide Number 44Slide Number 45Figure 9 An Inferior GoodSlide Number 47Slide Number 48Slide Number 49Slide Number 50Slide Number 51Changes in a Goods PriceChanges in a Goods PriceChanges in a Goods PriceChanges in a Goods PriceSlide Number 56Slide Number 57Slide Number 58Slide Number 59Slide Number 60

5.1 Consumer Surplus and Incidence of TaxConsumer Surplus and Tax IncidenceRevisiting the Market EquilibriumProducer and Consumer SurplusProducer and Consumer SurplusProducer and Consumer SurplusMarket EfficiencySlide Number 7Slide Number 8Slide Number 9The Costs of TaxationApplication: The Costs of TaxationSlide Number 12Slide Number 13Slide Number 14Slide Number 15What Goods Should Be Taxed and who bears the Tax?Slide Number 17Slide Number 18Slide Number 19Slide Number 20Slide Number 21Slide Number 22Slide Number 23Slide Number 24Slide Number 25Slide Number 26

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