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CONTACT US: 03084293988 1 CSS ECONOMICS-I NOTES FOR CSS-2022
CSS-2022 Economics 1 Notes
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CSS Economics-I Notes For CSS-2022
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I. Micro Economics……………………………………………………………………………5
Consumer behavior, Determination of market demand and supply i.e. concept of
elasticity of Demand & Supply, Static, Comparative Static Analysis, Distinction between
partial and general equilibrium analysis (basic level) theory of the Firm, Producer’s
equilibrium, Pricing of the factors of production.
II. Macro Economics………………………………………………………………………….66
Basic Economic Concepts, National Income Accounting, Consumption Function,
Multiplier, Accelerator, Component of Aggregate Demand, Labour Demand and Supply,
Un-Employment, Determination of equilibrium level of income and output (at least with
reference to two or three school of thought), Inflation.
III. Money and Banking……………………………………………………………………..192
Functions of Money, Quantity Theory of Money, The Fisher and Cambridge
Formulations, Systems of note issue, Credit Creation, Functions of Central
Banks, Instruments of Credit Control, Distinction between Goals, Operational &
Intermediate Target of Central Banks Policy, Concept of Reserves, Liquidity Premium,
Term Structure of Interest Rate, Fisher Equation etc; Transmission Mechanisms of
Monetary Policy, Theory of Liquidity Preference. TVM, Capital Structure, Capital
Restructuring, IS-LM Analysis and The role of Central Bank, Money Demand and Supply.
IV. Public Financing……………………………………………………………………….332
Government expenditure, Sources of Government Revenue, Privatization, Taxes and nontaxes,
Incidence of different taxes, Public Debt, Objectives, methods of repayment,
Deficit financing, General Equilibrium Analysis, Welfare Economics, Fiscal Policy.
V. International Trade……………………………………………………………………396
Theories of comparative advantage and Factor Endowments, Trade & Growth,
Colonialism, Imperialism and International Trade, Trade Restrictions, Economic
Integration, Trade Policy, Balance of Payments, Foreign Exchange, International
Monetary system, Custom Unions.

VI. Economic Development……………………………………………………………462
Concepts of development, Human development, Historical growth process and
Development, Theories of development, structural issues of development, Income
distribution and poverty, sectoral (agricultural, Industry, trade and fiancé) issues and
development, environment and development

Micro Economics:
Microeconomics is the study of individuals, households and firms' behavior in decision making
and allocation of resources. It generally applies to markets of goods and services and deals with
individual and economic issues.
Description: Microeconomic study deals with what choices people make, what factors influence
their choices and how their decisions affect the goods markets by affecting the price, the supply
and demand.
Microeconomics is the social science that studies the implications of incentives and decisions,
specifically about how those affect the utilization and distribution of resources. Microeconomics
shows how and why different goods have different values, how individuals and businesses
conduct and benefit from efficient production and exchange, and how individuals best coordinate
and cooperate with one another. Generally speaking, microeconomics provides a more complete
and detailed understanding than macroeconomics.
Understanding Microeconomics
Microeconomics is the study of what is likely to happen (tendencies) when individuals make
choices in response to changes in incentives, prices, resources, and/or methods of production.
Individual actors are often grouped into microeconomic subgroups, such as buyers, sellers, and
business owners. These groups create the supply and demand for resources, using money and
interest rates as a pricing mechanism for coordination.
The Uses of Microeconomics
Microeconomics can be applied in a positive or normative sense. Positive microeconomics
describes economic behavior and explains what to expect if certain conditions change. If a
manufacturer raises the prices of cars, positive microeconomics says consumers will tend to buy
fewer than before. If a major copper mine collapses in South America, the price of copper will
tend to increase, because supply is restricted. Positive microeconomics could help an investor
see why Apple Inc. stock prices might fall if consumers buy fewer iPhones. Microeconomics could
also explain why a higher minimum wage might force The Wendy's Company to hire fewer
workers.
These explanations, conclusions, and predictions of positive microeconomics can then also be
applied normatively to prescribe what people, businesses, and governments should do in order
to the most valuable or beneficial patterns of production, exchange, and consumption among
market participants. This extension of the implications of microeconomcis from what is to what
ought to be or what people ought to do also requires at least the implicit application of some sort
of ethical or moral theory or principles, which usually means some form of utilitarianism.

Method of Microeconomics
Microeconomic study historically has been performed according to general equilibrium theory,
developed by Léon Walras in Elements of Pure Economics (1874) and partial equilibrium theory,
introduced by Alfred Marshall in Principles of Economics (1890).1 The Marshallian and Walrasian
methods fall under the larger umbrella of neoclassical microeconomics. Neoclassical economics
focuses on how consumers and producers make rational choices to maximize their economic well
being, subject to the constraints of how much income and resources they have available.
Neoclassical economists make simplifying assumptions about markets—such as perfect
knowledge, infinite numbers of buyers and sellers, homogeneous goods, or static variable
relationships—in order to construct mathematical models of economic behavior.
These methods attempt to represent human behavior in functional mathematical language, which
allows economists to develop mathematically testable models of individual markets.
Neoclassicals believe in constructing measurable hypotheses about economic events, then using
empirical evidence to see which hypotheses work best. In this way, they follow in the “logical
positivism” or “logical empiricism” branch of philosophy. Microeconomics applies a range of
research methods, depending on the question being studied and the behaviors involved.
Basic Concepts of Microeconomics
The study of microeconomics involves several key concepts, including (but not limited to):
• Incentives and behaviors: How people, as individuals or in firms, react to the situations
with which they are confronted.
• Utility theory: Consumers will choose to purchase and consume a combination of goods
that will maximize their happiness or “utility,” subject to the constraint of how much income
they have available to spend.
• Production theory: This is the study of production—or the process of converting inputs
into outputs. Producers seek to choose the combination of inputs and methods of
combining them that will minimize cost in order to maximize their profits.
• Price theory: Utility and production theory interact to produce the theory of supply and
demand, which determine prices in a competitive market. In a perfectly competitive
market, it concludes that the price demanded by consumers is the same supplied by
producers. That results in economic equilibrium.

Consumer Behavior:
Consumer theory is the study of how people decide to spend their money based on their individual
preferences and budget constraints. A branch of microeconomics, consumer theory shows how
individuals make choices, subject to how much income they have available to spend and the
prices of goods and services.
Understanding how consumers operate makes it easier for vendors to predict which of their
products will sell more and enables economists to get a better grasp of the shape of the overall
economy.
Understanding Consumer Theory:
Individuals have the freedom to choose between different bundles of goods and services.
Consumer theory seeks to predict their purchasing patterns by making the following three basic
assumptions about human behavior:
• Utility maximization: Individuals are said to make calculated decisions when shopping,
purchasing products that bring them the greatest benefit, otherwise known as maximum
utility in economic terms
• Nonsatiation: People are seldom satisfied with one trip to the shops and always want to
consume more
• Decreasing marginal utility: Consumers lose satisfaction in a product the more they
consume it.
Working through examples and/or cases, consumer theory usually requires the following inputs:
• A full set of consumption options
• How much utility a consumer derives from each bundle in the set of options
• A set of prices assigned to each bundle
• Any initial bundle the consumer currently holds
Advantages of Consumer Theory
Building a better understanding of individuals' tastes and incomes is important because it has a
big bearing on the demand curve, the relationship between the price of a good or service and the
quantity demanded for a given period of time, and the shape of the overall economy.
Consumer spending drives a significantly large chunk of gross domestic product (GDP) in the
U.S. and other nations. If people cut down on purchases, demand for goods and services will fall,
squeezing company profits, the labor market, investment, and many other things that make the
economy tick.
Example of Consumer Theory
Let’s look at an example. Kyle is a consumer with a budget of $200, who must choose how to
allocate his funds between pizza and video games (the bundle of goods). If a pizza costs $10 and
a video game cost $50, Kyle could buy 20 pizzas, or four video games, or five pizzas and three
video games. Alternatively, he could keep all $200 in his pocket.

How can an outsider predict how Kyle is most likely to spend his money? Consumer theory can
help give an answer to this question.
Limitations of Consumer Theory
Challenges to developing a practical formula for this situation are numerous. For instance, as
behavioral economics points out, people are not always rational and are occasionally indifferent
to the choices available. Some decisions are particularly difficult to make because consumers are
not familiar with the products. There could also be an emotional component involved in the
decision-making process that isn't able to be captured in an economic function.
The many assumptions that consumer theory makes means it has come under heavy criticism.
While its observations may be valid in a perfect world, in reality there are numerous variables that
can expose the process of simplifying spending habits as flawed.
Going back to the example of Kyle, figuring out how he will spend his $200 is not as clear-cut as
it might at first seem. Economics assumes he understands his preferences for pizza and video
games and can decide how much of each he wants to purchase. It also presumes there are
enough video games and pizzas available for Kyle to choose the quantity of each he desires.
Introduction to Consumer Behavior:
Microeconomic theory tends to assume that individuals are the economic agents exercising the
act of consumption, the decision to purchase goods and services. The consumer is assumed to
choose among the available alternatives in such a manner that the satisfaction derived from
consuming commodities (in the broadest sense) is as large as possible.
This implies that he is aware of the alternatives facing him and is capable of evaluating them. All
the information pertaining to the satisfaction that the consumer derives from various quantities of
commodities is contained in his ‘utility function’.
We assume that each consumer or family unit has complete information on all matters pertaining
to its consumption decision. A consumer knows precisely what his money income will be during
the planning period. ‘Utility’ refers to subjective satisfaction derived from consumption of
commodities.
The 19th century economists, namely W. Stanley Jevons, Leon Walras and Alfred Marshall came
up with the cardinal theory of consumer behavior. They considered utility is measurable just as
the weight of objects. The consumer is assumed to possess a cardinal measure of utility when he
is able to assign every commodity, a number representing the amount or degree of utility
associated with it.
Under this theory, it is possible to measure marginal utility (MU) of a commodity, whereby by MU
we mean a change in utility due to a change in per unit of consumption of a commodity. Another
property is the existence of Law of Diminishing Marginal Utility (LDMU).

CONTACT US: 03084293988 10 CSS ECONOMICS-I NOTES FOR CSS-
2022
This means as a consumer keeps on consuming successive units of the same commodity,
consumption of other commodities held fixed, marginal utility diminishes. Total utility increases at
a decreasing rate for successive units of consumption of a particular commodity.
Assumptions of Consumer Behaviour under Cardinal Theory:
(i) Utility is numerically measurable.
(ii) Marginal utility is the unit of measurement of utility.
(iii) Marginal utility of money (or total budget) is constant.
(iv) The Law of DMU holds,
(v) Independence axiom holds.
Total utility can be expressed as sum of utilities pertaining to each commodity separately. For
example, let utility be a function of two goods x1 and x2, i.e.,
Cardinal theory of consumer behaviour also is helpful to explain the law of demand in the following
ways:
Mathematical Derivation of Consumer Behaviour:
Let U (x) be the utility from commodity X whose price is Px. Let N (x) be the net utility from x and
λ be the marginal utility of money (assumed constant).

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i.e., U”(x) < 0 which is true by the assumption of LDMU. Hence, utility can be maximised by finding
optimal (indicating consumption bundles).
Economic Interpretation of FOC:
Suppose that an individual purchases 1 unit of x. This leads to increase in utility by MUx On the
other hand, utility loss is λPX. At the optimum these two must be equal, i.e., MUX – λPX.
Alternatively, we may give another type of economic interpretation of such an optimality condition.
Suppose that an individual spends one additional unit of money on x. This leads to increase in
utility by MUx/Px .
On the other hand, utility loss is MUM = λ.
At the optimum, utility gained = utility sacrificed.
This implies that U'(x)/Px = λ or, U’(x) = λPx
Now, if, MUX > λ Px (additional 1 unit of x),
then, MUx/Px > MUM (additional 1 unit of money spent).
Ultimately, the consumer incurs sacrifice of utility. Given the law of DMU, consump-tion of x rises
and, therefore, MUX falls until equality between MUx and λPx holds. Hence once optimality has
been reached, it is always possible for the consumer to find the optimal demand function.
For many economists in the last century, the assumptions on which the theory of cardinal utility
was built were very restrictive. They reformulated the theory of consumer behaviour and named
it ‘The Ordinal Theory of Utility’.
According to the ordinal theory, utility is no longer a measurable concept. What is required is the
existence of a preference base such that an individual can rank the consumption bundles
according to his preference ordering. Let us define two binary evaluations ‘preference to’
(symbolically P) and ‘preference between’ (symbolically I).
This preference ordering is among/ between ‘consumption bundles’, which refers to certain
amount of different commodities. For example: X = {x1, x2,…, xn} is a consumption bundle
consisting of, n commodities x1, x2, ……, xn.

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The ordinal theory of utility is based on the following axioms of preference ordering:
1. Completeness:
Let there be two consumption bundles X’ and X”. An individual can rank these bundles in the
following mutually exclusive ways:
(a) X’ P X”, i.e., X’ is preferred to X”
(b) X” P X’, i.e., X” is preferred to X’
(c) X’ I X”, i.e., X’ is indifferent to X”
2. Transitivity:
For three commodity bundles, the axiom of transitivity states that if X’P X” and X” PX'”, then
automatically, X’ PX'”.
3. Non-Satiation:
If consumption bundle X’ contains more of at least one commodity and no less of other commodity
compared to X” and X'”, it means more is better than less.
4. Strict Convexity of Preference Ordering:
Let X’ I X”. Let us suppose X'” a consumption bundle which is a weighted average of X’ and X”.
In this case, X'” can be expressed as a convex combination of X’ and X”, i.e., X'” = αX’ + (1 – α)
X” where 0 < α < 1.
Now, according to this axiom,
X'” is preferred to both X’ and X”.
5. Continuity of Preference:
There exist a set of points in the consumption space which divides it into less preferred and more
preferred areas such that these points are indifferent to one another. Once these assumptions or
axioms are valid, it is easier to show consumer preferences in a commodity space as in Fig. 1 (in
a two-dimensional or two-commodity framework).

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Consumption Space
In Fig. 1 we divided consumption space into four zones — I, II, III, IV. Due to the axiom of non-
satiation it is observed that consumption bundle, XPY (X has more of x2 than Y for the same x1).
Similarly, ZPY Hence all the points in zone I are superior to Y and all the points in zone III are
inferior to Y.
The remaining two zones, viz., II and IV are important to draw indifference map as follows:
A ray through origin, OH, passes through Zone II. All Space points on OP are inferior to Y but
XPO i.e., somewhere between P and X where there is switch of preferences say point M.
Successive drawings of such a ray through origin can make us safely assert that there is a point
say M which is indifferent to X. Similar exercise can be carried out with Zone IV and joining these
points like W, M, Y, T, we get a curve called Indifference Curve.
An indifference curve is a locus of points in a commodity space—or commodity bundles—among
which the consumer is indifferent. Each point on an indifference curve yields the same utility as
any other point on that indifference curve. The IC approach has been applied in areas of
international trade and public finance, community (social) indifference curves (ICs and SICs) are
used to show gains from trade.
Similarly, ICs are used to compare to the welfare effects of a lumpsum tax and a price distorting
tax. IC approach including the Slutsky theorem is also used to show the effect of income tax on a
worker’s labour-leisure choice. At times SICs are used to compare cost of living indices and then
show the effects of price inflation.

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We may now summarise the basic properties of indifference curves as follows:
1. IC is Downward Sloping:
In Fig. 2, along the IC, utility is constant. Therefore, when consumption of one commodity
increases, given the level of other commodity, utility increases. But since total utility is constant,
additional utility has to be sacrificed by reducing the consumption of other commodity. Hence IC
is downward sloping.
2. ICs are Non-Intersecting:
In Fig. 3, CPB (since C has more of x1 than B for same x2). But CIA as both C and A lie in same
IC, IC0. Again, BIA, as both B and A lie on same IC1.
... Therefore, by the axiom of transitivity, CIB (or BIC) which is not possible or gives con-tradictory
results. Therefore ICs cannot intersect.

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3. Higher ICs give Higher Utility:
It can be seen that BPA, as more of x2 is consumed in B than A for the same amount of x1. Hence
all the points on IC1 are preferred to all the points on IC0, as it gives higher utility. Again, CPB as
for same x2, more of x1 is consumed. Therefore, all points on IC2 are preferred to all points on
IC0 and IC1 as it gives more utility. Higher IC gives higher utility (Fig. 4).
4. ICs are Convex to the Origin:
Axiom 4 leads to convexity of IC which implies diminishing MRS where by MRS we mean absolute
necessary reduction in consumption of x1 due to additional consumption of x2 by one unit such
that total utility is fixed (assuming two commodities x1 and x2 only)

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5. The Law of DMRS Holds:
This implies that due to the convexity of IC, as con-sumption of x1 increases successively by
equal unit, fall of x2 declines, i.e., for constant utility x2 falls at a diminishing rate. Thus, MRS falls
along an IC in Fig. 5.
Now we shall discuss about budget constraint and budget lines. The budget line is set off more
commodity bundles than can be purchased, if the entire money income is spent.
Hence, budget constraint is given by following equation:
Equation on Budget Constraint
where m = total money income (assumed constant).
Pi = price of ith commodity
Xi = ith commodity, i = 1, 2,…, n
In a two-commodity framework, therefore, the budget constraint will be
m=p1x1 + p2x2
or, x2 = (m/p2 – p1/p2) x1 [This is indeed the equation of a downward sloping straight line.]

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The solution of problem of maximisation of utility subject to the budget constraint is the main
motive behind the theory of consumer behaviour.
Properties of Demand Functions:
Demand functions are homogeneous of degree zero in prices and income which means that equi-
proportional and unidirectional changes in prices and money income do not alter optimality
condition. This homogeneity postulate suggests that the consumer is free from money illusion.
The Consumer’s Reaction to Income and Price Changes:
So long we assumed that the consumer maximizes his welfare subject to two constraints:
(i) A fixed level of money income and
(ii) A fixed set of commodity prices.
Now we may relax the assumptions one by one and do some comparative statics exercise.
Changes in m, with P1/P2 held constant. We first consider the consumers’ reaction to a change
in his money income holding the prices of the two purchasable goods constant. A change in the
consumer’s money income causes a parallel shift of the budget line with no change in slope as
shown in Fig. 6.
Consumers’ initial equilibrium is point E. Every time his income increases the budget line shifts F
and G are the corresponding equilibrium points. The locus of all the equilibrium points is called
income consumption curve. In the Fig. 6 both x1 and x2 are normal goods.

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If x1 is inferior the ICC will be backward bending and if x2 is inferior it will be forward falling. See
(Fig 7). If consumption of a good falls as income rises, then such a commodity is called inferior
goods. So one important prediction is that if the consumer spends all his income on two goods,
both cannot be inferior at the same time.
The relation between money income and quantity consumed is explained by a function is known
as the Engel’s curve. Now we allow the price of one of the two goods to fall. Suppose that of x1
falls. In this case the budget line be-comes flatter and the consumer is able to reach higher
in-difference curves and enjoy more utility or satisfaction, thus improving his level of welfare.
So every time P1 falls, the consumer moves to higher IC and reaches a new equilibrium point.
The locus of succes-sive equilibrium points is the price consumption curve (PCC) which shows
the consumer’s reaction to a single price change which changes the price ratio, i.e., p1/p2.
There are two uses of PCC. First, we can derive the consumer’s demand curve for a commodity
from the PCC. According to the ordinal approach, the demand curve for a normal good is
downward sloping due to price effect which has been decomposed by Hicks and Slutsky into two
parts, namely, substitution effect and income ef-fect. The slope of the demand curve depends on

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the relative strength of the two effects which, in turn, depends on the nature of the commodity
under consideration.
From the PCC we can predict price elasticity of demand (e) by using the total outlay method.
Three points will be noted in the context:
(i) If PCC is downward sloping, demand for x1 is price elastic.
(ii) If PCC is horizontal, demand for x1 is unitary price elastic.
(iii) If PCC is upward sloping, demand for x1 is price inelastic.
Essay # 5. Price Effect as a Sum-Total of Substitution Effect and Income Effect:
From the Marshallian demand curve (constant money income demand curve) it is not possible to
explain the price effect because Marshallian approach is based on LDMU, i.e., cardinal theory. It
was John Hicks and E. Slutsky who decomposed the price effect into two parts. Thus, two new
concepts of demand curve have emerged, namely,
(i) Real income constant demand curve (the Slutsky demand curve)
(ii) Total utility constant demand curve (the Hicks demand curve)
We shall now construct Marshallian demand curve and compensated demand curve for a normal
good in a two-commodity framework.

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From the price effect such derivation of the demand curve for x1 is as follows:
Let initial budget line be AS in Fig. 10(a) for price p1, corresponding equilibrium x1 at E0 is x1.
Hence for price p1, x1 is plotted in Fig. 10(b). If p1 falls slope of budget line falls and hence AB
becomes flatter. The budget line becomes AB’. The consumer reaches higher utility level on IC2
and new equilibrium x1 is x1M. Plotting this in Fig. 10(b) and joining E0 and EM in Fig. 10(b), we
get the negatively sloped demand curve for x1 which is the Marshallian demand curve, DM.
We will construct DH and DS for same ini-tial conditions as the one we considered while drawing
the Marshallian demand curve. Let price of x1, p1 fall from p1o to p1’. For Hicksian demand curve
we consider budget line, CD tan-gent to initial IC0 implying constant utility level even as new price
ratio P’1/P2 and hence parallel to AB’. Because of movement from E0 to EH, x1 rises from x1 to
x1H. This is purely substitution effect, and joining E0 and EM we get Hicksian demand curve DH.

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If we follow the Slutsky approach, we can make the following two Predictions:
(i) Perfect Substitutes:
If two commodities are perfect substitutes like blue and black ink for a colour blind person the IC
will be a straight line with PE = SE and IE = 0.
(ii) Perfect Compliments:
If two commodities are perfect complements like left and right shoe SE = 0 Thus, PE = IE. For
Slutsky demand curve we consider budget line C’ D’ , which passes through initial equilibrium
point E0 implying that consumer is just enough to purchase initial equilibrium commodities even
at new price ratio P’1/P2, hence parallel to AB.
This hypo-thetical budget line is thus to the right of CD and hence consumer reaches higher IC,
IC1. Consumption of x1 rises, hence when plotted in 10(b), we see that DS is flatter than DM. The
movement from ES to EM is the income effect.
The substitution effect is always negative because the entire IC approach is based on the of
substitution which suggests that the consumption of one commodity is always at the expense of
the other but IE is negative in case of normal good, if we consider change in real income. Thus in
case of a normal good the negative income effect reinforces the negative, SE so as to make the
price effect very strong in this case and the demand curve is relatively flat.
In case of an inferior good, IE is positive but less-strong than the substitution effect. So the price
effect is still negative but less strong than that in the case of a normal good. In case of a Giffen
good, which is essentially a price phenomenon, the positive income effect is stronger than the
negative substitution effect so as to cause price effect to be positive. This is one of the exceptions
to the empirical law of demand. These points are summarized in Table 1.
Price Effect in case of Three Types of Goods
An important aspect of ordinal theory is the derivation of Slutsky Equation. This is done in the
mathematical appendix.

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Essay # 6. The Hicksian Interpretation of Consumer Behaviour:
Hicks define own-price substitution effect in terms of constant utility.
This is own-price substitution effect according to Hicks. Under Slutsky interpretation, money
income is so adjusted that individual can purchase initial consumption bundle even at new prices.
Hence dm = x1dp1 + x2dp2 -dm + x1dp1 + x2dp2 = 0

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This is own-price substitution effect, according to Slutsky. Now let us derive the income effect.
From (7) we get
The Homogeneity Property of the Demand Function own-price substitution effect is always
negative. Modem economists like K. Lancaster and L.R. Klein have generalized the homogeneity
property and have emerged with the conclusion that the result holds even in situations when only
representative consumer purchases different goods instead of two. In fact, due to
interrelationships of demand the quantity demanded of each commodity is a function of ‘n’
absolute prices and the money income of the buyer. So the constrained optimisation problem
here is:

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Now to derive the homogeneity property of the demand functions we have to express the quantity
demanded of each commodity as a function of relative prices and real income. If there are ‘n’
absolute prices, there will be (n – 1) relative prices. So we can rewrite the demand functions as
In this case, if all absolute prices and the money income get doubled at the same time, the relative
prices and real income will remain constant and there is no reason why the consumer’s purchase
plan will be altered. It is a tribute to the Nobel laureate economist Paul A. Samuelson who
developed the re-vealed preference approach to show that if we eliminate the income effect of a
decrease in p, it is still possible to derive the downward sloping demand curve for x1 from the
actual choice of consumer in the market place.
Revealed preference is a relation that holds between the bundle that is actually demanded at
some budget and bundles that could have been demanded at that budget. For example, when we
say X = X (x1 , x2) is revealed preferred to Y = Y (y1 , y2), we are claiming that X is chosen when
Y could have been chosen, i.e., p1x1 + p2x2 ≥ P1Y1 + P2Y2.
Samuelson retains the two main assumptions of the IC approach, namely, rationality and
consistency and has provided a scientific basis of the theory of the consumer demand in terms of
two axioms of revealed preference, namely, weak axiom of revealed preference weak axiom of
revealed preference (WARP) and strong axiom of revealed prefer-ence (SARP). WARP implies
that, if (x1, x2) is directly preferred to (y1, y2) and the two bundles are not same, then it cannot
happen that (y1 y2) is directly revealed preferred to ( x1, x2).

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This implies that if (x1, x2) is purchased at price (p1, p2) and (y1, y2) is purchased at (q1, q2),
then if initially, P1x1 + p2x2 ≥ p1y1 + p2y2 then must be the case that q1y1 + q2y2 ≥ q1x1 + q2x2,
i.e., X is purchased when Y was affordable and when y was purchased, x must not be affordable.
Fig. 11 satisfies the WARP.
Satisfying the WARP:
According to SARP, if (x1, x2) is revealed preferred to (y1, y2) (either directly or indirectly) and
(y1, y2) is different from (x1, x2) then (y1, y2) cannot be directly or indirectly revealed preferred
to (x1 x2). Likewise, in the ordinal theory under revealed preference approach it can be proved
that substitution effect is always negative. Let prices be given by P° when a consumer purchases
a commodity bundle X° when X’ was affordable. This means X° is purchased at P° when X’ was
affordable. This is possible only when,

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Obviously, for such inequality to hold, we have assumed that P’ ≠ P°. Hence there must be strict
inequality i.e. (P’ – P°) (X’ – X°) < 0 which implies and proves that the substitution effect is always
negative. It may however, be noted that two approaches, namely, the indifference curve and
revealed preference approach are not mutually exclusive. Economists like W.J. Baumol and Hal
Varian have shown that it is possible to derive the consumers’ indifference map by using the
revealed preference approach.
Choice under Uncertainty:
So far we have a certain environment; now let us consider choice under uncertainty.
Let L = (x1 , x2 , p) denote a lottery, i.e., a consumer receives price x1 with probability p and x2
with probability (1 -p). Let M0 denote initial endowment. According to the expected utility theorem,
we have EU (L) =pU (M0 + x1) + (1 -p) U (x2 + M0) where U is a function of money value and is
cardinal. The utility is additive separable in x1 and x2 and is linear in p and (1 -p).
Let the utility function be U = √M and initial endowment be M0 = 36. Let us consider a gambler,
in which individuals coins 13 with probability 2/3 and loses 11 with probability 1/3. We needed to
examine whether the individual participates in gambler or not. For this we must calculate expected
utility from the gambler.

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Essay # 8. Modern Approach to Consumer Behaviour:
An alternative approach to the theory of consumer demand was pioneered by K. Lancaster. He
argued that goods are demanded as their characteristics. It is these characteristics that yield
utility. Thus, we may consider three different goods say sugar, honey and saccharixe. But they
may have only two characteristic, viz., sweetness and calories. If a new sweetener is produced
we analyse it not as a new good but as one better that has the same characteristics.
Thus, compared with traditional analysis, the new approach has two advantages:
(i) We can study the introduction of new goods,
(ii) We can study the effects of changes in quality.
Comparison with traditional approach:
In the traditional theory, the consumer’s indifference curves are given in terms of the original set
of goods. Now if a new good is introduced in the market we have to introduce a whole new set of
indifference curves or surfaces. All the information in the preference about old set of goods is
discarded.
In terms of the new approach we can make an insightful analysis of consumer choice. In the real
commercial world many of the so-called new goods are actually the same as the old goods with
the characterisation of different proportions.
Thus, if we consider the preferences in terms of characterisation we can analyse introduction of
new goods very easily. We do not have to discard any old set of prefer-ences as worse. If new
goods appear in the market with new characteristics, we have to intro-duce a new set of
preferences.

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A major advantage of the characteristic approach is that it per-mits the analysis of many goods.
At times the number of goods is considerably higher than the number of characteristics.
Furthermore, once we think in terms of characteristics we have to consider substitution effect
which is different from the substitution effect of the traditional theory.
Determination of Market Demand and Supply
Supply and demand, in economics, relationship between the quantity of a commodity that
producers wish to sell at various prices and the quantity that consumers wish to buy. It is the main
model of price determination used in economic theory. The price of a commodity is determined
by the interaction of supply and demand in a market. The resulting price is referred to as the
equilibrium price and represents an agreement between producers and consumers of the good.
In equilibrium the quantity of a good supplied by producers equals the quantity demanded by
consumers.

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Demand Curve
The quantity of a commodity demanded depends on the price of that commodity and potentially
on many other factors, such as the prices of other commodities, the incomes and preferences of
consumers, and seasonal effects. In basic economic analysis, all factors except the price of the
commodity are often held constant; the analysis then involves examining the relationship between
various price levels and the maximum quantity that would potentially be purchased by consumers
at each of those prices. The price-quantity combinations may be plotted on a curve, known as a
demand curve, with price represented on the vertical axis and quantity represented on the
horizontal axis. A demand curve is almost always downward-sloping, reflecting the willingness of
consumers to purchase more of the commodity at lower price levels. Any change in non-price
factors would cause a shift in the demand curve, whereas changes in the price of the commodity
can be traced along a fixed demand curve.

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Supply Curve
The quantity of a commodity that is supplied in the market depends not only on the price
obtainable for the commodity but also on potentially many other factors, such as the prices of
substitute products, the production technology, and the availability and cost of labour and other
factors of production. In basic economic analysis, analyzing supply involves looking at the
relationship between various prices and the quantity potentially offered by producers at each
price, again holding constant all other factors that could influence the price. Those price-quantity
combinations may be plotted on a curve, known as a supply curve, with price represented on the
vertical axis and quantity represented on the horizontal axis. A supply curve is usually upward-
sloping, reflecting the willingness of producers to sell more of the commodity they produce in a
market with higher prices. Any change in non-price factors would cause a shift in the supply curve,
whereas changes in the price of the commodity can be traced along a fixed supply curve.

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Market Equilibrium
It is the function of a market to equate demand and supply through the price mechanism. If buyers
wish to purchase more of a good than is available at the prevailing price, they will tend to bid the
price up. If they wish to purchase less than is available at the prevailing price, suppliers will bid
prices down. Thus, there is a tendency to move toward the equilibrium price. That tendency is
known as the market mechanism, and the resulting balance between supply and demand is called
a market equilibrium.
As the price rises, the quantity offered usually increases, and the willingness of consumers to buy
a good normally declines, but those changes are not necessarily proportional. The measure of
the responsiveness of supply and demand to changes in price is called the price elasticity of
supply or demand, calculated as the ratio of the percentage change in quantity supplied or
demanded to the percentage change in price. Thus, if the price of a commodity decreases by 10
percent and sales of the commodity consequently increase by 20 percent, then the price elasticity
of demand for that commodity is said to be 2.
The demand for products that have readily available substitutes is likely to be elastic, which means
that it will be more responsive to changes in the price of the product. That is because consumers
can easily replace the good with another if its price rises. The demand for a product may be
inelastic if there are no close substitutes and if expenditures on the product constitute only a small
part of the consumer’s income. Firms faced with relatively inelastic demands for their products
may increase their total revenue by raising prices; those facing elastic demands cannot.
Supply-and-demand analysis may be applied to markets for final goods and services or to markets
for labour, capital, and other factors of production. It can be applied at the level of the firm or the
industry or at the aggregate level for the entire economy.

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CONCEPT OF ELASTICITY OF DEMAND &
SUPPLY:
Elasticity of Demand and Supply # 1. Subject Matter:
Demand and Supply Theory is essential for an understanding of economics.
But if price changes, by how much does quantity demanded or supplied change? It could be that
a large price increase/decrease will have little effect of quantity demanded or supplied.
On the other hand, a small price increase/decrease might result in a substantial change in demand
or supply. Theoretically it is impossible to say exactly what will happen in cases like these. Each
product may have a different price-quantity reaction. It is a matter for economists to collect
evidence and calculate this relationship.
However, theoretical economists can provide a useful guidance for studying this relationship.
Elasticity is a measure of the relationship between quantity demanded or supplied and another
variable, such as price or income, which affects the quantity demanded or supplied.
Elasticity of Demand and Supply # 2. Meaning of Price Elasticity of Demand:
Price Elasticity of demand measures the degree of responsiveness of the quantity demanded of
a commodity to change in its price. Thus its measure depends upon comparing the percentage
change in the price with the resultant percentage change in the quantity demanded.
There is a slight problem with computation of percentage changes in this manner. We get different
answers depending on whether we move up or down the demand curve. One way out of this
difficulty is to take the average of two prices and the two quantities over the range we are
considering and comparing the change of the average, instead of comparing it to the price or
quantity at the start of the change.

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The formula for calculating price elasticity of demand then becomes:
Elasticity of Demand and Supply # 3. Different Kinds of Price
Elasticities:
We have different ranges of price elasticities, depending on whether a 1% change in price elicits
more or less than a 1% change in quantity demanded.
a. Price-Elastic Demand:
If the price elasticity of demand is greater than one, we call this a price-elastic demand. A 1%
change in price causes a response greater than 1% change in quantity demanded: ΔP < ΔQ

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b. Unitary Price Elasticity of Demand:
It has been argued that certain relationships exist between price and quantity demanded and
supplied, other things remaining constant

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b. Unitary Price Elasticity of Demand:
In this case, a 1% change in price causes a response of exactly 1% change in the quantity
demanded
c. Price-Inelastic Demand:
Hence, a 1% change in price causes a response of less than 1% change in quantity demanded:
ΔP > ΔQ.
Elasticity of Demand and Supply # 4. Elasticity and Slope:
Elasticity and Slope are not the same. We will demonstrate that along a linear demand curve (that
is, a straight line with a constant slope) elasticity falls with price. As a matter of fact, the elasticity
along a downward-sloping Straight line demand curve goes numerically from infinity to zero as
we move down the curve.
We must, therefore, specify the price range when discussing price elasticity of demand, since
most goods have ranges of both elasticity and inelasticity. The only time we can be sure of the
elasticity of a straight-line demand curve by looking at it is if it is either perfectly horizontal or
perfectly vertical. The horizontal straight line demand curve has infinite elasticity at every quantity
as given in Fig. 3.4(a).
The vertical demand curve has zero elasticity at every price as given in Fig. 3.4(b):

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Extreme Elasticities:
In Fig. 3.4(a), we show complete responsiveness. At a price of 20p, consumers will demand an
unlimited quantity of the commodity in question. In Fig. 3.4(b), we show complete price
unresponsiveness. The demand curve is vertical at the quantity Q1 unit. That means the price
elasticity of demand is zero here. Consumers demand Q1 units of this particular commodity — no
matter what the price is.
Elasticity of Demand and Supply # 5. Elasticity and Total Revenue/Total Expenditure:
It is generally thought that the way to increase total receipts or total expenditure is to increase
price per unit. But is this always the case? Is it possible that a rise in price per unit could lead to
a decrease in total revenue? The real answers to these questions depend on the price elasticity
of demand.
In Table 3.1, we show in column 1 price of petrol in pounds, in column (2) units demanded (per
time period), in column (3) total revenues (P x Q) and in column (4) values of elasticity. Notice
what happens to total revenue throughout the schedule.
They rise steadily as the price rises from £1 to £5 per unit; then, when the price rises further to £6
per unit, total revenue remains constant at £30. At prices higher than £6, total revenue actually
falls as price is increased. So it is not safe to assume that a price increase is always the way to
greater revenues.

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Indeed, if prices are above £6 per unit in our example, total revenue can only be increased by
cutting prices.
Here, in Table 3.1, we show the elastic, unit elastic and inelastic sections of the demand schedule
according to whether a reduction in price increases total revenue, causes them to remain

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constant, or causes them to decrease. In Fig. 3.5, we show graphically what happens to total
revenue in elastic, unit-elastic and inelastic part of the demand curve.
Hence, we have three relationships among the three types of price elasticity and total revenue:
a. Price-Elastic Demand:
A negative relationship exists between small changes in price and changes in total revenue. That
is, if price is lowered, total revenue will rise when the firm faces price-elastic demand. And, if it
raises price, total revenue will fall.
b. Unit Price-Elastic Demand:
Small changes in price do not change total revenue. In other words, when the firm is facing
demand that is unit-elastic, if it increases price, total revenue will not change; if it decreases price,
total revenue will not change either.
c. Price-Inelastic Demand:
A positive relationship between small changes in price and total revenue. That is, when the firm
is facing demand that is price-inelastic, if it raises price, total revenue will go up; if it reduces price,
total revenue will fall. We can see in Fig. 3.5 the areas in the demand curve that are elastic, unit-
elastic and inelastic. For price rise from £1 to £5 per unit, total revenue rises from £10 to £30, as
demand is price-inelastic.
When price changes from £5 to £6, however, total revenue remains constant; at £30, demand is
unit-elastic. Finally, when price rises from £6 to £11, total revenue decreases from £30 to 0.
Clearly, demand is price-elastic. This has been shown distinctly in Fig. 3.5.

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The relationship between the price elasticity of demand and total revenue brings together some
important microeconomic concepts. Total revenue is the product of price per unit times quantity
of units sold (P x Q).
The theory of demand states that, along a given demand curve, price and quantity changes will
move in opposite directions one increases and other decreases. Consequently, what happens to
the product of price times quantity depends on which of the opposing changes exerts a greater
force on total revenue. This is what price elasticity of demand is designed to measure
responsiveness of quantity to a change in price.
The relationship between price elasticity of demand and total revenue is summarized:
Elasticity of Demand and Supply # 6. Determinants of Price Elasticity:
a. Ease of Substitution:
The greater the number of substitutes available for a product, the greater will be its elasticity of
demand. For example, food as a whole has a very inelastic demand but when we consider any
particular item of food we will find that the elasticity of demand is much greater. This is because,
while we can find no substitute for food as a whole, we can, however, always find substitute for
one type of food for another.
b. Number of Uses:
The greater the number of uses to which a commodity can be put, the greater is its elasticity of
demand. For example, electricity has many uses — heating, lighting, cooking, etc. A rise in the
price of electricity might cause people not only to economise in all these areas but also to
substitute other fuels in some cases.
c. Proportion of Income Spent on the Product:
If the price of a packet of salt were to rise by 50%, for example from 20p to 30p, it would
discourage very few people because it constitutes a very small proportion of their income.
However, if the price of a car were to rise from £4,000 to £6,000, it would have an enormous effect
on sales, even though it would be the same percentage increase.

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The greater the proportion of income which the price of the product represents the greater its
elasticity of demand will tend to be.
d. Time:
In general, elasticity of demand will tend to be greater in the long-run than in the short-run. The
period of time we are considering plays an important role in shaping the demand curve. For
example, if the price of meat rises disproportionately to other foods, eating habits cannot be
changed immediately.
So, people will continue to demand the same amount of meat in the short-run. But, in the long-
run, people will begin to seek substitutes. Whether or not this is a noticeable effect will depend
upon whether or not consumers discover adequate substitutes. It may also be possible to obscure
the opposite effect.
e. Durability:
The greater the durability of a product, the greater its elasticity of demand will tend to be. For
example, if the price of potatoes rises, it is not possible to eat the same potatoes twice. However,
if the price of furniture rises, we can make our existing furniture last longer.
f. Addiction:
Where a product is habit-forming, for example, cigarettes, this will tend to reduce its elasticity of
demand.
g. The Price of Other Products:
We know that a rise in the price of a product will cause the demand for its substitutes to rise and
the demand for its complements to fall. Thus, an increase (or decrease) of demand by a constant
percentage leaves elasticity unchanged, but a rightward shift of the curve by a fixed amount
reduces elasticity.
In both diagrams in Fig. 3.6, there has been an increase in demand which has moved the demand
curve rightwards. In diagram 3.6(a), it can been seen that the shift of the whole curve to the right
has reduced its elasticity. In Fig. 3.6(b), however, demand has increased by a constant
percentage at every price, elasticity has remained constant

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(a) Elasticity decreases when the whole demand curve moves out wards.
(b) Elasticity remains unchanged when demand curve swivels.
Elasticity of Demand and Supply # 7. Value of Elasticity:
An increase (+) in price will cause a fall (-) in quantity and, conversely a decree (-) in the value of
the answer must always be negative. The coefficient is expressed as S by putting a minus sign in
front of the equation, thus: ED = –

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Elasticity of Demand and Supply # 8. Arc Elasticity:
It is an estimate of elasticity along a range of a demand curve.
It can be calculated for both linear and non-linear demand curves using the following formula:
Arc elasticity of demand:
In this formula P1 and q1 represent the original price and quantity, and P2 and q2 represent the
new price and quantity.
Thus, (P1 + P2)/2 is a measure of the average price in the range along the demand curve and
(q1 + q2) / 2 is the average quantity in this range.
Elasticity of Demand and Supply # 9. Short-Run and Long-Run:
The P elasticity of demand varies with time in which consumers can adjust their spending patterns
which prices change. The most dramatic price change of the last 50 years — the oil price rise of
1973-74 — caught many households with a new but fuel-inefficient car. At first, they expected
that the higher oil price may not last long.
Then they must have planned to buy a smaller car with greater fuel use. But in countries like the
US few small cars were yet available. In the SR, households were stuck. Unless they could
rearrange their lifestyles to reduce car use, they had to pay the higher petrol prices. Demand for
petrol was inelastic.
Over a longer period, consumers had time to sell their big cars and buy cars with better fuel
economy, or to move from the distant suburbs closer to their place of work. Over this long period,
they could reduce the quantity of petrol demanded much more than initially.
The price elasticity of demand is lower in the SR than in the LR when there is more scope to
substitute other goods. This result is very general. Even if addicted smokers can’t adjust to arise
in the price of cigarettes, fewer young people start smoking and, gradually, the number of smokers
falls.
Demand responses to a change in the price of chocolate should be completed within a few
months, but the full adjustment to changes in the price of oil or cigarettes may take years.

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Elasticity of Demand and Supply # 10. Using Income Elasticity of
Demand
Income elasticities help us forecast the pattern of consumer demand as the economy grows and
people get richer. Suppose real incomes grow by 15% over the next 5 years. The estimates of
demand imply that tobacco demand will fall, but the demand for substantially.
The growth prospects of these two industries are very different. These forecasts will affect
decisions by firms about whether to build new factories and government projections of tax revenue
from cigarettes of alcohol. Similarly, as poor countries get richer, they demand more luxuries such
as televisions, washing machines, and cars.
Free Markets and Price Control:
Free markets allow prices to be determined purely by forces D & S Government action may shift
d and s curves, as when changes in safety legislation shift the Sc, but the government makes no
attempt to regulate prices directly.
If prices are sufficiently flexible, the pressure of ED or ES will quickly bid prices in a free market
to their equilibrium level. Market will not be free when effective price controls exist. Price controls
may be floor prices (minimum prices) or ceiling prices (maximum prices).
Price controls are government rules or laws that forbid the adjustment of prices to clear markets.
Price ceiling makes it illegal for sellers to charge more than a specific max price. Ceiling may be
introduced when a shortage of a commodity threatens to raise its price a lot. High prices are the
way a free market ration goods in scarce supply.
This solves the allocation problem, ensuring that only a small quantity of the scarce commodity is
demanded, but it may be thought to be unfair, a normative value judgement. High food prices
mean hardship for the poor. Faced with a national food shortage, a government may impose a
price ceiling on food so that poor people can afford it.

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Free market equm is at E. The high price P0 choked off quantity demanded to ration scarce
supply. A price ceiling at P1 succeeds in holding down the price but leads to ED AB. It also
reduces QS from Q0 to Q1. A price ceiling at P2 is irrelevant since the free market equm is at E
can still be attained.
Fig. 3.7 shows the market of food. Wars have disrupted imports of food. The sc is far to the left of
free market equn price P0 is very high. Instead of allowing free market equn at E, the government
imposes a P ceiling P1. The quantity sold is Q1 and ED is the distance AB. The price ceiling
creates a shortage of supply relative to demand by holding food prices below their equilibrium
level.
The ceiling price P1 allows the poor to afford food, but it reduces total food supplied from Q0 to
Q1 with ED AB at the ceiling price, rationing must be used to decide which potential buyers are
actually supplied. This rationing system could be arbitrary.
Food may go to suppliers’ friends, not necessarily the poor, or may take bribes from the rich who
jump the queue. Holding down the price of food may not help the poor after all. Ceiling prices are
often organised by rationing by quota to ensure that available supply is shared out fairly,
independently of ability to pay.
Whereas the aim of a price ceiling is to reduce the price for consumers, the aim of a floor price is
to raise the price for suppliers. One example of a floor price is a national minimum wage or floor
price for agricultural products.

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Fig. 3.8 shows a floor price P1 for butter. In previous examples we assumed that the quantity
traded would be the smaller of QS and QD at the controlled price since private individuals cannot
be forced to participate in a market. There is another possibility, the government may intervene
not only to set the control price but also to buy or sell quantities of the good to supplement private
purchases and sales.
At the floor price P1 private individuals demand Q1 but supply Q2. In the absence of government
sales or purchases the quantity traded will be Q1, the smaller of Q1 + Q2.
However, the government may agree to purchase the ES AB so that neither private suppliers nor
private demanders need be frustrated. Because European butter prices are set above the free
market equilibrium price as part of the CAP, European governments have been forced to
purchase massive stocks of butter that would otherwise have been unsold at the controlled price.
Hence the famous butter mountain.

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At floor price P1 supply is Q2, but demand Q1. Only Q1 will be traded. By buying up the ES AB,
the government can satisfy both suppliers and consumers at the price P1.

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Elasticity of Demand and Supply # 11. Income Elasticity:
We know that the demand for a product has several determinants. So far we have been concerned
with how demand changes in response to price changes. Another important determinant of
demand is income (Y). The response of demand to changes in income may also be measured.
Income elasticity of demand measures the degree of responsiveness of the quantity demanded
of a product to changes in income. Income elasticity of demand
Ey = Percentage change in quantity demanded/Percentage change in income
This may be written as or x where Y = income
For most commodities, increase in income leads to an increase in demand, and, therefore, income
elasticity is positive. We have the same subdivision of income elasticity as of price elasticity. Thus,
commodities may be income-elastic, income-inelastic, and unit income elastic.
Virtually all commodities have negative price elasticities. But income elasticity could be both
positive and negative. Goods with positive income elasticities are called normal goods. Goods
with negative income elasticities are called inferior goods; for them rise in income is accompanied
by a fall in quantity demanded. Normal goods are much more common than inferior goods.
Elasticity of Demand and Supply # 12. Cross-Elasticity:
The responsiveness of quantity demanded of one commodity to changes in the prices of other
commodities is often of considerable interest. This type of responsiveness is called cross-
elasticity of demand.
Cross-elasticity varies from minus infinity to plus infinity. Complementary goods have negative
cross-elasticities and substitute goods have positive cross-elasticities.

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Elasticity of Demand and Supply # 13. Elasticity of Supply:
Much of what we have said about elasticity of demand will hold true for elasticity of supply.
Definition of elasticity of supply is very similar.
Elasticity of supply measures the degree of responsiveness of quantity supplied to changes in
price.
Thus, the elasticity of supply may be written as:
This appears to be identical with the formula for elasticity of demand. However, you will recall that
price elasticity of demand is always negative. But price elasticity of supply is normally positive
since the supply curve slopes upwards from left to right; except in the case of a backward-bending
supply curve, in which case it would have negative elasticity.

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Elasticity of Demand and Supply # 14. Classifying Supply Elasticities:
There are three cases of supply elasticity as in Fig. 3.9. SS is a perfectly elastic supply curve,
S’S’ is a zero elastic (or perfectly inelastic) supply curve and OS” is a unit-elastic supply curve.
Any straight line supply curve that passes through the origin has an elasticity of unity irrespective
of steepness of the curve.
Elasticity of Demand and Supply # 15. Price Elasticity of Supply and Length of Time for
Adjustment:
We already know that the longer the time allowed for adjustment, the greater the price elasticity
of demand. The same proposition also applies to supply.
The longer the time for adjustment, the more price-elastic the supply curve becomes:
1. The longer the time allowed for adjustment, the more firms are able to figure out ways to
increase production in an industry.
2. The longer the time allowed, the more resources can flow into an industry through expansion
of existing firms.

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We, therefore, talk about short-run and long-run price elasticities of supply. The short-run is a
time-period during which full adjustment has not yet taken place. The long-run is the time- period
during which firms have been able to adjust fully to the change in price.
We can show a whole set of supply curves similar to the ones we did for demand. In Fig. 3.10,
when nothing can be done in the short-run, the supply curve is vertical SS, when price is Pe and
quantity supplied is Qe.
With a given price increase to P1, there will be no change in the short-run in quantity supplied; it
will remain at Qe. Given same time for adjustment, the supply curve will rotate at price Pe to
S1S1. The new quantity supplied will shift out to Q1 at P1. Finally, the long- run supply curve is
shown by S2S2. The quantity supplied again increases to Q2 at P1 and so on.
Elasticity of Demand and Supply # 16. Determinants of Supply
Elasticity:
Supply elasticities are very important in economics.
As with demand there are a number of factors which affect elasticity of supply:
(a) Time:
This is the most significant factor as we have seen how elasticity increases with time.
(b) Factor Mobility:
The ease with which factors of production can be moved from one use to another will affect
elasticity of supply. The higher the factor mobility, the greater will be the elasticity of supply.
(c) Natural Constraints:
Nature would place restrictions upon supply. If, for example we wish to produce more vintage
wine it will take years to mature before it becomes vintage.

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(d) Risk-Taking:
The more willing entrepreneurs are to take risks, the greater will be the elasticity of supply. This
will be partly influenced by the system of incentives in the economy. If, for example, marginal rate
of tax is very high, it may reduce the elasticity of supply.
(e) Costs:
Elasticity of supply depends to a great extent on how costs change as output is varied. If unit
costs rise rapidly as output rises, then the stimulus to expand production in response to a price
rise will quickly be choked-off by those increases in costs that occur as output increases. In this
case, supply will rather be inelastic.
If, on the other hand, unit costs rise only slowly as production increases, a rise in price that raises
profits will call forth a large increase in quantity supplied before the rise in costs puts a halt to the
expansion in output In this case, supply will tend to be rather elastic.
Static, Comparative Static Analysis
Static economics deals with explaining the determination of equilibrium values with a given data.
Any change in the determinants of equilibrium disturbs the equilibrium position.
In other words, when there is a change in the factors which establish equilibrium of demand and
supply, a new equilibrium position comes into being. Comparative static economics studies the
comparison of the old and new equilibrium positions. It does not study the path of change.
In comparative static economics, we take only the first equilibrium position and the final one; we
can compare them to find out the change. Instead of examining step by step the whole process
of transition from one stage of equilibrium to another, we take only two “Still” pictures and compare
them.
This method of analysis is called comparative statics. For example, when the demand as well as
the supply of onions is 50 kgs., price is one Re. per kg. Now suppose the demand increases to 6
kg’s. while supply remains the same. Price of onions increases to Rs. two per kg.
The study of the two equilibrium prices of onions is called comparative economic statics.
According to Prof. Lipsey, “Comparative statics involves a comparison of a new equilibrium
position with original equilibrium position due to change in some economic variable.”
According to Baumol, “Comparative static analysis can be used to show economic equilibrium
before and after a change in one or more variables without regard to the time required.”

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We can explain the meaning of comparative static economics through Figure 1.3.
The diagram shows the determination of equilibrium price through the interaction of the forces of
demand and supply. E is the point where demand for and supply of the good are equal and OP
price is determined. Now due to some reason or the other, demand for the commodity increases.
That is why the DD demand curve shifts to D1D1. The new demand curve D1D1 intersects the
supply curve SS on point E1. Here the equilibrium price is determined at the level OP1 In
comparative static economics the old and the new equilibrium positions are compared.
In the above figure, we can compare E and E1 points of equilibrium. But it does not show how the
new point of equilibrium i.e. has been reached. In other words, comparative static economics
does not show the path of change. Here we can only compare the two still pictures of the
competitive market.

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Distinction between partial and general equilibrium analysis
(basic level) theory of the Firm,
Partial Equilibrium General Equilibrium
(a) Micro economics uses partial
equilibrium analysis based on the
assumption, other things remaining
constant.
(a) Macro economics uses general equilibrium.
It is not based on any` assumption.
(b) Partial equilibrium studies the
equilibrium of a consumer, a firm, an
industry or a market.
(b) It deals with the equilibrium position of the
economy as a whole.
(c) It deals with one or two variables
at a time. So it is a simple method. It
is independent.
(c) It deals with all the variables of the
economic system simultaneously. So it is
sophisticated. There is interdependence
between variables.
(d) Partial Equilibrium is regarded as
a worm's eye-view.
(d) General Equilibrium is a bird's eye-view.
Difference between Partial Analysis and Equilibrium Analysis!
How equilibrium price and quantity of a commod-ity or a factor is determined through demand
and supply, assuming prices of other commodities and factors would remain the same when
changes occur in the price of the commodity under consider-ation.
That means the effect, if any, of the changes in price of a commodity on the demand for other
commodities is ignored. This type of analysis where we do not take into account the
interrelation-ship or inter-dependence between prices of commodities or between prices of
commodities and factors of production is called partial equilibrium analysis. In this partial
equilibrium analysis each product or factor market is considered as independent and self-
contained for the proper explanation of the determination of price and quantity of a commodity or
a factor.
However, partial equilibrium analysis is not useful and relevant to apply when there is
inter-relationship between commodities or between factors. Thus when markets for various
commodities and factors are interdependent, that is, when changes in the price of a commodity
or a factor have important repercussions on the demand for other commodities or factors, partial
equilibrium analy-sis would not yield correct results.
In such cases when there is significant inter-relationship between various markets or that the
changes in one market would significantly affect others, we should em-ploy general equilibrium

2022
analysis which considers simultaneous equilibrium of all markets taking into account all effects of
changes in price in one market over others.
It may be mentioned that both types of equilibrium analysis are useful, each being valuable in its
own way. Partial equilibrium analysis is useful when the changes in conditions in one market have
little repercussions on other markets.
However, when the changes in conditions in one market have significant effects on other markets,
general equilibrium analysis should be used. Thus, in partial equilibrium analysis when we
consider the determination of market price of a commodity we assume that prices of other goods
do not change.
For example, the rise in price of petrol following imposition of a tax on it would cause little effect
on the prices of goods such as wrist watches, drapers, bowling balls, and in turn there would be
negligible feedback effect of changes in prices of these goods on the demand and price of petrol.
If prices of petrol and of only these commodities are to be considered and since there are little
repercussions of changes in prices of petrol on these other commodities, the use of partial
equilib-rium analysis of price determination of petrol would be quite reasonable.
However, when market for automobiles is considered, the rise in price of petrol would have an
important effect on their demand and price. Therefore, the assumption of partial equilibrium
analysis that prices of automo-biles would remain constant, when the price of petrol changes
would be seriously wrong.
This is because petrol and automobiles being complements to each other, their markets are inter-
related and mutually inter-dependent and changes in their prices would significantly affect each
other. In such cases when there exist inter-relationship and inter-dependence of the markets for
goods (whether they are complements or substitutes), the general equilibrium analysis should be
used. In general equilibrium analysis, all prices are considered variable and the analysis of
simultaneous determi-nation of equilibrium in all markets is made.
In fact when we look at the economic system as a whole, there is a great deal of inter-relation-
ship and inter-dependence among various markets for commodities and factors and there are a
large number of decision making agents—consumers, producers, workers, (who supply labour)
and other resource owners.
All these agents are self-interested and would behave to maximise their goals; consumers would
maximise their utility, and producers would maximise their profits. A comprehen-sive analysis of
the economic system when prices and quantities of all commodities and factors are considered
as variable and which would take into account all inter-relationships and inter-dependence could
be made only through general equilibrium analysis. The general equilibrium would occur when
markets for all commodities and factors and all decision-making agents, consum-ers, producers,
resource owners are simultaneously in equilibrium.
To sum up, partial equilibrium analysis focuses on explaining the determination of price and
quantity in a given product or factor market when one market is viewed as independent of other
markets. On the other hand, general equilibrium analysis deals with explaining simultaneous
equi-librium in all markets when prices and quantities of all products and factors are considered

2022
as variables. Thus, in general equilibrium analysis inter-relationship among markets of all
products and factors are explicitly taken into account.
In what follows we shall explain the conditions of general equilibrium of exchange and produc-tion
in an Economy.
We shall concentrate on the conditions of general equilibrium with regard to the, following three
aspects:-
1. The distribution of goods and services for consumption among individuals in the society;
2. The allocation of productive factors to the production of various goods and services; and
3. The composition of production (or output mix) together with the distribution of consump-tion.
Although the question of existence of general equilibrium is an abstract one, it is very important
because many propositions of economics rest on the existence of general equilibrium.
Producer’s Equilibrium:
Producer’s Equilibrium: MR-MC Approach, Perfect Competition and Diagrams!
Conditions of Producer’s Equilibrium – MR-MC Approach:
Producer’s equilibrium is often explained in terms of marginal revenue (MR) and marginal cost
(MC) of production. Profit is maximized (or a producer strikes his equilibrium) when two conditions
are satisfied – (i) MR = MC, and (ii) MC is rising (or MC is greater than MR beyond the point of
equilibrium output). Let us understand the significance/rationale of these conditions with reference
to Table 1.
In Table 1, MR = MC in two situations – (i) when 2 units of output are produced, and (ii) when 10
units of output are produced. However, while in situation 1 (when output = 2 units) MC is falling,

2022
in situation 2 (when output = 10 units) MC is rising. A producer will strike his equilibrium only when
MC is rising.
Implying that the equilibrium will be struck when 10 units of output are produced, not when 2 units
of output are produced. Reason is simple. Given the price, falling MC only increases the difference
between TR and TVC (recall, ΣMC = TVC, and ΣMR = TR). So that TR – TVC tends to rise, or
that profits tend to rise in a situation of falling MC.
Accordingly, it would be an irrational decision for a producer to strike his equilibrium in a situation
of falling MC. It is only when MC is rising that a producer would strike his equilibrium. Thus,
equilibrium will be struck when MR = MC = 12, and MC is rising. The producer will maximize
profits when 10 units of output are produced. Let us illustrate this point further with reference to
Table 1.
Table 1 offers us two different situations when MR = MC, as under:

2022
We find that the difference between TR and TVC tends to rise, as output is increased from 2 to
10. In fact, it is only when output = 10 units that the profit (π) is maximum. If output is increased
beyond 10 units, π will reduce.
Thus, if 11 units of output are produced, ΣMR = 132, while ΣMC = 115, so that π = TR – TVC
=132 – 115 = 17 (which is less than 20 when output = 10).
It is only when MR = MC, and when MC is rising that a producer will reach the point of equilibrium,
where profit is maximized.
For Complete Economics-I Notes
for CSS 2022
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2022
For Complete Economics-I Notes
for CSS 2022
Contact Us:
03084293988, 03314019933

CSS Economics Books By Entire Education

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