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ECONOMICS

Economics is the science of how


societies manage their scarce
resources in accomplishing the goals
of the society.
Scarce Resource
A resource shall be a scarce resource if at
zero level of price, demand is higher than
its supply. All societies take decisions to
allocate or assign these scarce resources
among competing ends so as to obtain the
maximum possible social welfare.
Economic Problem
Economic problem is said to exist whenever
scarce means are pilled against alternative
ends.
Scarcity
Scarcity is a necessary but not a sufficient
condition for our economic problem to
exist. The problem arises due to choice as
a single resource has competing uses. No
economic problem shall exist if scarce
means were used to satisfy a single, un-
ambiguous ends.
Micro Economics VS
Macro Economics
Micro Economics is primarily concerned with individual
economic units a consumer, a producer, a speculator, a
commodity etc. and deal with their decision making
process, their interaction which constitute markets and
industry and decision making related to the interactive
behavior.
Macro Economics deals with national aggregates or total
value aggregate consumption, investment, saving etc. in
isolation as well as their interaction. The policy framework
is developed to influence these aggregates, their
composition and issues / problem related to their
interaction.
Production Possibility
Frontier

Law of increasing opportunity cost


Market System
vs
Command System

Circular Flow Diagram


Demand / Supply Analysis
Markets always contain a Supply side and a Demand
Side. Their interaction determines the price and quantities
produced that are sold.
Demand side is discussed with respect to stock-dominated
market a market in which the demand is for a commodity
to own or hold a certain amount.
Flow dominated market is one in which the buyer
purchases and consumes at some rate per unit of time
and output is more or less continuous over time.
Demand Analysis in case of Micro Economics deals with
Flow-dominated market or a mixture of both flow and
stock.
LAW of Demand
We may state Demand as a function of many
determinants such as Price, Taste of consumers, number
of buyers, income level, price of related goods
(substitutes, complements), and consumer expectations.
QDX = f (PX , T, I, B, PY, E)
Law of Demand states the given the determinants (other
things held equal) there is an inverse relationship
between the price and commodity and its quantity
demanded. As the price of a product falls, the
corresponding quantity demanded rises or, alternatively as
price increases, the corresponding quantity demanded
falls.
The demand curve is down wards sloping.
Change in Quantity Demanded
VS change in Demand
Change in quantity demanded relates to movement
along the demand curve.
Change in demand deals with shift in demand curve.
Graphical Representation
Price
Per unit
of X

PX
D2
D1
Q1 Q2

Quantity of X per unit of time


The movement along the demand curve D1 is
attributed to change in price.
The shift in demand curve from D1 to D2 is
caused by change in any other determinants
than price, say income. Then at the same price,
more quantity (i.e. Q2) is demanded.
The Quantity demanded and income would have
a positive relationship. However, it is true about
a Normal Good only.
Graphical Representation

Quantity D1
of X per
unit of Q2
time Q1

I1 I2
Income per Unit of time

The Demand curve for an inferior Good shall not


show a +ve relation of Quantity demanded with
income.
Graphical Representation

Quantity
of X per
unit of Q2
time Q1
D
I1 I2
Income per Unit of time

At higher level of income i.e. I2, quantity demanded is lower


i.e. Q2 relative to I1 and Q1.
The supply side of the Market
Supply analysis is mostly concentrated on
flow supply where in the existing quantity
is augmented by production and depleted
through consumption:-

The firms (suppliers) are willing to offer


quantity for sale depends on the price they
expect to receive per unit of output.
Law of Supply
Law of supply states that a direct
relationship prevails between price and
quantity supplied. As price rises, the
quantity supply rises, as price falls, the
quantity supply falls.
Graphical Representation

S1 S2
P2
Price P1

Q1 Q2 Q3
Quantity Supplied
QS(x) = f ( PX, PI, T, TX / Sub, PO, E, NS)

A shift is Quantity supply is caused by change in determinants over


than price.

A change in price shall cause a movement along the supply curve.


Market Equilibrium

Market equilibrium shall give price and


Quantity at equilibrium.
Graphical Representation

Surplus S

P1
P*
P2
Shortage D

Q*

Quantity

A surplus shall drive the price down and equilibrium shall


be achieved.
A shortage shall drive the price up and equilibrium shall be
achieved.
The impact of change in Demand / Supply
on Equilibrium

Graphical Presentation
S

P1
P2 D1
D2

Q2 Q1
A decrease in Demand
Graphical Representation

S1
S2

P1
P2
D
Q1 Q2
An increase in Demand
Applications of Equilibrium
Price / output
Rational Function of Price

The equilibrium price clears the market and


At this price selling and buying become
consistent
Those who are not willing to purchase at
equilibrium price shall go without and all those
who are not willing and able to sell at this price
shall not sell.
Efficient Allocation

Equilibrium determined through competition


forces the producers to use the best technology
and right mix of productive resources to produce
all lowest achievable per-unit cost. This results
in Productive Efficiency.
Competitive markets also produce allocative
efficiency.

Allocative efficiency refers to the particular mix


of goods and services most highly valued by
society (minimum cost of production assumed).
The equilibrium price and quality in
competitive markets produce an assignment
of resources that is right from an Economic
perspective. Other criteria may lead to
different output combinations.
Price Ceilings and Price Floors

S
Price
P1

P1 P2

P2
D

QD Q1 QS
QS Q1 QD Quantity

Price Ceilings Price Floors


Analysis of consumer behavior
Cardinal utility approach
Marginal Utility is change in total utility per unit change in
the quality of a given commodity consumed per unit of
time.
Law of Diminishing Marginal Utility states that given all
other things constant, the greater the rate of
consumption per unit of time of any particular good, the
less is the marginal utility.
Equi-marginal Principal states that Marginal utility refers
to marginal benefit while marginal cost refers to price of
commodity.
The consumer shall be equilibrium where
MUA MUB MUC
------- = ------- = -------
PA PB PC

And PA. QA + PB. QB + PC.QC = Income


Cardinal utility approach
Indifference curve gives various combinations
of two goods X and Y among which the
consumer is indifferent.

Indifference curves are downwards sloping.

Farther is the indifference from origin, higher


level of satisfaction it depicts
Good y IC2

IC1

Good x

The budget line gives the combinations of goods X and Y


which the consumer may purchase if entire money income
spent.

Good y - Budget Line

Good x
Equilibrium takes place where willingness and
ability would be equal.

Good y Slope of budget = Slope of Indifference


y*
line -px
----- = Curve (MRS)
x* Good x py
Impact of a price change on equilibrium

X1 X2 X3 X

There are two effects


Substitution Effect X1 to X2
Income Effect X1 to X3
Total Effect X1 to X3
Price Elasticity of Demand
% change in Quantity Demanded
Elasticity of Demand is = -----------------------------------------
% change in Price

Q P
= -------- --------
P Q

| EP | < 1 Inelastic Demand


| EP | > 1 Elastic Demand
| EP | = 1 Unitary Elastic
Elasticity and Total Revenue
P
|E| > 1

|E| = 1

|E| < 1
Q

- TR

1) In case of Elastic Demand


P TR P TR

2) In case of Inelastic Demand


P TR P TR
Income Elastic of Demand
% change in Quantity Demanded
Income Elasticity of Demand is = --------------------------------------------
% change in Income

Q I
= -------- --------
I Q

| EI | < 1 Income Inelastic


| EI | > 1 Income Elastic
Cross Price Elasticity of Demand
QX PY
EC = -------- --------
PY QX

EC = +ve Goods are substitute


EC = -ve Goods are complement
Market Structure
- Continuum of the Basic Market Models

Pure Monopolistic Oligopoly Duopoly Pure


Competition Competition Monopoly
MARKET STRUCTURE

PURE MONOPOLISTIC PURE


CHARACTERISTICS OLIGOPOLY
COMPETITION COMPETITION MONOPOLY

Number of firms A very large no. Many Few One


of firms
Type of products Homogeneous / Differentiated Standardized or Unique
Standardized Differentiated No close
substitute
Control over price None Some but - Limited by mutual Considerable
within rather interdependence
narrow limits - Considerable with
collusion
Conditions of entry Very easy no Relatively easy Significant obstacles Blocked
obstacle
Non-price competition None Considerable Typically a great Mostly with
emphasis on deal particularly with public
advertising pre differentiated relations
brand names, advertising
trade marks
Industry example Agriculture Retail trade, - Automobile Local utilities
shoes, cooking - Airconditioners
oil - Many other
appliances
Pure Competition
Large Numbers of Buyers and Sellers
Homogeneous and Divisible Products
Perfect Flow of Information
Each Firm is Price Taker
Exit and Entry is free

Most important feature of Perfect Competition is that the


firms face a horizontal demand curve where Price elasticity
of Demand is infinite.

P D

Q
In the long-run, each firm operates where
P = ATC (min).
Thus there is no economic profit for the firm.

LATC
P D=AR=MR

Since entry and exit is free, the advantage of any


innovation or cost effectiveness is passed on to the
consumers as more supply shall bring the price down.
Pure Monopoly
A pure Monopolist is a single seller selling a product which does not
have a close substitute.
-Monopolist faces a downwards sloping demand curve.

Price

D
Q

The Monopolist can have control over its price and can increase its
output supplied to the market by reducing the price.
-Monopolist optimizes his output / price where his MR = MC
Monopolist Power is influenced by elasticity of
demand
P MC 1
---------- = ----------
P |E|
Myths about Monopoly
Monopolist charges the highest possible price
Monopolist can not suffer loss
Monopolist faces an inelastic demand curve.
Monopolistic Competitor
Monopolisticcompetitor lacks one of the
major structural requirements for pure
competition, namely homogeneity of
products.
Differentiated
products are produced
which have close substitutability but are
perceived by the consumers as Different
Goods.
Duopoly
Two firms having mutual interdependence
Competitive adjustment is made in output
and price.
Cournot Model, Stackalberg Model
Bertrand Model, Edgeworth Model,
Hotelling Model, Chamberlin Mode.
Oligopoly
As against Duopoly, oligopoly represents a
market situation with a few large firms.
It is also possible to have a large firm dominating
the industry with competitive fringe consisting of
few small firms.
The important aspect of oligopoly is mutual
interdependence and competitive adjustments in
output and price.
Price leadership by dominant firm Model, Kinked
Demand Curve Model, Cartel etc are example of
oligopoly market Models.
Basic Characteristics of the Four Market Models

Market Model Pure Monopolistic Oligopoly Monopoly


Characteristics Competition Competition
1- Number of Many and Many and Generally few Over and
Firms independent independent and inter- independent
dependent
2- Size of the firms Very small Very Small Generally large Complete
relative to market domination
3- Type of Products Homogeneous Differentiated Homogeneous/ Unique
Differentiated
4- Degree of control None Limited Considerable if Considerable
over price Collusion;
otherwise
restrained by
interdependence
5- Conditions of Entry Very easy Easy Significant Blocked
Obstacles
6- Amount of Non- None Considerable Considerable Limited
price competitor
Market Failures
The situations where market intervention becomes essential
There are such substantial economies of large scale that optimal
size of the firm is large relative to market demand; only one or few
firms can operate efficiently
Public regulation VS Public Ownership
There are external effects on either consumption or production side.
The market fails to account for harmful or beneficial effects. One
economic agent production or consumption effects other economic
agents production or consumption, which are not captured in
competitive market place.
Public Goods case which covers such goods having features
Non-exclusive
Indivisible
MC for additional users is zero
Public good is a good for which the extent of consumption by one
person does not diminish the quantities available for consumption by
other people.
Thank You.