Micro economics unit 2

Unit-2 : Application of Supply & Demand,
Demand and Consumer Behavior.

Meaning of Elasticity
The term elasticity was developed by Alfred Marshall,
and is used to measure the relationship between price
and quantity demanded.
Elasticity means responsiveness.

Elasticity
A measure of a variable's sensitivity to a change in
another variable.
In economics, elasticity refers the degree to which
individuals (consumers/producers) change their
demand/amount supplied in response to price or
income changes.

Elasticity
In economics, elasticity is the measurement of how
responsive an economic variable is to a change in
another.
For example:
 "If I lower the price of my product, how much more
will I sell?"
 "If I raise the price of one good, how will that affect
sales of this other good?"
 "If we learn that a resource is becoming scarce, will
people scramble to acquire it?"

 An elastic variable (or elasticity value greater
than 1) is one which responds more than
proportionally to changes in other variables.
In contrast, an inelastic variable (or elasticity
value less than 1) is one which changes less
than proportionally in response to changes in
other variables.
 Elasticity can be quantified as the ratio of
the percentage change in one variable to
the percentage change in another variable,
when the latter variable has a causal
influence on the former.

Elasticity of supply
“Elasticity of supply refers to the degree of response of
the supply of a commodity to the change in price”
“Responsiveness of producers to changes in the price of
their goods or services”
Elasticity of supply is measured as the ratio of
proportionate change in the quantity supplied to
the proportionate change in price.
“Supply elasticity is defined as the percentage change
in quantity supplied divided by the percentage change
in price”

Price elasticity of supply
“The price elasticity of supply measures how the amount of
a good that a supplier wishes to supply changes in
response to a change in price.”
Elasticity of supply measures the responsiveness of supply
to a change in price.
“THE RATIO BETWEEN % CHANGE IN
QUANTITY SUPPLIED TO THE % CHANGE
IN PRICE.”

Price Elasticity of Supply
Percentage Change in Quantity Supplied
Percentage Change in Price
PES =
Remember:
Es = coefficient of price elasticity
QS = Quantity Supplied
P = Price
PES =
% ∆QS
% ∆P

•PEs > 1 supply is elastic
•PEs < 1 supply is inelastic
•PEs = 1 Unitary Elastic
•PEs= ∞ Perfectly Elastic
•PEs= 0 perfectly In-Elastic
Types of price elasticity of supply

Figure 1. Elastic Supply Curve
PRICE
P1
P2
0
Q1 Q2
S
QUANTITY
When the
proportionate
change in supply is
more than the
proportionate
changes in price, it
is known as elastic
supply or relatively
elastic supply.

Figure 2. Inelastic Supply Curve
PRICE
P1
P2
0
Q1 Q2
S
QUANTITY
When the
proportionate
change in supply is
less than the
proportionate
is known as
inelastic supply or
relatively inelastic
supply

Figure 3. Unitary Supply Curve
PRICE
P1
P2
0
Q1 Q2
S
QUANTITY
When the
proportionate
change in supply
is equal to
proportionate
changes in price,
it is known as
unitary elastic
supply

Figure 4. Perfectly Elastic Supply
Curve
PRICE
P1
0
S
QUANTITY
 We say that
supply is
perfectly elastic
when a 1% change
in the price
would result in an
infinite change in
quantity
supplied.

Figure 5. Perfectly Inelastic
Supply Curve
PRICE
P1
P2
0
S
QUANTITY
 We say that supply
is perfectly
inelastic when a
1% change in the
price would result
in no change in
quantity supplied.

Problem #1
An individual used to raise 10 bags which sell on the
market at a minimum of $8 each. For some reasons, the
market price per bag reached $10. He decided to raise
20. Let us find out how elastic or responsive the
production was to price.

Given variables?
Qs1 = 10
P1 = $8 each
Qs2 = 20
P2 = $10
∆Qs = ? ; ∆P = ?
PES = ?

Q2-Q1 20-10 10
∆Qs = = = = 1
Q1 10 10
P2-P1 10-8 2
∆P = = = = 0.25
P1 8 8

∆Qs 1
PES = = = 4
∆ P 0.25
We conclude that the PEOS is 4 .
So PEOS is used to see how responsive
or sensitive is supply of a good to
change in price.

What factors affect the elasticity of supply
•Spare production capacity: If there is plenty of spare capacity then a
business can increase output without a rise in costs and supply will be
elastic in response to a change in demand.
•Stocks of finished products and components: If stocks of raw
materials and finished products are at a high level then a firm is able to
respond to a change in demand - supply will be elastic.
•The ease and cost of factor substitution: If both capital and labour are
occupationally mobile then the elasticity of supply for a product is
higher than if capital and labour cannot easily be switched.
•Time period and production speed: Supply is more price elastic the longer the time
period that a firm is allowed to adjust its production levels. In some agricultural
markets the momentary supply is fixed and is determined mainly by planting decisions
made months before, and also climatic conditions, which affect the production yield.

“Elasticity of demand refers to the responsiveness
of quantity demanded of a commodity to change
in its determinant”
Elasticity of Demand
“The degree to which demand for a good or
service varies with its price. Normally, sales
increase with drop in prices and decrease with
rise in prices”
“The demand elasticity refers to how sensitive
the demand for a good is to changes in other
economic variables.”

Price elasticity of demand
Price elasticity of demand is a measure
used in economics to show the
responsiveness, or elasticity, of the
quantity demanded of a good or service
to a change in its price.
More precisely, it gives the percentage change
in quantity demanded in response to a one
percent change in price (ceteris paribus, i.e.
holding constant all the other determinants
of demand, such as income).

The Price Elasticity of Demand
Price elasticity of demand: The percentage
change in quantity demanded caused by a 1
percent change in price.
Price elasticity of demand: how sensitive is the
quantity demanded to a change in the price of the
good.
This is a measure of the responsiveness of quantity
demanded relative to a given price change.
% Quantity
Ep
% Price
D
=
D

•PED > 1 Demand is elastic
•PED < 1 Demand is inelastic
•PED = 1 Unitary Elastic
•PED= ∞ Perfectly Elastic
•PED= 0 perfectly In-Elastic
The Price Elasticity of Demand

Degrees Of Price Elasticity Of Demand
1) Perfectly elastic demand
2) Relatively elastic demand
3) Elasticity of demand equal to unity
4) Relatively inelastic demand
5) Perfectly inelastic demand

Perfectly elastic demand
P
R
I
C
E
y
0 x
Perfectly elastic
demand curve
D D
When the
demand for a
product changes
–increases or
decreases even
when there is no
change in price,
it is known as
perfectly elastic
demand.

Relatively elastic demand
Relatively elastic demand
curve
P
R
I
C
E
demand0 x
y
D
D
When the
proportionate
change in
demand is more
than the
proportionate
changes in
price, it is
known as
relatively elastic
demand.

Elasticity of demand equal to unity
Elasticity of
demand equal
to unity curve
y
x0 demand
P
R
I
C
E
D
D
When the
proportionate
change in
demand is equal
to proportionate
changes in price,
it is known as
unitary elastic
demand

Relatively inelastic demand
Relatively inelastic
demand curve
XO
Y
demand
D
D
P
R
I
C
E
When the
proportionate
change in demand
is less than the
proportionate
is known as
relatively inelastic
demand

Perfectly inelastic demand
demand
D
D
Perfectly inelastic
demand curve
0
Y
X
P
R
I
C
E
When a change in
price, however
large, change no
changes in quality
demand, it is
known as
perfectly inelastic
demand

Choice and utility theory
Utility : An economic term referring to the total
satisfaction received from consuming a good or
service.
 Total utility:
 Total utility is the total satisfaction obtain by a
consumer by consuming all units of commodity.
Marginal utility is the additional satisfaction you get
for every additional unit
 Marginal utility :
 Marginal utility is a term used in the field of
economics. This term describes the utility of a
product or item. In other terms, it is the marginal use,
or the amount of use, of a good or service.

Difference:
 The difference between total utility and
marginal utility refers to the fact that a
marginal utility is in addition to the total
utility. When a consumer increases the total
utility of a good consumed, the additional
increase is then referred to as a marginal
utility.

Definition
of
Law of Diminishing Marginal Utility
The law of diminishing marginal utility states that as
consumer consumes more and more
units of a specific commodity,
utility from the successive units
goes on diminishing’.

Explanation and
Example of Law of
Diminishing Marginal Utility:
 Suppose, a man is very thirsty. He
goes to the market and buys one
glass of sweet water. The glass of
water gives him immense
pleasure or we say the first glass
of water has great utility for him.
 If he takes second glass of water
after that, the utility will be less
than that of the first one
 If he drinks 3rd glass of water the
utility declines again and so on….

Units Total Utility Marginal Utility
1st glass 20 20
2nd glass 32 12
3rd glass 40 8
4th glass 42 2
5th glass 42 0
6th glass 39 -3
Schedule of Law of Diminishing Marginal Utility
From the above table, it is clear that in a given span of time, the
first glass of water to a thirsty man gives 20 units of utility. When
he takes second glass of water, the marginal utility goes on down to
12 units; When he consumes fifth glass of water, the marginal
utility drops down to zero and if the consumption of water is
forced further from this point, the utility changes into disutility (-
3).

Curve/Diagram
of Law of Diminishing Marginal Utility:
In the figure (2.2), along OX we measure units of a commodity
consumed and along OY is shown the marginal utility derived
from them. The marginal utility of the first glass of water is
called initial utility. It is equal to 20 units. The MU of the
5th glass of water is zero. It is called satiety point. The MU of
the 6th glass of water is negative (-3). The MU curve here lies
below the OX axis. The utility curve MM/ falls left from left
down to the right showing that the marginal utility of the
success units of glasses of water is falling.

Assumptions
of Law of Diminishing Marginal Utility
The law is true under certain assumptions as follows:
 (i) Rationality: The consumer aims at maximization of
utility subject to availability of his income.
 (ii) Constant marginal utility of money: The marginal
utility of money for purchasing goods remains constant.
 (iii) Diminishing marginal utility: The utility gained
from the successive units of a commodity diminishes in a
given time period.
 (iv)Utility is additive: The utilities of different
commodities are independent.

 (v) Consumption to be continuous
 (vi) Suitable Reasonable quantity: If the units
are too small, then the marginal utility
instead of falling may increase up to a few
units.
 (vii) Character of the consumer does not
change.
 (viii) No change to fashion, Customs and
Tastes.
 (ix) No change in the price of the commodity.

Limitations/Exceptions
of Law of Diminishing Marginal Utility
(i) Case of intoxicants: The more a person
drinks liquor (alcohol), the more s/he likes
it.
(ii) Rare collection: If there are only two
diamonds in the world, the possession of
2nd diamond will push up the marginal
utility.
(iii) Application to money: It is true that
more money the man has, the greedier he is
to get additional units of it.

Law of diminishing return
“A concept in economics that if one factor of
production (number of workers, for example)
is increased while other factors (machines and
workspace, for example) are held constant, the
output per unit of the variable factor will
eventually diminish.”
“The law of diminishing returns is a classic
economic concept that states that as more
investment in an area is made, overall return on
that investment increases at a declining rate,
assuming that all variables remain fixed.”

Total, average and marginal product
 Total product: This is the quantity of output
produced by a given number of workers over a given
period of time. Remember the amount of capital (or
machines) is fixed.
 Average product: This is the quantity of output per
unit of input. In this model, the input is labour. In
other words, we are dealing with the output per
worker, on average.
 Marginal product:The addition to total output
produced by one extra unit of input (again, labour). It
is the extra output produced at the margin (i.e. by
adding a marginal unit of labour).

Example
 Look at the table below. Let us assume that the firm in
question is making computer laser printers and they
have four machines in the factory (capital = 4).
Capital Labour (L)
Marginal
product (MP)
Total product
(TP)
Average
product (AP)
4 0 - 0 -
4 1 5 5 5.0
4 2 8 13 6.5
4 3 10 23 7.7
4 4 11 34 8.5
4 5 10 44 8.8
4 6 7 51 8.5
4 7 4 55 7.9
4 8 1 56 7.0
4 9 -2 54 6.0

 Remember that capital is fixed in the short
run. I have assumed that capital is fixed at 4
units (or machines, in this case).
 The second column shows the progressive
addition of units of labour.
 The third column shows marginal product
(MP). Each figure represents the output
produced as a result of adding an extra
worker.

 The fourth column gives total product (TP). This
is calculated quite easily by adding, cumulatively,
the marginal products. The first worker makes 5
units, so the total is 5. The second worker adds a
further 8 units, so the total is now 13 (5 + 8), and so
on. In fact, you can work out the marginals from
the totals. Take the sixth worker, for example. His
marginal product is 7. This can be calculated by
taking the TP from six workers and subtracting the
TP from five workers (51 - 44).
 Algebraically:
 MP6 = TP6 − TP5. (i.e. 7 = 51 − 44).

 The fifth column gives average product (AP). The
figures in this column represent output (or product)
per worker. The average product once the eighth
worker has been added is 7. This was calculated by
taking the TP with eight workers and dividing by the
number of workers (also eight). Algebraically:

 Notice that the point at which diminishing marginal
returns sets in is to the left of the point where diminishing
average returns begins. Also, the total product keeps rising
even though the marginal, and the average, product is falling.
This is not hard to understand. Just because the marginal
product is falling, it is still positive. Hence, these extra
workers may well be adding less than previous workers, but
they are still contributing to the grand total. Total product
keeps rising, albeit at a diminishing rate. It is only when the
marginal product is negative, with the addition of the ninth
worker that total product starts to fall.
 Finally, notice that the marginal product curve cuts the average
product curve at its highest point, where it is momentarily flat.
It is important that you understand why this happens because
this concept is applied to the cost and revenue curves.

 Definition: Consumer surplus is defined as the
difference between the consumers' willingness to
pay for a commodity and the actual price paid by
them, or the equilibrium price.
 An economic measure of consumer satisfaction,
which is calculated by analyzing the difference
between what consumers are willing to pay for a
good or service relative to its market price.
 A consumer surplus occurs when the consumer is
willing to pay more for a given product than the
current market price.
Consumer Surplus

“Consumer surplus is the difference between what
consumers are willing to pay for a good or service
(indicated by the position of the demand curve) and
what they actually pay (the market price).”
The level of consumer surplus is shown by the area
under the demand curve and above the ruling market
price

Consider the demand for public transport shown in the diagram. The
initial fare is price P for all passengers and at this price, Q1 journeys are
demanded by local users.
At price P the level of consumer surplus is shown by the area APB. If the
bus company cuts price to P1 the demand for bus journeys expands and
the new level of consumer surplus rises to AP1C. This means that the
level of consumer welfare has increased by the area PP1CB.

Indifference curve
A diagram depicting equal levels of utility (satisfaction)
for a consumer faced with various combinations of
goods.
Definition: An indifference curve is a graph showing
combination of two goods that give the consumer
equal satisfaction and utility.
Each point on an indifference curve indicates that a
consumer is indifferent between the two and all points
give him the same utility.
Indifference curve, in economics, graph showing
various combinations of two things (usually consumer
goods) that yield equal satisfaction or utility to an
individual.

As an example, consider the diagram above.
This consumer would be most satisfied with
any combination of products along curve U3.
This consumer would be indifferent between
combination Q1a, Q1b, and Q2a, Q2b

 The above diagram shows the U indifference curve showing
bundles of goods A and B. To the consumer, bundle A and
B are the same as both of them give him the equal
satisfaction. In other words, point A gives as much utility as
point B to the individual. The consumer will be satisfied at
any point along the curve assuming that other things are
constant

Characteristics of indifference
curve
1) An indifference curve is always negatively sloping
downward from left to right.

 2) An indifference curve is always convex to the
origin.

 3) Indifference curve to the right represent higher level
of satisfaction

 4) Two or more than two indifference curve never
intersect/cross each other.

 5) Another additional property of an indifference
curve is that an indifference curve never touches "X"
axis or "Y" axis.

6. Indifference curves are infinite: Sample pictures of
indifference curves may show you one or two
indifference curves. However, the fact is that you can
draw an infinite number of indifference curves
between two indifference curves.

 7. Indifference curves are not influenced
by market or economic circumstances.
 An indifference curve is purely a subjective
phenomenon and it has nothing to do with
the external economic forces.
 Indifference Map : A set of indifference
curves which shows different combinations
is called an indifference map.

Marginal rate of substitution :
 In economics, the marginal rate of substitution is
the rate at which a consumer is ready to give up one
good in exchange for another good while maintaining
the same level of utility.

 The marginal rate of substitution (MRS) is calculated
between two goods placed on an indifference curve,
displaying a frontier of equal utility for each combination
of "good A" and "good B".
The marginal rate of substitution is always changing for a
given point on the curve, and mathematically represents
the slope of the curve at that point. MRS is calculated using
the following formula:
MRS= ∆Y÷∆X
Good A
Good B

Budget line
A budget is defined as a financial plan. Its a
good idea to have a plan, a budget for your
home and your business.
A budget is a financial plan , expressed
numerically , prepared in a year prior to the
execution year.
A budget line is a line showing the alternative
combinations of any two goods that a
consumer can afford at given prices for the
goods and a given level of income

Budget constraint
Budget line :A graphical depiction of the various
combinations of two selected products that a consumer can
afford at specified prices for the products given their particular
income level.
When a typical business is analyzing a two product budget
line, the amounts of the first product are plotted on the
horizontal X axis and the amounts of the second product are
plotted on the vertical Y axis

The budget line is the total amount of money a
consumer is has to spend on 2 goods. The price of the
goods and the income of the consumer are the
constraints that limit the consumer from buying how
much he really wants. He has to decide on the correct
combination of the goods to buy and this would happen
where the budget line is tangent to the indifference
curve.
Indifference curve showing budget line
An individual should consume at (Qx, Qy).

Shift in budget line
 Budget line is drawn with the assumptions
of constant income of consumer and
constant prices of the commodities. A new
budget line would have to be drawn if either
(a) Income of the consumer changes, or (b)
Price of the commodity changes.

 1. Effect of a Change in the Income of Consumer:
 If there is any change in the income, assuming no change
in prices of apples and bananas, then the budget line will
shift. When income increases, the consumer will be able to
buy more bundles of goods, which were previously not
possible. It will shift the budget line to the right from ‘AB’
to ‘A1B1‘, as seen in Fig. 2.9. The new budget line A1B1 will be
parallel to the original budget line ‘AB’.

 2. Effect of change in the relative Prices (Apples
and Bananas):
 If there is any change in prices of the two
commodities, assuming no change in the money
income of consumer, then budget line will change. It
will change the slope of budget line, as price ratio will
change, with change in prices.

 (i) Change in the price of commodity on X-axis
(Apples):
 When the price of apples falls, then new budget line is
represented by a shift in budget line (see Fig. 2.10) to the
right from ‘AB’ to ‘A1B’. The new budget line meets the Y-
axis at the same point ‘B’, because the price of bananas has
not changed. But it will touch the X-axis to the right of ‘A’
at point ‘A1, because the consumer can now purchase more
apples, with the same income level.
 Similarly, a rise in the price of apples will shift the budget
line towards left from ‘AB’ to ‘A2B’.

 (ii) Change in the price of commodity on Y-axis
(Bananas):
 With a fall in the price of bananas, the new budget line
will shift to the right from ‘AB’ to AB1 (see Fig. 2.11).
The new budget line meets the X-axis at the same
point ‘A’, due to no change in the price of apples. But it
will touch the Y-axis to the right of ‘B’ at point ‘B1‘,
because the consumer can now purchase more
bananas, with the same income level.
 Similarly, a rise in the price of bananas will shift the
budget line towards left from ‘AB’ to ‘AB2‘.

Utility maximization
 The process or goal of obtaining the highest level of
utility from the consumption of goods or services. The
goal of maximizing utility is a key assumption
underlying consumer behavior studied in consumer
demand theory.
 Economics concept that, when making a purchase
decision, a consumer attempts to get the greatest value
possible from expenditure of least amount of money.
His or her objective is to maximize the total value
derived from the available money

Micro economics unit 2

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Micro economics unit 2