Micro Economics CBMBE3T02

Syllabus topics (RTMNU)

• Meaning, Definition, Nature, Features, Scope, Importance and Limitations of Micro Economics study
• Difference between Micro and Macro Economics
• Problems in Micro Economics study
• Meaning, Concept, Nature, Feature of Utility
• Measurement of Utility
• Marginal and Total Utility
• Difference between Marginal and Total Utility
• Law of Diminishing Marginal Utility
• Consumers Equilibrium

Micro Economics: Meaning, Definition, Nature and Features

Meaning: The word "micro" comes from the Greek word mikros, which means "small". Micro Economics studies the economic behaviour of individual units — one consumer, one firm, one industry, or the price of one product.

Definitions:

• K. E. Boulding: Micro Economics is the study of particular firms, particular households, individual prices, wages, incomes, individual industries and particular commodities.
• A. P. Lerner: Micro Economics looks at the economy through a microscope, to see how the millions of cells (individuals and firms) play their part in the working of the whole economy.
• Simple definition (for exam): Micro Economics is the branch of economics that studies how individual consumers and firms make choices and how the price of a single good or factor is determined.

Nature / Features:

1. Study of individual units: It studies one household, one firm or one market, not the whole country.
2. Price theory: It explains how the price of a product (e.g. onions in the Nagpur APMC market) and of factors (rent, wage, interest, profit) is fixed.
3. Partial equilibrium: It studies one market at a time and assumes other things remain the same (ceteris paribus).
4. Assumes full employment: It takes the total level of output and employment as given.
5. Based on choice and scarcity: Resources are limited and wants are many, so consumers and firms must choose.
6. Uses marginal analysis: Decisions are taken by comparing one extra unit (marginal utility, marginal cost).

Scope, Importance and Limitations of Micro Economics

Scope (subject matter):

1. Theory of demand / consumer behaviour: utility, law of demand, elasticity.
2. Theory of production and cost: how a firm combines land, labour, capital and enterprise.
3. Theory of product pricing: price under perfect competition, monopoly etc.
4. Theory of factor pricing (distribution): rent, wage, interest and profit.
5. Welfare economics: efficient use of resources and economic welfare.

Importance:

1. Explains price determination of goods and factors through demand and supply.
2. Helps business decisions: a firm like Amul or Parle uses demand and cost study to fix price and output.
3. Helps government policy: e.g. deciding GST rates or Minimum Support Price (MSP) for crops.
4. Explains efficient use of scarce resources.
5. Base for international trade and for understanding welfare.

Limitations:

1. Unrealistic assumptions such as full employment and perfect competition.
2. Ignores the whole economy: it cannot explain unemployment, inflation or national income.
3. Fallacy of composition: what is true for one person may not be true for all (one person saving more is good; the whole nation saving more may reduce demand).

Difference between Micro and Macro Economics

Problems in Micro Economics Study

1. Collecting correct data about individual consumers and firms is difficult and costly.
2. Human behaviour is not always rational, so predictions can fail.
3. The ceteris paribus assumption is hard to apply because many things change together.
4. Results for one unit cannot always be added up for the whole economy.

Utility: Meaning, Concept, Nature and Features

Definition: Utility is the want-satisfying power of a commodity or service. A glass of water has utility for a thirsty person.

Features / Nature:

1. Subjective: it is a feeling in the mind; it differs from person to person (meat has no utility for a vegetarian).
2. Relative: it changes with time and place (a woollen sweater has more utility in winter).
3. Not the same as usefulness: cigarettes harm health but have utility for a smoker.
4. Not the same as pleasure: medicine is bitter but has utility.
5. Ethically neutral: economics does not judge whether the want is good or bad.

Measurement of Utility; Total and Marginal Utility

Measurement: Two approaches exist. (1) Cardinal approach (Marshall): utility can be measured in numbers called utils, or in money a person is willing to pay. (2) Ordinal approach (Hicks and Allen): utility cannot be measured in numbers, only ranked (first, second, third) using indifference curves.

Total Utility (TU): the total satisfaction from consuming all units of a good. Marginal Utility (MU): the extra satisfaction from one more unit. Formula: MU_n = TU_n − TU_n−1.

Illustration (rotis eaten by a hungry student):

When MU falls, TU rises at a slower rate; when MU = 0, TU is maximum (point of satiety, 6th roti); when MU is negative, TU falls.

Difference between TU and MU:

Law of Diminishing Marginal Utility

Statement (Marshall): The additional benefit a person gets from a given increase in his stock of a thing diminishes with every increase in the stock he already has. In simple words, as we consume more units of a good, the marginal utility of each extra unit goes on falling.

Assumptions: units are homogeneous (same size and quality); consumption is continuous (no time gap); units are of a suitable size; tastes, income and the consumer's mind do not change; utility is cardinally measurable; marginal utility of money is constant.

Explanation: See the roti table above — MU falls from 10 to 8, 6, 4, 2, 0 and then −2. Diagram (in words): units on the X-axis and MU on the Y-axis; the MU curve slopes downward from left to right and cuts the X-axis at the 6th unit.

Exceptions: hobbies (stamp or coin collection), money for a miser, drunkards, rare items, and very small units at the start (the second spoonful may give more satisfaction than the first).

Importance: it explains the law of demand, the diamond-water paradox, progressive taxation (a rupee taken from the rich hurts less), and why firms offer variety.

Consumer's Equilibrium

Meaning: A consumer is in equilibrium when he spends his limited income on goods in such a way that he gets maximum total satisfaction and has no reason to change his spending.

One good: equilibrium when MU of the good (in money) = its price, i.e. MU_x = P_x.

Two or more goods — Law of Equi-Marginal Utility: the consumer is in equilibrium when MU_x/P_x = MU_y/P_y = MU of money, and the whole income is spent. If MU per rupee is higher for X, he buys more X and less Y until the ratios become equal.

Likely exam questions

1. (Long, 8/16 marks) Define Micro Economics. Explain its nature, scope, importance and limitations.
2. (Long, 8/16 marks) State and explain the Law of Diminishing Marginal Utility with a table and diagram. Mention its assumptions and exceptions.
3. (Short, 4 marks) Distinguish between Micro and Macro Economics.
4. (Short, 4 marks) Explain the difference between Total Utility and Marginal Utility.
5. (Short, 4 marks) What is consumer's equilibrium? State its condition in the case of two goods.

Syllabus topics (RTMNU)

• Concept and Features of Demand
• Factors affecting Demand
• Law of Demand, Exceptions and Assumptions
• Elasticity of Demand
• Types of Elasticity of Demand
• Factors affecting elasticity of Demand
• Methods of measuring Elasticity of Demand

Concept and Features of Demand

Meaning: In economics, demand is not just a wish. Demand = desire to buy + willingness to pay + ability (money) to pay, for a given quantity at a given price, at a given time and place. A poor student may desire a car, but without money it is only a wish, not demand.

Definition (Benham): The demand for anything at a given price is the amount of it which will be bought per unit of time at that price.

Features:

1. Desire backed by purchasing power.
2. Always related to a price.
3. Always related to a period of time (per day, per month).
4. Related to a place / market.
5. Demand is relative — it changes with income, taste and fashion.
6. Individual demand (one buyer) and market demand (all buyers together).

Factors Affecting Demand (Determinants)

1. Price of the commodity: lower price, more demand.
2. Income of the consumer: higher income raises demand for normal goods; for inferior goods (coarse grain) demand may fall.
3. Prices of related goods: substitutes (tea and coffee) — if coffee becomes costly, tea demand rises; complements (petrol and bike) — if petrol becomes costly, bike demand falls.
4. Tastes, habits and fashion.
5. Population size and composition.
6. Expectations of future prices: if people expect gold prices to rise, they buy more now.
7. Advertisement and sales promotion.
8. Season and climate: umbrellas in monsoon, coolers in summer.
9. Government policy: taxes, subsidies, credit facilities.

Demand function: D_x = f (P_x, Y, P_r, T, E, …) — demand for X depends on its price, income, prices of related goods, tastes, expectations etc.

Law of Demand, its Assumptions and Exceptions

Statement (Marshall): Other things being equal, the amount demanded increases with a fall in price and diminishes with a rise in price. There is an inverse relation between price and quantity demanded.

Demand schedule (mangoes, per dozen):

Diagram (in words): quantity on the X-axis, price on the Y-axis; the demand curve DD slopes downward from left to right.

Why does the demand curve slope downward? (1) Law of diminishing marginal utility; (2) Income effect — a fall in price raises real income; (3) Substitution effect — the good becomes cheaper than substitutes; (4) New buyers enter the market; (5) Multiple uses of the good (e.g. electricity).

Assumptions: income of consumer is constant; tastes and preferences do not change; prices of related goods are constant; no expectation of future price change; population is constant; no change in government policy.

Exceptions (demand rises with price):

1. Giffen goods: very cheap inferior goods of poor people (Sir Robert Giffen's example of bread in 19th-century Britain).
2. Veblen goods / prestige goods: diamonds, luxury cars — bought because they are costly (Thorstein Veblen's "conspicuous consumption").
3. Expectation of further price rise: people buy more shares or gold when prices are rising.
4. Ignorance: buyers think a costly item is of better quality.
5. Necessities: salt or life-saving medicines are bought in the same quantity even if price rises.
6. Emergencies such as war or famine.

Elasticity of Demand and its Types

Meaning: Elasticity of demand means the degree of responsiveness of quantity demanded to a change in its determinants. Marshall: elasticity is great or small according as the amount demanded increases much or little for a given fall in price.

Kinds: (1) Price elasticity — response to price; (2) Income elasticity — response to income; (3) Cross elasticity — response to the price of a related good (positive for substitutes, negative for complements).

Five degrees of price elasticity:

Factors Affecting Elasticity of Demand

1. Nature of commodity: necessities inelastic, luxuries elastic.
2. Availability of substitutes: more substitutes, more elastic (soaps, toothpaste brands).
3. Number of uses: goods with many uses (electricity, milk) are elastic.
4. Share of income spent: matchbox, salt — small share, inelastic.
5. Habits and addiction: tobacco is inelastic.
6. Possibility of postponement: if purchase can be delayed, demand is elastic.
7. Time period: demand is more elastic in the long run.
8. Level of price and income: very costly and very cheap goods are less elastic.

Methods of Measuring Elasticity of Demand

1. Percentage (proportionate) method: E_d = percentage change in quantity demanded ÷ percentage change in price. (The minus sign is usually ignored.)

Example: price falls from ₹10 to ₹8 (−20%) and demand rises from 100 to 150 units (+50%). E_d = 50 ÷ 20 = 2.5 → relatively elastic.

2. Total outlay / expenditure method (Marshall): compare total spending (P × Q) before and after the price change.

In our example, spending was ₹10 × 100 = ₹1,000 and became ₹8 × 150 = ₹1,200; it rose when price fell, so demand is elastic.

3. Point (geometric) method: on a straight-line demand curve, E_d at a point = lower segment ÷ upper segment. At the mid-point E_d = 1; above it > 1; below it < 1; at the Y-axis ∞; at the X-axis 0.

4. Arc method: used for a big change between two points; it takes the average of the old and new price and quantity: E_d = (ΔQ ÷ average Q) ÷ (ΔP ÷ average P).

Likely exam questions

1. (Long, 8/16 marks) State and explain the Law of Demand. What are its assumptions and exceptions?
2. (Long, 8/16 marks) What is elasticity of demand? Explain its types and the methods of measuring price elasticity of demand.
3. (Short, 4 marks) Explain any five factors affecting demand.
4. (Short, 4 marks) Why does the demand curve slope downward?
5. (Short, 4 marks) Explain the factors affecting elasticity of demand.

Syllabus topics (RTMNU)

• Concept and Features of Supply
• Factors affecting Supply
• Law of Supply, Exceptions and Assumptions
• Elasticity of Supply
• Types of Elasticity of Supply
• Factors affecting elasticity of Supply
• Methods of measuring Elasticity of Supply

Concept and Features of Supply

Meaning: Supply is the quantity of a commodity that sellers are willing and able to offer for sale at a given price, during a given period of time. Stock is the total quantity available with the seller; supply is only the part of the stock actually offered at a price. A farmer may have 50 quintals of soybean (stock) but offer only 30 quintals at today's price (supply).

Definition (Meyers): Supply is a schedule of the amounts of a good that would be offered for sale at all possible prices at any one instant of time.

Features:

1. Always related to a price.
2. Always related to a period of time.
3. Supply is a part of stock; stock is the upper limit of supply.
4. Willingness and ability of the seller are both needed.
5. Individual supply (one firm) and market supply (all firms together).
6. Supply is a flow concept (per day, per month).

Factors Affecting Supply (Determinants)

1. Price of the commodity: higher price, more supply.
2. Cost of production: if wages, raw material or power become costly, supply falls.
3. Technology: better technology lowers cost and raises supply.
4. Prices of other goods: if cotton gets a better price, farmers may shift land from soybean to cotton.
5. Goal of the firm: profit maximisation or sales maximisation.
6. Number of firms in the market.
7. Government policy: taxes reduce supply, subsidies increase it.
8. Natural factors: good monsoon increases supply of farm goods; drought reduces it.
9. Expectations of future prices: if a seller expects a price rise, he holds back stock now.
10. Transport and communication facilities.

Supply function: S_x = f (P_x, C, T, P_o, G, …) — supply depends on its price, cost, technology, prices of other goods, government policy etc.

Law of Supply, its Assumptions and Exceptions

Statement: Other things being equal, the quantity supplied of a commodity increases with a rise in its price and decreases with a fall in its price. There is a direct (positive) relation between price and quantity supplied.

Supply schedule (wheat, quintals):

Diagram (in words): quantity on the X-axis, price on the Y-axis; the supply curve SS slopes upward from left to right.

Why does supply rise with price? Higher price gives more profit; firms produce more; new firms enter; sellers release stock from godowns; and at higher output marginal cost rises, so a higher price is needed to cover it.

Assumptions: cost of production remains the same; technology does not change; prices of other goods are constant; no change in government taxes or subsidies; no change in natural conditions; sellers do not expect future price changes.

Exceptions:

1. Backward-bending supply curve of labour: after a high wage level, workers prefer leisure and supply less labour.
2. Perishable goods: vegetables, fish and milk must be sold even at low prices.
3. Expectation of future fall in price: sellers sell more now even if price is falling.
4. Urgent need of cash: a seller may sell more at a lower price.
5. Agricultural goods: supply depends on monsoon, not only on price.
6. Rare goods and antiques: supply is fixed whatever the price.
7. Closing-down sale: a firm leaving business sells at low prices.

Elasticity of Supply and its Types

Meaning: Elasticity of supply is the degree of responsiveness of quantity supplied to a change in price.

Formula: E_s = percentage change in quantity supplied ÷ percentage change in price. E_s is positive because price and supply move in the same direction.

Five types:

Factors Affecting Elasticity of Supply

1. Nature of the commodity: perishable goods have inelastic supply; durable goods have elastic supply.
2. Time period: supply is inelastic in the very short period (market period) and more elastic in the long run, when firms can expand plants.
3. Cost of production: if extra output raises cost sharply, supply is inelastic; if cost stays the same, supply is elastic.
4. Availability of factors: easy availability of labour and raw material makes supply elastic.
5. Technique of production: simple techniques allow quick change; complex ones make supply inelastic.
6. Spare capacity: unused capacity makes supply elastic.
7. Risk-taking: if producers are willing to take risk, supply is elastic.
8. Natural factors: agricultural supply depends on season and is inelastic.

Methods of Measuring Elasticity of Supply

1. Percentage (proportionate) method: E_s = (ΔQ ÷ Q) ÷ (ΔP ÷ P).

Example: price rises from ₹10 to ₹12 (+20%) and supply rises from 100 to 130 units (+30%). E_s = 30 ÷ 20 = 1.5 → relatively elastic.

2. Point / geometric method: extend the straight-line supply curve until it meets an axis.

• If it passes through the origin, E_s = 1.
• If it meets the price (Y) axis above the origin, E_s > 1.
• If it meets the quantity (X) axis, E_s < 1.

3. Arc method: for a large price change, E_s = (ΔQ ÷ average of old and new Q) ÷ (ΔP ÷ average of old and new P).

Likely exam questions

1. (Long, 8/16 marks) State and explain the Law of Supply with a schedule and diagram. Mention its assumptions and exceptions.
2. (Long, 8/16 marks) Define elasticity of supply. Explain its types and the factors affecting it.
3. (Short, 4 marks) Distinguish between stock and supply.
4. (Short, 4 marks) Explain any five factors affecting supply.
5. (Short, 4 marks) How is elasticity of supply measured by the percentage method? Give an example.

Syllabus topics (RTMNU)

• Features and Nature of Land, Labour, Capital and Enterprise
• Returns on Factors (Rent, Wage, Interest, Profits)
• Types of Rent
• Ricardian Theory of Rent
• Modern Theory of Rent
• Quasi Rent
• Difference between rent and quasi rent
• Interest: Definition and features
• Types of Interest
• Liquidity Preference Theory
• Loanable Funds Theory of Interest
• Profits and types of Profit (Gross profit, Net profit, Normal and abnormal profits)

Features and Nature of Land, Labour, Capital and Enterprise

Factors of production are the resources used to produce goods and services. There are four factors, and each earns a reward (return).

Returns on Factors and Types of Rent

Returns on factors: land earns rent, labour earns wage, capital earns interest and the entrepreneur earns profit. Together these make up the national income. Wage may be money (nominal) wage — the amount paid in rupees — or real wage — the goods and services that money wage can buy.

Types of rent:

1. Contract rent: the amount actually paid to the land owner as agreed (e.g. ₹10,000 per month for a shop).
2. Economic rent: the surplus earned by a factor over its minimum supply price (transfer earning).
3. Gross rent: contract rent including payment for capital improvements, repairs etc.
4. Scarcity rent: rent arising because total land is limited.
5. Differential rent: rent due to differences in fertility or location of land.
6. Quasi rent: short-period surplus on man-made machines (explained below).

Ricardian Theory of Rent

Statement (David Ricardo, 1817): Rent is that portion of the produce of the earth which is paid to the landlord for the use of the original and indestructible powers of the soil. Rent is a differential surplus: it arises because lands differ in fertility or location.

Assumptions: land has original and indestructible powers; lands differ in fertility; law of diminishing returns applies; perfect competition; land is used only for farming; there is a no-rent (marginal) land.

Explanation: Suppose the same cost (₹1,000 of labour and capital) is used on three grades of land:

Land C only covers its cost, so it earns no rent. Lands A and B earn surplus over C; that surplus is rent. Rent can also arise in intensive cultivation, when more doses of labour and capital are applied to the same land and the last dose gives just enough to cover cost.

Criticism: soil powers are neither original nor indestructible; there is no no-rent land in practice; ignores scarcity of land; assumes perfect competition; rent is earned by other factors too.

Modern Theory of Rent

Modern economists (associated with Pareto, Joan Robinson and K. E. Boulding) say rent is not limited to land. Any factor whose supply is less than perfectly elastic can earn rent. Rent = actual earning − transfer earning, where transfer earning is the minimum payment needed to keep the factor in its present use.

Example: a film actor earns ₹50 lakh; in the next-best job he would earn ₹10 lakh. His economic rent is ₹40 lakh. When supply is perfectly inelastic, the whole earning is rent; when perfectly elastic, there is no rent.

Quasi Rent and Difference between Rent and Quasi Rent

Quasi rent (Alfred Marshall): the extra income earned in the short run by man-made appliances (machines) whose supply is fixed for the time being. Quasi rent = Total revenue − Total variable cost. It disappears in the long run, when new machines are added.

Interest: Definition, Features and Types

Meaning: Interest is the price paid for the use of capital (money) for a period. Keynes: interest is the reward for parting with liquidity for a specified period.

Features: paid for borrowed money; expressed as a percentage per year; reward for waiting and risk; paid by borrower to lender.

Types: Gross interest = net interest + payment for risk + management charges + inconvenience. Net (pure) interest = reward only for the use of capital. Also simple and compound interest, and fixed and floating rates.

Liquidity Preference Theory and Loanable Funds Theory of Interest

Liquidity Preference Theory (J. M. Keynes, 1936): interest is fixed by the demand for money (liquidity preference) and the supply of money. People demand money for three motives: (1) transaction motive — daily spending; (2) precautionary motive — emergencies; (3) speculative motive — to gain from changes in bond prices. The supply of money is fixed by the central bank (RBI). The rate of interest is decided where demand for money equals supply of money. At a very low rate, people hold any amount of money — the liquidity trap.

Loanable Funds Theory (Wicksell, Ohlin, Robertson): interest is the price at which the demand for loanable funds equals their supply. Demand comes from investment, consumption loans and hoarding. Supply comes from savings, dishoarding, bank credit and disinvestment. Criticism: it mixes real and monetary factors and assumes full employment.

Profits and Types of Profit

Profit is the reward of the entrepreneur for organising production and bearing risk. It is a residual income — what is left after paying rent, wage and interest.

1. Gross profit: total revenue minus explicit costs of production (rent, wages, raw material, interest paid). It includes implicit costs and net profit.
2. Net profit: gross profit minus implicit costs (rent of own land, salary of own work, interest on own capital) and depreciation. It is the pure reward for risk-bearing.
3. Normal profit: the minimum profit just enough to keep the entrepreneur in the industry; it is treated as part of cost (AR = AC).
4. Abnormal (super-normal) profit: profit above normal profit (AR > AC); common in monopoly or in the short run under competition.

Likely exam questions

1. (Long, 8/16 marks) Critically explain the Ricardian Theory of Rent. How does the modern theory of rent differ from it?
2. (Long, 8/16 marks) Explain the Liquidity Preference Theory of interest. Also explain the Loanable Funds Theory.
3. (Short, 4 marks) Explain the features of land and labour as factors of production.
4. (Short, 4 marks) Distinguish between rent and quasi rent.
5. (Short, 4 marks) Explain gross profit, net profit, normal profit and abnormal profit.