Economics-I UNIT 1 2 3 4 CPJ FAIRFIELD NOTES

Economics-I: Micro
Economic Analysis
Paper Code: BA LLB 113

Unit-II: Demand and Supply
• Theories of demand - demand function, law of demand Concept of
utility and utility theory-utility approach, indifference curve approach
• Law of supply, supply function
• Price determination; shift of demand and supply
• Elasticity of demand and supply; consumer surplus
• Applications of demand and supply –tax floor and ceilings;
applications of indifference curves-tax, work

Consumer’s Equilibrium
• A consumer is one who buys goods and services for satisfaction of wants.
• The objective of a consumer is to get maximum satisfaction from spending
his income on various goods and services, at their given prices.
• Suppose a consumer wants to buy a commodity. How much of it should he
buy? Two approaches are used for getting an answer to this question.
These are:
1. Utility approach
2. Indifference curve approach

Utility
• It refers to the want satisfying power of a commodity
• It means realized satisfaction to a consumer when he is willing to spend money on a stock
of commodity which has the capacity to satisfy his want.
• A commodity has utility for a consumer even when it is not consumed (realized and
expected utility)
• Utility is essentially a subjective concept depending upon the intensity of consumer’s
desire or want for that commodity at that time.
• Utility is a cardinal concept i.e., it can be measured
• Unit of measurement of utility as utils i.e., say consumption of 2 units of X gives 10 utils
• According to Marshall, money should be used to measure utility i.e., say consumption
of 2 units of X give utility worth Rs 10

Total Utility (TU)
• It is the sum of all the utilities that a consumer derives from the consumption of a certain amount of a
commodity.
• Mathematically, TU can be obtained by the sum of marginal utilities from the consumption of different
units of the commodity.
Marginal Utility (MU)
It is addition made to the total utility as consumption is increased by one more unit of the commodity.
Mathematically, it is calculated as:

Relationship between Total and Marginal
Utility
1. As the consumer has more of the good, the TU increases less than in
proportion and the MU gradually declines but is positive.
2. When TU is maximum, called saturation point, MU is zero.
3. When TU falls, MU becomes negative.
4. If consumer is rational, he will stop at 8 units. This is because if he consumes
more than 8 units, then TU will decline and MU will become negative (the good
will give disutility).

Relationship between TU and MU Curves
(a) TU curve starts from the origin, increase at a decreasing rate, reaches a maximum and then
starts falling.
(b) MU curve is the slope of the TU curve, since MU= ΔTUx / ΔQx
(c) When TU is maximum, MU is zero, it is called saturation point. (since slope of TU curve
at that point is zero). Units of the good are consumed till the saturation point.
(d) When TU curve is falling, MU curve becomes negative.
(e) The falling MU curve shows the law of diminishing marginal utility.

The Law of Diminishing Marginal Utility
• The law states that as a consumer consumes more and more units of a
commodity, marginal utility derived from each successive unit goes on
diminishing.

Assumptions of the Law of DMU. The law of DMU holds good when the following assumptions are
satisfied:
1. Standard unit of measurement is used: If the unit of measurement is very large or very small
then the law will not hold. Examples of inappropriate units are: rice measured in grams, water in
drops, diamonds in kilograms.
2. Homogeneous commodity: All units of the commodity consumed are homogeneous and perfect
substitutes.
3. Continuous consumption: The law of DMU holds only when consumption of successive units of
a commodity is without a time gap.
4. Mental and social condition of the consumer must be normal: The law will hold when
consumer’s mental condition is normal. His income and tastes are unchanged and his behaviour is
rational.

Consumer’s equilibrium with utility approach
A consumer is said to be in equilibrium when he maximizes his satisfaction, given income and
prices of the commodities
Assumptions:
1. Utility can be measured, i.e. can be expressed in exact units. Utility is measurable in
monetary terms.
2. Consumer’s income is given.
3. Prices of commodities are given and remain constant.
4. Constant Marginal Utility of Money. It means that importance of money remains
unchanged. Marginal utility of money is addition made to utility of the consumer as he spends
one more unit of the money income. This is assumed to be constant.

Consumer’s equilibrium with utility approach
Case I. One Commodity Case
A consumer is in equilibrium when he satisfies the following condition:
i.e., MU of the good = Price of the product or MUx = Px
• Consumer derives MU of worth Rs 6 @ 2units i.e. MUx> Px
• Consumer derives MU of worth Rs 4 @ 4units i.e. Mux< Px
• To maximize utility a consumer will buy that quantity of the
good where the MU of the good is equal to the price that he
has to pay.

• The consumer’s equilibrium condition is geometrically illustrated at point E, where MUx = Px.
• The equilibrium price is given at OP.
• The consumer will buy OQ quantity of X in order to maximise his utility.
• Total gain falls if more is purchased after equilibrium.

Consumer’s Equilibrium with Indifference Curve
Approach
An indifference curve shows different combinations of two goods that yield the
same level of utility or satisfaction to the consumer.
Assumptions:
1. Rationality: The consumer is assumed to be rational. He aims at maximising
his benefits from consumption, given his income and prices of the goods.
2. Ordinality: Utility is expected satisfaction that a consumer gets from a given
market basket. In indifference curve analysis, utility is an ordinal concept.
Consumer can order or rank the subjective utilities derived from the
commodities.

3. Diminishing Marginal Rate of Substitution:
• Indifference curves are downward sloping
• Convex-to-the origin curves.
• The slope of indifference curve is called Marginal Rate of Substitution (MRS) of X for Y.
• MRS is defined as the amount of good Y the consumer is willing to give up to consume an
additional unit of good X, while leaving total utility unchanged.
• An important assumption is that the MRS of X for Y, decreases with greater quantities of good X,
i.e. the greater the quantities of X, the less willing the consumer will be to give up Y in exchange
for X.
• This relationship is known as the Law of Diminishing Marginal Rate of Substitution.

4. Consistency of Choice. Consumer is consistent in his choice. It means that if good X is
preferred over good Y in one time period, then consumer will not prefer Y over X in another
time period.
5. Transitivity of Choice. Consumer’s choices are characterized by the property of
transitivity. If good X is preferred to good Y and good Y is preferred to good Z, then good X is
preferred to good Z or x > z.
6. Monotonic Preference. A consumer’s preferences are monotonic if and only if between
any two bundles, the consumer prefers the bundle which has more of at least one of the goods
and no less of the other good as compared to the other bundle.

Properties or Features of Indifference Curve
1. Downward Sloping to the Right. It is because if the quantity of one
good is reduced then the quantity of the other good is increased.
Thus, indifference curve must be downward sloping to the right.
2. Convex to the Origin. An indifference curve is convex to the origin
because of diminishing marginal rate of substitution.

Properties or Features of Indifference Curve
3. Two Curves do not Intersect each other:
• Points A and B lie on the same indifference curve I1. So, the consumer must
be indifferent between them.
• By the same logic consumer must be indifferent between points B and C lying
on I2.
• By the assumption of transitivity, consumer must be indifferent between point
A and C.
• On Comparing points A and C, C is better than A as it has more units of good Y.

4. A higher indifference curve represents a higher level of satisfaction.
A higher indifference curve shows a higher level of satisfaction, it is because of the assumption that preferences are
monotonic.
Since higher indifference curve represents more quantities of one or both goods, a higher indifference curve shows
higher utility level.

Budget Line
• It shows all combination of Good X & Y that a consumer can buy with
his given income and prevailing prices of the good
M=Px.Qx + Py. Qy
• If Qx = 0, then Qy = M/Py
• If Qy = 0, then Qx = M/Px
• Slope of Budget Line = OY/ OL
=M/Py / M/Px
=Px/ Py

Consumer Equilibrium through Indifference
Curve Approach
• Slope of Indifference Curve= Slope of Budget Line
Or
MRSxy = Px/Py
• Diminishing MRS

IC = Indifference Curve
AB = Budget Line
Point E = Budget Line is tangent to IC2 and is the equilibrium point.
This is because if the consumer moves away from Point E to suppose Point G, then the consumer is on lower IC1 which
will give consumer lower satisfaction.
Also at Point G, MRS < Px/Py.
So the consumer will move back to Point E
Also if the consumer is at Point F, then the consumer is again on lower IC1 which will give consumer lower
satisfaction.
Also at Point F, MRS > Px/Py.
So the consumer will move back to Point E
At Point E, MRSxy = Px/Py and MRS is diminishing

Demand
• Demand refers to entire relationship between price and quantity.
• Demand for a commodity is defined as the quantity of that
commodity which a consumer is willing to buy at a particular price
during a particular period of time.
• For example: a consumer demands 2 kg of wheat in a month at the
price of ` 20 per kg is a demand statement. This is a complete
example of demand for a commodity as it has all the three
components of demand—quantity, price and time.

Features of Demand
(a) Demand depends upon utility of the commodity. A consumer is
rational and demands only those commodities which provide utility.
(b) Demand always means effective demand i.e., demand for a
commodity or the desire to own a commodity should always be backed
by purchasing power and willingness to spend.
(c) Demand is a flow concept, i.e., so much per unit of time.
(d) Demand means demand for final consumer goods.

Demand Function
Dx = f (Px, Pz,Y, T, E, N, Yd )
Where,
Dx = Demand for commodity X
Px = Price of commodity X
Pz = Prices of related goods
Y = Income of consumer
T = Taste and preferences of consumer
E = Future expectation
N = No. of consumers
Yd = Distribution of income

Factors affecting individual demand for a good
1. Price of the Commodity: There is inverse relationship between price
of a commodity and demand for a commodity.
2. Prices of Other Goods: Demand for good x is influenced by the prices
of other good (z). It is called cross price demand.
Dx = f (Pz), ceteris paribus
The relationship depends upon the relation between two goods x and z.
Two situations can arise:
(a) When X and Z are Substitutes: Substitute goods are those which are

Example. If the price of tea rises from Rs 200 to Rs 250 per kg it would cause an increase in demand
for coffee from C1 units to C2 units at price OP1. Fig. illustrates a rightward shift in the demand
curve to coffee from d to d1 when the goods tea and coffee are substitutes.
An increase in the price of a substitute good increases the quantity demanded of the other good. If
there is an increase in the price of a substitute good, the demand curve shifts rightward.
Thus, demand for a good usually moves in the same direction to a change in price of its
substitutes.

(b) When X and Z are Complements: Complementary goods are those which are jointly used or
consumed together to satisfy a want.
Examples are: tea and sugar; car and petrol; pen and ink; bread and butter; cigarettes and cigarette
lighter; compact disc player and compact discs.
Example. If price of petrol rises from Rs 35 to 40 a litre, then quantity demanded of car will reduce
from C1 to C2 units at price of rate OP1, other things remaining the same. This is graphically shown in
Fig. There is a leftward shift of the demand curve of car from d to d1 when the two goods are
complementary. That is, if there is increase in the price of complementary good, the demand curve
shifts leftward.
Thus, demand for a good moves in the opposite direction to a change is price of its
complementary good.

3. Income of the Consumer
Changes in money of the consumer changes the budget constraint facing the consumer, causing him
to change his demand for goods. It is called income demand. Symbolically,
DX = f (Y), ceteris paribus
How a change in the income will affect the demand for a good depends upon the type of the good:
(a)If x is a normal good then with an increase in income, consumer buys more of the good. Goods
whose demand rises when income rises are called normal goods. Example: clothes, books, etc.
(b) If x is an inferior good then an increase in income causes its demand to decrease. This is because
as income rises, purchasing power rises and consumers substitute more superior goods for inferior
goods. Goods whose demand falls when income rises are called inferior goods. Example: Coarse
cereals.

4. Consumer’s Tastes and Preferences
Any change in consumer’s tastes causes demand to change. If there is a change in tastes in favour of a
good, then it will lead to increase in demand and any unfavourable change will lead to decrease in
demand.

5. Future Expectations of Buyers
Future expectation is also one of the factor which causes change in demand. If it is expected by the
consumer that the price of the commodity will rise in future, he will start buying more units of the
commodity in the present, at the existing price. Similarly, if he expects that price will fall in future, he
will buy less quantity of the commodity in the

Law of Demand
There is a definite inverse relationship between the price of the good
and the quantity demanded of that good if other things remain
constant. Symbolically,
Dx = f (Px), ceteris paribus
where,
Dx = Quantity demanded of good X
Px = Price of the good X

Assumptions:
(a) The price of the related goods remains the same.
(b) The income of the consumers remains unchanged.
(c) Tastes and preferences of the consumers remain the same.
(d) All the units of the goods are homogeneous.
(e) Commodity should be a normal good.

Reasons behind Downward Slope of the
Demand Curve
(a) Law of Diminishing Marginal Utility: This law was formulated by Marshall and it
states that as the consumer has more and more of a good its marginal utility to him
goes on declining. A consumer is not interested in buying more units of the same
commodity at the same price. Instead, he is ready to pay a price equal to his
marginal utility and marginal utility goes on diminishing. In other words, consumer
is willing to pay a lesser price for more units of a good. This implies that demand
curve is downward sloping.

(b) Substitution Effect:
Substitution effect means with fall in the price of a good, consumer feels a rise in
relative price of other goods, which in turn leads to more demand for the good. When
the price of a good rises, consumer buys more of substitute goods and less of the good
whose price has risen. This shows inverse relationship between price and quantity
demanded.
Substitution effect is defined as change in the optimal quantity of a good when its price
changes and the consumer’s income is adjusted so that consumer can just buy the bundle
he was buying before the price change.

(c) Income Effect. Income effect means with fall in the price of a good, consumer’s real income or purchasing power
rises and he demands more units of the good (normal good). Thus, when price falls, demand rises. Income effect is
defined as the change in the optimal quantity of a good when the purchasing power changes consequently upon a change in
the price of the good.
(d) New Consumers Creating Demand. As price of a commodity falls, new consumer class appears, who can now afford
the commodity. Thus, the total demand for the commodity increases, i.e., with fall in price, quantity demanded rises.

Exceptions to the Law of Demand
1. Giffen Goods: The good is name after Sir Robert Giffen. Giffen good is necessarily an inferior good
with very high negative income elasticity of demand. The good is consumed by low paid wage
earners who spend a large proportion of their income to buy it. Examples of giffen good s are jowar
and bajra. In case of giffen goods, the demand curve is upwards sloping.
2. Veblen Goods: The good is name after Thornstein Veblen. Veblen goods are prestigious good or
goods with status symbol. It promotes social prestige of the holder. Examples: diamonds. Diamonds
and other precious stones are all status goods. Higher the price, more is the demand for them.
3. Expectation of Price rise in future: Buyer’s expectations about price dominate their buying
behavior. If prices rises and buyer expect further rise in price then it causes increase in the quantity
brought at higher prices. The reverse also holds true. This is specially true in case of shares.
4. Bandwagon Effect: Bandwagon Effect refers to a kind of demonstration effect shown by a section of
society which tends to imitate the consumption pattern of higher income groups or some popular film
star or some charismatic personality. In this case, the law of demand gets violated because people
demand more of that commodity which the upper class are buying, even at higher prices. For
example, teenagers are obsessed to copy the consumption habits of their favorite film stars.

5. Emergency: in case of emergencies like war, flood, drought or famine, the law of demand doesn’t hold true. In
such cases, there is a general insecurity and fear of shortage of necessities. Hence, consumers demand more good
even at higher prices.
6. Good with uncertain product quality: For some goods prices act as signals of its quality. Examples: marble
stones is available at many similar qualities but their prices vary drastically. People demand more of a good at
higher prices since it means better quality to them.
7. Snob Appeal: certain items of historical, cultural and sociological importance have a snob appeal. Examples of
items of snob appeal are classic pieces of art, antique, sculptures, original manuscript etc. whenever these items
are auctioned in the market, their demand rises with rise in prices.
8. Brand loyalty: consumers shows some kind of attachment to the product due to brand loyalties. The consumers
like the product to such an extend that their demand does not fall even if their prices rise.

Market Demand
Market Demand is the aggregate of the quantities demanded by all consumers in the
market at different prices per time period.
Factors affecting market demand are:
1. To 5. as Individual Demand
6. Number of Consumers in the Market: More the consumers in the market, more will
be the market demand for the commodities.
7. Distribution of Income: More even the distribution of income in a country, more will
be the market demand for the commodity.
8. Age and Gender Composition of Population: The age group and gender composition
of the consumers decide the pattern of market demand.

Change in Quantity Demanded (Movement)
• Movement: Change in Quantity Demanded
• A movement along the demand curve is caused by a change in the price
of the good, other things remaining constant. It is also called change in
quantity demanded of the commodity.
• Movement is always along the same demand curve, i.e., no new demand
curve is drawn. Movement along a demand curve can bring about:

Change in Demand (Shift) of Demand Curve
A shift of the demand curve is caused by changes in factors other than price of
the good. A change in factors causes shift of the demand curve. It is also called
change in demand. In a shift, a new demand curve is drawn. A shift of the
demand curve can bring about:
(a) Increase in demand, or
(b) Decrease in demand

(a) Increase in Demand. It refers to more demand at a given price. The causes of increase in demand are:
(i) Increase in the income of the consumers in case of normal goods.
(ii) Decrease in the income of the consumers in case of inferior goods.
(iii) Increase in the price of substitute goods.
(iv) Fall in the price of complementary goods.
(v) Consumers’ taste becoming stronger in favour of the good.
(b) Decrease in Demand. It refers to less demand at the given price. It occurs due to unfavourable changes in
factors other than the price of the good. The causes of decrease in demand are:
(i) Fall in the income of the consumers in case of normal goods.
(ii) Rise in the income of the consumers in case of inferior goods.
(iii) Fall in the price of substitute goods.
(iv) Rise in the price of complementary goods.
(v) Consumers’ taste becoming unfavourable towards the good.

Measurement of Price Elasticity
A. Outlay or Expenditure Method: When price of good changes,
it brings changes in total revenue.
1. Elastic demand (E > 1): Qty demanded increases in greater
proportion to fall in price, TE increases. P & TE are moving in
opposite direction.
3 P 2
2 Q 5
6 TE 10
2. Unitary elasticity (E = 1): Qty demanded increases in equal
proportion to fall in price, TE remains unchanged. With increase

Measurement of Price Elasticity
A. Outlay or Expenditure Method: When price of good changes, it brings
changes in total revenue.
1. Elastic demand (E > 1): Qty demanded increases in greater proportion to
fall in price, TE increases. P & TE are moving in opposite direction.
2. Unitary elasticity (E = 1): Qty demanded increases in equal proportion to
fall in price, TE remains unchanged. With increase in Price, there is no
change in TE.
3. Inelastic demand (E <1): Qty demanded increases in less than proportion
to fall in price, TE falls. P & TE are moving in same direction.

2. Inelastic demand (0<e<1): ∆P >∆Q

3. Unitary elastic demand (e=1): ∆P =∆Q

4. Elastic demand (e>1): ∆P <∆Q

5.Perfectly Elastic demand (e = ∞): ∆Q/∆P = ∞

Factors affecting Price Elasticity of Demand
1. Availability and closeness of substitutes
• Close Substitute will have elastic demand (e.g. coke. Pen, etc)
• No close Substitute will have inelastic demand (e.g. medicines, cigarettes)
• Demand of salt is inelastic but demand of Tata salt is elastic because of
Aashirvad brand of salt
2. Adjustment time and availability of substitutes
• Longer the time available for adjustment, more elastic is the demand and vice
versa
• Example: flying by aeroplane has inelastic demand as no substitutes are

3. Luxuries V/S necessities
• The price elasticity of demand is likely to be low for necessities and high for luxuries. A necessity is a
good or service that the consumer must have such as food (bread, milk) and medicines.
• If the price of necessities rise, then demand will not fall by a greater proportion because their purchase
cannot be delayed. That is why, the price elasticity of demand in case of necessity is low.
4. Cost relative to total income
• Higher the cost of the good relative to total income of the consumer, more will be the price elasticity of
demand.
• If the price of bread, ink, salt, match box, etc., which is relatively low, doubles it would have almost no
effect on the quantity demanded of them.
• On the other hand, if price of car doubles then the quantity demanded will fall by a greater proportion
showing high price elasticity of demand.

5. No. of uses of purchased commodity
• The more the number of uses a commodity can be put to, the more elastic is the demand. If a
commodity has few uses, it has an inelastic demand.
• Examples: goods like milk, eggs and electricity can be put to many different uses and hence, enjoy
elastic demand, i.e., when prices are low, demand increases by a greater proportion as the goods
can now be put to less important uses also.
6. Price Level
• If the price of the commodity is high, then a further rise in the price will lead to greater fall in its
quantity demanded.
• Price elasticity of demand is more.

Value of Ey Type of good
Ey > 1, High Income Elasticity Luxury Goods
Ey = 1, Unitary Income Elasticity Normal Goods which is a necessity as
well as semi luxurious
0<Ey<1, Low Income Elasticity Necessity
Ey= 0, Zero Income Elasticity Between a necessity and inferior good
Ey < 0, Negative Income Elasticity Inferior good

Cross- Price Elasticity of Demand

Value of Exz Relation between Good X & Z
Exz = +∞ Perfect Substitutes
Exz > 0 Substitutes
Exz = 0 Unrelated
Exz < 0 Complementary
Exz = -∞ Perfect Complementary

Supply
• Supply of a commodity means quantity of the commodity which a
firm is willing to sell at a given price during a particular time.
• Example. Firm A supplies 50 kg of wheat at price of Rs 10 per kg in a
month is a statement of supply.

The Law of Supply
• According to the law of supply, other things remaining the same,
quantity supplied of a commodity is directly related to the price of
the commodity
• Symbolically, the law of supply is expressed as:
Sx = f (Px), ceteris paribus
where,
Sx = Quantity Supplied of good X
Px = Price of the good X

Assumptions of the Law of Supply. The law of supply is based on the assumption that
all factors, other than the price of the commodity, that affect the supply remain the same.
These are following:
1. Prices of the related good should remain unchanged.
2. Prices of factors of production (i.e., prices of inputs) should remain unchanged.
3. Level of technology should remain unchanged.
4. Government policy regarding taxation should remain unchanged.
5. Goals of the firm should remain unchanged.

Supply Function
Sx = f (Px, Pz, T, C, GP)
where, Sx = Supply of commodity X
f = function of
Px = Price of commodity X
Pz = Price of related good, Z
T = Technological changes
C = Cost of production or price of inputs
GP = Government policy or excise tax rate.

Factors affecting supply of a commodity
1. Price of the Commodity: Producer offers more quantity of the commodity
for sale at a higher price and less quantity of the commodity is offered for
sale at a lower price. There is a direct relationship between price and
quantity supplied as shown by law of supply.
2. Price of Related Good (Z): If the price of a commodity remains constant
and the price of its substitute good Z increases, the producers would
prefer to produce substitute good Z. As a result, the supply of commodity
X will decrease and that of substitute good Z will increase. Thus, an
increase in the price of substitute good will lead to decrease in supply
curve of the other good and vice-versa.
If the price of petrol (complementary good) rises, supply of car will fall.

3. State of Technology
If there is an upgradation in the technique of production or new discovery, it will lead to a fall in the cost of
production. Thus supply of commodity will increase.
4. Prices of Inputs/ Cost of Production
A change in the cost of production, i.e., prices of factors of production will also affect the supply of a
commodity.
If wages of labour or price of raw materials increase, then MC (marginal cost) of production will rise.
As a result, supply of the good will fall because producers would prefer to produce some other commodities
that can be produced at a lower cost.
Thus, an increase in input price or cost will shift the supply curve to the left (decrease in supply) and vice-versa.

5. Government Policy
Government’s policy also affects the supply of a commodity.
If heavy excise taxes are imposed on a commodity, it will discourage producers and as a result, its supply will
decrease.
(This is because excise duty is levied on the total production cost of a firm. And an increase in excise duty will
raise firm’s total variable cost, which will raise MC curve. MC curve will shift to the left. Thus, supply curve
will also shift to the left.) Thus, an increase in excise tax will shift the supply curve to the left and vice-versa.
If subsidies are granted by the government to the producers, then producer’s MC will fall and supply will
increase.

Reasons Behind Upward Sloping Supply Curve
(a) Law of Diminishing Marginal Productivity: The law states that as
more units of the variable factor are employed, the addition made to
total production falls, i.e., cost of production rises. Thus, more quantity
is supplied only at higher prices so as to cover the rise in cost of
production.
(b) Goal of Profit Maximization: The aim of producers is to maximize
profits. The aim can be achieved by raising the price of the goods. At
higher price producers increase the supply of the goods.

Change in Quantity Supplied (Movement)
• A movement along the supply curve is caused by changes in the price
of the good, other things remaining constant. It is also called change
in quantity supplied of the commodity. In a movement, no new
supply curve is drawn.
• Movement along a supply curve can bring about:
(a) Expansion or extension of supply, or
(b) Contraction of supply.

• Expansion or extension of supply refers to rise in supply due to rise in price of the good.
• Contraction of supply refers to fall in supply due to fall in price of the good.

Change in Supply (Shift)
• A change (or shift) in supply curve is caused by changes in factors
other than the price of the good.
• In a shift, a new supply curve is drawn. A shift of the supply curve can
bring about:
(a) Increase in supply, or
(b) Decrease in supply.

(a) Increase in Supply (i.e., Rightward shift in supply curve)
When supply of a commodity rises due to favourable changes in factors other than price of the commodity, it is called
increase in supply. Favourable changes imply:
(i) Improvement in technique of production
(ii) Fall in the price of related goods
(iii) Fall in the prices of inputs
(iv) Fall in excise tax
Increase in supply means more quantity supplied at the same price. It also means that same quantity supplied at a lower
price.
SS is the original supply curve. An increase in supply is shown by rightward shift of the supply curve from SS to S1S1.
An increase in supply shows that:
(i) either at the original price of Rs10, more units (30 units) of the good are supplied. In the original situation 20 units were
supplied.
(ii) or same units (20 units) are supplied at a lower price of Rs 5.

(b) Decrease in Supply (i.e., Leftward shift in supply curve)
When supply of a commodity falls due to unfavourable changes in factors other than its price, it is called
decrease in supply. The causes of decrease in supply are:
(i) Obsolete technique of production
(ii) Increase in the price of related goods
(iii) Increase in the prices of inputs
(iv) Rise in excise tax.
Decrease in supply means less quantity is supplied at the same price. It also means that same
quantity is supplied at a higher price.
In the figure, SS is the original supply curve. A decrease in supply is shown by leftward shift of the supply curve from SS
to S1S1. A decrease in supply shows that:
(i) either at the original price of Rs 10, lesser units (10 units) of the good are supplied. In the original situation 20 units
were supplied.
(ii) or same units (20 units) are supplied at a higher price of Rs 20.

Types of Elasticity of Supply
• Perfectly Elastic Supply (Es= ∞)

Unitary Elastic Supply (Es = 1)

Perfectly Inelastic Supply (Es = 0)

Consumer Surplus
• This concept of Consumer Surplus was given by Marshall
• Alfred Marshall, define consumer’s surplus as follows: “Excess of the price
that a consumer would be willing to pay rather than go without a
commodity over that which he actually pays.”
• Hence, Consumer’s Surplus = The price a consumer is ready to pay – The
price he actually pays
• Further, the consumer is in equilibrium when the marginal utility is equal to
the price. That is, he purchases those many numbers of units of a good at
which the marginal utility is equal to the price. Now, the price is fixed for all
units. Hence, he gets a surplus for all units except the one at the margin.
This extra utility is consumer surplus.

Let us take a look at an example of consumer surplus.
• There is a marginal increase in the consumption of units and simultaneously the marginal utility falls.
• Now, Marginal utility is the price the consumer is willing to pay for that unit
• And the actual price of the unit is fixed at Rs 4
• Therefore, the consumer enjoys a surplus on all purchases until the fourth unit. When he buys the fourth unit, he is in
equilibrium, since the price he is willing to pay is equal to the actual price of the unit.
UNITS MU PRICE CONSUMER
SURPLUS
1 10 4 10-4 = 6
2 8 4 8-4 = 4
3 6 4 6-4 = 2
4 4 4 4-4 = 0

Applications of demand and supply –tax floor and
ceilings
• Equilibrium is achieved when the quantity demanded by the
consumers of a certain commodity is equal to the quantity supplied
by the producers of that commodity.

Market Equilibrium
• A market is said to have reached equilibrium price when the supply of
goods matches demand.
• Disequilibrium is the opposite of equilibrium and it is characterized by
changes in conditions that affect market equilibrium.

Shifts in Demand and Supply
• While determining EP, demand and supply conditions were assumed
to be constant.
• But in real life factors continue to affect both demand and supply and
there may be shift of only demand curve or shift of supply curve or
simultaneous shift of both demand and supply curve

Change in demand
Change in demand refers to an increase (or decreases) in demand following a rise (or fall) in consumer’s money
income, tastes and preferences, etc. Under the circumstances, own price of the commodity remains fixed. Thus,
change in demand means shifting of the demand curve—either in the upward or in the downward direction.
In the figure below, we have shown how equilibrium price and quantity change when demand curve shifts. In Fig.
(a) initial price and quantity determined by the intersection of DD and SS curves are OP and OQ, respectively.
If demand increases, demand curve will shift to D1D1 and the new equilibrium price will rise to OP1and quantity
demanded and supplied will increase to OQ1. Similarly, when demand curve shifts downward to D2D2, price and
quantity decline to OP2 and OQ2, respectively.
In Fig. (b), the supply curve has been assumed to be perfectly elastic. Initial equilibrium price and quantity are
represented by OP and OQ, respectively. Now an increase or decrease in demand will not cause equilibrium price
(OP) to change. An increase in demand will only cause equilibrium quantity to rise to OQ1.
If the supply curve is drawn perfectly inelastic [as in Fig. (c)] an increase in demand will cause price to rise to OP1.
Equilibrium quantity will remain the same (OQ).

Change in supply
By change in supply, we mean shifting of the supply curve. If supply increases (or decreases) supply curve will
shift rightward (or leftward). In Fig. (a), OP* is the initial equilibrium price and OQ* the equilibrium quantity
Now, suppose supply increases and the new supply curve S1S1 intersects the demand curve. As a result,
equilibrium price drops to OP1 and the equilibrium quantity demanded and supplied increases to OQ2. Similarly, a
fall in supply results in an opposite effect.
In Fig. (b), the intersection between perfectly elastic demand curve and the SS supply curve determines equilibrium
price OP* and equilibrium quantity OQ*. As supply increases, supply curve shifts to S1S1. As a result, equilibrium
quantity rises to OQ1, but equilibrium price remains unchanged at OP*.In Fig.(c), a perfectly inelastic demand
curve has been drawn.
Initial equilibrium price and quantity are OP* and OQ*, respectively. Increase in supply means shifting of the
supply curve to S1S1. However, new equilibrium price declines to OP1, while equilibrium quantity remains
stationary at OQ*.

Change in Both Demand and Supply
Finally, if both demand and supply increase (or decrease) by the same amount equilibrium price will remain unchanged at OP*,
but equilibrium quantity will increase (decrease) as shown in Fig. (a). If increase in supply is greater than the increase in
demand as in Fig. (b), new equilibrium price will be lower than the initial price.
Equilibrium quantity will increase. Or if increase in demand is greater than the increase in supply as in Fig. (c), equilibrium
price and equilibrium quantity will be higher than the initial situation.
Increase in demand and decrease in supply will lead to an increase in price [Fig.(d)], but equilibrium quantity may increase or
decrease. However, equilibrium quantity may remain unchanged at OQ* if increase in demand is offset by a decrease in supply
by the same amount.
Same conclusion holds if decrease in demand and increase in supply take place [Fig. (e)]. Anyway, how much equilibrium
quantities and equilibrium price will undergo a change largely depends on the elasticities of demand and supply.

Applications of Demand and Supply in Tax
How taxes on buyers affect market outcomes?
• We first consider a tax levied on buyers of a good. Therefore, initial impact of the taxis is on the demand of a good.
• The supply curve is not affected because, for any given price of a good, sellers have the same incentive to provide a good to
the market.
• By contrast, buyers now have to pay tax to the government whenever they buy the good. Thus the tax shifts the demand
curve for that good. Because the tax on buyers makes buying the good less attractive, buyers demand a smaller quantity of
the good at every price. As a result the demand curve shifts to the left.
• Having determined how the demand curve shifts, we can now see the effect of the tax by comparing the initial equilibrium
and the new equilibrium.
• Because sellers sell less and buyers buy less in the new equilibrium, the tax on the good reduces the size of the goods
market.
• To sum up, the analysis yields two lessons:
 Taxes discourage market activity. When a good is taxed, the quantity of the good sold is smaller in the new
equilibrium.
 Buyers and sellers share the burden of takes. In the new equilibrium, buyers pay more for the good and sellers receive
less.

How taxes on sellers affect market outcomes?
Now we consider a tax levied on sellers of a good. In this case, the immediate impact of the tax is on the sellers. Because
tax is not levied on buyers, the quantity demanded at any given price is the same, thus, the demand curve does not
change. By contrast, the tax on sellers makes the business less profitable at any given price, so it shifts the supply curve.
Because the tax on sellers raises the cost of producing and selling the good, it reduces the quantity supplied at every
price. The supply curve shifts to the left. The equilibrium price rises and the equilibrium quantity falls. Once again, taxes
reduce the size of the market. And once again buyers and sellers share the burden of the tax.
In both cases the tax places a wedge between the price that buyers pay and the price the sellers receive. The wedge
between the buyers price and the sellers price is the same, regardless of whether the tax is levied on buyers or sellers. In
either case, the wedge shifts the relative position of the supply and demand curves.
In the new equilibrium, buyers and sellers share the burden of the tax. The only difference between taxes on buyers and
taxes on seller is who sends the money to the governmen

How price ceilings affect market outcomes?
A legal maximum on the price at which a good can be sold is called a price ceiling.
When the government imposes a price ceiling on the market, two outcomes are possible. If the equilibrium price is lower
than the ceiling, the price ceiling is not binding. Market can naturally move the economy to the equilibrium and the price
ceiling has no effect on the price or the quantity sold.
If the government imposes a price ceiling lower than the equilibrium, the ceiling is a binding constraint on the market. The
forces of supply and demand tend to move the price towards the equilibrium price, but when the market price hits the
ceiling, it can rise no further. Thus, the market price equals the price ceiling. At this price, the quantity demanded exceeds
the quantity supplied. A shortage develops and the buyers do get to pay a lower price, but some buyers can’t buy the good
at all. In other words, when government imposes a binding price ceiling on a competitive market, a shortage of the good
arises and sellers must ration the scarce goods among the large number of potential buyer. The rationing mechanisms that
develop under a price ceiling are rarely desirable.

How price floor affect market outcomes?
A legal minimum on the price at which a good can be sold is called a price floor.
Price floors, like price ceilings, are an attempt by the government to maintain prices at other than equilibrium levels.
Whereas price ceilings place a maximum on prices, a price floor places a legal minimum.
If the price floor is underneath the equilibrium, the price floor is not binding. Market forces naturally move the economy to
the equilibrium and the price floor has no effect.
If the equilibrium price is below the floor, the price floor is a binding constraint on the market. The forces of supply and
demand tend to move the price towards the equilibrium price, but when the market price hits the floor, it can fall no further.
The Market price equals the price floor. At this floor, the quantity supplied exceeds the quantity demanded. A binding price
floor causes a surplus. In the case of the price floor, some sellers are unable to sell all they want at the market price.
Evaluating price controls to economists, prices are not the outcome of some haphazard process. Prices, they contend, are
the result of the millions of business and consumer decisions that lie behind the supply and demand curves. Prices have the
crucial job of balancing supply and demand and, thereby, coordinating economic activity.
Policy makers are led to control prices because they view the market’s outcome as unfair. Price controls are often aimed at
helping the poor. But price controls often hurt those they are trying to help.

Applications of indifference curves-tax
• An important application of indifference curves is to judge the welfare
effects of direct and indirect taxes on the individuals. In other words,
if the Government wants to raise a given amount of revenue whether
it will be better to do so by levying a direct tax or an indirect tax from
the view point of welfare of the individuals.
• We shall study below that indirect tax (such as excise duty) causes
excess burden on the individuals, i.e. indirect tax reduces welfare
more than the direct tax (say income tax) even when an equal
amount of revenue is raised through them.

• Consider the figure where on the X-axis, good X and on the Y-axis money/ money income is measured. With a given
income of the individual and the given price of good X, the price line is PL1 which is tangent to indifference curve IC3 at
point Q3 where the individual is in equilibrium position.
• Suppose now that Government levies an excise duty (an indirect tax) on good X. With the imposition of excise duty, the
price of good X will rise. As a result of the rise in price of good X, the price line rotates to a new position PL2 which is
tangent to indifference curve IC1 at point Q1.
• It is thus clear that as a result of the imposition of excise duty, the individual has shifted from a higher indifference
curve IC3 to a lower one IC1, that is, his level of satisfaction or welfare has declined. It is worth noting that the
movement from Q3 on indifference curve IC3 to Q1 on indifference curve IC1 is the combined result of the income effect
and substitution effect caused by the excise duty.
• It should be further noted that at point Q1 (that is, after the imposition of excise duty) the individual is purchasing ON
amount of good X and has paid PM amount of money for it. At the old price (before the excise duty was imposed), he
could purchase ON quantity of good X for PT amount of money.
• Thus, the difference TM (or KQ1) between the two is the amount of money which the individual is paying as the excise
duty

(NOTE: Direct taxes are those taxes whose incidence cannot be shifted to others. Lump sum tax, proportionate and
progressive income taxes, wealth tax, death duty are the examples of direct tax. On the other hand, an indirect tax is one
which can be passed on or shifted to others by raising the prices of the goods. The excise duty, sales tax are the
examples of indirect tax)
• Now, suppose that instead of excise duty, Government levies a direct tax of the type of lump-sum tax on the
individual when the individual is initially at point Q3 on indifference curve IC3. With the imposition of lump sum tax,
the price line will shift below but will be parallel to the original price line PL1.
• Further, if the same amount of revenue is to be raised through lump-sum tax as with the excise duty, then the new
price line AB should be drawn at such a distance from the original price line PL1 that it passes through the point Q1.
So, it will be seen from Figure that with the imposition of lump sum tax equivalent in terms of revenue raising to the
excise duty, we have drawn the budget line AB which is passing through the point Q1.
• However, with AB as the price line, individual is in equilibrium at point Q2 on indifference curve IC2 which lies at a
higher level than IC1. In other words, at point Q2 individual’s level of welfare is higher than at Q1. Lump-sum tax has
reduced the individual’s welfare less than that by the excise duty. Thus, indirect tax (excise duty) causes an excess
burden on the individual.

• Now, the important question is why an indirect tax (an excise duty or a sales tax on a commodity) causes excess
burden on the consumer in terms of loss of welfare or satisfaction. The basic reason for this is that whereas both
the lump-sum tax (or any other general income tax) and an indirect tax reduce consumer’s income and produce
income effect, the indirect tax in addition to the income effect, also raises the relative price of the good on which
it is levied and therefore causes substitution effect.
• The imposition of a lump-sum tax (or any income tax) does not affect the prices of goods because it is not levied
on any saleable goods. Since lump-sum tax or any income tax does not alter the relative prices of goods it will not
result in any substitution effect.
• With the imposition of a lump-sum tax (or any other income tax), a certain income is taken away from the
consumer and he is pushed to the lower indifference curve (or a lower level of welfare) but he is free to spend the
income he is left with as he likes without forcing him to substitute one commodity for another due to any change
in relative price.

• Thus, in the Figure, imposition of an equivalent lump-sum or income tax, the consumer moves from the
equilibrium position Q3 on indifference curve IC3 to the new position Q2 on indifference curve IC2 which
represents the income effect.
• On the other hand, an indirect tax not only reduces the purchasing power or real income of the consumer causing
income effect, but also produces price-induced substitution effect and thus forcing him to purchase less of the
commodity on which indirect tax has been levied and buy more of the non-taxed commodity.
• And this later substitution effect caused due to the price-distortion by the indirect tax further reduces his welfare.
As will be seen from Figure, as a result of income effect of the indirect tax the consumer moves from point Q3 on
indifference curve IC3 to point Q2 on lower indifference curve IC2 and as a result of substitution effect he is
further pushed to point Q1 on still lower indifference IC1.

Applications of indifference curves-work
• Indifference curve analysis can be used to explain an individual’s
choice between income and leisure and to show why a overtime
wage rate must be paid if more hours of work are to be obtained from
the workers.
• Income is earned by devoting some of the leisure time to do some
work. That is, income is earned by sacrificing some leisure. The
greater the amount of this sacrifice of leisure, that is, the greater the
amount of work done, the greater income an individual earns.

• Further, income is used to purchase goods, other than leisure for consumption.
• In economics leisure is regarded as a normal commodity, the enjoyment of which yields satisfaction to the
individual.
• While leisure yields satisfaction to the individual directly, income represents general purchasing power
capable of being used to buy goods and services for satisfaction of various wants. Thus income provides
satisfaction indirectly. Therefore, we can draw indifference curves between income and leisure both of which
give satisfaction to the individual.
• An indifference map between income and leisure is depicted in Figure below and has all the usual properties
of indifference curves. They slope downward to the right, are convex to the origin and do not intersect. Each
indifference curve represents various alternative combinations of income and leisure which provides equal
level of satisfaction to the individual and the farther away an indifference curve is from the origin, the higher
the level of satisfaction it represents for the individual.

• The slope of the indifference curve measuring marginal rate of substitution between leisure and income
(MRSLM ) shows the tradeoff between income and leisure. This trade-off means how much income the
individual is willing to accept for one hour sacrifice of leisure time. In geometric terms, it will be seen
from Figure 11.14 that on indifference curve IC1 at point A the individual is willing to accept ∆M income for
sacrificing an hour (∆L) of leisure.
• Thus the trade-off between income and leisure at this point is ∆M/∆L. At different income-leisure levels, the
trade-off between leisure and income varies. Indifference curves between income and leisure are therefore
also called trade-off curves.

Income-Leisure Constraint:
• The actual choice of income and leisure by an individual would also depend upon what is the market rate of
exchange between the two, that is, the wage-rate per hour of work.
• Wage rate is the opportunity cost of leisure. In other words, to increase leisure by one hour, an individual
has to forego the opportunity of earning income (equal to wage per hour) which he can earn by doing work
for an hour.
• The maximum amount of time available per day for the individual is 24 hours. Thus, the maximum amount
of leisure time that an individual can enjoy per day equals 24 hours.
• In order to earn income for satisfying his wants for goods and services, he will devote some of his time to
do work. Consider Figure below where leisure is measured in the rightward direction along the horizontal
axis and the maximum leisure time is OT (equal to 24 hours).

• If the individual can work for all the 24 hours in a day, he would earn income equal to OM. Income OM
equals OT multiplied by the hourly wage rate (OM = OT*w) where w represents the wage rate. The straight
line MT is the budget constraint, which in the present context is generally referred to as income-leisure
constraint and shows the various combinations of income and leisure among which the individual will have
to make a choice.
• Thus, if a person chooses combination C, this means that he has OL1 amount of leisure time and OM1
amount of income. He has earned OM1 amount of income by working TL1 hours of work. Choice of other
points on income-leisure line MT will show different amounts of leisure, income and work.
• Income, OM= OT*w
i.e. OM/OT = w
• Thus, the slope of the income-leisure curve OM/OT equals the wage rate.

Income-Leisure Equilibrium:
• Now, we can bring together the indifference map showing ranking of preferences of the individual between income
and leisure, and the income-leisure line to show the actual choice of leisure and income by the individual in his
equilibrium position.
• We will further show how much K work effort (i.e. supply of labour in terms of hours worked) he would put in this
optimal M situation. Our analysis is based on two assumptions. First, he is free to work as many hours per day as he
likes. Second, wage rate is the same irrespective of the number of hours he chooses to work.
• Figure below displays income-leisure equilibrium of the individual. With the given wage rate, the individual will
choose a combination of income and leisure lying on the income-leisure line MT that maximises his satisfaction.
• It will be seen from Figure above that the given income-leisure line MT is tangent to the indifference curve IC2 at
point E showing choice of OL1 of leisure and OM1 of income. In this optimal situation, income- leisure trade off (i.e.
MRS between income and leisure equals the wage rate (w) that is, the market exchange rate between the two. In this
equilibrium position the individual works for TL1 hours per day (TL1 = OT-OL1). Thus, he has worked for TL1 hours to
earn OM1 amount of income.

Economics-I UNIT 1 2 3 4 CPJ FAIRFIELD NOTES

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