Micro Economics for Business-I PDF

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Microeconomics for Business- I Programs Offered Post Graduate Programmes (PG) Master of Business Administration Master of Computer Applications Microeconomics Master of Commerce (Financial Management / Financial Technology) Master of Arts (Journalism and Mass Communication) for Business- I Master of Arts (Economics) Master of Arts (Public Policy and Governance) Master of Social Work Master of Arts (English) Master of Science (Information Technology) (ODL) Master of Science (Environmental Science) (ODL) Diploma Programmes Post Graduate Diploma (Management) Post Graduate Diploma (Logistics) Post Graduate Diploma (Machine Learning and Artificial Intelligence) Post Graduate Diploma (Data Science) Undergraduate Programmes (UG) Bachelor of Business Administration Bachelor of Computer Applications Bachelor of Commerce Bachelor of Arts (Journalism and Mass Communication) Bachelor of Arts (General / Political Science / Economics / English / Sociology) Bachelor of Social Work Bachelor of Science (Information Technology) (ODL) Product code AMITY Amity Helpline: (Toll free) 18001023434 For Student Support: +91 - 8826334455 Support Email id: [email protected] | https://amityonline.com Microeconomics for Business- I  Contents Page No. Module -I: Introduction to Consumer Behaviour 01 1.1 Economics: Define, Scope and Importance 1.1.1 Economics: Definitions, Scope, and Importance 1.2 Themes of Micro Economics 1.2.1 Economics Concepts: Tradeoffs, Markets, Equilibrium and Analysis 1.3 Understanding Markets 1.3.1 Market Types and Price Distinctions Module - II: Concept of Utility 18 2.1 Concept of Utility 2.1.1 Utility Approach and Laws 2.2 Description of Prefrences 2.2.1 Indifference Curves and Properties 2.3 The Consumption decisions/Consumers’ Optimum Choice 2.3.1 Budgets, Consumption, and Equilibrium 2.3.2 Income Changes and ICC 2.3.3 Price Changes and PCC 2.3.4 Price Effect: Hicksian Approach 2.3.5 Price Effect: Slutsky Approach 2.4 Ordinary and compensated demand curves 2.4.1 Demand Curves and Compensated 2.5 Revealed Prefrence 2.5.1 Revealed Preference and Substitution Effect 2.6 Demand and Supply 2.6.1 Demand and Supply Concepts 2.7 Elasticities of Demand and Supply 2.7.1 Elasticities and Concepts 2.8 Market Mechanism and Government Intervension 2.8.1 Government Taxes and Subsidies Module - III: Production and Cost 75 3.1 Cost Production 3.1.1 Types of Cost 3.1.2 Short-run Costs: TC, TVC, TFC, AC, AVC, AFC, MC 3.1.3 Long-run Costs: LTC, LMC, LAC 3.1.4 LAC Shape and Scale Economies  3.2 Technology of Function and Production Function 3.2.1 Short vs. Long Run Production 3.2.2 Short-run Production: One Input - TP, AP, MP, Law of Proportions 3.2.3 Long-run Production: Two Inputs - Isoquants 3.3 Cost Minimization and Expansion Path 3.3.1 Producer Equilibrium: Isoquants and Iso-costs 3.3.2 Optimal Input: Output Max and Expansion Path 3.3.3 Input Substitution Elasticity 3.4 Returns to Scale 3.4.1 Returns to Scale: Isoquants Analysis 3.5 Types of Production function 3.5.1 Cobb Douglas Production Function 3.5.2 Linear Homogeneous Production Function (LHPF) 3.5.3 CES Production Function Module - IV: Profit Maximisation and Perfect Competition 118 4.1 Firm Profitability: Assumptions, MR, MC 4.1.1 Perfect Competition Traits: AR, MR and MC 4.1.2 Short-run Firm Equilibrium and Supply Curve 4.1.3 Long-run Firm Profit Maximisation 4.1.4 Surplus and Rent: Short vs. Long Run 4.2 Industry’s Long-run Supply Curve 4.2.1 Long-run Industry Equilibrium and Supply Curves Module - V: Monopoly 134 5.1 Monopoly: Assumption, AR and MR 5.1.1 Monopoly Features: TR, AR, MR Curves 5.2 Output Decision 5.2.1 Short-run Monopoly Equilibrium 5.2.2 Long-run Monopoly Equilibrium 5.3 Monopoly: Power,Sources and Social Cost of Monopoly Power 5.3.1 Monopoly Emergence and Power Metrics 5.3.2 Monopoly Social Costs: Labor, Price and Output 5.4 Monopsony 5.4.1 Monopsony Vs Monopoly Microeconomics for Business-I 1 Module - I: Introduction to Consumer Behaviour Notes Learning Objectives At the end of this module, you will be able to: Define Economics Identify the scope of Economics Explain the importance of Economics Describe the Economics Concepts Explain the Market Types and Price Distinctions Introduction Consumer behaviour in microeconomics is a multifaceted field that delves deeply into the intricacies of how individuals, households, or consumers make decisions regarding the allocation of their resources in order to fulfil their wants and needs. This area of study encompasses a broad range of factors, both economic and non-economic, that influence the decision-making process of consumers. At its core, consumer behaviour is concerned with understanding the process by which consumers identify their needs or desires, evaluate the available options and ultimately make a choice. This decision-making process is influenced by a myriad of factors, including individual preferences, income levels, prices of goods and services and psychological elements such as emotions and perceptions. One of the fundamental concepts in consumer behaviour is utility, which refers to the satisfaction or pleasure that consumers derive from consuming a good or service. Consumers aim to maximise their utility within the constraints of their budget, seeking to achieve the highest level of satisfaction possible from their consumption decisions. The law of demand is another cornerstone principle in consumer behaviour, asserting that, ceteris paribus, as the price of a good or service decreases, the quantity demanded increases and vice versa. This law reflects the inverse relationship between price and quantity demanded, rooted in the assumption that consumers are rational beings who seek to optimise their utility given the prevailing market conditions. Moreover, consumer behaviour analysis considers the concept of elasticity, which measures the responsiveness of quantity demanded to changes in price or other factors. Elasticity provides insights into how sensitive consumers are to changes in prices or incomes, thus aiding in the understanding of market dynamics and consumer behaviour patterns. In addition to economic factors, consumer behaviour is also influenced by a wide array of non-economic factors. These may include personal tastes and preferences, cultural influences, social norms, peer pressure, advertising and marketing strategies and individual psychological traits such as risk aversion or impulsivity. Understanding consumer behaviour is of paramount importance for businesses seeking to thrive in competitive markets. By gaining insights into consumer preferences, attitudes and behaviours, firms can develop effective marketing strategies, pricing policies and product innovations that resonate with their target audience and drive sales. Amity University Online 2 Microeconomics for Business-I Likewise, policymakers rely on insights from consumer behaviour research to formulate regulations and policies aimed at protecting consumer welfare and promoting market Notes efficiency. By understanding the factors that shape consumer choices, policymakers can design interventions that enhance consumer empowerment, foster competition and mitigate market failures. 1.1 Economics: Define, Scope and Importance Economics, often referred to as the “science of choice,” is the study of how individuals, businesses, governments and societies allocate scarce resources to satisfy unlimited wants and needs. Its scope encompasses the analysis of production, distribution and consumption of goods and services, as well as the behaviour of markets and economies at large. Understanding economics is vital for making informed decisions, crafting effective policies and fostering prosperity, as it provides insights into how resources can be utilised efficiently to enhance welfare and promote sustainable development. 1.1.1 Economics: Definitions, Scope and Importance An elaborate analysis regarding concepts of micro and macroeconomics was done by Adam Smith, which has led to the emergence of micro economics as an important branch of study in the field of economics and business. Some of the popular definitions of economics as a subject by different authors are as follows: Alfred Marshall: “Economics is the study of mankind in the ordinary business of life. It helps in examining part of an individual and social action that is closely connected to gaining the use of material requisites of wellbeing. Thus, it involves both: ™™ A study of wealth ™™ A study of man Lionel Robbins: “As a science, Economics deals with the study of human behaviour.” This involves: ™™ Relationship between ends ™™ Relationship between scarce means which have alternative uses Some other popular definitions are: “As a science, Economics involves utilisation, distribution and consumption of services and materials” “Economics is the science of household affairs that best describes management of domestic issues. “Economics involves allocation of scarce resources and defines how this allocation is performed amid forces of supply and demand”. Amity University Online Microeconomics for Business-I 3 Notes Economics can be divided into two parts: - Economics Micro Macro Here: ™™ Microeconomics focuses on individual people and business ™™ Macroeconomics focuses on behaviour of economy as a whole Microeconomics: - Analysis of certain aspects of human behaviour involving understanding of how individual consumers behave. These individuals can be: ™™ A single person ™™ A household ™™ A business/organisation ™™ A government agency Microeconomics helps us to understand: ™™ How and why different goods are not valued the same ™™ How individuals make financial decisions ™™ How individuals best trade, coordinate and cooperate amongst one another ™™ The study of micro economics also assists in: ™™ Business organisations taking decisions on the smaller and critical aspects ™™ Arriving at factors that affect business organisations in taking such decisions into consideration ™™ Understanding of individual supply and demand determinants of the market Macroeconomics:- This part of economics studies economy as in whole, including overall economy featuring both national and international aspects. The topics studied under this include: Amity University Online 4 Microeconomics for Business-I ™™ Government fiscal and monetary policy ™™ Unemployment rates Notes ™™ Foreign trade ™™ Inflation ™™ Interest rates ™™ The growth of total production ™™ Gross Domestic Product Micro economics and macroeconomics are studied together by the economists so as to understand certain situations which can support us in undertaking of more informed decisions while allocating resources. Some authors or economists also believe that microeconomics’ constitutes macroeconomic phenomena that works as a base for individuals and firms and supports them to act in aggregate. Microeconomics Macroeconomics Studies Individual income Studies national income Analyzes demand and supply of labour Analyzes total employement in the economy Deals with households and firms decisions Deals with aggregate decisions Studies individual prices Studies overall price level Analyzes demand and supply of goods Analyzes aggregate demand and aggregate supply Scope of Economics Different economists give different views in regard to the scope of economics. It is a broad subject and includes subject matter as well as other important topics including those that support passing of value judgments. Further, it also helps in: ™™ Suggesting solutions to practical issues ™™ Offering a scientific platform for handling of issues Some modern economists hold the view that economics is a social science and hence should not study the problem of choice faced by a single individual. As per these economists, it should study the choice issues from a much broader social perspective as man lives in society and as an individual, he often interacts with other members of society. For e.g., price controls on petrol have the desired effect of reducing transport expenditures for some consumers, but they also reduce both con¬servation of petrol by those consumers and the incentive of producers to introduce more petrol to the market. To understand the proper scope of economics the following four aspects needs to discussed in detail:- 1. Science or Art: Since a long time, there was controversy among various economists, whether it is a science or an art. According to classical writers, economics is simply the study of cause-and-effect relationship. 2. Adam Smith, T. R. Mathus and David Ricardo, were of the view that it was a pure science as it evolves around the cause of economic issues such as: ™™ Unemployment Amity University Online Microeconomics for Business-I 5 ™™ Inflation ™™ Slow growth or even trade deficit Notes ™™ As per modern economists, they define economics as both a part of science and an art of tacking the issues in hand. In other words, economics is both a ‘light-bearing and fruit bearing’ science. The problems with which economics is especially concerned today involves important central issues such as: ™™ Inflation ™™ Unemployment ™™ Monopoly price rises ™™ Problem related to supply and demand ™™ Economic growth ™™ Productivity and other current issues as well ™™ Therefore, economics can be defined as a problem- based social science. Subject matter: The main purpose of economic is to satisfy human wants for goods and services. The issue starts in a situation where there are no limits for wants whereas on the other hand, the resources available to meet those demands like land, labor, capital and organisation to produce those goods and services are limited in supply. As resources are scarce in relation to their demand, this scarcity means that we must always work on making choices. Thus, economics can be defined as a science of scarcity or as a medium to study the problems of scarcity. Positive or Normative: Another topic of controversy in economics is whether it needs to be neutral or as a medium for passing of value judgments. Today, most economists lay stress on conducting of positive economic analysis. as they do not believe in making any normative statement or passing any value judgment on the economic decisions. Some modern economists also think that economics should stand neutral as regards ends. But, as it is important for the welfare of the society to pass judgment on certain things that are good or bad, in such a situation, an economist needs to suggest certain measures that needs to be adopted by the government for solving issues related to inequality, thus portraying economics as both a positive and a normative science. Positive economics involves scientific study of ‘what is’ among economic relationships. Normative economics involves judgments about ‘what ought to be’ in economic matters. 1. Problem-solving Nature: The most important role and responsibility of a econo¬mist is to formulate policies and based on that suggest solutions to economic problems. As understanding of economics is essential for policymaking, here, economists can suggest solutions to economic problems such as: ™™ Unemployment ™™ Price rise ™™ Trade deficit ™™ Issues related to slow growth and inflation Seeing importance of economics in the field of policy making, today’s modern governments take the help of economists for formulating monetary fiscal and exchange rate policies involving economy of a country. Amity University Online 6 Microeconomics for Business-I Importance of Economics: 1. Overcoming Market Failure: One of the best uses of economics involves offering Notes solutions for overcoming of market failures. The importance of economics is that we can examine whether– ™™ Society is better off through government intervention to influence changes in the provision of certain goods. ™™ A scenario of free markets is more preferable which can result into many failures such as over production or under production of goods. ™™ An economist here can suggest policies that can support overcoming of these types of market failures. 2. Individual Economics: Economics is also important for an individual as well as for businesses as it supports them in taking of informed decisions in different fields. It is true that people living in society are affected by economics in some way or the other as it not only educates but also assists in making critical analysis in different situations. 3. Economics supporting modern modes of production The study of economics provides businessmen and industrialists desired knowledge in relation to modern methods of production and at the same time maintaining the production flow at lower costs. 4. Economics supports overcoming shortage of raw materials The support of economics as a subject allows for looking at possible effects as we run short of raw materials involved in the production of end products such as gas and oil. 5. Economics teaches ways to distribute resources in society It helps in understanding if a situation of inequality is necessary for creating of economic incentives or does presence of inequality support creation of unnecessary economic and social problems. 6. Opportunity cost and Economics. Economics helps in taking effective decisions after taking into consideration of effect of opportunity cost in every decision which an individual makes. 7. Knowledge and understanding Economics helps one to understand the changes taking place in the economy as well as helps in conducting investigations in relation to reasons for: ™™ Poverty ™™ Unemployment ™™ Low economic growth 8. Economics Support Making of Forecast It is a difficult task to make economic forecasts based on understanding of the current situation. Although forecasts are not always reliable, these can support decision-makers in arriving at possible outcomes. Examples of the importance of economics Amity University Online Microeconomics for Business-I 7 How to distribute How to achieve resources? social efficiency Notes Opportunity cost of decisions Give info to make Importance of informed choices economics Understanding consumer behaviour Give forecasts How to fix for economy market failure? 1.2 Themes of Micro Economics In microeconomics, several fundamental themes shape the analysis of individual economic agents and markets. These themes include scarcity and choice, supply and demand, elasticity, market structures, consumer and producer behaviour, market failures, government intervention and income distribution. Each theme provides insights into how individuals, firms and governments make decisions and allocate resources within markets, contributing to a deeper understanding of economic dynamics at the micro level. 1.2.1 Economics Concepts: Tradeoffs, Markets, Equilibrium and Analysis Microeconomics and Optimal Trade-offs 1. Consumer Theory 2. Workers 3. Theory of the Firm The themes of Microeconomics define Trade-Offs and how theses tradeoffs can be best made off. These tradeoffs are explained below: - Consumers: Consumers have limited incomes, which can either be spent on a variety of goods and services, or can be saved for future usage. It explains different ways where consumers based on their preferences can maximise their resources by trading off and purchasing some of the goods and services against purchasing less of other goods and services. Workers: Workers also face constraints and for overcoming them make trade-offs. When to enter the workforce, what type of employment, choice between labor and leisure, are examples of trade-offs. Because the kind of jobs available depends on the education and skills they have, one-person tradeoff by deciding on – ™™ Whether to work now for earning immediate income ™™ Whether to gain education in order to improve hopes of earning a higher income in the future. Firms: Firms also face limits in terms of: ™™ Kinds of products that they can produce ™™ The resources available to produce them Amity University Online 8 Microeconomics for Business-I The Themes of Microeconomics Notes Microeconomcs Allocation of Scarce Resources and Trade-offs ™™ In a planned economy ™™ Ina market economy Microeconomics and Optional Trade-offs ™™ Consumer Theory ™™ Workers ™™ Theory of the Firm Markets Definition of Markets: “Economists understand ‘Market’ as not any particular market place where things are bought and sold. As per them, market comprises the whole of any region where buyers and sellers are in free intercourse with one another which allows the prices of the same goods to gain equality, easily and quickly.” The above definition brings out the following points to understand the market : Region: Market is not an particular place it may be district, state, country , or even the whole country from where the buyers and the sellers come together. Buyers and sellers: There must be a business relationship between the buyers and sellers and they must be aware of the prices offered and prices accepted amongst them. Price: There must be price for every good and services and the same price should rule for the same thing at the same time. Some other definitions of Market: “Originally a market was a public place in town where provision and other objects were exposed for sale, but the word has been generalized so as to mean any body or persons, who are in intimate business realtion and carry on extensive transaction in any commodity.” Jevons- Amity University Online Microeconomics for Business-I 9 “The term market refers not necessarily to a place but always to commodity or co- modities and the buyers and sellers of the same who are in direct copetition with each other.” Notes Chapmen- “We must therefore, define a market as any area over which buyers and sellers are in sch close touch with one another either directly or through dealers that the prices obtainable in one part of the market affect the prices in other parts.” Prof. Behham- Features of market: 1. Perfect Competition: It is a situation in a market where buyers and sellers are so well informed that all elements of monopoly are absent. Further, the market price of a commodity is beyond control of individual buyers and sellers. In the market there exists perfect competition between buyers and sellers. 2. One Price: There needs to be single price for one commodity in the market. This is possible only through attaining perfect competition scenario. 3. Commodity: Market” is not to be used as a reference to a particular place but as reference to commodity or commodities i.e. for example like wheat market, a gold market and so on. 4. Buyers and Sellers: A group of potential sellers and potential buyers need to be present at different places. 5. Area: In economics it refers to whole area or region of operations concerning demand and supply. 6. Business relationship between Buyers and Sellers: A perfect business relationship need to be maintained between buyers and sellers. Though it is not necessary to be physically present in the market, but business relationship needs to be carried on. 7. Perfect Knowledge of the Market: Buyers and sellers need to have perfect knowledge of the market especially in regard to the current trends happening in the market. 8. Presence of Speculators: Presence of speculators is important just for supplying of business information and prices that are prevalent in the market. Price Price comprises monetary value of a good, service or resource that is established during a transaction. We can also say that a price is the quantity of payment/compensation that is provided by one party to another in return for one unit of goods or services. Here, price factor can be influenced by factors such as: ™™ Production costs ™™ Supply of the desired item ™™ Demand for the product Determination of prices: These can be determined by: ™™ A monopolist ™™ It may be imposed on the firm by market conditions Market price is usually based on the relationship between supply and demand. Amity University Online 10 Microeconomics for Business-I Equilibrium Definition: Equilibrium comprises the market state where supply and demand are equal Notes as as a result of that stability of prices is achieved. In general terms, an over-supply of goods or services leads to the prices going down, which in turn result in higher demand. Here, the balancing effect of supply and demand helps in achieving a state of equilibrium. important point Adam Smith believed that a free market scenario would lead towards gaining equilibrium. For example, in the event of shortage of any one commodity would create a higher price which in turn would reduce demand, thus leading to an increase in supply. The same result would occur in reverse order provided there was excess in any one market. Understanding of Equilibrium important point Equilibrium comprises the price at which supply of goods match up to the demand. It can be said that in a scenario where forces of supply and demand are relatively equal then that market state can be called as a state of equilibrium. The law of demand The quantity of commodity as demanded by the consumers in inverse proportion with the prices of the commodity. This is so with all other factors being constant. This can also be explained as a case where if the price of any commodity increases, the demand regarding the same commodity will decrease. The law of supply An increase brought in the price of any commodity would lead to an increase in supply and vice versa, with all other factors being constant. From this we can infer that producers attempt to maximise their profits by increasing the quantity in a scenario where there is rise in the price. Equilibrium point It is the point where demand curve and supply curve intersects. At this point, the price and quantity are respectively known as the equilibrium price (P*) and equilibrium quantity (Q*). Because of changes in any of the economic or consumer factors, a shift is seen in the market that is away from the equilibrium point. However, the economy factor brings the market back to the equilibrium point. important figure Amity University Online Microeconomics for Business-I 11 Example of Equilibrium A store manufactures 1,000 pens and retials them at INR 100 per piece. But no one is willing buy them at that price. To pump up demand, the store reduces their price to INR Notes 80. There are 250 buyers at that price point. In response, the store further slashes the retail cost to INR 50 and Gaines five hundred buyers in total. Upon further reduction of the price to INR 20, one thousand buyers of the Pens materialize. At this price point, supply equals demand. Hence INR 20 is equilibrium price for the Pens. Normative and Positive Analysis Economists generally distinguish between ‘positive’ and ‘normative’ economics. Positive Analysis: Here, economists always convey good news and often make very, well, negative- positive statements which can be tested, at least in theory, if not always in practice. Positive Analysis means that – ™™ Economists use scientific principles to arrive at objective, testable conclusions. ™™ The analysis is concerned with development and testing of positive statements in regard to the world that is objective and verifiable Normative Analysis: Normative analysis is defined in reference to the process of making recommendations. This is in regard to – ™™ Action that needs to be taken ™™ Taking a particular viewpoint on a topic The analysis involves formation of an opinion or a point of view. Normative statements generally make use of factual evidence as support, but they are not by themselves factual. Instead, these incorporate opinions and underlying morals and standards of people who are making the statements which can never be tested. Examples of Positive vs. Normative The difference between positive and normative statements can be understood through following examples: Currently, the unemployment rate is at 9 percent. The above statement is a positive statement as it conveys factual, testable information in regard to the world. Other statements such as: ™™ The unemployment rate is on an increase. ™™ The government needs to take action so as to bring reduction in the unemployment rate. These statements are normative statements as they include value judgments as well as are of prescriptive nature. It’s important to understand that, despite the fact that the two normative statements above are instinctively related to the positive statement, they cannot be logically concluded from the available objective information. Amity University Online 12 Microeconomics for Business-I Positive v Normative Economics Notes  Positive economics  Connects cause and effect  Descriptive  Normative economics  Makes recommendations  Prescriptive  Effects don’t necessarily make a policy “good” or “bad”  Need a philosophy of fairness! 1.3 Understanding Markets In microeconomics, understanding markets is central to analysing how goods and services are bought and sold and how prices are determined. Markets serve as the mechanisms through which buyers and sellers interact, exchanging goods, services and information. By studying market dynamics, economists gain insights into factors such as supply and demand, competition, pricing strategies and market efficiency. Understanding markets is essential for predicting and explaining economic outcomes, as well as for formulating policies to improve market performance and promote economic welfare. 1.3.1 Market Types and Price Distinctions Cournot’s definition – The French economist Cournot defined a market thus “Economists understand by the ‘Market’ not any particular market place in which things are bought and sold but the whole of any region in which buyers and sellers are in such free intercourse with one another that the prices of the same goods tend to equality, easily and quickly.” Jevons Definition – “Originally a market was a public place in a town where provision and other objects were exposed for sale, but the word has been generalised so as to mean anybody or persons, who are in intimate business relation and carry on extensive transaction in any commodity. Chapmen Definition – “The term market refers not necessarily to a place but always to commodity or commodities and the buyers and sellers of the same who are in direct competition with each other.” Prof. Behham Definition – “We must therefore, define a market as any area over which buyers and sellers are in such close touch with one another either directly or through dealers that the prices obtainable in one part of the market affect the prices in other parts.” Classification /Types of Markets: We can divide the market types based on Geographical location, based on time and competition level. Amity University Online Microeconomics for Business-I 13 Notes Based on Geo location: Local Market: This sort of business sectors is situated in a little region in an unassuming community or in a town. Individuals can purchase and sell their day by day needs merchandise here. Regional Markets: This sort of market types covers a wide scope of region which can be region, urban areas. National Markets: These kinds of market situated over the entire nation and permit to moved products anyplace in the area according to necessity International Market: When it goes to the global market products and ventures can be exchanged universally and shipped to the outside of the nation. Based on Time: Very Short Period Market: Here the cost of the item relies upon the interest. In the event that request is high the cost will be high and the interest is the low cost will be less. For example, Vegetable market and blossom market. Short Period Market: This is for a more extended period than the brief time frame market, where request can be changed and the cost can likewise be adjusted. Long Period Market: This sort of market item flexibly can be changed dependent available So, it relies upon the market interest and changes the creation according to Amity University Online 14 Microeconomics for Business-I require. The cost of the item can be distinctive in various time spans in light of the fact that the cost is set by request and flexibly. Notes Competitive v. Non-Competitive Markets Competitive Markets: Competitive market sectors are the place where the gracefully of any item rises to the interest of that item. Competitive market sectors when dealers are value takers, not value creators, which implies they need to set costs dependent available condition. As the opposition is available in the market dealers will be needed to undermine their cost in the event that it is excessively high. Also, there is circumstance when demand = supply, we’re at harmony. It’s not possible for anyone to undermine anybody any longer and this is the correct cost for both the purchasers and merchants. In reality, serious business sectors are self-evident. Dealers make a solid effort to get purchasers by cutting costs, separating their items. In any case, then again is we state there are additionally, perfectly competitive markets, which is hypothetical, this is where all items are the very same, all the costs are the equivalent and entering and leaving the market is so natural. In any case, in the two cases, firms are value takers. Non-competitive Markets: In Non-competitive business sectors venders are the value creators. For simple understanding we can say that restraining infrastructure is a genuine illustration of a non- serious market, as we have just examined in past passages monopolist is a firm that has a market all to themselves. Consider the possibility that there was just a single provider of PCs on the planet. That firm would be an imposing business model and it could raise the costs on all the Laptops. In that definite, less laptops would be purchased; however, the monopolist obviously would really get more cash-flow doing this. We have non-competitive business sectors when venders are more intrigued by to avoid a balance circumstance where flexibly approaches request, on the grounds that in that circumstance they can go about as value creators and it’s impractical for them to bring in more simpler cash. Real vs. Nominal Prices Definition: Real Price: The relative or real price is its value in terms of some other good, service, or bundle of goods. We use term “relative price” to make comparisons of different goods at the same time. Whereas, we use term “real price” tends to be used to make comparisons of one good to a group or bundle of other goods across different time periods, such as one year to the next. Nominal Price: The nominal price of a good is its value in terms of money, such as in Rupees, dollars, French francs, or yen. Examples: Real price: The real price of tea rose in the last year, so to buy a kg of tea I now have to skip a burger or buy fewer songs on iTunes. My cost of living rose 2% last year in real terms. Nominal price: That CD costs Rs.50. Relative price: A year of college costs about the value of a Toyota, In nova. Those tickets to see Lady Gaga cost me three weeks’ worth of food. Amity University Online Microeconomics for Business-I 15 For simple understanding we can say that in economics, nominal value is measured in terms of money, whereas real value is measured against goods or services.... In contrast with a real value, a nominal value has not been adjusted for inflation and so changes in Notes nominal value reflect at least in part the effect of inflation. Summary An elaborate analysis regarding concepts of micro and macroeconomics was done by Adam Smith, which has led to the emergence of micro economics as an important branch of study in the field of economics and business. Micro economics and macroeconomics are studied together by the economists so as to understand certain situations which can support us in undertaking of more informed decisions while allocating resources. Different economists give different views in regard to the scope of economics. It is a broad subject and includes subject matter as well as other important topics including those that support passing of value judgments. Consumers have limited incomes, which can either be spent on a variety of goods and services, or can be saved for future usage. It explains different ways where consumers based on their preferences can maximise their resources by trading off and purchasing some of the goods and services against purchasing less of other goods and services. Price comprises monetary value of a good, service or resource that is established during a transaction. We can also say that a price is the quantity of payment/ compensation that is provided by one party to another in return for one unit of goods or services. The French economist Cournot defined a market thus “Economists understand by the ‘Market’ not any particular market place in which things are bought and sold but the whole of any region in which buyers and sellers are in such free intercourse with one another that the prices of the same goods tend to equality, easily and quickly. Competitive market sectors are the place where the gracefully of any item rises to the interest of that item. Competitive market sectors when dealers are value takers, not value creators, which implies they need to set costs dependent available condition. Microeconomics delves into specific aspects of human behaviour, such as understanding how individual consumers and companies make decisions regarding the allocation and utilisation of resources. Two key themes in microeconomics are the concept of scarcity, where resources are limited and unlimited human wants. Equilibrium in microeconomics refers to the price at which the supply of goods matches the demand. It signifies a state where the forces of supply and demand are relatively balanced. Macroeconomics, on the other hand, studies the economy as a whole, encompassing national and international aspects. It examines various factors including government fiscal and monetary policies, unemployment rates, foreign trade, inflation, interest rates and Gross Domestic Product (GDP) growth. A market is any place where buyers and sellers interact. Market structures are characterised by factors such as the types of products and services offered, the number of buyers and sellers, pricing and other economic conditions. Markets can be categorised based on geographical location, time and the level of competition. Understanding market structures is crucial for assessing the degree of competition within an economy and describing its overall economic landscape. Amity University Online 16 Microeconomics for Business-I Glossary Microeconomics: The branch of economics that analyses the behaviour of individuals Notes and firms in making decisions regarding the allocation of scarce resources and the interactions among these individuals and firms. Macroeconomics: The branch of economics that studies the economy as a whole, including topics such as inflation, unemployment, economic growth and monetary and fiscal policy. Scarcity: The fundamental economic problem of having seemingly unlimited human wants in a world of limited resources. This necessitates choices to be made about how resources are allocated and utilised. Equilibrium: The state in which the supply of goods or services matches the demand for those goods or services, resulting in stable prices. It represents a balance between opposing forces in a market. Market Structure: The organisational and competitive characteristics of a market, including the number and size of firms, the degree of product differentiation, the ease of entry and exit and the extent of government regulation. Different market structures include perfect competition, monopolistic competition, oligopoly and monopoly. Check Your Understanding 1. Who is credited with an elaborate analysis of concepts in micro and macroeconomics, leading to the emergence of microeconomics as an important branch of study? a) John Maynard Keynes b) Adam Smith c) Karl Marx d) Milton Friedman 2. Why do economists’ study both microeconomics and macroeconomics together? a) To understand individual consumer behaviour b) To analyse government policies c) To make informed decisions in resource allocation d) To study market structures 3. What is the fundamental economic problem addressed by the concept of scarcity? a) Unlimited human wants b) Limited government resources c) Excess production d) Unlimited resources 4. How is equilibrium defined in microeconomics? a) When the government intervenes in the market b) When supply exceeds demand c) When the forces of supply and demand are relatively balanced d) When there is a shortage of goods 5. What does macroeconomics study? a) Individual consumer behaviour b) Market structures Amity University Online Microeconomics for Business-I 17 c) The economy as a whole, including national and international aspects d) Resource allocation decisions Notes Exercise 1. Define economics and discuss its scope and importance in modern society, highlighting its role in decision-making, resource allocation and understanding human behaviour. 2. Explain the concept of tradeoffs in economics, providing examples of how individuals and societies make choices when faced with limited resources and unlimited wants. 3. Describe what markets are in economics and how they function, including the interaction between buyers and sellers, price determination and the role of competition. 4. Define equilibrium in the context of economics and explain its significance in market analysis, including how it represents a balance between supply and demand. 5. Discuss different types of markets and the distinctions in pricing mechanisms within each type, considering factors such as competition levels, product differentiation and geographical location. Learning Activities 1. Students research and find real-world examples of economic terms related to definitions, scope and importance. They present their findings to the class, explaining the significance of each term. 2. Students participate in a scenario-based activity making decisions involving tradeoffs. They discuss and justify their decisions, focusing on the concept of opportunity cost. Check Your Understanding-Answers 1. b) 2. c) 3. a) 4. c) 5. c) Amity University Online 18 Microeconomics for Business-I Module - II: Concept of Utility Notes Learning Objectives At the end of this module, you will be able to: Discuss Utility Approach and Laws Learn Indifference Curves and Properties Know Budgets, Consumption and Equilibrium Describe Income Changes and ICC Differentiate Price Changes and PCC Discuss Price Effect Know Demand Curves and Compensated Identify Demand and Supply Concepts Describe Elasticities and Concepts Know Government Taxes and Subsidies Introduction The concept of utility lies at the heart of understanding consumer behaviour, preferences and decision-making processes. Utility refers to the satisfaction, happiness, or well-being that individuals derive from consuming goods and services. It represents a subjective measure of the benefits or value that people perceive when they use or consume a particular product or service. Central to the concept of utility is the idea that individuals seek to maximise their overall satisfaction or well-being given their limited resources, such as income or time. This pursuit of utility guides consumers in making choices about what to buy, how much to buy and how to allocate their resources among different goods and services. Utility is often depicted graphically using utility functions or indifference curves. Utility functions express the relationship between the quantities of different goods consumed and the total utility derived from consuming those goods. Indifference curves, meanwhile, represent combinations of goods that provide the same level of utility, showing consumers’ preferences between different bundles of goods. A key assumption in microeconomic analysis is that individuals are rational decision- makers who aim to maximise their utility. This assumption forms the basis of economic models used to analyse consumer behaviour and predict market outcomes. Rationality implies that consumers make choices that they believe will bring them the greatest level of satisfaction or utility, given the constraints they face. Understanding utility enables economists to make predictions about how changes in prices, incomes, or preferences will affect consumer choices. For example, the law of diminishing marginal utility suggests that as a person consumes more of a good or service, the additional satisfaction gained from each additional unit decreases. This principle helps explain why demand curves slope downwards: as the price of a good decreases, consumers buy more of it because the marginal utility gained from consuming an extra unit exceeds the price they pay. Moreover, utility plays a crucial role in welfare analysis and policy evaluation. Economists use measures such as consumer surplus, which reflects the difference Amity University Online  Microeconomics for Business-I 19 between what consumers are willing to pay for a good and what they actually pay, to assess the welfare implications of policy interventions or changes in market conditions. By understanding how changes in policies or market conditions affect consumers’ utility and Notes well-being, policymakers can make more informed decisions to promote economic welfare. The concept of utility is central to microeconomic analysis, providing insights into consumer preferences, decision-making processes and market behaviour. By understanding how individuals derive satisfaction from consuming goods and services, economists can better predict and explain economic phenomena and make recommendations for improving economic welfare and efficiency. 2.1 Concept of Utility In microeconomics, the concept of utility is fundamental to understanding how individuals make choices about what to consume. Utility refers to the satisfaction or pleasure that people derive from consuming goods and services. It represents the subjective value individuals place on different goods and helps economists analyse consumer preferences, decision-making and market behaviour. By considering utility, economists can better predict and explain economic phenomena and recommend policies to improve overall welfare and efficiency. 2.1.1 Utility Approach and Laws The neo-classical economists believed that utility is measurable. The customer can express his satisfaction in cardinal or quantitative numbers, such as 1,2,3 and so on. So, they developed the theory of consumption based on the assumption that utility is measurable and can be expressed cardinally. For this, they developed a hypothetical unit called ‘Util’, where 1 util = 1 Rupee. The utility of money remains constant. important Assumptions to Cardinal Utility Approach topic Rationality It is assumed that the consumers are rational, and they satisfy their wants in the order of their preference. The means they will purchase those commodities first which yield the highest utility and then the second highest and so on. L i m i t e d R e s o u r c e s The consumer has limited money to spend on the purchase of (Money) goods and services and thus this makes the consumer buy those commodities first which is a necessity. Maximize Satisfaction: Every consumer aims at maximizing his/her satisfaciton for the amount of money he/she spends on the goods and services. U t i l i t y i s C a r d i n a l l y It is assumed that the utility is measurable, and the utility derived from Measurable one unit of the commodity is equal to the amount of money, which a consumer is ready to pay for it, i.e. 1 Util = 1 unit of money. Diminishing Marginal This means, with the increased consumption of a commodity, the Utility utility derived from each successive unit goes on diminishing. This laws holds true for the theory of consumer behaviour. Marginal Utility of Money It is assumed that the marginal utility of money remains constant is Constant irrespective of the lvel of a consumer’s income. Utility is Additive The cardinal theorists believe that not only the utility is measurable but also the utility derived from the consumption of different commodities are added up to realise the total utility. Amity University Online  20 Microeconomics for Business-I Gradually, it was realised that the absolute measure of utility is not possible. The feeling of satisfaction could not be measured in numbers. Also, it was difficult to quantify Notes other factors like change in the moods of the consumer, change in preferences and so on. So, it was difficult to quantify utility. However, utility lays down the basis to study consumer behaviour. The basis of the consumption theory is that the consumer aims at maximising his utility. All actions of the consumer are directed towards utility maximisation. The consumption theory seeks to find out the answers to the following questions: How does a consumer decide on the optimum quantity of a commodity that he/she wishes to consume? How consumers allocate their disposable incomes between several commodities of consumption, such that utility is maximised? To seek out answers to the above-stated questions, the cardinal utility approach used in analysing consumer behaviour depends on the following assumptions: “The additional benefit which a person derives from a given increase in the stock of a thing diminishes with every increase in the stock that he already has.” Alfred Marshall- Thus, the cardinal utility approach explains the behaviour of the consumer where every individual aim at maximising his/her utility (satisfaction) for the amount of money he/she spends on the consumption of a commodity. most important The Law of Diminishing Marginal Utility topic The law of diminishing marginal utility is a very important law under marginal utility analysis. It was given by Alfred Marshall. As we know, a utility is the satisfaction that a person derives from consuming a commodity. So, we can understand marginal utility as the significant change in utility with the consumption of an additional unit of the commodity. The diminishing marginal utility implies that as the consumption increases, marginal utility declines with every additional unit consumed. i This law is based on the fundamental tendency of human nature. We know that humans want are unlimited. However, every single want is capable of being satisfied. As we consume more and more units of a good, the intensity of our want for that good decreases. Eventually, there comes a point when we don’t want it anymore. Let us understand it with the help of an example. Suppose a hungry man gets chapatis to eat. So, the satisfaction or utility that he will derive after eating the first chapati would be much more than his subsequent chapatis. With each additional chapati, the satisfaction derived would decline and at one point in time, he will not need any more chapati. So, as we consume more units of a good, the extra satisfaction that we derive from the extra unit diminishes. Given below is a table which presents the total and marginal utility derived by an individual X from consuming a number of coffee cups per day: Quantity of Coffee Total Utility Marginal Utility 1 30 30 2 50 20 3 65 15 4 77 12 5 87 10 Amity University Online Microeconomics for Business-I 21 Notes So, with every additional cup consumed the marginal utility declines. Gradually, after a certain point, the total utility will reach its maximum and marginal utility will get 0. Eventually, both will continue to decline, with marginal utility becoming negative. Relationship between total and marginal utility 1 As the total utitlity rises, the marginal utility diminishes. 2 When the total utility is maximum, the marginal utility is zero 3 As the total utility starts diminishing, the marginal utility becomes negative Let us understand the relationship between Total Utility and Marginal Utility: The Law of diminishing marginal utility helps us understand how a consumer reaches equilibrium in the case of a single commodity. A consumer utilises a commodity until its marginal utility is equal to the market price. This is the point where he derives maximum satisfaction, or utility by being in equilibrium concerning the quantity of the commodity. Any fall in the price of the commodity will disturb the equality between marginal utility and price. Hence, the consumer will consume more units of the good leading to a fall in the marginal utility, till the equilibrium is achieved. Vice versa, the consumer will consume less, if there is a rise in the price of the commodity. Limitations of the law of Diminishing Marginal Utility The law has certain assumptions like: Homogeneous units – It assumes that different units of a commodity are identical in all respects. The income, taste, temperament, habit, etc. of the consumer also remains unchanged. Standard units of consumption – The units of consumption consist of standard units and need to be defined properly. Also, the utility can be measured and expressed in quantitative terms. Continuous consumption – The consumption of units is continuous and there is no room for any gaps. Not applicable to prestigious goods – The law does not apply to prestigious goods like Amity University Online 22 Microeconomics for Business-I money, gold, etc. The satisfaction will increase in direct proportion to the increase in quantity. Notes Related goods –The utility of goods can be affected by the absence of related goods. For instance, the consumption of tea will decrease if there is non-availability of sugar. Law of Equi-marginal Utility: Explanation, Limitations and Other Details The Law of Equimarginal Utility, also known as the Law of Substitution or the Law of Maximum Satisfaction, is another important law in the field of Economics. Since wants are limited, but the resources which are needed to fulfil these wants are limited, so it is important to choose the most important wants that give maximum satisfaction. The consumer would try to make the best use of his money and choose those wants from which he can get maximum satisfaction. Explanation of the Law: The idea of the law is that the consumer should choose between different commodities such that the last rupee spent on each commodity should generate equal marginal utility. The consumer simply substitutes some units of the commodity which has greater utility for some units of the commodity of which has less utility. The crux of the law is to derive maximum satisfaction with limited income. When we substitute some units of the commodity of greater utility for some units of the commodity of less utility, the marginal utility of the former will fall and that of the latter will rise, till both are equalised. MUA / PA = MUB / PB = … = MUN / PN Where MU represents marginal utilities and P represents the price of commodities. Let us assume that we have only 7/- to spend and a choice is to be made between two commodities X and Y. The marginal utility derived from two is given as: Units Marginal utility of X Marginal utility of Y 1 10 8 2 8 6 3 6 4 4 4 2 5 2 0 6 0 -2 7 -2 -4 In this case, the most optimal solution will be 4 units of X and 3 units of Y. Total utility of 4 (X): 10+8+6+4 = 28 Total utility of 3 (Y): 8+6+4 = 18 Total utility: 28+18 = 46 Thus, maximum satisfaction is derived at spending 4/- on X and 3/- on Y, given that 7/- to be spent. If we would have spent 3/- on X and 4/- on Y, then the utility would have been 44, which is less than 46. Amity University Online Microeconomics for Business-I 23 Y AP Y OR Marginal Utility Notes L1 P 1 P N Gain of utility Loss of utility X X O MN O N1M1 Units of Money Units of Money Equi-marginal utility To conclude, maximum satisfaction is achieved when we equalise marginal utilities by substituting some units of the more useful for the less useful commodity. Limitations of the law of Equimarginal Utility The limitations of Equimarginal Utility can be stated as: Ignorance: Any form of ignorance on the part of the consumer can restrict him to make the best choice. The consumer will not be able to differentiate between greater utility and lesser utility. Any kind of irrational decision based on fashion, attitude, belief, etc. will not lead to the rational use of money spent. Since the marginal utilities from his expenditure can¬not be equalised, the utility or satisfaction may not be the maximum. Inefficient Organisation: Inefficiency and incompetency on the part of the owner will not attain maximum utility. The incompetent owner may not be able to divert expenditure to more profitable channels from the less profitable ones and get the best results from land, labour and capital employed. Unlimited Resources: The law holds good when a choice is made between limited resources. However, natural resources like air, water, soil, etc. are abundant in nature and there is no need to prioritise these resources. Hold of Custom and Fashion: If the consumer is too fashion-conscious, or rigid in his choices, then the law will not have any importance. The consumer will make choices as per his will and not attain maximum utility. In other cases, the consumer will not give up the consumption of those goods to which he is accustomed or habitual. Frequent Changes in Prices: If the prices of commodities change frequently, then the law will not hold good. The change in prices would make it difficult to compare the marginal utility of goods and the consumer will find it difficult to adjust the expenditures. Practical Importance of the Law of Substitution: Since resources are limited and everyone wants to get maximum value for money, the law of Equi marginal utility can be applied in various areas like: Consumption: While making consumption decisions, the consumer has to act rationally. The law of Equi marginal utility enables us to make the best choice between the alternatives. The consumer can thus decide upon the best option which will yield maximum satisfaction from the marginal units of money spent on the various commodities he purchases. Production: The prime goal of any business is to earn profit. As many factors of production are available, the choice is to be made such that maximum benefits can be attained. The producer has to substitute one factor of production over other factors Amity University Online 24 Microeconomics for Business-I of production. Choice has to be made between labour intensive, or capital intensive; usage of raw material X or raw material Y; and so on. Notes Exchange: Exchange is simply the substitution of one thing for another. When we sell any commodity, we get money. This money is used to buy another commodity. So, in reality, the former commodity has been substituted for the latter. Distribution: It is on the principle of marginal productivity that the share of each factor of production is determined. The use of each factor, land, labour and capital is pushed up to the point where its marginal product is equal to the marginal product of every other factor. Public Finance: The government has to cater to public welfare needs. So, it has to differentiate between wasteful expenses and useful expenses. Choice has to be made between various expenses so that maximum welfare facilities are attained. Influences Prices: The scarce goods tend to be expensive than those which are easily available. So, consumers substitute scarce goods for those which are accessible. The fall in demand eventually leads to a fall in the prices of these goods. Thus, the law of substitution regulates the prices of goods. 2.2 Description of Preferences A C Tea B D Coffee Preferences refer to the ranking or ordering of choices made by individuals based on their subjective evaluations of various goods and services. Preferences reflect individual tastes, desires and priorities and they play a crucial role in shaping consumer behaviour and decision-making. By understanding preferences, economists can analyse how consumers allocate their limited resources to maximise their satisfaction or utility. Preferences are central to economic models that aim to predict and explain market outcomes, as they provide insights into how individuals make choices in the face of scarcity. 2.2.1 Indifference Curves and Properties Individual preferences are represented on a graph which is known as the indifference curve. Thus, the indifference curve shows the combination of those two commodities which give equal utility to the consumer. The consumer would be equally satisfied by consuming either of the two commodities. The graphical representation makes it easy to understand consumer preferences. The consumer is indifferent to the combinations on the curve as he has an equal preference for the goods shown. The indifference curve is an important concept in the field of microeconomics. Let us understand the curve: Amity University Online Microeconomics for Business-I 25 B Notes E Cups of tea A consumed per week C D Cups of coffee consumed per week The adjoining graph shows the weekly consumption of tea and coffee of a consumer. The consumer consumes both beverages with equal ease. Point A represents a bundle of both tea & coffee. Point D also describes the same, but it is not good as it does not satisfy the assumption ‘the more, the better’. Point E represents is better than A & D as it offers more quantity of both beverages. Point B & C represents more quantity of one beverage at the cost of sacrificing the other. Hence, the curve allows us to understand the combination of two goods while providing a better classification of substitutes and complementary goods. Upward Sloping Indifference Curves Violate the More-is-Better Assumption In the adjoining figure, the curve is sloping upwards. This is a violation of the assumption that the consumer prefers more of one good to less of another good. So, he sacrifices one good for another. But here, both are increasing. So, the curve cannot slope upwards. Crossing Indifference Curves Violate the Transitivity Assumption In the adjoining figure, the curves are intersecting. This is also not possible because all the points on the curve denote utility at the same level. Here, the point of intersection is on both the curves. This means all combinations on both curves will give the same level of utility. Each curve represents a particular level of utility. Both curves cannot represent the same level of satisfaction. B Tea A Coffee Amity University Online 26 Microeconomics for Business-I Preference for Variety Means that Indifference Curves are Bowed In Notes Item B Item A 8 Tea 4 2 2 4 8 Coffee Points to Remember 1 More is better implies indifference curves are downward sloping. 2 Transitivity and more is better imply indifference curves do not cross. 3 Preference for variety implies indifference curves are bowed in In the adjoining figure, the curve is convex to the origin. The reason being, the consumer increases his consumption of one product over the other product. So, this represents the marginal rate of substitution, whereby one commodity is sacrificed for another commodity. The curve is downward sloping to right: When the consumer wants one commodity, the other has to be sacrificed, given that income is constant and the consumer derives the same utility from the two goods. Refer the adjoining figure. Y Chips C Ic2 A B IC1 O X Chocolates The curves do not intersect each other: If the curves will intersect, the assumption of ‘transitivity’ would be violated. Let us understand this from the given graph: Point A represents more of both the goods in comparison to Point C. So, Bundle A is preferred. Similarly, Point B represents more of both the goods in comparison to Point D. So, Bundle B is preferred. Amity University Online Microeconomics for Business-I 27 But A & D and B & C lie on the same curves, which means bundles A & D and C & B should be equally preferred in comparison to each other. So, A is preferred to C and C is equal to B, which means A is preferred to B. Similarly, Notes B is preferred to D and D is equal to A, so B should be preferred to A. But both A & B cannot be preferred at the same time. Each curve represents a particular level of satisfaction. Thus, indifference curves do not, rather cannot intersect. A Tea C B D Coffee The curves are convex to the origin: The curves are bowed inward. When a consumer substitutes one commodity, say tea for another commodity, say coffee, the marginal rate of substitution of tea for coffee is the amount of coffee that the consumer will sacrifice to get a marginal unit of tea. The marginal rate of substitution (MRS) does not increase or remains constant. An increased MRS would depict a concave slope curve, whereas a constant MRS will have a diagonal straight line at a 45° angle. It is the diminishing MRS that shows a convex curve. The important properties of indifference curve are: ™™ The curve slopes downwards towards right ™™ The curves do not intersect each other ™™ They are convex to the origin ™™ Higher curve represents higher level of satisfaction ™™ The curves can neither touch each other, nor can intersect ™™ The curve cannot touch x-axis, or y-axis ™™ The curves are like bangles ™™ The curves are not necessarily parallel to each other A higher curve represents a higher level of satisfaction: Any combination of two goods at a higher level will give more satisfaction than those at a lower level. In the given graph, the consumer gets both chips (ON) and chocolates (OM) at point P. However, at point Q, chips remain the same, but the number of chocolate increases. So, IC2 will give more satisfaction than IC1. Y P Q Chips Ic2 IC1 O X M M1 Chocolates Amity University Online 28 Microeconomics for Business-I The curves can neither touch each other, nor can intersect: In the given graph, IC2 will give more satisfaction. Point A is on IC2 and point B is on IC1. However, point C is on both Notes IC1 & 2. So, A is preferred to B and C will give the same level of satisfaction. But this is not possible as each curve has separate levels of satisfaction. The curve cannot touch the x-axis or y-axis: If the curve will touch either of the two axes, then it means that only one commodity is being considered and the consumer is not having another commodity. This is invalid as the assumption that the consumer buys in combinations gets violated. MRS of good X for good Y (MRSxy) = Y/ X Where, Y represents change in commodity Y, and X represents change in commodity X The curves are like bangles: As stated before, the indifference curve slope downwards (negatively sloped) and are convex to the origin. If we look at the given graph, if the consumer increases his consumption beyond OX, his total utility will fall. Similarly, he cannot increase his consumption beyond OY. From I1, he can move to I2, then I3, till the level of saturation. But he cannot go beyond OX or OY. The curves are not necessarily parallel to each other: It is because, firstly they do not follow, or have cardinal measurability of utility as their basis. Secondly, it is not mandatory that the rate of substitution between the two goods will always be the same. So, it’s not necessary that the curves will be parallel to each other always, but they will not intersect with each other. Marginal Rate of Substitution In simple words, the Marginal Rate of Substitution (MRS) is the rate at which the consumer will sacrifice some amount of commodity X in comparison to commodity Y, given that both X and Y give the same level of utility. Y I3 I1 I2 Y S Bannas O X X Oranges As we know, consumers like varieties. On an indifference curve, the consumer will opt for more of commodity X and less of commodity Y. He is substituting one commodity for another. It is important to note that both these commodities give equal satisfaction to the consumer. So, one commodity will be more and another will be less. The assumption ‘more is better’ supports the fact that if more of X gives you more satisfaction, then you should have less of Y. To express this logic in technical terms, the concept of Marginal Rate of Substitution (MRS) is given in economics. It is important to understand MRS in order to understand consumer behaviour. Mathematically expressed: Example: Suppose a child has 7 chocolates and 1 packet of chips. Now he wants 1 more packet of chips and willing to sacrifice 3 chocolate