Micro Economics 1-7

CHAPTER 1- INTRODUCTION TO MICRO
ECONOMICS
Micro Economics
Economic theory is broadly divided into micro economics and macro economics. These terms
were first introduced by Ragnar Frisch. The term micro economics is derived from the Greek
word micros which means small. The term macro economics is derived from the Greek word
macros which means large. Thus, micro economics deals with a small part of the economy of a
country. In other words, microeconomic theory (Price Theory) studies the economic behavior of
individual decision making units (eg., consumers, resource owners, and business firms) in an
economy.
Definition of Micro economics
Micro means a millionth part. Micro economics is the study of the economic actions of
individuals and small group of individuals. Thus micro economics may be defined as that branch
of economic analysis which studies the economic behavior of the individual unit – a person, a
household or a firm.
In micro economics, we study the various units of the economy and how they function and how
they reach their equilibrium. In other words in micro economics, we analyse only a tiny part of
the economy at a time.
In micro economics, we attempt only a microscopic study of the national economy. In micro
economics, we enquire about how a particular person maximizes his satisfaction or how a
particular firm maximises it's profits.
Scope of Micro economics
Micro economics studies about price and value theory, the theory of the household, the firm and
the industry. It also studies about production and welfare theory.
Micro Economics Page 1

In short micro economics studies about:
a. Theory of Product Pricing with its two components, namely the theory of consumer‘s
behavior and the theory of production and costs.
b. Theory of factor pricing or the theory of distribution. This aspect studies about the theories of
wages, rent, interest and profits.
c. The theory of economic welfare. It is sometimes referred to as Price theory. Thus the prices
are the core of microeconomics.
Importance of Microeconomics
Microeconomics is an important method of economic analysis and it occupies an important

place in the study of economic theory. Microeconomics tells us how a free market economy with
its millions of consumers and producers works to decide about the allocations of productive
resources among the thousands of goods and services.
It tells us how the goods and services produced are distributed among the various people for
consumption through price (Market) mechanism. Microeconomic theory explains the conditions
of efficiency in consumption and production and highlights the factors which are responsible for
the departure from the efficiency (optimum). Thus, microeconomics has theoretical and practical
importance which can be summarized as follows:
a. Helps to Use Resources Efficiently: Microeconomics is helpful in the efficient employment

of the limited, scarce resources of a country. The principal problem faced by the modern
governments is the allocation of its scarce resources among competing uses. Microeconomics
theory explains the conditions of efficiency in consumption and production, which are the vital
parts of economics. Microeconomic theory suggests suitable policies which should be adopted
by modern governments to promote economic efficiency for achieving the all-round
development and stability of the economy of the country.
b. Helps to Understand a Free enterprise Economy. Microeconomics is of great importance in

understanding the working of free enterprise economy without any central planning and control.

c. Basis for welfare economics. The greatest advantage of micro economics is that it provides
the basics for welfare economics. The entire structure of welfare economics has been built on
price theory which is an ingredient of micro economics.
Limitations of Microeconomics
It should be noted that there are certain limitations to micro economics which are briefly
explained below:
1. Fallacy of Composition: What is true of an individual may not be true in the case of
aggregates. For example, thrift may be good for an individual but bad or harmful to the society
as a whole. If the society starts saving more, effective demand will come down and the
employment will decline and the economy as a whole would suffer on account of thrift.
2. Microeconomic analysis is based on unrealistic assumptions like full employment which is

really unrealistic.
3. There are certain problems which cannot be analysed with the aid of micro economics. For
example, important problems relating to public finance, monetary policy and fiscal policy etc.
are beyond the view of microeconomics.
Macroeconomics:
The word 'macro‘ is derived from the Greek word 'macros‘ meaning large and therefore,
macroeconomics is concerned with the economic activity in the large. Macroeconomics may be
defined as that branch of economic analysis which studies the behavior of not one particular unit,
but of all the units taken together.
Macroeconomics study is a study of aggregates. Hence, it is often called Aggregative

Economics. It is the study of the economic system as a whole. It is the study of the overall
conditions of the economy like total production, total consumption, total savings and total
investment.
[Public finance is part of the field of economics, and primarily concerned with activities that
involve the government and how it allocates resources and spends money ]

According to K.E.Boulding, ―Macroeconomics deals not with individual quantities as such but
with aggregates of these quantities; not with individual incomes; but with the national incomes;
not with individual price but with the price level, not with individual outputs but with the
national output. As such macroeconomics deals with great averages and aggregates of the
system.
Differences between Micro and Macro Economics
1. In microeconomics, we study the working of individual markets where as in macroeconomics;

we study about aggregates or totals such as total output, total employment and total income.
2. In micro economics, the unit of study is a part where as in macro economics we study about
the economy as a whole. For example, micro economics takes the general price level as given
whereas in macro economics we take it as a variable.
3. In micro economics we are concerned with limited equilibrium where as in macro economics
we are concerned with general equilibrium.
4. In micro economics we study about relative prices assuming that the general price level is
given whereas in macro economics we study about changes in general price level like inflation
and deflation.
[A relative price is the price of a commodity such as a good or service in terms of another; i.e., the ratio
of two prices, Microeconomics, as one branch of economic theory, is defined as the study of the
behavior of individual economic agents. These agents are divided up into producers (business firms) and
consumers (households) and thus microeconomics is the study of how these agents react to changes in
relative prices, For example given the price of two goods -- houses and apartments, where we may
observe that the price of houses are increasing relative to apartment rents. An index that measures the
change in price of goods in an economy over time and hence the purchasing power of the currency of the
country. For instance, in the U.S. it is represented by the CPI (Consumer Price Index)]

Wants
Human Wants
Man is a bundle of desires. Human needs are material items people need for survival, such as
food, clothing and housing. In other words, human needs are generally understood as things
necessary to enable a human to continue to live. It is generally understood that humans need
food, clothing, and shelter without which existence of man‘s life is not possible. Hence human
needs are limited. On the other hand, human wants are infinite in variety and number. Wants also
vary from individual to individual and they multiply with the stages of development of a country.
Consumption studies about the satisfaction of human wants. All men have wants. Existence of
human wants is the starting point of all economic activity. Under consumption, we study about
the nature of wants, the classification of wants and the laws relating to consumption.
Characteristics of Human Wants:
1. Human wants are unlimited: Man is never completely satisfied and hence there is no end to
human wants. When one want is satisfied another want will crop up to take its place and thus
there is a never ending cycle of wants. Hence, no man is completely satisfied forever.
2. A Particular want is Satisfiable: Although we cannot satisfy all our wants, we can satisfy a
particular want if there are resources.
3. Wants are Complementary: Sometimes for satisfying a particular want we need several
things together. For example, to write one should have pen and ink. Hence, the relationship
between pen and ink is complementary.
4. Wants are Competitive: Wants compete with each other for our limited resources (Money).
For example with AED 25, one can have meals or can see a Cinema or buy a note book. So one
has to make a choice.
5. Wants are alternative: There are several ways of satisfying a particular want. For example, If
a man is hungry, his hunger may be satisfied by bread, rice or fruits. The final choice depends
upon availability of money and the relative prices.

6. Wants vary with time place and person: Wants are not always the same. It varies with
individual to individual. People want different things at different times and in different places.
7. Wants multiply with Development: With the level of economic development wants multiply.
With the development of a country, the demand for radio, T.V, motor-car etc, increases.
8. Wants are Recurring: Some wants are recurring in nature, e.g. food we require food again
and again.
9. Wants are influenced by income, salesmanship and advertisement: If income is higher

more wants can be satisfied. Many things we buy of particular brands due to salesmanship or
advertisement.
10. Wants are the result of custom or convention: As a part of custom and convention we buy
many things. Really they are not required but unlikely we have to purchase it e.g. expenses on
social ceremonies.
Classification of Wants
Wants may be classified into necessaries, comforts and luxuries.
A. Necessaries: Necessaries are those things which are most essential and without which we
cannot live. These can be sub divided as:
 Necessaries of existence: The things without which we cannot exist e.g. water, food,
clothing, shelter.
 Conventional necessaries: The things which we are forced to use by social custom, e.g.
wearing of new clothes on marriage, decorating houses on functions, cutting cakes on
birthdays etc.,
B. Comforts:
After satisfying our necessaries we desire to have some comforts. Comforts give pleasure and
add to the efficiency of the person. For example table and chair for a student help to increase the
efficiency. But cushioned costly chair is not a comfort.

C. Luxuries:
Luxury means superfluous(unnecessary) consumption. After getting comforts, man desire

luxury. Luxuries increases pleasure of a person but do not increase one‘s efficiency and hence
some luxuries are waste. Motor cars, diamond jewellery, designer clothes, etc. are examples of
luxuries. These things may not increase efficiency or comfort but they provide us happiness and
status in society.
The above classification of wants is not rigid. A thing which is a comfort or luxury for one
person or at one point of time may become a necessity for another person or at another point of
time.
For example, a car may be a luxury for a laborer, a comfort for a teacher but a necessity for a
doctor. Whether a certain want is a necessity, a comfort or a luxury depends upon the person, the
place, the time and the circumstances.
Scarcity
The word scarce means limited or insufficient. Scarcity of resources is the fundamental problem
of every society. As the resources of every society are limited (scarce), the ability of the society
to produce goods and services are also limited. In other words, human wants are unlimited and
the means to satisfy them are limited, every society is faced with the twin problems of scarcity
and choice. Hence, all societies face some basic (fundamental) problems - production, technique
of production (combination of factors) and distribution.
The Problem of Scarcity
We live in a world where everything is scarce. People want a variety of goods and services. This
implies that human wants are unlimited and the means to fulfill them are limited. At a particular
time, the economy can produce only a limited amount of goods and services. This is because of
the scarcity of resources like land, labour, capital and organization. These factors of production
(inputs) are used to produce goods and services (Economic goods). These factors explain scarcity

is the basic problem of every society. Thus the law of scarcity states that human wants are
unlimited and the resources available to satisfy theses wants are limited.
The Problem of Choice
As the resources to produce goods and services are limited, a society can produce only a small
portion of goods and services it want. Therefore, scarcity of resources results in the fundamental
(basic) economic problem of choice. As a society cannot produce all the goods and services to
satisfy all the wants of the people, it has to make a choice regarding the goods and services to be
produced at present. The economic problem fundamentally revolves around the idea of choice.
A decision to produce one good may result in a decision not to produce another good. So choice
involves sacrifice.
Thus every society is faced with the basic problem of deciding what it is willing to sacrifice to
produce the goods it wants the most. For example, if the country decides to have more hospitals,
it may have to reduce the resources available for the construction of schools. The sacrifice of the
alternative (Schools) in the production of a good (Hospitals) is called the opportunity cost.
Similarly there arise the problem of choice in selecting techniques of production (combination of
factors) when there are alternative ways of producing goods.
THE PRODUCTION POSSIBILITY CURVE (PPC)
Choices (alternatives) can be explained with the help of a production possibility curve. A
production possibility curve shows all the possible combinations of two goods that a society can
produce within a specified time period when the resources are fully (efficiently) utilised. In other
words, production possibility curve is the locus of all combinations of two goods that can be
produced with the given resources. PPC is also known as Production Possibility Frontier (PPF)
or Product Transformation Curve.

Production Possibility Curve
(Explained With Diagram)
The production possibility curve represents graphically alternative
production possibilities open to an economy.
The productive resources of the community can be used for the

production of various alternative goods.
But since they are scarce, a choice has to be made between the
alternative goods that can be produced. In other words, the economy
has to choose which goods to produce and in what quantities. If it is
decided to produce more of certain goods, the production of certain
other goods has to be curtailed.
Let us suppose that the economy can produce two commodities, cotton
and wheat. We suppose that the productive resources are being fully
utilized and there is no change in technology. The following table gives
the various production possibilities.
It all available resources are employed for the production of wheat,

15,000 quintals of it can be produced. If, on the other hand, all
available resources are utilized for the production of cotton, 5000
quintals are produced. These are the two extremes represented by A

and F and in between them are the situations represented by B, C, D
and E. At B, the economy can produce 14,000 quintals of wheat and
1000 quintals of cotton.
At C the production possibilities are 12,000 quintals of wheat and

200u quintals of cotton, as we move from A to F, we give up some
units of wheat for some units of cotton For instance, moving from A to
B, we sacrifice 1000 quintals of wheat to produce 1000 quintals of
cotton, and so on. As we move from A to F, we sacrifice increasing
amounts of cotton.
This means that, in a full-employment economy, more and more of

one good can be obtained only by reducing the production of another
good. This is due to the basic fact that the economy’s resources are
limited.
The following diagram (21.2) illustrates the production possibilities set

out in the above table.
In this diagram AF is the production possibility curve, also called or

the production possibility frontier, which shows the various
combinations of the two goods which the economy can produce with a
given amount of resources. The production possibility curve is also
called transformation curve, because when we move from one position
to another, we are really transforming one good into another by
shifting resources from one use to another.

It is to be remembered that all the points representing the various
reduction possibilities must lie on the production possibility curve AF
and not inside or outside of it. For example, the combined output of
the two goods can neither be at U nor H. (See Fig. 21.3) This is so
because at U the economy will be under-employing its resources and
H is beyond the resources available.
CIRCULAR FLOW OF ECONOMIC ACTIVITY
Economists have developed a model of how an economy works and this is known as the
Circular Flow Model. Circular model explains the interaction between households and firms.
The flow of economic activity represents employment, production; consumption, capital
formation etc. In other words, through economic activity, business firms and households are
linked with each other.
Thus, Circular flow means movement of money and goods in the economy. It attempts to
illustrate the flow of money and goods in the economy from households and business enterprises
and back to households. The economic activities and money have a circular flow.
Households and business firms interact in product markets and factor markets. Households sell
factors or production to business firms in the factor market and purchases goods and services
from business firms from the product markets. Hence, households are sellers in the factor

markets and buyers in the product markets. The consumption expenditure of households
represents the income (money receipts) of business firms. The business firms purchase the
services (factors of production) from households. Thus, the production cost of business firms
represents the money income of households.
[Factor Market: A marketplace where factors of production such as labor, capital, and resources
are purchased and sold. For example, the labor services of workers are exchanged through factor
markets NOT the actual workers. It is important to point out that factor market is different from
those markets that sell goods and services. In other words, the market for goods and services
entails selling or marketing products that are finished. Factor market centers around the factors
that are needed to get to a finished product. Without the factor market, the goods and services
market could not be completed.Buying and selling the actual workers is not only slavery (which
is illegal) it's also the type of exchange that would take place through product markets, not factor
markets. More realistically, capital and land are two resources than can be and are legally
exchanged through product markets. The services of these resources, however, are exchanged
through factor markets. The value of the services exchanged through factor markets each year is
measured as national income. In goods markets firms sell and households buy, but in factor
markets firms buy and households sell.]
Two Sector Model
The simplest form of the model is called the two-sector circular flow model. In this model, we
assume that there are only two sectors - the household sector and the business sector.
Households own all economic resources: these are, as you know, land, labour, capital and
enterprise. A two-sector model consists of households and business firms. Households own all
factors of production or resources. These resources are either labour force (human resources) or
capital stock (non-human resources) or both.
Households are fundamentally consumer units and their ultimate aim is satisfaction of their
wants.

On the other hand, business firms are production units. They employ the factors of production
(resources or inputs) and produces goods (output) for sale. Business firms pay money for the
purchase of factor services (scarce resources) from the markets and they receive money from
households in return for the sale of goods and services. Thus, flow of goods and services in one
direction are always matched by the flow of money in the opposite direction. This is explained in
the below diagram.
Figure: Circular Flow of Economic Activity: Two Sector Model
Households sell their resources to firms and they use these factors of production to produce
goods and services. Households are paid for their resources (see the flow ''payments for
resources''). It is assumed that there are no savings and investments in this model. The household
sector constitutes consumers while business sector constitute producers.
In this model, there are two clear flows. The first is the outer flow; economic resources are
provided to firms, who use them to produce goods and services. This flow is called the real flow
of resources and production.
The second, inner flow is the money flow. Firms pay households for their resources, and in turn
households use this income to buy goods and services from firms. Households spend their

income on goods produced by firms. Firms spend their money on production, buying resources
from households. The model indicates that total demand will always equal total supply. That is,
total spending equals total production. The economy is always in equilibrium and there is no
tendency for a change.
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CHAPTER 2;PRICE DETERMINATION AND

FUNCTIONS OF PRICES
Prices
All are interested in prices whether they are consumers or producers. A consumer is interested to
know whether the prices of the products he wanted to buy has gone up or down. Similarly a
producer is also interested to know whether the prices of his products have gone up or down.
Hence, economists are interested in explaining how prices are determined and the reasons behind
their variation.

The price mechanism works in a free market (capitalist) economy through supply and demand of
goods in competitive markets. The demand and supply are also determined by prices. Prices
determine the production of innumerable goods and services. They organize production and
helps in distribution of goods and services. They also ration the scarce goods and services.
The role of prices are very important in a free enterprise economy as price or price mechanism
decides what goods are to be produced in what quantities they are to be produced, how they
decided goods are to be produced and how to distribute the produced goods among the
contributors of factors of production (people) and how to utilize the resources fully and how to
achieve rapid economic growth in a country.
Limitations of Price Mechanism
There are certain limitations to the operations of the price mechanism. They are:
1. The government regulates the prices of many commodities to protect the social interest.
2. The price mechanism functions under the assumptions of perfect competition and perfect
completion do not exist anywhere in the world.
[Note: Conditions for perfect competition
1. All firms sell an identical product.

3. All firms have a relatively small market share.
4. Buyers know the nature of the product being sold and the prices charged by each firm.
5. The industry is characterized by freedom of entry and exit.]
3. Price mechanism has resulted in unequal distribution of income and wealth in a country.
Value and Price
Definition of Price
Price is the amount of money paid by the buyer to the seller in exchange for any
product and service. The amount charged by the seller for a product is known as

its price, which includes cost and the profit margin. For example- If you buy a
product for Rs 250, then it is the price of that product.
Definition of Value
Value is the usefulness of any product to a customer. It can never be

determined n terms of money and varies from customer to customer. For
example- If you are going to a gym by spending 1000 bucks a month, the output
seen is worth the expense, then it is the value that you create for a gym, regarding
the service being offered there. Here the worth is its value.
Economists sometimes make a difference between Value and Price. Value of a commodity is the
purchasing power of one commodity. Value is a real quantity. In other words, value of a
commodity is the quantities of commodities that are obtained in exchange for a commodity.
Value expressed in money is called price.
Households (Consumers) are interested in prices. They wanted to know whether the prices of the
products they wanted to buy has gone up or down. Similarly, the producers are interested in
whether the prices of the products or inputs he uses have gone up or down.
In Economics, Economists are interested and tried to explain how the prices are determined and
how and when they are high or low. Micro economics itself is known as Price Theory and the
vital part of micro economics is explanation of the behavior of individual units and how the
prices of goods and services are determined. Fluctuations in commodity prices are an important
factor affecting the standard of living of the people.
Price Determination
One of the important aspects of microeconomic theory is the determination of market prices. We
know that the price determination differ from market structure to market structure. In the market
when prices increases, buyers will reduce the quantity demanded while the sellers will be ready
to increase their sales. On the other hand, when the prices come down, the buyers are ready to
buy more whereas the sellers will reduce their supply of goods. Changes in prices would change
demand and supply. Thus price changes will change demand and supply. Thus, it is true that the
demand and supply of a commodity are both affected by the price of a commodity.

On the other hand, both the demand and supply of a commodity influence the price of a
commodity. Hence, we can say that forces of demand and supply determine the price of a
commodity. In other words, in a perfectly competitive market, the prices are determined by the
intersection of forces of demand and forces of supply in the market.
Equilibrium Price
We know that buyers of a commodity demand more of it at a lower price and less of it a higher
price. In other words there is an inverse relationship between price and quantity demanded which
is known as the law of demand.
Hence the demand curve slopes downward to the right showing a negative slope.
On the other hand sellers of a commodity supply more of it at a higher price and less of it at a
lower price. Thus, there is a direct relationship between quantity supplied and price of a
commodity which is known as the law of supply.

The supply curve rises upward to the right showing a positive slope. There can be a price of the
commodity at which quantity demanded and quantity supplied is equal. This price of is called the
equilibrium price.
Thus equilibrium price of a commodity is the price at which quantity demanded and quantity
supplied is equal. It should be noted that at the equilibrium price, there would be no further
changes in the demand and supply. Thus equilibrium, price of a commodity is the price at which
quantity demanded and quantity supplied is equal.

PRICE DETERMINATION
The market price is determined by demand and supply under perfectly competitive market
situation. We know that a demand curve normally slopes downward. In other words, with the fall
in price quantity demanded rises and vice versa.
On the other hand the supply curve of a commodity usually slopes upward. In other words, an
industry will offer to sell more quantity of a good at a higher price than at a lower price. The
level of price at which demand and supply curves intersect each other will finally come to stay in
the market.
In other words, the price which will come to prevail in the market is one at which quantity
demanded is equal to quantity supplied. The price at which quantity demanded equals quantity
supplied is called equilibrium price because at this price the two forces of demand and supply
exactly balance each other. The quantity of the good which is purchased and sold at this
equilibrium price is called equilibrium amount. Thus the intersection of demand and supply
curves determines price, quantity equilibrium and hence the equilibrium price.
There will be discrepancy between quantity demand and quantity supplied if the price is not at
equilibrium. In the following figure, at the price P1, the quantity supplied exceeds the quantity
demanded. The difference between the quantity supplied and the quantity demanded is called the
excess supply. This means that the firms are not able to sell all of their output and hence they
will be forced to reduce the price so as to increase their sales. Reduction in price increases the
quantity demanded and will reduce the quantity supplied. On the other hand, if the price is P2,
the quantity demanded exceeds the quantity supplied. The difference between the quantity
demand and the quantity supplied is called the excess demand. When the demand exceeds the
supply, consumers cannot buy the quantity they would like to purchase and these results in a
tendency to offer a higher price. As the price increases, the quantity demanded decreases and the
quantity supplied increases. When the price is P, the quantity demanded equals the quantity
supplied and there is no tendency to change the price either by buyers or sellers. Thus, P is the
equilibrium price which prevails in the market.

Figure: Price Determination
CONCEPT OF MARGIN
Marginal means addition to total. The marginal unit of anything is the last to be added. The
marginal is the smallest increase in ones stock of a commodity. Hence marginal unit of
something is the smallest additional amount the consumer considers to be worth buying. The
marginal concept can be applied to satisfaction (utility) or psychological influences such as the
propensity to consume.
Marginal Cost: Marginal cost is the extra (additional) cost of producing one more unit of a
product. In other words, marginal cost is the addition to the total cost of producing n units
instead of n-1 units where n is any given number.
MC n = TC n – TC n-1
Where MC is the Marginal Cost, TC is the Total Cost. Thus, if it costs Rs.110 to produce 50
units of a commodity and 115 to produce 51 units, marginal cost is Rs.5.

Marginal Product
Marginal product is the extra output resulting from the employment of one more unit of land,
labour or capital. In other words, marginal product of a factor is the addition to the total
production by the employment of an extra unit of a factor. Suppose when 2 workers are
employed to produce rice in an agricultural farm and they produce 100 quintals of rice per year.
Now if 3 workers are employed and as a result production of rice increases to 140 quintals, then
the third worker has added 40 quintals of rice to total production. Thus, 40 quintals is the
marginal product.
Marginal Revenue
Marginal revenue is the extra revenue (income) obtained from the sale of one more unit of
output. It is the increase in total revenue by selling one more unit of the commodity. In other
words, marginal revenue is the addition made to the total revenue by selling n units of a product
instead of n-1 where n is any given number.
We may write marginal revenue as:
MR n = TR n - TR n -1
where MR is Marginal Revenue, TR is Total Revenue.
Marginal rate of substitution Marginal rate of substitution is the rate at which an individual will
exchange successive units of one commodity for another.
For example if you can sell 10 units at £20 each or 11 units at £19 each, then your marginal
revenue from the eleventh unit is (10 × 20) - (11 × 19) = £9.
Marginal utility
Marginal utility is the additional amount of satisfaction (utility) to be obtained from the
consumption of one more unit of a commodity.

For example, if you were really thirsty you'd get a certain amount of satisfaction from a glass of
water. This satisfaction would probably decrease with the second glass, and then decrease even
more with the third glass. The additional amount of satisfaction that comes with each additional
glass of water is marginal utility.
Take, for example, a chocolate bar. Let's say that after eating one chocolate bar your sweet tooth
has been satisfied. Your marginal utility (and total utility) after eating one chocolate bar will be
quite high. But if you eat more chocolate bars, the pleasure of each additional chocolate bar will
be less than the pleasure you received from eating the one before - probably because you are
starting to feel full or you have had too many sweets for one day.
This table shows that total utility will increase at a much slower rate as marginal utility
diminishes with each additional bar. Notice how the first chocolate bar gives a total utility of 70
but the next three chocolate bars together increase total utility by only 18 additional units.
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CHAPTER 3;BASIC DEMAND AND SUPPLY
ANALYSIS
Market Analysis
A market is a network of communications between individuals and firms for the purpose of
buying and selling of goods and services. A market can, but need not, be a specific place or
location where buyers and sellers actually come face to face for the purpose of transacting their
business. That is, the idea of a particular locality or geographical place is not necessary to the
concept of market. What is required for the market to exist is the contact between sellers and
buyers so that transaction at an agreed price can take place between them. There is a market for
each good or services or resource bought or sold in the economy. Some of these markets are
local; some are regional while others are national or international in character.
Thus, market is a collection of buyers and sellers that determine the prices that are established
and quantities that are transacted. Markets provide the framework for the analysis of the forces of
demand and supply that, together, determines prices of goods and services.
The Nature of Demand
In economics, demand refers to the various quantities of a good or service that people will be and
able to purchase at various prices during a period of time. It is important to note that a mere
desire for a good or service does not constitute demand. Demand implies both the desire to
purchase and ability to pay for the good. Unless demand is backed by purchasing power, it
does not constitute demand. Further, demand does not refer to the specific quantity that will be
purchased at some particular price, but refer to a series of quantities and their associated prices.
Demand Function
Demand for a commodity is determined by several factors. An individual's demand for a

commodity depends on the own price of the commodity, his income, prices of related

commodities, his tastes and preferences, advertisement expenditure made by the producers of the
commodity, expectations etc. Thus, individual's demand for a commodity can be expressed in the
following general functional form,
Qxd = f (Px, I, Pr, T, A, E)
where,
Qxd = Quantity demanded of commodity ―x;
Px = Price of commodity x;
I = Income of the individual consumer;
Pr = Price of related commodities;
T = Tastes and preferences of individual consumer;
A = Advertisement expenditure;
E = Expectations
The demand function is just a short hand way of saying that quantity demanded , which is
recorded in the left hand side depends on the variables that are recorded on the right hand side.
For many purposes in economics, it is useful to focus on the relationship between quantity
demanded of a good and its own price, while keeping other determining factors constant. Thus,
we can write the demand function as:
Qxd = f (Px)
This implies that the quantity demanded of the commodity x is a function of its own price, other
determinants remaining constant.

The Market Demand
As mentioned above, the quantity of a product demanded by one individual depends on the
product‘s price, other things being equal. To explain the market behaviour, we need to know the
total demand of all individuals. The market demand for a commodity gives the alternative
amounts of the commodity demanded at various prices by all individuals in the market during a
period of time. To obtain the market demand, we sum the quantities demanded by each
individual at a particular price to obtain the total quantity demanded at that price. We repeat the
process for each price to obtain market demand schedule at all possible prices. The market
demand for a commodity depends on the all the factors that determine the individual‘s demand.
In addition, it also depends on the number of buyers of the commodity in the market.
Geometrically, the market demand curve for a commodity is obtained by the horizontal
summation of the entire individual‘s demand curve for the commodity.
Let us assume there are only three consumers in a hypothetical market of product. The following
table shows their individual demand schedules as well as the market demand which is obtained
by horizontally adding the quantities demanded by individuals at a given price.
The following chart shows the individual demand curves as well as the market demand curve.
The points on individual and market demand curves have same vertical coordinate i.e. price per
unit of the product. But the horizontal coordinates of the points on market demand curve are the
sums of the horizontal coordinates of the points on individual demand curves i.e. quantities
demanded by individual customer.
At any given price different quantities may be demanded by different consumers and the
difference in slopes of the individual curves shows that their elasticity of demand may also be
different. However a single consumer has insignificant effect on equilibrium in a large market.
Therefore we use market demand and market supply curves to determine equilibrium price and
quantity.

The above figure illustrates the proposition that the market demand curve is the horizontal sum
of the demand curves of all the individuals who buy in the market. The market demand curve
will also slope downwards from left to the right because the individual demand curves whose

lateral summation gives the market demand curve normally slope downward from left to the
right.
Reasons for law of Demand
Let us analyse the reasons for the inverse relationship between price and quantity demanded.
This is due to both ―income effect and ―substitution effect.
When the price of the commodity falls, the consumer can buy more quantity of the commodity
with his given income. If he chooses to buy the same amount of the commodity as before, some
money will be left with him. That is, consumer‘s real income or purchasing power increases.
This increase in real income induces the consumer to buy more of the commodity. This is called
the income effect of the change in price of the commodity. This is the reason why a consumer
buys more of a commodity whose price falls. Similarly, an increase in the price of the
commodity results in the reduction of real income of the consumer. Hence, the consumer buys
less of a commodity whose price rises.
Again, when price of the commodity falls, it becomes relatively cheaper than other commodities.
This induces the consumer to substitute the commodity whose price has fallen for other
commodities which have now become relatively dearer. This change in quantity demanded
resulting from substituting one commodity for another is referred to as substitution effect of the
price change. As a result of this substitution effect, the quantity demanded of the commodity
whose price has fallen rises. For normal commodities, the income and substitution effect of a
price decline are positive and reinforce each other leading to a greater quantity demanded of the
commodity. Apart from the income effect and substitution effect, there is an additional reason
why the market demand curve for a commodity slopes downwards.
When the price of the commodity is relatively high, only few consumers can afford to buy it.
When the price of the commodity falls, a greater number of consumers will be able to afford to
buy it. In other words, the size of the market expands. Thus, the quantity demanded increases.
This is called the ―market size effect.
Exceptions to the Law of Demand

Law of demand is generally believed to be valid in most situations. However, some exceptions
have been pointed out. According to Thorestein Veblen, some consumers measure the utility of a
commodity entirely by its price. That is, for them, the greater the price of the commodity, the
greater it‘s utility. These consumers demand more of such commodities the more expensive
these commodities are in order to impress people. E.g. Diamonds. This form of conspicuous
consumption is called ―Veblen effect. When the price of such commodities goes up, their
prestige value also goes up. Consequently, quantity demanded also will rise and law of demand
breaks down.
Another exception to the law of demand is the case of some inferior commodities and was
pointed out by 19th century English economist Sir Robert Giffen. He introduced the case of
some inferior goods in which there is a direct price-quantity demanded relationship. If the price
of an inferior good falls, consumer‘s real income increases. So, instead of buying more inferior
goods, consumers substitute other superior goods. In such case, quantity demanded of inferior
goods falls as price falls. After the name of Robert Giffen, such goods are called ―Giffen
Goods. In the case of Giffen goods, positive substitution effect is smaller than negative income
effect when the price of such goods falls. With the rise in the price of such goods, its quantity
demanded increases and with the fall in the price, its quantity demanded decreases. Thus, the
demand curve will slope upwards to the right and not downward in the case of Giffen goods. It
should be noted that Giffen good is an inferior good but all inferior goods are not Giffen goods.
Though occurs rarely in the real world, Giffen goods represent an exception to the law of
demand.
Determinants of Demand
Income, prices of related goods, taste and preferences of the consumer, expectations, number of
buyers in the market, distribution of income etc are likely to affect the demand for the product.
These factors are called ―non-price determinants and are assumed to be constant while deriving
the demand schedule and demand curve. But any change in these non-price determinants will

change the demand schedule and demand curve. Let us analyse how these factors can affect the
demand for the product.
(1) Income: The demand depends up on income of the people. The greater the income of the
people, the greater will be their demand for goods and services. If their income increases, people
will tend to buy more goods and services than they did before the increase in income. This is the
case of most goods and services. Hence economists refer to goods whose demand varies directly
with income as ―normal goods. Although most commodities are normal goods, there are cases
when consumers may not buy some goods more as their income increases. Instead they buy less.
Such goods are called ―inferior goods because as people‘s income increases they actually
reduce the purchase of such goods.
(2) Prices of related goods: Goods and services may be related to each other in two ways; they
may be substitutes or they may be complements. One good is said to be substitute for a second
good if it can be used in the place of second good. Example: tea and coffee, beef and chicken.
Two goods are said to be complementary if they are used together. Complementary goods are
demanded jointly. Example: scooter and petrol, computer and computer software. In general, if
the price of a substitute commodity increases, consumers tend to increase their purchases of the
substitute in question. Goods are substitutes when an increase in the price of one leads to an
increase in the quantity demanded of the other. For instance, if the price of coffee increases,
people will substitute tea for coffee and as a result demand for tea increases. On the other hand,
if the price of complement falls, people will tend to increase their purchases of the commodity in
question. Two goods are complements if a fall in the price of one leads to increase in the quantity
demanded of the other. For instance, if the price of scooter falls, the demand for them will
increase which in turn will increase the demand for petrol.
(3) Taste and Preferences: The quantity of a commodity that people will buy will be affected
by the taste and preferences. Companies spend millions of Rupees in advertisement in an attempt
to influence consumer‘s tastes in favour of their products. Consumer‘s taste and preferences
often change and as a result, there is a change in the demand for products. A good for which
consumer‘s tastes are greater, its demand would be larger. On the contrary, any good goes out of
fashion or people‘s taste and preferences no longer remain favourable to them, the demand for
them decreases.

(4) Expectations: The expectations of the consumers regarding the price in the future will affect
present purchases of goods and services. If consumers expect the price of the product to increase
in the future, they are likely to increase their present purchases to stock up on the good and thus
postpone paying the ensuing higher price for as long as possible. Conversely, if the price is
expected to fall in future, consumers will attempt to delay their present purchases in order to take
advantage of the lower future prices. The expectations of the consumer about the future change
in income will also affect the purchases of goods and services. If people expect substantial
increase in their income sometime in the near future, they are likely to buy more goods and
services even before the increase in income materialises. If the people expect decrease in their
income, they are likely to buy fewer goods and services.
(5) Number of buyers in the market: The quantity of the commodity that people will buy
depends on the number buyers in the market for that particular commodity. The greater the
number of buyers of a good, the greater the market demand for it. If population increases we can
expect the demand for most goods and services to increase as a consequence.
(6) Distribution of income: Distribution of income in the society also affects demand for
goods. If the distribution of income is more equal, then the propensity to consume of the society
as a whole will be higher which results in greater demand for goods. On the other hand, if the
distribution of income is more unequal, then the propensity to consume of the society will be
relatively less because propensity to consume of rich people is less than that of poor people.
Extension and Contraction in Demand
When as a result of change in price, the quantity demanded rises or falls, extension and/or
contraction in demand is said to have taken place (change in quantity demanded). When the
quantity demanded of a good rises due to a fall in price, it is called extension of demand. When
the quantity demanded falls due to rise in price, it is called contraction in demand.
It should be remembered that extension and contraction in the demand takes place as a result of
changes in the price alone when other non-price determinants of demand such as income, prices
of related goods etc remain constant. The extension and contraction in demand is shown below.

Increase and Decrease in Demand (Shifts in Demand)
If the non-price determinants of demand such as income of the consumer, prices of related
commodities etc change, the whole demand curve will change. The demand curve will shift to a

new position in response to changes in any of the factors or variables that were held constant
when original demand curve was drawn. When as a result of changes in these factors, the
demand curve shifts upwards to the right, an increase in demand is said to have occurred.
Increase in demand means the consumer buys more of the goods at various prices than before.
An increase in demand occurs due to the following reasons:
(a) A rise in consumer‘s income;
(b) A rise in price of the product‘s substitutes;
(c) A fall in the price of complementary goods;
(d) Change in the taste in favour of the product;
(e) Increase in the number of buyers in the market;
(f) Changes in distribution of income favouring those having high propensity to consume.
An increase in demand is shown below:

In the figure, DD is the original demand curve and DlDl is the new demand curve. An increase in
demand is shown by a shift in the demand curve to the right. The location of the demand curve
has now changed. Now at any given price greater quantity is purchased.
On the other hand, a decrease in demand means entire demand curve shifts to a lower position to
the left. Decrease in demand does not occur due to the rise in price but due to changes in other
determinants of demand.

A decrease in demand occurs due to the following reasons:
(a) A fall in consumer‘s income;
(b) A fall in price of the product‘s substitutes;
(c) An increase in the price of complementary goods;
(d) Change in the taste away from the product;
(e) number of buyers in the market declines;
(f) a redistribution of income favouring those having high propensity to save and away from
those who favours the commodity
A decrease in demand is shown below

In the figure, DD is the original demand curve and DoDo is the new demand curve. A decrease
in demand is shown by the leftward shift in the demand curve. A decrease in demand would
mean that at any given price smaller quantity would be purchased. Thus, a change in the price of
the commodity will not cause change in the demand, it will cause a change in the quantity
demanded. Only a change in the non-price determinants can cause a change in demand, that is,
cause the entire demand curve to shift. These non-price determinants are often referred to as
―demand shifters‖ or ―shift factors‖.
Nature of Supply
Supply refers to the various quantities of a good or service that sellers will be able to offer for
sale at various prices during a period of time. It shows how price of a good or service is related
to the quantity which the sellers are willing and able to make available in the market. As in the
case of demand, supply refers not to a specific quantity that will be sold at some particular price,
but to a series of quantities and a range of associated prices. Supply is a desired flow. That is, it
shows how much firms are willing to sell per period of time, not how much they actually sell.
Supply Function
Like demand, supply also depends on many things. In general, quantity supplied of a product is
expected to depend on own price, prices of related products, prices of inputs, state of technology,
expectations, number of producers (sellers) in the market etc. This list can be summarised in a
supply function

QXS = f (Px, Pr, Pi, T, E, N)
Where.,
QXS = Quantity supplied of commodity x
Px = Price of the commodity x
Pr = Prices of related products
Pi = Prices of inputs
T = State of technology
E = Expectations
N = Number of producers in the market
For a simple theory of price, we need to know how quantity supplied varies with the product‘s
own price, all other things being held constant. Thus we can write the supply function as
QXS = f (Px)
That is, quantity supplied of commodity x is a function of its own price, other determinants are
assumed to remain constant.
Law of Supply
The functional relationship between price and quantity supplied is called the law of supply.
According to the law of supply, as the price of the commodity falls, the quantity supplied
decreases or alternatively, as the price of the commodity rises the quantity supplied increases,
other things being equal. Therefore, there is a direct relationship between of the commodity and
quantity supplied.
The law of supply can be illustrated through a supply schedule and supply curve. Supply
schedule is a table that shows various quantities of a good or service that sellers are willing and
able to offer for sale at various possible prices during some specified period. A supply schedule
is presented below

Price Quantity Supplied
5 40
10 60
15 80
20 100
25 120
Supply schedule shows that as price rises, a greater quantity is offered for sale. By plotting the
information contained in the supply schedule on a graph we can derive the supply curve as
shown below.
The supply curve is a graph showing various quantities of a good or service that sellers are
willing and able to offer for sale at various possible prices. The supply curve slopes upwards
because of the direct relationship between price and quantity supplied. Note that the entire
supply curve represents supply while a point on the supply curve represents quantity supplied at
some specific price.
Why there is a direct relationship between price and quantity supplied? The main reason is that
higher prices serve as an incentive for sellers to offer greater quantity for sale. The sellers or
producers can be induced to produce and offer a greater quantity for sale by higher prices. It is
assumed that sellers or producers aim to maximise profit from the production and sale of the
commodity. The higher the prices of the commodity, other things being equal, the greater the

potential gain producers can expect from producing and supplying it in the market. Moreover,
increases in price may invite new suppliers in the market.
Determinants of Supply
The quantity of a good or service that sellers are willing and able to offer for sale depends on the
price of good or service. The non-price factors such as prices of related products, input prices,
technology, expectations and number of producers in the market are likely to affect supply. Let
us analyse each of them.
(1) Prices of related products
Goods can be substitutes or complements in production. Goods are substitutes in production if

they are produced as alternatives to each other. Example: rice and vegetables (as farmer can
produce one or the other on the same piece of land). Goods are complements in production if
they are produced together; the production of one good implies the production of the other.
Complements in production are also called ‗joint products‘. Example sugar and molasses, beef
and hides. In general, if the price of a substitutable product increases, sellers will tend to reduce
the supply of the substitute in question. At the same time, if the price of a complement in
production falls, the supply of the good in question will also falls.
(2) Prices of inputs
An increase in the production cost will results in a reduction in the supply of the product.
Payments for factor inputs represent a significant part of production cost. The higher the prices
of these inputs, the greater the cost of production will be and the supply will be less. On the other
hand, a reduction in input prices will cause an increase in supply.
(3) Technology
Overtime, knowledge and production technologies change and it will affect the supply of the
product. A technological change that decreases cost will increase profits earned at any given
price. Since increased profitability leads to increased production, it will cause an increase in
supply.
(4) Expectations

If producers expect prices to rise in the future, now they might begin to expand their productive
capacity and thus increase their present output levels. However, it is also possible that
expectations of higher future prices may lead producers into building up stocks now so that they
will have larger quantity to sell at future higher prices. Such action will reduce current supply.
Therefore, generalisation should not be made about the effects of expected price changes on
supply.
(5) Number of Producers : Obviously, the number of sellers in the market will have some effect
on the total market supply. This is so because the market supply of a good or service is the sum
of the quantities offered for sale by all individual sellers in the market. We can expect market
supply to increase as number of sellers‘ increases and to decrease as number of sellers‘
decreases.
Changes in quantity Supplied
A change in quantity supplied refers to the change in the quantity that would be offered for sale
as a result of a change in price, other factors being held constant. That is, change in the price of
the commodity will not cause a change in supply, it will cause a change in quantity supplied.
Since there is a direct relationship between price and quantity supplied; at a higher price more
will be supplied and vice versa. Change in quantity supplied involves a movement from one
point on the supply curve to another point on the same curve, as shown below.
At price Pl, Ql quantity supplied. If price rises to P2, quantity supplied rises Q2. This change in
quantity supplied is represented by a movement along the same supply curve from point A to
point B in the figure.

Changes in Supply
A change in supply refers to the change in the supply curve due to changes in factors other than
product‘s own price like prices of related goods, input prices, technology, expectations, number
of producers etc. That is, only a change in non-price determinant can cause a change in the
supply of the commodity. Changes in these factors cause the entire supply curve to shift to a new
position. Therefore, these non-price determinants are called ―supply shifters‖.
An increase in supply means an increase in quantity supplied at each price of the commodity.
Increase in supply causes a rightward shift in the supply curve. That is, producers supply more of
the commodity at each price.
Major factors that causes increase in supply is listed below.
(a) Decrease in the price of production substitutes
(b) Increase in the price of production complements
(c) Fall in the price of inputs

(d) Technological change that decreases cost
(e) Increase in the number of producers
An increase in supply is shown below
S is the original supply curve and Sl is the new supply curve. The increase in supply is shown by
shifting the entire supply curve to the right. The location of the curve has now changed. At any
given price, greater quantity is supplied.
Decrease in supply means a reduction in quantity supplied at each price of the commodity.
Decrease in supply causes a leftward shift in supply curve. That is producer‘s supply less of the
commodity at each price.
Major factors that causes decrease in supply is listed below.
(a) Increase in the price of production substitutes
(b) decrease in the price of production complements
(c) rise in the price of inputs
(d) decrease in the number of producers

(e) Imposition of tax on the sales and/or production of commodity by the government.
A decrease in the supply is shown below
S2 is the original supply curve and S1 is the new supply curve. Decrease in supply is represented
by a leftward shift in the supply curve. A decrease in supply curve would mean that, at any given
price, a smaller quantity is supplied.
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CHAPTER 4; DEMAND AND PRICE ELASTICITY
OF DEMAND
We have seen that the demand for a commodity is determined by its own price, income of the
consumer, prices of related goods etc. Quantity demanded of a good will change because of a
change in the size of any of these determinants of demand.
Elasticity measures the sensitivity of one variable to another. Specifically, it is a number that
tells us the percentage change that will occur in the variable in response to one percent increase
in another variable. Therefore, elasticity of demand refers to the sensitiveness or responsiveness
of quantity demanded of a good to a change in its own price, income and prices of related goods.
Accordingly, there are three kinds of elasticity of demand. They are
1. Price elasticity of demand
2. Income elasticity of demand
3. Cross elasticity of demand
Price elasticity of demand measures the sensitivity of quantity demanded to change in own
price of g good. Income elasticity of demand measures the sensitivity of quantity demanded to
change in income of the consumer. While cross elasticity of demand analyses the
responsiveness of quantity demanded of one good to changes in the price of another good.
PRICE ELASTICITY OF DEMAND
It is given by the percentage change quantity demanded of a good divided by the percentage
change in its price. The elasticity is usually symbolized by Greek letter eta (η). Thus, we have
η = Percentage change in quantity demanded /Percentage change in price
Now denoting ΔQ for change in quantity demanded and ΔP for the change in price (the symbol
Δ is Greek letter delta; it means ―the change in‖) we have the formula for the price elasticity of
demand as

η = ΔQ/Q / ΔP/P That is, η = ΔQ . P/ Q. ΔP
Or
η = ΔQ . P / ΔP . Q
Since, price and quantity demanded are inversely related the coefficient of price elasticity of
demand (η) is a negative number. In order to avoid dealing with negative values, a minus sign is
often introduced into the formula of price elasticity of demand. That is
η = -ΔQ . P / ΔP. Q
Degrees of Elasticity of Demand
The value of price elasticity of demand ranges from zero to infinity. That is, 0< η <∞. Based on
the value of elasticity or degree of responsiveness of quantity demanded, price elasticity of
demand is classified into five categories.
They are:
(i) Perfectly inelastic demand,
(ii) Inelastic demand,
(iii) Unitary elastic demand,
(iv) Elastic demand,
(v) Perfectly elastic demand.
Now let us analyse each of them in detail:
(1) Perfectly inelastic demand
When quantity demanded does not change as a result of change in price, demand is said to be
perfectly inelastic. Quantity demanded is unchanged when price changes or demand shows no
response to change in price. In other words, same quantity will be bought whatever the price may

be. Numerical value of elasticity will be zero (η = 0) when there is perfectly or completely
inelastic demand. The following figure illustrates the case of perfectly inelastic demand.
Figure:
A change in price from P0 to Pl leaves quantity demanded unchanged at Qe units. That is,
quantity demanded D does not change at all when price changes.
(2) Inelastic Demand
As long as there is some positive response of quantity demanded to change in price, the absolute
value of elasticity will exceed zero. The greater the response, the larger the elasticity. However,
when percentage change in quantity demanded is less than percentage change in price, demand is
said to be inelastic. That is, a certain percentage change in price leads to a smaller percentage in
quantity demanded. The coefficient of elasticity will be less than one but greater than zero (0< η
<1) when demand is inelastic. This is shown below.

When change in price from OP to OP1 causes a less than proportionate change in quantity
demanded. That is, quantity demanded changes by a smaller percentage than the change in price.
(3) Unitary Elastic Demand
If a certain percentage change in price leads to an equal percentage change in quantity

demanded, then demand said to have unitary elasticity. Unitary elasticity is the boundary
between elastic and inelastic demand. The coefficient of elasticity will be equal to one when
demand is unitary elastic (η=1). The demand curve having unitary elasticity over its whole range
is shown below

OP1 and OQ1 are the initial price and quantity. A fall in price from OP1 to OP2 causes an equal
proportional change in quantity demanded from OQ1 to OQ2.
(4) Elastic Demand
When the percentage change in quantity demanded exceeds the percentage change in price, the
demand is said to be elastic. That is, a certain percentage change in price leads to a greater
percentage change in quantity demanded. The value of coefficient of elasticity will be greater
than one but less than infinity when demand is elastic (1<η<∞). This is shown below.
An increase in price from OP2 to OP1 causes a more than proportionate increase in quantity
demanded as shown by the change in quantity demanded from OQ1 to OQ2. Thus, a small rise in
price brings in more than proportionate fall in quantity demanded.
(5) Perfectly Elastic demand
If a small change in price leads to an infinitely large change in quantity demanded, we can say
that demand is perfectly elastic. When demand is perfectly elastic, small price reduction will
raise demand to infinity. At the same time, a slightest rise in price causes demand to fall to zero.
At the going price, consumers will buy an infinite amount (if available).above this price, they
will buy nothing. The coefficient of elasticity will be infinity when demand will be infinite when
demand is perfectly elastic (η =∞). The graph for perfectly elastic demand is shown below.

When it is perfectly elastic, demand curve is a horizontal straight line. In his case an infinitely
large amount can be sold at the going price OP. A small price increase from OP decreases
quantity demanded from an infinitely large amount to zero (hyper sensitive demand).
The following table summarises the terminology of price elasticity of demand.
Term Numerical Measure Shape of the demand Verbal description

of elasticity curve
Perfectly inelastic Zero Vertical (parallel to Quantity demanded

Y-axis that measures does not change an
price) price changes
Inelastic Greater than zero but Steeper Quantity demanded
less than one changes by a smaller
percentage than does
price
Unitary elastic One Rectangular Quantity demanded
hyperbola changes exactly the
same percentage as
does price
Elastic Greater than one but Flatter Quantity demanded
less than infinity changes by a larger
percentage than does

price
Perfectly elastic Infinity Horizontal (parallel to Buyers are prepared to
X- axis that measures buy all they can at
quantity) some price and none
at all at higher prices.
Determinants of price Elasticity of Demand:
Important determinants of elasticity of demand of a commodity with respect to its own price are
explained below.
(1) Availability of Substitutes One of the most important factors likely to influence the price
elasticity of demand for a commodity or service is whether or not substitutes are available. If a
commodity has many close substitutes, its demand is likely to be elastic. This is so because if the
price of that commodity rises buyers will switch to some of many close substitutes available.
Hence quantity demanded of that commodity will tend to fall significantly. The greater the
possibility of substitution, the greater the price elasticity of demand for it. On the other hand, if
there are not many substitutes quantity demanded will tend to fall as a result of the higher price,
but not by much. That is, if there are few or no close substitutes, demand tend to be inelastic.
(2) Nature of the commodity Whether the commodity is a luxury or a necessity has some effect
on its price elasticity of demand. In general, necessities are price inelastic. If the price of a basic
necessity increases, say by 10%, quantity demanded will not probably fall by that proportion.
Consumers tend to sacrifice some other commodities rather than a substantial reduction in the
quantity of necessities. On the other hand, luxury goods are price elastic. An increase in the price
of luxury good is likely to cause a more than proportionate decrease in the quantity bought, other
things being equal.
(3) Time Period The time period being considered will also have some effect on the elasticity of
demand for the product. In general, the longer the time period being considered, the more elastic
the demand is likely to be. This is largely due to the fact that it takes time for people to substitute
one commodity for another. At the same time, in the short run, substitution of one commodity
by another is not so easy. Hence demand tends to be relatively inelastic.

(4) Number of Uses In general, the greater the number of uses of a commodity has, the more
price elastic the demand for that commodity is likely to be. A decrease in the price of a
commodity that has large number of uses (milk, for example) more of it will be bought to
allocate to different uses. On the other hand, if the commodity has only one or two uses, it is
unlikely that a fall in its price will cause a significant increase in quantity demanded.
(5) Proportion of income spent on the commodity Another factor that is likely to affect price
elasticity of demand is the proportion of income spent on the commodity. If only a negligible
percentage of consumer‘s income is spend on the commodity, the demand for that commodity is
likely to be inelastic. An increase in the price of such commodity has no appreciable effect on the
consumer‘s budget. Example, matches, soap. The greater the proportion of income spent on the
commodity the greater will be its price elasticity of demand.
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CHAPTER 5;SUPPLY AND PRICE ELASTICITY
OF SUPPLY

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CHAPTER 6; MARKET STRUCTURE
MEANING OF MARKET
The word ‘Market’ is generally understood to mean a particular place or locality where
goods are sold and purchased. However, in economics, the term ‘market’ do not mean any
particular place or locality where transactions take place. What is required for a market is the
existence of contract between sellers and buyers so that transactions take place at an agreed price
between them. The seller and buyer may be spread over a whole region, sometimes in different
countries, but they contact and communicate and sell and buy commodities.
In the words of Augustine Cournot, a French economist “Economists understand by the term
market not a particular market place in which things are bought and sold, but the whole of any
region in which buyers and sellers are in such free intercourse with one another that the price of
the same goods tend to equality easily and quickly’.
The essentials of a market are :
1. A commodity to deal with.
2. The existence of buyers and sellers.
3. A place, it may be a particular place, a region or the whole country or the entire world.
4. The facilitites for free interaction between sellers and buyers.
Based on the territorial spread of the area, markets may be classified in to local market,
regional market, national market or international market.
Based on the degree of competition, i.e., based on the number of sellers and buyers and the
various practices adopted in the market, markets are classified into:
1. Perfectly competitive markets.
2. Monopolistically competitive market,
3. Monopoly market.
4. Oliogophy markets.
All the above markets, except the first one, is broadly referred to as imperfectly Competitive
markets.

I. PERFECT COMPETITION MARKET
Features of a Perfectly Competitive Market :
a. Large No of buyer and sellers. In a perfectly competitive market there should be a large
number of buyers and sellers in the market. The action of individual buyers or sellers do not
influence market price.
b. Homogenous Product. Perfectly competitive market condition assumes that the

producers produce identical products. Products of all producers are similar to one another.
c. Uniform market price. Because of the identical nature of the product and other unique
features, it is assured that a uniform market price prevail-All sellers sell their products at the
same price.
d. Freedom of entry and exit. Perfect competition assumes an open market without barriers for
the entry and exit of new firms.
e. Perfect Knowledge on the part of buyers about the product and seller about the market and
market conditions.
f. No Transport cost. It is assured that in a perfectly competition market, there is no transport

cost.
g. Free mobility of factors of production also is assumed in a perfectly competition market.
The demand curve for the product of a firm under perfect competition is perfectly elastic. It
means that whatever be the quality sold in the market, it is at the prevailing uniform market
price.
Eg. Retailing on the Internet, it is said, is almost perfectly competitive. THE explosive growth of
the Internet promises a new age of perfectly competitive markets. With perfect information about
prices and products at their fingertips, consumers can quickly and easily find the best deals. In
this brave new world, retailers’ profit margins will be competed away, as they are all forced to
price at cost. Or so we are led to believe. And yes, studies do show that online retailers tend to be
cheaper than conventional rivals, and that they adjust prices more finely and more often. But
they also find that price dispersion (the spread between the highest and lowest prices) is often as
wide on the Internet as it is in the shopping mall—or even wider. Moreover, the retailers with the
keenest prices rarely have the biggest sales. Such price dispersion is usually a sign of market

inefficiency. In an ideal competitive market, where products are identical, customers are
perfectly informed, there is free market entry, a large number of buyers and sellers and no search
costs, all sales are made by the retailer with the lowest price. So all prices are driven down to
marginal cost. Search costs on the Internet might be expected to be lower and online consumers
to be more easily informed about prices. So price dispersion online ought to be narrower than in
conventional markets. But it does not seem to be. A recent paper*, by Michael Smith and Erik
Brynjolfsson of the Massachusetts Institute of Technology’s Sloan School of Management and
Joseph Bailey of the University of Maryland, looks at the main research on this topic. One study
it cites, by Mr. Bailey, finds that price dispersion for books, CDs and software is no smaller
online than it is in conventional markets. Another, by Messrs Brynjolfsson and Smith, finds that
prices for identical books and CDs at different online retailers differ by as much as 50%, and on
average by 33% for books and 25% for CDs. A third, by Eric Clemons, Il-Horn Hann and Lorin
Hitt of the University of Pennsylvania’s Wharton School, finds that prices for airline tickets from
online travel agents differ by an average of 28%.
Perfect competition is often distinguished from pure competition, but they differ only in degree.
Pure competition means, competition unalloyed with monopoly elements,” whereas perfect
competition involves perfection in many other respects than in the absence of monopoly.” The
practical importance of perfect competition is not much in the present times for few markets are
perfectly competitive except those for staple food products and raw materials. That is why,
Chamberlin says that perfect competition is a rare phenomenon.”
Though the real world does not fulfil the conditions of perfect competition, yet perfect competi-
tion is studied for the simple reason that it helps us in understanding the working of an economy,
where competitive behaviour leads to the best allocation of resources and the most efficient
organisation of production. A hypothetical model of a perfectly competitive industry provides
the basis for appraising the actual working of economic institutions and organisations in any
economy.

2. MONOPOLISTICALLY COMPETITIVE MARKET
Monopolistic competition refers to a market situation where there are many firms selling a differ-
entiated product. “There is competition which is keen, though not perfect, among many firms
making very similar products.” No firm can have any perceptible influence on the price-output
policies of the other sellers nor can it be influenced much by their actions. Thus monopolistic
competition refers to competition among a large number of sellers producing close but not
perfect substitutes for each other.
Features:-
(1) Large Number of Sellers:
In monopolistic competition the number of sellers is large. They are “many and small enough”
but none controls a major portion of the total output. No seller by changing its price-output
policy can have any perceptible effect on the sales of others and in turn be influenced by them.
Thus there is no recognised interdependence of the price-output policies of the sellers and each
seller pursues an independent course of action.
(2) Product Differentiation:
One of the most important features of the monopolistic competition is differentiation. Product
differentiation implies that products are different in some ways from each other. They are
heterogeneous rather than homogeneous so that each firm has an absolute monopoly in the
production and sale of a differentiated product. There is, however, slight difference between one
product and other in the same category.
(3) Freedom of Entry and Exit of Firms:
Another feature of monopolistic competition is the freedom of entry and exit of firms. As firms
are of small size and are capable of producing close substitutes, they can leave or enter the
industry or group in the long run.

(4) Nature of Demand Curve:
Under monopolistic competition no single firm controls more than a small portion of the total
output of a product. No doubt there is an element of differentiation nevertheless the products are
close substitutes. As a result, a reduction in its price will increase the sales of the firm but it will
have little effect on the price-output conditions of other firms, each will lose only a few of its
customers.
(5) Independent Behaviour:
In monopolistic competition, every firm has independent policy. Since the number of sellers is
large, none controls a major portion of the total output. No seller by changing its price-output
policy can have any perceptible effect on the sales of others and in turn be influenced by them.
(6) Product Groups:
There is no any ‘industry’ under monopolistic competition but a ‘group’ of firms producing
similar products. Each firm produces a distinct product and is itself an industry. Chamberlin
lumps together firms producing very closely related products and calls them product groups,
such as cars, cigarettes, etc.
(7) Selling Costs:

Under monopolistic competition where the product is differentiated, selling costs are essential to
push up the sales. Besides, advertisement, it includes expenses on salesman, allowances to sellers
for window displays, free service, free sampling, premium coupons and gifts, etc.
(8) Non-price Competition:
Under monopolistic competition, a firm increases sales and profits of his product without a cut in
the price. The monopolistic competitor can change his product either by varying its quality,
packing, etc. or by changing promotional programmes.
3.MONOPOLY MARKET
Monopoly is a market situation in which there is only one seller of a product with barriers to
entry of others. The product has no close substitutes. The cross elasticity of demand with every
other product is very low. This means that no other firms produce a similar product. According
to D. Salvatore, “Monopoly is the form of market organisation in which there is a single firm
selling a commodity for which there are no close substitutes.” Thus the monopoly firm is itself
an industry and the monopolist faces the industry demand curve.
The demand curve for his product is, therefore, relatively stable and slopes downward to the
right, given the tastes, and incomes of his customers. It means that more of the product can be
sold at a lower price than at a higher price. He is a price-maker who can set the price to his
maximum advantage.
Features:-
1. Under monopoly, there is one producer or seller of a particular product and there is no differ-
ence between a firm and an industry. Under monopoly a firm itself is an industry.

2. A monopoly may be individual proprietorship or partnership or joint stock company or a co-
operative society or a government company.
3. A monopolist has full control on the supply of a product. Hence, the elasticity of demand for a
monopolist’s product is zero.
4. There is no close substitute of a monopolist’s product in the market. Hence, under monopoly,
the cross elasticity of demand for a monopoly product with some other good is very low.
5. There are restrictions on the entry of other firms in the area of monopoly product.
6. A monopolist can influence the price of a product. He is a price-maker, not a price-taker.
7. Pure monopoly is not found in the real world.
8. Monopolist cannot determine both the price and quantity of a product simultaneously.
9. Monopolist’s demand curve slopes downwards to the right. That is why, a monopolist can
increase his sales only by decreasing the price of his product and thereby maximise his profit.
The marginal revenue curve of a monopolist is below the average revenue curve and it falls
faster than the average revenue curve. This is because a monopolist has to cut down the price of
his product to sell an additional unit.
Eg:-Natural monopoly (public utilities best example, railway tracks), economies of scale,
„ Capital requirements on production or big sunk costs on entry
„ Patents (17 years), trade secrets (Coke)
„ Exclusive or unique assets (minerals, talent)

„ Locational advantage (popcorn shop in cinema – but in general you pay rent for these
advantages)
„ Regulation (TV, taxi, telephone in the past)
„ Collusion by competitors
The following is done to confirm monopoly:-
Excessive patenting and copyright
„ Limit pricing (set price below monopoly price)
„ Extensive advertising to create brand name to raise cost of entry
„ Create intentionally excess capacity as a warning for a price war
4.OLIGOPOLY MARKETS
Oligopoly is a market situation in which there are a few firms selling homogeneous or differenti-
ated products. It is difficult to pinpoint the number of firms in ‘competition among the few.’
With only a few firms in the market, the action of one firm is likely to affect the others. An
oligopoly industry produces either a homogeneous product or heterogeneous products.
The former is called pure or perfect oligopoly and the latter is called imperfect or differentiated
oligopoly. Pure oligopoly is found primarily among producers of such industrial products as
aluminium, cement, copper, steel, zinc, etc. Imperfect oligopoly is found among producers of
such consumer goods as automobiles, cigarettes, soaps and detergents, TVs, rubber tyres,
refrigerators, typewriters, etc.

Features:-
(1) Interdependence:
There is recognised interdependence among the sellers in the oligopolistic market. Each
oligopolistic firm knows that changes in its price, advertising, product characteristics, etc. may
lead to counter-moves by rivals. When the sellers are a few, each produces a considerable
fraction of the total output of the industry and can have a noticeable effect on market conditions.
He can reduce or increase the price for the whole oligopolistic market by selling more quantity or
less and affect the profits of the other sellers. It implies that each seller is aware of the price-
moves of the other sellers and their impact on his profit and of the influence of his price-move on
the actions of rivals.
(2) Advertisement:
The main reason for this mutual interdependence in decision making is that one producer’s
fortunes are dependent on the policies and fortunes of the other producers in the industry. It is for
this reason that oligopolist firms spend much on advertisement and customer services.
(3) Competition:
This leads to another feature of the oligopolistic market, the presence of competition. Since
under oligopoly, there are a few sellers, a move by one seller immediately affects the rivals. So
each seller is always on the alert and keeps a close watch over the moves of its rivals in order to
have a counter-move. This is true competition.
(4) Barriers to Entry of Firms:
As there is keen competition in an oligopolistic industry, there are no barriers to entry into or exit
from it. However, in the long run, there are some types of barriers to entry which tend to restraint
new firms from entering the industry.

(5) Lack of Uniformity:
Another feature of oligopoly market is the lack of uniformity in the size of firms. Finns differ
considerably in size. Some may be small, others very large. Such a situation is asymmetrical.
This is very common in the American economy. A symmetrical situation with firms of a uniform
size is rare.
(6) Demand Curve:
It is not easy to trace the demand curve for the product of an oligopolist. Since under oligopoly
the exact behaviour pattern of a producer cannot be ascertained with certainty, his demand curve
cannot be drawn accurately, and with definiteness.
(7) No Unique Pattern of Pricing Behaviour:
The rivalry arising from interdependence among the oligopolists leads to two conflicting
motives. Each wants to remain independent and to get the maximum possible profit. Towards
this end, they act and react on the price-output movements of one another in a continuous
element of uncertainty.
THE ROLE OF MARKET STRUCTURE

1. Pure competition: the small size of competitive firms and the fact hat they earn zero
economic profit in the long run leads to serious questions as to whether such producers can
finance substantial R&D programs. The firms in this market structure would spend no
significant amount. However, firms of the same industry may gather their resources and develop
R&D programs.
2. Monopolistic competition: there is a strong profit incentive to engage in product development
in this market structure as the firms depend on product differentiation to stand out from a large
number of rivals. However, most firms remain small which limits their ability to secure
inexpensive financing for R&D and any economic profits are usually temporary. Therefore,
spending on R&D is limited in this market structure.

3. Oligopoly: many of the characteristics of oligopoly are conducive to technical advances
including: their large size, ongoing economic profits, the existence of barriers to entry and a large
volume of sales. Firms in oligopoly spent the highest amount on R&D among the four different
market structures.
4. Pure monopoly: monopoly has little incentive to engage in R&D as the profit is protected by
absolute barriers to entry, the only reason for R&D would be defensive – to reduce the risk of a
new product or process which would destroy the monopoly.
=====================================================================

Chapter 7; THE BASIC ECONOMIC PROBLEM
AND THE ECONOMIC SYSTEMS
ECONOMICS: An introduction
ECONOMY is the system of trade and industry by which the wealth of a country is made and
used. An economy is a system that attempts to solve the basic economic problems. The function
of the economy is to allocate scarce resources among unlimited wants.
ECONOMICS is the study or social science of human behaviour in relation to how scarce
resources are allocated and how choices are made between alternative uses Economics studies
mankind’s activities, which are production, distribution (or exchange) and consumption of goods
and services that are capable of satisfying human wants and desires.
Economics studies human behavior in many settings. At the household level, economics
investigates how a household allocates its income across goods, and how a household chooses
how much to work, spend, and save. At the market level, economics investigates consumer
decisions (what to buy and how much to spend); decisions firms make about their production
methods and levels of output; and how these decisions jointly determine market prices, structure,
and performance. At the aggregate level, economics investigates the determinants of growth and
fluctuations of national income, the determinants of inflation and unemployment, the nature of
trade and financial flows between nations, and how all of these are influenced by government
monetary and fiscal policy.
Branches of economics are:
1. Microeconomics – this is the branch of economics that is concerned with the behaviour of
individual entities such as market, firms and households e.g. how individual prices are set, how
prices of land, labour, capital are set, inquires into the strength and weakness of the market
mechanism.
2. Macroeconomics – is the branch of economics that is concerned with the overall

performance of the economy e.g. studies the effect of unemployment on the economic, growth,
inflation etc.
3. Econometrics – Application of mathematics to economic theories. The branch of

economics that uses the methods of statistics to measure and estimate quantitative economic
relationships.

1.2. THE BASIC ECONOMIC PROBLEM
The basic economic problem faced by all individuals, nations and world at large is the problem
of scarcity. All societies face the economic problem, which is the problem of how to make the
best use of limited, or scarce, resources.
Hence,
1. SCARCITY:
In economics, scarcity refers to limitations—insufficient resources, goods, or abilities to
achieve the desired ends. Figuring out ways to make the best use of scarce resources or find
alternatives is fundamental to economics. Scarcity means that people want more than is
available. Scarcity limits us both as individuals and as a society. As individuals, limited income
(and time and ability) keep us from doing and having all that we might like. As a society, limited
resources (such as manpower, machinery, and natural resources) fix a maximum on the amount
of goods and services that can be produced. For example, although air is more important to us
than gold, it is less scarce simply because the production cost of air is zero. Gold on the other
hand has a high production cost. It has to be found and processed, both of which require a great
deal of resources.
People cannot have everything they want.so people have to make choice.
2. CHOICE:
Scarcity requires choice. People must choose which of their desires they will satisfy and which
they will leave unsatisfied. When we, either as individuals or as a society, choose more of
something, scarcity forces us to take less of something else. Economics is sometimes called the
study of scarcity because economic activity would not exist if scarcity did not force people to

make choices. Making a choice made normally involves a trade-off – this means that choosing
more of one thing can only be achieved by giving up something else in exchange.
Hence choice is the act of selecting among restricted alternatives. All economic problems
involve choice because there are many ways to allocate scarce resources in order to best satisfy
the unlimited wants of people.
All societies must make 3 fundamental choices. These are:
1.What to produce?(Allocation of resources)
Societies have to decide the best combination of goods and services to meet their needs. For
example, how many resources should be allocated to consumer goods, and many resources to
capital goods, or how many resources should go to schools, and how many to defense, and so on.
2.How to produce?(Choice of technology)
Societies also have to decide the best combination of factors to create the desired output of goods
and services. For example, precisely how much land, labour, and capital should be used produce
consumer goods such as computers and motor cars.
3.For whom to produce?(Distribution of national income)
Finally, all societies need to decide who will get the output from the country’s economic activity,
and how much they will get. For example, who will get the computers and cars that have been
produced? This is often called the problem of distribution.
3. OPPORTUNITY COSTS:
Every choice involves a sacrifice. An opportunity cost refers to a benefit that a person could
have received, but gave up, to take another course of action. Stated differently, an opportunity
cost represents an alternative given up when a decision is made. This cost is therefore most
relevant for two mutually exclusive events, whereby choosing one event, a person cannot choose
the other.
Using a simple example, if a farmer is able to pick five apples from an apple tree or five oranges
from an orange tree but cannot pick both, he faces a mutually exclusive event. Then, if he
decides to pick the apples, his opportunity cost is the five oranges he cannot pick. Or If we have
£20 we can spend it on an economic textbook or we can enjoy a meal in a restaurant. If we spend that
£20 on a textbook, the opportunity cost is the restaurant meal we cannot afford to pay.
Since every resource (land, money, time, etc.) can be put to alternative uses, every action, choice,
or decision has an associated opportunity cost.Opportunity costs are fundamental costs in
economics, and are used in computing cost benefit analysis of a project. Such costs, however, are

not recorded in the account books but are recognized in decision making by computing the cash
outlays and their resulting profit or loss.
To a student, the opportunity cost of attending college full time includes not only the money
spent on books and fees ,but also the opportunity cost of income foregone by not working
fulltime.
The term opportunity cost is often used in finance and economics when trying to choose one
investment, either financial or capital, over another. It is a measure of any economic choice as
compared to the next best one.
The concept of opportunity cost is one of the most important ideas in economics. Consider the
question, “How much does it cost to go to college for a year?” We could add up the direct costs
like tuition, books, school supplies, etc. These are examples of explicit costs, i.e., costs that
require a money payment. However, these costs are small compared to the value of the time it
takes to attend class, do homework, etc. The amount that the student could have earned if she had
worked rather than attended school is the implicit cost of attending college. Implicit costs are
costs that do not require a money payment. The opportunity cost includes both explicit and
implicit costs.
Explicit costs are costs that require a money payment.
Implicit costs are costs that do not require a money payment.
Opportunity cost includes both explicit and implicit costs. The notion of opportunity cost helps
explain why star athletes often do not graduate from college. The cost of going to school
includes the millions of dollars they could earn as professional athletes.
An economic problem arises when:
1.People’s wants for goods and services are unlimited.
2.The resources available to produce goods and services to satisfy the wants of people are scarce.
3.Wants are gradable according to the order of importance and,
4.Scarce resources are capable of alternate uses-they can be put to different uses.
ECONOMIC SYSTEMS
Economic systems are the means by which countries and governments distribute resources and
trade goods and services. They are used to control the five factors of production, including:
labor, capital, entrepreneurs, physical resources and information resources. In everyday terms,

these production factors involve the employees and money a company has at its disposal, as well
as access to entrepreneurs, the people who want to run companies or start their own businesses.
The physical materials and resources needed to run a business, along with the data and
knowledge companies use to be successful, are also factors in production. Different economic
systems view the use of these factors in different ways.
TYPES OF ECONOMIC SYSTEMS

There are four primary types of economic systems in the world: traditional, command, market
and mixed. Each economy has its strengths and weaknesses, its sub-economies and tendencies,
and, of course, a troubled history.
Below we examine each system in turn and give ample attention to the attributes listed above.
It’s important to understand how different parts of the world function economically, as the
economy is one of the strongest forces when it comes to balancing political power, instigating
war and delivering a high (or low) quality of life to the people it serves.
1.TRADITIONAL ECONOMIC SYSTEM

A traditional economic system is the best place to start because it is, quite literally, the most
traditional and ancient type of economy in the world. There are certain elements of a traditional

economy that those in more advanced economies, such as Mixed, would like to see return to
prominence.
Characteristics:
 Traditional economies still produce products and services that are a direct result of
their beliefs, customs, traditions, religions, etc.
 Vast portions of the world still function under a traditional economic system. These
areas tend to be rural, second- or third-world, and closely tied to the land, usually
through farming. However, there is an increasingly small population of nomadic
peoples, and while their economies are certainly traditional, they often interact with
other economies in order to sell, trade, barter, etc.
 Minimal Waste: Traditional economies would never, ever, in a million years see
the type of profit or surplus that results from a market or mixed economy.
 In general, surplus is a rare thing. A third-world and/or indigenous country does
not have the resources necessary (or if they do, they are controlled by wealthier
economies, often by force), and in many cases any surplus is either distributed,
wasted, or paid to some authority that has been given power.
Advantages:
 Certainly one of the most obvious advantages is that tradition and custom is preserved
while it is virtually non-existant in market/mixed economies.
 There is also the fact that each member of a traditional economy has a more specific and
pronounced role, and these societies are often very close-knit and socially satisfied.
Disadvantages:
 The main disadvantage is that traditional economies do not enjoy the things other
economies take for granted: Western medicine, centralized utilities, technology, etc.
But as anyone in America can attest, these things do not guarantee happiness, peace,
social or, most ironically of all, economic stability.
2.COMMAND ECONOMIC SYSTEM

In terms of economic advancement, the command economic system is the next step up from a
traditional economy. This by no means indicates that it is fairer or an exact improvement; there
are many things fundamentally wrong with a command economy.

Characteristics:
 Centralized Control: The most notable feature of a command economy is that a large
part of the economic system is controlled by a centralized power; often, a federal
government.
 This kind of economy tends to develop when a country finds itself in possession of a very
large amount of valuable resource(s). The government then steps in and regulates the
resource(s).
 Often the government will own everything involved in the industrial process, from the
equipment to the facilities.
 It tries to provide social and economic equality.
Supposed Advantages:
You can see how this kind of economy would, over time, create unrest among the
general population. But there are actually several potential advantages, as long as the
government uses intelligent regulations.
 First of all, a command economy is capable of creating a healthy supply of its own
resources and it generally rewards its own people with affordable prices (but because it is
ultimately regulated by the government, it is ultimately priced by the government).
 It is a welfare state
 It tries to achieve an equal society
 It is likely to be more stable
 It tries to provide employment to all
Disadvantages:
 Hand In The Cookie Jar: Interestingly the government in a command economy only
desires to control its most valuable resources. Other things, like agriculture, are left to be
regulated and run by the people.
 There is no incentive to work hard
 People are exploited by the state
 These economies are often inefficient
 There is no economic or political freedom.
3. FREE MARKET ECONOMIC SYSTEM
The government does not control vital resources, valuable goods or any other major segment of
the economy. In this way, organizations run by the people determine how the economy runs, how
supply is generated, what demands are necessary, etc. Most of the resources are privately owned

and the fundamental economic choices are made by the consumers and producers and
implemented through demand and supply.
Characteristics:
 Capitalism And Socialism: No truly free market economy exists in the world. For
example, while America is a capitalist nation, our government still regulates (or attempts
to regulate) fair trade, government programs, moral business, monopolies, etc. etc. The
advantage to capitalism is you can have an explosive economy that is very well
controlled and relatively safe. This would be contrasted to socialism, in which the
government (like a command economy) controls and owns the most profitable and vital
industries but allows the rest of the market to operate freely; that is, price is allowed to
fluctuate freely based on supply and demand.
 People have the right to own private property
 People can inherit their parents’wealth
 People can start any business of their choice
 People are governed by self interest
 Profit maximization is the ultimate motive behind all economic activities
 Limited role of Govt in economic affairs
Advantages:
 Market Economy And Politics: Arguably the biggest advantage to a market economy
(at least, outside of economic benefits) is the separation of the market and the
government.
 This prevents the government from becoming too powerful, too controlling and too
similar to the governments of the world that oppress their people while living lavishly on
controlled resources. In the same way that separation of church and state has been to vital
to America’s social success, so has a separation of market and state been vital to our
economic success.
 This economy responds quickly to people’s needs
 The market produces a wide variety of goods and services
 New and better techniques are used in production
 Incentives are provided to people for them to do the best
 This economy is highly efficient
 This encourages savings and investment
 Economic and political freedom are granted to people.
Disadvantages:

 Hand In The Cookie Jar: Interestingly – or maybe, predictably – the government in a
command economy only desires to control its most valuable resources. Other things, like
agriculture, are left to be regulated and run by the people. This is the nature of a
command economy and many communist governments fall into this category.
 This economy is unstable as it suffers from inflation and deflation
 There is great inequality in the distribution of income and wealth
 Problem of monopoly which exploit customers by charging high er prices and producing
poor qualities.
 There is no guarantee of employment
 It only produces goods which are profitable.
4.MIXED ECONOMIC SYSTEM

A mixed economic system (also known as a Dual Economy) is just like it sounds (a combination
of economic systems), but it primarily refers to a mixture of a market and command economy
(for obvious reasons, a traditional economy does not typically mix well). As you can imagine,
many variations exist, with some mixed economies being primarily free markets and others being
strongly controlled by the government.
Features:
 Large public sector and large private sector co-exist
 Democratic economic planning
 Co-existence of freedom and control
 Presence of cooperative sector and joint sector
Advantages of A Mixed Economy:

 In the most common types of mixed economies, the market is free of government
ownership except for a few key areas. These areas are usually not the resources that a
command economy controls. Instead, as in America, they are the government programs
such as education, transportation, USPS, etc. While all of these industries also exist in the
private sector in America, this is not always the case for a mixed economy.
 Reasonable freedom of consumption for consumers
 Co-existence of profit motive and social welfare
 More stability
Disadvantages Of A Mixed Economy:

 While a mixed economy can lead to incredible results (America being the obvious
example), it can also suffer from similar downfalls found in other economies. For

example, the last hundred years in America has seen a rise in government power. Not
just in imposing laws and regulations, but in actually gaining control, becoming more
difficult to access while simultaneously becoming less flexible. This is a common
tendency of mixed economies.
 Unemployment
 Inequalities of income and wealth distribution
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CHAPTER 1- INTRODUCTION TO MICRO

Definition of Micro economics

Scope of Micro economics

Micro Economics Page 1

Microeconomics is an important method of economic analysis and it occupies an important

a. Helps to Use Resources Efficiently: Microeconomics is helpful in the efficient employment

b. Helps to Understand a Free enterprise Economy. Microeconomics is of great importance in

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2. Microeconomic analysis is based on unrealistic assumptions like full employment which is

Macroeconomics study is a study of aggregates. Hence, it is often called Aggregative

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Differences between Micro and Macro Economics

1. In microeconomics, we study the working of individual markets where as in macroeconomics;

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Characteristics of Human Wants:

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9. Wants are influenced by income, salesmanship and advertisement: If income is higher

Wants may be classified into necessaries, comforts and luxuries.

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Luxury means superfluous(unnecessary) consumption. After getting comforts, man desire

The Problem of Scarcity

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The Problem of Choice

THE PRODUCTION POSSIBILITY CURVE (PPC)

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The productive resources of the community can be used for the

It all available resources are employed for the production of wheat,

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At C the production possibilities are 12,000 quintals of wheat and

This means that, in a full-employment economy, more and more of

The following diagram (21.2) illustrates the production possibilities set

In this diagram AF is the production possibility curve, also called or

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CIRCULAR FLOW OF ECONOMIC ACTIVITY

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Two Sector Model

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Figure: Circular Flow of Economic Activity: Two Sector Model

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CHAPTER 2;PRICE DETERMINATION AND

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Limitations of Price Mechanism

[Note: Conditions for perfect competition

1. All firms sell an identical product.

Value and Price

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Value is the usefulness of any product to a customer. It can never be

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We may write marginal revenue as:

where MR is Marginal Revenue, TR is Total Revenue.

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The Nature of Demand

Demand for a commodity is determined by several factors. An individual's demand for a

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