BAQ108_Micro Economics(English)

BACHELOR OF ARTS MICRO ECONOMICS - I BAQ108

BACHELOR OF ARTS MICRO ECONOMICS - I BAQ108 D. M. Mithani

CHANDIGARH UNIVERSITY Institute of Distance and Online Learning Course Development Committee Chairman Prof. (Dr.) R.S. Bawa Vice Chancellor, Chandigarh University, Punjab Advisors Prof. (Dr.) Bharat Bhushan, Director, IGNOU Prof. (Dr.) Majulika Srivastava, Director, CIQA, IGNOU Programme Coordinators & Editing Team Master of Business Administration (MBA) Bachelor of Business Administration (BBA) Co-ordinator - Prof. Pragya Sharma Co-ordinator - Dr. Rupali Arora Master of Computer Applications (MCA) Bachelor of Computer Applications (BCA) Co-ordinator - Dr. Deepti Rani Sindhu Co-ordinator - Dr. Raju Kumar Master of Commerce (M.Com.) Bachelor of Commerce (B.Com.) Co-ordinator - Dr. Shashi Singhal Co-ordinator - Dr. Minakshi Garg Master of Arts (Psychology) Bachelor of Science (Travel & TourismManagement) Co-ordinator - Ms. Nitya Mahajan Co-ordinator - Dr. Shikha Sharma Master of Arts (English) Bachelor of Arts (General) Co-ordinator - Dr. Ashita Chadha Co-ordinator - Ms. Neeraj Gohlan Master of Arts (Mass Communication and Bachelor of Arts (Mass Communication and Journalism) Journalism) Co-ordinator - Dr. Chanchal Sachdeva Suri Co-ordinator - Dr. Kamaljit Kaur Academic and Administrative Management Prof. (Dr.) Pranveer Singh Satvat Prof. (Dr.) S.S. Sehgal Pro VC (Academic) Registrar Prof. (Dr.) H. Nagaraja Udupa Prof. (Dr.) Shiv Kumar Tripathi Director – (IDOL) Executive Director – USB © No part of this publication should be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording and/or otherwise without the prior written permission of the author and the publisher. SLM SPECIALLY PREPARED FOR CU IDOL STUDENTS Printed and Published by: Himalaya Publishing House Pvt. Ltd., E-mail: [email protected], Website: www.himpub.com For: CHANDIGARH UNIVERSITY Institute of Distance and Online Learning CU IDOL SELF LEARNING MATERIAL (SLM)

Micro Economics - I Course Code: BAQ108 Credits: 3 Course Objectives:  To enable the students to describe the origin of economics.  To train the students to interpret the various forms of markets  To enable the students to enlist the various types of sellers and variety of products in the market Syllabus Unit 1 – Meaning, Nature and Scope of Economics Unit 2 – The Economic Problem: Scarcity and Choice Unit 3 – The question of what to produce, how to produce and how to distribute output Unit 4 – Utility Analysis and Indifference Curve Unit 5 – Consumers Surplus and its Measurements Unit 6 – Law of Demand and its Exceptions; Elasticity of Demand and its Measurement, Law of Supply Unit 7 – Concept and Types of Production Function: Laws of Returns to Scale and Law of Variable Proportions, Cost Concepts and Cost Curves in Short and Long period Unit 8 – Behavior of Average Revenue and Marginal Revenue under Perfect and Imperfect Competition; Relationship between Average Revenue. Unit 9 – Price and Output Determination of the Firm and Industry: Under Perfect Competition in the Short and Long run; Firm’s Equilibrium under Monopoly in the Short and Long run; Discriminating Monopoly, and Monopolistic Competition. Unit 10 – Concept of Rent and Quasi Rent; Ricardian Theory and Modern Theory of Rent; Concept of Interest, Classical and Loanable Funds Theory; Concept of Profit, Gross and Net Profit, Risk and Uncertainty Theories of Profit. CU IDOL SELF LEARNING MATERIAL (SLM)

Reference Books: 1. Ahuja, H.L.(1999). Advanced Economic Theory. New Delhi: S.Chand&Co. 2. Chopra, P.N.(1998). Micro Economic Theory and Welfare Economics. New Delhi: Kalyani Publishers. 3. Chopra, P.N.(2006). Advanced Economic Theory. New Delhi: Kalyani Publishers. 4. Lekhi, R.K., Walia, H.S. & Talwar,S.J.(2003). Micro Economics. New Delhi: Kalyani Publishers. 5. Lipsey, R.G. & Chrystal, K.A.(2004). Economics. New Delhi: Oxford University Press. 6. Mandal, R.K.(2007). Micro Economics Theory. New Delhi: Atlantic Publishers. 7. Ray, N.C.(1980). An introduction to Micro Economics. New Delhi: The Macmillan Company of India. 8. Salvatore, D. (2003). Micro Economics: Theory & Applications. New York: Oxford University Press. 9. Singh, M. (1971). MangSidhant Ate Mishrat Arth-VivsthaVich Arthik Ganana. Patiala: Punjabi University. 10. Vohra, P.& Mehta, R. (2007). Micro Economics. New Delhi: Commonwealth Publishers. Web Sources: 1. https://en.wikipedia.org/wiki/Microeconomics 2. https://www.youtube.com/watch?v=IFtOcNbej0o&list=PLFNFJbo2hfBGRTC MuroZGyk NzacwmAH2L CU IDOL SELF LEARNING MATERIAL (SLM)

CONTENTS 1 - 19 20 - 27 Unit 1: Meaning, Nature and Scope of Economics Unit 2: The Economic Problem: Scarcity and Choice 28 - 37 Unit 3: The Question of What to Produce, How to Produce and 38 - 95 96 - 105 How to Distribute Output 106 - 148 Unit 4: Utility Analysis and Indifference Curve 149 - 205 Unit 5: Consumers Surplus and Its Measurements 206 - 225 Unit 6: Law of Demand and Its Exceptions 226 - 278 Unit 7: Concept and Types of Production Function 279 - 325 Unit 8: Revenue Analysis Unit 9: Price and Output Determination of the Firm and Industry Unit 10: Concepts and Theories of Rent, Interest, Profit CU IDOL SELF LEARNING MATERIAL (SLM)

Meaning, Nature and Scope of Economics 1 UNIT 1 MEANING, NATURE AND SCOPE OF ECONOMICS Structure: 1.0 Learning Objectives 1.1 Introduction 1.2 Subject-Matter of Economics 1.3 Nature of Economics 1.4 Scope of Economics Micro and Macroeconomics 1.5 Distinction Between Micro and Macroeconomics 1.6 The Subject-Matter and the Scope of Microeconomics 1.7 Importance and Uses of Microeconomics 1.8 Limitations of Microeconomics 1.9 Importance of Macroeconomics 1.10 Limitations of Macroeconomics 1.11 Summary 1.12 Key Words/Abbreviations 1.13 LearningActivity 1.14 Unit End Questions (MCQs and Descriptive) 1.15 References CU IDOL SELF LEARNING MATERIAL (SLM)

2 Micro Economics - I 1.0 Learning Objectives After studying this unit, you will be able to:  Explain the meaning of Economics  Describe economics  Elaborate the nature of Economics as a social science in the business world.  Discuss the need for micro and macro economic analysis  Apply the limitations of micro and macro economics against the complexities of reality of man’s behaviour. 1.1 Introduction Economics is characteristically a social science, as it deals with man’s behaviour as a member of society. Economics studies man’s economic behaviour, i.e., behaviour to satisfy wants and utilisation of available resources, which is the ordinary business of man’s life. Economics as a social or behavioural science is comparable with political science, sociology, psychology and ethics, each of which studies a different aspect of man’s social life and behaviour in relation to wants and resources. It studies how individuals, business, government in the nation as a whole make choices on allocation of modern economics is a science of rational choice or discriminating under condition of scarcity. Economics is essentially a logic of choice. In today’s economy people find a growing number of supermarket. Hence, they come across more items, more categories of products, more brands, more choice. Consumer behaviour is confined to choices. Economics study as such usually started with demand analysis in the learning process conducted by the university teachers world over. The term ‘Economics’ is derived from the Greek words “Oikos” and “Nomos” meaning “Household Management.” In the modern period, the scope of economics has grown much wider. CU IDOL SELF LEARNING MATERIAL (SLM)

Meaning, Nature and Scope of Economics 3 Right from the birth till the last moments of his life, man is battling against several economic problems in his day-to-day life. Definition of Economics 1. Smith’s definition: Adam Smith regarded economics as a ‘science of wealth’ which studies the process of production, corruption and accommodation of wealth. To Smith, the great object of the political Economy of every country is to increase the riches and prices of the country. In short, economics is concerned with the generation of the wealth of nation. It ignored non-material aspects of human life. The central focus of economics should be on scarcity and choices. Smith ignored this simple but essential aspect of any economic system. 2. Marshall’s Definition: Alfred Marshall defined economics as it a study of men as they live and move and thinks in the ordinary business of life. Economics is a means to an end - human welfare. 3. Robbin’s view: Lionel Robbins remarked that economics is a positive science. Robbins defined economics as : the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses. 4. In line, as Paul Samuelson stated, Economics is the study of how men and society choice, with or without the use of money, the employing scarce productive sources which could have alternative uses, to produce various commodities over times and distributed for consumption now and then in the near future among various people. 1.2 Subject-matter of Economics Economics is a positive science with many facets. Fundamentally, it is the study of man’s behaviour in the economic society. It includes, first of all, all those activities which involve the use of scarce resources to satisfy our many wants. The use of scarce resources to satisfy different wants are seen in all the traditional branches of economics such as consumption production, distribution and exchange. Consumption involves the use of scarce resource to satisfy our immediate wants. Production involves the use of resources to produce goods to satisfy wants. Distribution involves the CU IDOL SELF LEARNING MATERIAL (SLM)

4 Micro Economics - I sharing. of what is produced, The four factors of production are land, labour, capital and organisation. In exchange, we study the buying, and selling of goods and how, the prices of goads are determined. In a modern economy, government also participates in the economic arena. The phenomenon of how the government raises money and how it sends is studied in the special branch of economics called ‘Public Finance.’ Economics studies the problems of production, distribution, consumption and exchange both from static and dynamic points of view and also from micro and macro-economic points of view. In economic static we assume various to be constant and only limited factors variable. In economic dynamic, we take all factors in a given situation as changing and then study their effects. In micro- economics we study a particular situation, e.g., the study of a firm. In macro-economics,we study the economic system as a whole, e.g., in micro-economics we study how national income is created and how it is distributed, while in macro-economics, we study not only how national income is created and distributed but furthermore how the distribution of national income in turn influences the level of national income, Economics also studies also studies the problems of economic development and growth. Economics is a science and it is a social science. As Lipsey stated: Economics is the study of the use of scarce resources to satisfy unlimited human wants. It follows that economics is the study of how society manages its scarce resources towards meetings its chosen ends. Economics is used by the government to choose better policies and by corporation to make good management decisions. 1.3 Nature of Economics It is only customary but also logical to begin the study of any subject with its definition. But, when we come to economics, we are seriously handicapped in this regard, as there is neither a single comprehensive definition of the subject nor a general agreement amongst economists on the appropriateness of a particular definition. Economics being a developing and dynamic subject, its true range is not yet fixed. It cannot be fixed, either. This is because, economies move with time; so does economics: its scope — boundaries of the subject-matter, range, method and mode of analysis, approach to thinking on ecomomic ideas and institutions, their role and significance, evrything on economic ideas and institutions, their role and significance, everything changes when time moves. CU IDOL SELF LEARNING MATERIAL (SLM)

Meaning, Nature and Scope of Economics 5 Perhaps, for these reasons, economists like Hutchinson and Myrdal are of the opinion that economists need no tbe rigid regarding the precise definition of economics since a mere definiion is of little use in explaining and solving the economi problems faced by man in his life. This, however, does not mean that one can remain silent on the question of defining economics. An attempt at providing a systematic, comprehensive and analytical definition of the subject is essential to know its nature, scope, significance and limitations. “Definition”, as Erich Rolls says, “is an essential part of any systematic discipline.”1 There is need to have, at least, a working definition whose function is to describe the basic phenomenon as well as the nature of the science concerned. it also indicates the demarcation of the scope of the subject. For brevity:  Adam Smith indicated Economics as a science of wealth.  Alfred Marshall regarded Economics to be a science of human welfare.  L. Rollins assented Economics as the pragmatic science of dealing with scarcity in human society.  Economics, by and large, has focus on optimum utilisation of resorces : 5Ms : Men, Machines, Materials, Management and Money. Economics as a science The point can be established at an outset by defining science. Science is a systematic study of knowledge and fact which develops the relationship between cause and effect. All facts to be collected systematically, classified and analysed. Economics is a social science. It is systematic study of knowledge and facts above economic behaviour of people. All economic laws are , by and large universally applicable. Say, for instance when price falls, demand rise and vice versa. In this way, economics is regarded as a positive science in starting facts are they are. It implies practical approach. 1. Roll Erich, The Elements of Economic Theory, p. 2. CU IDOL SELF LEARNING MATERIAL (SLM)

6 Micro Economics - I Since economics is concerned with the mankind, it is also a normative science. It refers to the social norms of human behaviour. As a normative science, economics offers suggestions to the problems solutions. Prof. Robbins claimed economics is a positive science. Prof. Marshall, Prof. Pigou regarded economics as normative science. It implies various judgements. Economics as an Art. Knowledge is a science. Action is art. Economics is an art in the sense that it involves practical application of knowledge for achieving particular goals. Economics is virtually an integration of science and art both. If economics is not regarded by some people as a positive science, it cannot be levied as a human study discipline. Today the government can function independently without seeking the advice from its economic department. Finance Minister portfolio is totally economic based. Economic advisors often helps to stop committing mistakes of making bad financial decisions. 1.4 Scope of Economics Micro and Macroeconomics Microeconomics and macroeconomics are the two major branches of modern economic theory. The terms “microeconomics” and “macroeconomics” were originated by Ragnar Firsch in 1933. The prefixes “micro” and “macro” have been derived from the Greek words Mikros and Makros which mean “small” and “large”, respectively. In other words, “micro” means individualistic and “macro” means aggregative. Meaning of Microeconomics Micro means a small part. Microeconomics, is thus, the branch of economics which is concerned with the analysis of the behaviour of the individual (specific or particular) economic units or variables, such as an individual consumer or a producer or the price of a particular commodity, etc. Microeconomics, as Boulding puts, “is the study of particular firms, particular households, individual prices, wages, incomes, individual industries, particular commodities.” Essentially, microeconomics is a study of particular economic organisms (consumers, producers, etc.) and their interactions, and of particular economic quantities (prices, wages, income, etc.) and their determination. CU IDOL SELF LEARNING MATERIAL (SLM)

Meaning, Nature and Scope of Economics 7 Microeconomic theory is often called the ‘price theory’ or ‘value theory’ because it is primarily concerned with determination of relative prices of different goods. The subject-matter of microeconomics fundamentally covers the following areas: (i) Theory of Value, i.e., ‘Product Pricing’ and ‘Factor Pricing’, and (ii) Theory of Economic Welfare. Meaning of Macroeconomics “Macro” means large or aggregate (total). Macroeconomics is, thus, a branch of economics which deals with the aggregate behaviour of the economy as a whole. Macroeconomics is essentially an aggregate economics. It makes a study of the economic system in general. Macroeconomics perceives the overall dimensions of economic affairs of a country. It looks at the total size, shape and functioning of the economy as a whole, rather than working of articulation or dimensions of the individual parts. To use Marshall’s metaphorical language, macroeconomics views the forest as a whole, independently of the individual trees composing it. Microeconomics did refer to aggregates like market demand, market supply, industry, etc., but these are not considered in relation to the economy as a whole. On the other hand, macroeconomics concerns itself with aggregates relating to the economy as a whole. In macroeconomics, economic phenomena are studied in their aggregate size, shape and behaviour. Macroeconomics is, in fact, a study of very large, economy-wide aggregate variables like national income, total savings, total consumption, total investment, money supply, price levels, unemployment, economic growth rate, etc. 1.5 Distinction Between Micro and Macroeconomics Broadly speaking, microeconomic analysis is individualistic, whereas macroeconomic analysis is aggregative. In essence, thus, microeconomics deals with the part (individual) units while macroeconomics deals with the whole (all units taken together) of the economy. Since both approaches tend to provide an insight or understanding into the working of an economic system, both are interrelated. Hence, the differences between microeconomics and macroeconomics are bound to be more or less of a degree rather than of kind. CU IDOL SELF LEARNING MATERIAL (SLM)

8 Micro Economics - I For analytical reasons, however, microeconomics and macroeconomics may be distinguished on the following counts: Difference in Nature Microeconomics is the study of the behaviour of the individual units, in particular, consumers, firms and resource-owners (factors of production), rather than aggregates. Macroeconomics, on the other hand, is the study of the behaviour of the economy as a whole. Difference in Methodology Individualistic and aggregative. Microeconomics is individualistic, whereas macroeconomics is aggregative in the methodological approach. Traditional economic analysis, especially that followed by the neoclassical economists, was largely confined to the study of individual aspects of economic behaviour activities, problems, experiences — and the equilibrium process of an economic activity, isolated from the general set- up. Obviously, as the overall macroeconomic system is highly synchronized and interconnected in nature, no one part of the system can be considered in isolation from the others. A separate branch of study was needed to comprehend the aggregative economic relations. Macroeconomics was consequently developed to describe the typical nature of aggregate economic behaviour as distinct from isolated individual activities. Microeconomics, of course, did refer to aggregates like market demand, market supply, industry, etc., but these were not considered in relation to the economy as a whole. On the other hand, macroeconomics concerns itself with aggregates relating to the economy as a whole. In macroeconomics, economic phenomena are studied in their aggregate size, shape and behaviour. Difference in Economic Variables Micro quantities and Macro quantities. Microeconomics is concerned with the behaviour of micro variables or micro quantities such as individual demand, supply, particular commodity prices, wages, individual industries, etc. CU IDOL SELF LEARNING MATERIAL (SLM)

Meaning, Nature and Scope of Economics 9 Macroeconomics is, however, concerned with the behaviour of macro variables or macro quantities such as national income, price levels, national output, total investment, total consumption, total savings in the economy, etc. In short, microeconomics deals with the individual incomes and output, whereas macroeconomics deals with the national income and national output. Difference in the Field of Interest Microeconomic theories and macroeconomic theories. Microeconomics primarily deals with the problems of pricing and income distribution. It seeks to explain the determination of relative prices of particular commodities in the product markets. It is also concerned with the determination of factor pricing such as rent, wages, interest and profit and in turn, the theory of income distribution. Macroeconomics, on the other hand, pertains to the problems of the size of national income, economic growth and the general price level. Difference in Outlook and Scope In fact, both microeconomics and macroeconomics deal with the phenomena of aggregation. However, from the point of view of scope, the concept of aggregation in microeconomics is different from that of aggregation in macroeconomics. In macroeconomics, usually, behavioural elements of units with homogeneous characteristics are aggregated. For example, the concept of ‘industry’ in microeconomics is an aggregate concept. Industry refers to a set of all firms producing homogeneous goods taken together. Similarly, market is the aggregate concept. Likewise, market demand is measured as the summation of all individual consumer’s demand for a given product in the market. Also, market supply is the aggregate of the production supplied by individual firms. As such, microeconomics, however, never uses aggregates relating to the economy-wide total. Its scope is limited. CU IDOL SELF LEARNING MATERIAL (SLM)

10 Micro Economics - I Macroeconomics, on the other hand, uses aggregates which relate to the entire economy or to a large sector of the economy and when it considers industrial output, it refers to the whole of output produced by the industrial sector and similarly, agricultural output for the entire agricultural sector. These are sub-aggregates constituting the economy’s total output. Likewise, when macroeconomists talk of aggregate demand, they refer to the demand for all products by all households taken together for the economy as a whole. Thus, aggregate demand covers all market demands. In short, macroeconomics always considers aggregates as economy-wide total. Its scope is total or much wider than the partial scope of the microeconomics in using the concept of aggregates. Demarcation in Areas of Study Theory of value and theory of economic welfare are the major areas covered in microeconomics. The theory of value includes pricing and distribution, i.e., product pricing and factor pricing. On the other hand, income and employment theory and monetary theory are the core topics of macroeconomics. In a broad sense, public finance, growth and international trade are also included in the fields of macroeconomics. 1.6 The Subject-Matter and the Scope of Microeconomics Microeconomics is basically concerned with market behaviour and allocation of resources. It, thus, seeks to examine the fundamental questions of economic analysis, such as:  What goods shall be produced out of the given resources and in what quantities?  Who will produce them and how?  How these goods shall be valued or priced in the exchange process?  To whom and how the wealth so produced shall be distributed?  How efficiently are the resources allocated for production and consumption in the economic society? The subject-matter of microeconomics is, thus, confined to the following major fields: (i) Pricing; (ii) Distribution; and (iii) Welfare. CU IDOL SELF LEARNING MATERIAL (SLM)

Meaning, Nature and Scope of Economics 11 Pricing A major part of microeconomic theory is confined to the price theory. Microeconomics assumes the total quantity of resources available in an economic society as given and seeks to explain how these shall be allocated to the production of particular goods for the satisfaction of chosen wants. In a free market economy, the allocation of resources is based on the relative prices and profitability of different goods. As such, to explain the allocation of resources, microeconomics seeks to explain the pricing phenomenon. Price theory explains how the price of a particular commodity is determined in the commodity market. For in-depth analysis of price determination it contains:  Theory of demand of the analysis of consumer behaviour.  Theory of production and cost or the analysis of producer behaviour.  Theory of product pricing or price determination under different market structures. Distribution Distribution is an equally important branch of microeconomics. The theory of distribution basically deals with factor pricing. It seeks to explain how rewards of the individual factors of production such as land, labour, capital and enterprise are determined for their productive contribution. In other words, it is concerned with the phenomena of rent, wages, interest and profits, as the respective rewards of these four categories of factors, viz.: land, labour, capital and enterprise. Since demand and supply of each of these factors are characteristically different, there are separate theories to explain rent, wages, interest and profits. Thus, distribution field includes, general theory of distribution, theories of rent, theories of wages, theories of interest and theories of profits. Welfare Welfare economics is an important branch of microeconomics as it seeks to explain how efficient is the allocation of resources so determined. It seeks to explain under what conditions the efficiency in production, efficiency in distribution and overall economic efficiency, i.e., the efficiency in the direction of production are attainable. CU IDOL SELF LEARNING MATERIAL (SLM)

12 Micro Economics - I The theory of economic welfare explains how an individual consumer maximises his satisfaction when production efficiency is achieved by allocation of resources or reallocation of resources in such a way as to maximise output from a limited set of input. Along with individual economic welfare, welfare economics is also confined to the social welfare. Social welfare is based on overall economic efficiency of the system. When maximum individual wants are satisfied at the best possible or optimum level by a production pattern through efficient allocation of resources, overall economic efficiency or ‘Pareto optimality’ condition is reached. Conditions of overall economic efficiency, i.e., Pareto optimality conditions, are of great help in raising the standard of living of the population and maximisation of social welfare. The subject- matter and scope of microeconomics may be thus pinpointed as in Chart 1.1 given below: Chart 1.1 Microeconomics Pricing Distribution Welfare (Theory of Value) (Factor Pricing) (Welfare Economics) Theory Theory Theory General Theories of of of of Theory of Demand Production Pricing Distribution Rent Wages Interest Profits CU IDOL SELF LEARNING MATERIAL (SLM)

Meaning, Nature and Scope of Economics 13 1.7 Importance and Uses of Microeconomics Microeconomics has great theoretical and practical significance.  It explains price determination and the allocation of resources. It provides an understanding of the working of market mechanism in a capitalist/free enterprise economy.  It has direct relevance in business decision-making. The knowledge of price theory has its own significance in practical business decision-making. It is useful to a businessman in determining the price policy. It guides him in attainment of maximum productivity through optimum allocation of his given resources. It teaches him the analysis of the costs of production and estimation of the demand for his product.  It serves as a guide for business/production planning. Tools of microeconomics are useful in preparing the expansion plan of a business. It is also helpful in investment decision taking by the firm.  It serves as a basis for prediction. Microeconomic theory is useful to make conditional predictions. Demand forecasting, for instance, rests on microeconomic principles of demand.  It teaches the art of economising. Microeconomic principles deal with the economising of scarce resources and show how to use them efficiently so as to gain maximum out of minimum.  It is useful in determination of economic policies of the government. For instance, in determining a tax policy the government can know the effect and incidence of a particular tax through microeconomic tools and then judge its rationality and desirability. It also provides the principle for determining the price policy for the public enterprise.  It serves as the basis for welfare economics. It suggests how to eliminate wastages and have optimisation of resources so as to fetch maximum social welfare which is the underlying goal of welfare economics. CU IDOL SELF LEARNING MATERIAL (SLM)

14 Micro Economics - I  It explains the phenomena of international trade. Microeconomic theories explain many aspects of international trade such as the emergence, nature and gains of international trade, determination of exchange rate, impact of tariffs on prices, etc. 1.8 Limitations of Microeconomics Despite being a significant major branch of economic science and its immense usefulness in explaining economic behaviour of the individual economic units, microeconomics has inherent limitations as follows:  Impractical concept of marginalism. Microeconomic theories are based on the principle of marginalism. Marginal change refers to the addition of just a single unit more. There are concepts like marginal utility, marginal cost, marginal product, marginal revenue, etc. It, thus, refers to a bit by bit change in the total variation. The theories, thus, imply equilibrium conditions in terms of margin, such as a consumer equating marginal utility with price for the maximisation of total satisfaction, a producer equating marginal cost with marginal revenue for maximisation of profits, etc. In practice, however, it is very difficult to realise this marginal approach.  Unrealistic assumption of full employment and over simplification. The entire microeconomics is based on the assumption of full employment even in a short-term analysis, which is unrealistic. By assuming full employment microeconomic theories have over simplified the conditions of reality.  Pure capitalist model. Microeconomic theories assume laissez-faire policy and pure- capitalism in their behaviouristic models. Today there is no pure capitalism, so most of the microeconomic theories have no significant relevance to practice.  Incomplete explanation and misleading generalisation. Microeconomics studies specific economic units separately from the rest of the whole economy. It, thus, explains only a part and not the whole of working of an economic system. Microeconomics, thus, does not furnish a complete explanation of the whole phenomenon. Again, application of deductive method in generalisation from particular behaviour is often misleading. What is true for an individual may not be true for the entire system. CU IDOL SELF LEARNING MATERIAL (SLM)

Meaning, Nature and Scope of Economics 15 To recapitulate, in a nutshell, microeconomics has certain inherent limitations:  Most of the microeconomic theories are abstract.  Most of the microeconomic theories are static — based on ceteris paribus, i.e., assuming “other things being equal.”  Microeconomics unrealistically assumes ‘laissez-faire’policy and pure capitalism.  Microeconomics studies only parts and not the whole of the economic system. Thus, it cannot explain the functioning of the economy at large.  By assuming independence of wants and production in the system, microeconomics has failed to consider their ‘dependence effect’ on economic welfare.  Microeconomics misleads when one tries to generalise from the individual behaviour. It is improper to portray the character and behaviour of aggregate, simply by generalising from character and behaviour of the individual components. 1.9 Importance of Macroeconomics Macroeconomics has its unique importance:  It explains the working of the economic system as a whole.  It examines the aggregate behaviour of the macroeconomic entities like firms, households and the government.  Its knowledge is indispensable for the policy-makers for formulating macroeconomic policies such as monetary policy, fiscal policy, industrial policy, exchange control, income policy, etc.  It is very useful to the planner for preparing economic plans for the country’s development.  It is helpful in international comparison. For example, microeconomic data like national income, consumption, saving-income ratio, etc., are required for a comparative study of different countries. CU IDOL SELF LEARNING MATERIAL (SLM)

16 Micro Economics - I  It explains economic dynamism and intricate interrelationships among macroeconomic variables, such as price level, income, output and employment.  Its study facilitates overall purposes of control and prediction. 1.10 Limitations of Macroeconomics Macroeconomics has certain limitations.  It ignores, individual behaviour altogether.  It has a tendency to excessive generalisation. Thus, analysing in aggregate terms, it pays least attention to the differences involved in the constituents.  It is not easy to get correct and complete measures of economic aggregates. Thus, macroeconomic analysis lacks precision in actual practice.  Macroeconomic predictions are not fully reliable when they are based on incomplete information or inaccurate measures. National income, price index number, etc., are only rough indicators.  Often macro-level policies may not produce the same results at micro-levels. The manager or businessman should be aware of the changing economic policies at national, international and global levels. In most countries, a shift is taking place from state intervention to a freer market economy. Macroeconomic policies such as monetary, fiscal, industrial and trade policies are now oriented more to stable and sustainable economic growth and development with human face rather than being just anti-cyclical in nature. Knowledge of macroeconomics in this respect is essential for an effective business management. 1.11 Summary  Economics is an evolutionary social science.  Economics studies human economic behaviour.  Economics analyses the problems of production, distribution, consumption and exchange. CU IDOL SELF LEARNING MATERIAL (SLM)

Meaning, Nature and Scope of Economics 17  In micro economics the focus is on individual economic entity : firm, household.  In macro economics aggregate behaviour people in the economy as a whole are traced.  Price theory is the King-pin of micro economics  Income theory is pivotal in the subject matter of macro economics. 1.12 Key Words/Abbreviations  Economics: Logic of choice.  Micro economics: Focus on individual economic behaviour.  Micro economics: Focus on aggregate behaviour of the people in the economy as a whole.  Micro: Small  Macro: Large  5 Ms: Men, Machines, Materials, Management and Money. 1.13 Learning Activity 1. Search from internal/different text-books economics distinctive definitions of economics and enlist them as: -------------------------------------------------------------------------------------------------------- -------------------------------------------------------------------------------------------------------- ‘A note on Definitions of Economics: Selective Approach. 2. Identify areas of business decision-making in which economic principles can be applied. -------------------------------------------------------------------------------------------------------- -------------------------------------------------------------------------------------------------------- CU IDOL SELF LEARNING MATERIAL (SLM)

18 Micro Economics - I 1.14 Unit End Questions (MCQs and Descriptive) A. Descriptive Types Questions 1. Briefly explain the meaning and nature of Economics. 2. Distinguish between microeconomics and macroeconomics. 3. What is the subject-matter of microeconomics? 4. Trace the significance of microeconomics. 5. What are the limitations of microeconomics? B. Multiple Choice/Objective Type Questions 1. Economics is a characteristically a __________. (a) Social Science (b) Human Science (c) Economic Science (d) Static Science 2. Economic is a science of wealth, regarded by __________. (a) Marshal (b) Adam Smith (c) J.R. Hicks (d) Samuelson 3. Economics science dealing with scarcity. Whose view? (a) L.Robbins (b) J.R. Hicks (c) Jevons (d) Friedman 4. Microeconomics analysis __________. (a) aggregation behaviour (b) govern judge (c) Individual economic behaviour (d) All of the above CU IDOL SELF LEARNING MATERIAL (SLM)

Meaning, Nature and Scope of Economics 19 5. Managerial Economic is __________. (a) Evolutionary science (b) Social Science (c) Useful science (d) None of these Answers 1. (a), 2. (b), 3. (a), 4. (c), 5. (a) 1.15 References 1. Ahuja, H.L., 1999, “Advances Economic Theory”. 2. Chpra, P.N., 2006, “Advanced Economic Theory”, Kalyani Publishers, New Delhi.. 3. Libsey, R.G.m Chrystal, K.A., 2004, “Economics”, Oxford University Pres, New Delhi. 4. Salvator, D., 2003, “Micro Economics - Theory & Applications”, Oxford University Press, New york. Web Source 1. https://en.wikipedia.org/wiki/Microeconomics 2. https: www.youtube.com CU IDOL SELF LEARNING MATERIAL (SLM)

20 Micro Economics - I UNIT 2 THE ECONOMIC PROBLEM: SCARCITYAND CHOICE Structure: 2.0 Learning Objectives 2.1 Introduction 2.2 Economic Problem and Decision-making 2.3 Summary 2.4 Key Words/Abbreviations 2.5 LearningActivity 2.6 Unit End Questions (MCQs and Descriptive) 2.7 References 2.0 Learning Objectives After studying this unit, you will be able to:  Explain the meaning of scarcity.  Describe the need for choice to deal with scarcity.  Elaborate how economic problem relates to scarcity and choice. Know the essence of business problem in reality as economic problem.  Discuss the role of managerial Economic on Decision-making. CU IDOL SELF LEARNING MATERIAL (SLM)

The Economic Problem: Scarcity and Choice 21 2.1 Introduction At the heart of economics and the very core of human behaviour lies the notion of scarcity. Scarcity implies a fewness of things. Nature has provided plenty of resources to satisfy human wants. Human wants are multiple and ever changing and enlarging. As such, the available resources before the mankind too out to be relatively scarce. Since the industrial revolution in economic societies, people’s economic evolution has gone hard in hard with exploiting the available natural resources in a beneficial way. People come across economic problems on account of limited resources available as a time against unlimited wants. To deal with the problem of scarcity. How, people had to make a choice in satisfying their wants. Most urgent wants are chosen first to satisfy. An individual (householder) facing an economic problem in the course of spending his ,monthly income. Say, when a monthly income is received, in the beginning the person will allocate the needed account toward buying food, cloth and shelter,then will think of spending towards entertainment or luxuries. Even here too, he thinks of keeping out some portion of money as savings. Traditionally, economists assumed rationality in human behaviour in making economic choice. Behavioural Economics ideas posed in recent years by some modern economists have started emphasising that people act irrationally in making their choices. The field of modern economics has been transformed by behavioural insights. It has been suggested that people do not always act rationally and in their own self-interest. The truth is that, people are more complex in their economic behaviour. Anyway, scarcity has always remain a major economic issue. A rational choice is the right solution that a decision has to he made. Focus of new economic should be on the process and practice of decision making in business and personal life. 2.2 Economic Problem and Decision-Making Scarcity is the root cause of an economic problem. Decision-making is the main function of a manager. Scarcity to deal with the business problem caused by resources. CU IDOL SELF LEARNING MATERIAL (SLM)

22 Micro Economics - I Decision-making is an art as well as science. Many managerial decisions are addressed in a routine manner. Rules of thumb or the tried-and-true decision rules are, however, invalidated by the changes in routine situations. Dynamic changes in business situations need that decisions are to be addressed in a proactive manner. In proactive decision-making, many alternatives have to be explored; conditions and assumptions have to be reviewed and structured in a perspective manner. Managerial economics offers an understanding of business and economic perspectives, jargons, tools, technique and tactics that will facilitate manager’s development as a proactive decision-maker — a decision- maker who addresses dynamic business situations in a critical, comprehensive and careful manner, right in time, using formal analytical tools and skills that are guided by the knowledge, judgement, experience and intuition. Managers have to acquire the insight of both microeconomics and macroeco- nomics as the former analyses the behaviour of individual economic entities such as consumer and producers, while the later exposes issues pertaining to their behaviour in the economy as a whole. Most managerial decisions are made under conditions of varying degrees of uncertainty about the future. To reduce this element of uncertainty, it is essential to have homework of research/ investigation on the problem solving before the action is undertaken. For example, if a businessman when decides to adopt a new variety of product in his product mix, it would pay him a rich dividend if he conducts some market research in advance to ascertain the customer needs, their likings, and the possibility of the market acceptance of the new product envisaged. The process of such business research involves some common steps such as: (i) problem definition, (ii) research design, (iii) data collection, (iv) data analysis and (v) interpretation of results. Knowledge of managerial economics coupled with management science and statistical techniques will be of great help to a manager in understanding, interpretation and evaluation of quantified variables pertaining to market and business economy. Modern business decision-making is more fact-based, evidence-based and as such has greater degree of validity and reliability. Ostensibly, knowledge of managerial economics is a boon to a manager/businessman/entrepreneur. In these days of competition and dynamism, it is inevitable for a manager/businessman to specialise in his business, management as well as economics of business (i.e., managerial economics) to determine and realise the competitive advantage of the firm and the concerned industry to win. Modern businessman never believes in sheer luck. He bangs on skilful management and appropriate timely economic decision-making. This art is facilitated by the science of managerial economics. CU IDOL SELF LEARNING MATERIAL (SLM)

The Economic Problem: Scarcity and Choice 23 Managerial economics deals with practical business-problems relating to production, pricing and sale. These problems are theoretically analysed by traditional economics. For conceptual understanding and analysis of relevant business problems, we need to resort to economics theory. For further databased analysis on practical side, we make use of tools and techniques of decision sciences such as statistics and econometrics. Statistics shown how to collect, summarise and analyse data. Econometrics technique are useful in tracing empirical relationships. For example, how much to produce is a business decision. This can be arrived at through demand analysis. For this we may construct a statistical and econometric; and econometric demand function and its estimation gives up a quantitative insight for appropriate decision. In modern business, it is the management which is crucial in determining the sucess of the business. Business prospers only when management is sound and pragmatic. Modern busines involves huge investment and undertakes big risks. Management through appropriate decisions seeks to minimise risks and tries to make business a successful venture. Quick, correct and cost-effective decisions are very important for the management. When the world is approaching to a new millennium soon, there is a fourth industrial revolution in terms of computer and information technology. This has forced a new revolution in management style and concepts. Today strategic management is based on application of managerial economics with the growing use of information technology and computer. Information technologists and managerial economists are the knowledge workers who are indispensible. These knowledge workers have brought the unprecedented management revolution in the business world in the global setting. Managerial economics is an evolutionary science, it is a journey with continuing understanding and application of economic knowledge — theories, models, concepts and categories in dealing with the emerging business/managerial situations and problems in a dynamic economy. In short, managerial economics essentially implies the application of economics principles and methodologies to the decision-making process within the firm under conditions of uncertainty, ‘it seeks to establish rules and principles to facilitate the attainment of the desired economic goals of management. These economic goals relate to costs, revenues and profits, and are important within both the business and non-business institution.’ (E.J. Douglas) CU IDOL SELF LEARNING MATERIAL (SLM)

24 Micro Economics - I The role of managerial economics in the decision-making process is illustrated in Fig. 2.1. Economic Theory Business Business Economics Optional Decision Business Problems Decision Science: Tools and Techniques Fig. 2.1: Role of Managerial Economics in Decision-making To appreciate the point narrated in Fig. 2.1, let us consider a hypothetical case of a business firm. The firm’s business behaviour depends on its objective. Suppose the firm, objective is profit maximization. Its output decision towards profit maximization is based on application of economics theory that the firm needs to equate its Marginal Cost (MC) with Marginal Revenue (MR). To meaning the MR, the firm has to trace the empirical relationships of cost function and revenue function using econometric models (decisions science tools). Once optimal output level is produced the business marketing strategy advertising, etc., should be carried on accordingly as per the market structure. This suggests that the knowledge of business economics is very useful in rational decision- making in modern business. 2.3 Summary  People confront scarce resources.  All our wants cannot he satisfies at a time since our resources are limited.  Since resources are scare people how to make rational choices. CU IDOL SELF LEARNING MATERIAL (SLM)

The Economic Problem: Scarcity and Choice 25  An implication of scarcity is that people must make choices.  Choice is the challenge to scarcity.  Making choice is the track of decision- making.  Traditional economics assumes rationality in economic choice.  Behaviour economics assume people’s behaviour may be irrational in making choice. 2.4 Key Words/Abbreviations  Scarcity: Shortage of resources.  Rationality: Thoughtfulness  Irrationality: behave without paying thoughts  Managerial Economics: Economic principles applied in business decisions.  Economic Problem: Problem to deal with scarcity through ration choice making. 2.5 Learning Activity 1. Conceive economic problem to be faced by a garment factory in Mumbai. Enlist the major points. -------------------------------------------------------------------------------------------------------- -------------------------------------------------------------------------------------------------------- 2. Discuss in class the role of managers in a hotel business with reference to economic problem. -------------------------------------------------------------------------------------------------------- -------------------------------------------------------------------------------------------------------- CU IDOL SELF LEARNING MATERIAL (SLM)

26 Micro Economics - I 2.6 Unit End Questions (MCQs and Descriptive) A. Descriptive Types Questions 1. Write an explanatory note on : Scarcity and choice. 2. Decision -making is an art as well as science. Elucidate 3. Describe the role of managerial economics in the decision-making process. B. Multiple Choice/Objective Type Questions 1. Human wants are __________. (a) Unlimited (b) Several (c) Social (d) Money- spending 2. Choice challenges __________. (a) Rationality (b) Scarcity (c) Decisions (d) All of the above 3. Business prospers only when manage is __________. (a) Conscious (b) Rational (c) Pragmatic (d) Policy-oriented 4. Economic problem arises on account of __________. (a) Extravagancy (b) Government taxes (c) Irrational behaviour (d) Scarcity resources 5. In their economic behaviour people are __________. (a) More complex (b) More careful (c) More conscious (d) More courageous Answers 1. (a), 2. (b), 3. (c), 4. (d), 5. (a) CU IDOL SELF LEARNING MATERIAL (SLM)

The Economic Problem: Scarcity and Choice 27 2.7 References 1. Mandul, R.K., 2007, “Micro Economics Theory”, Atlantic Publishes, New Delhi. 2. Ray, N.C., 1980, “An Introduction to Micro Economics”, Macmillan Co., New Delhi. 3. Vohra, P., and Mehta, R., 2007, “Micro Economics”, Common wealth Publishers, New Delhi. CU IDOL SELF LEARNING MATERIAL (SLM)

28 Micro Economics - I UNIT 3 THE QUESTION OF WHAT TO PRODUCE, HOW TO PRODUCE AND HOW TO DISTRIBUTE OUTPUT Structure: 3.0 Learning Objectives 3.1 Introduction 3.2 Business Problem:An Economic Problem 3.3 Alternative Mechanism of ResourceAllocation towards Production: Output 3.4 Summary 3.5 Key Words/Abbreviations 3.6 LearningActivity 3.7 Unit End Questions (MCQs and Descriptive) 3.8 References 3.0 Learning Objectives After studying this unit, you will be able to:  Explain the problem of resource allocation.  Describe how business problems is essentially an economic problem.  Apply the contents of business output decisions.  Discuss the different economic system working towards resources allocation. CU IDOL SELF LEARNING MATERIAL (SLM)

The Question of What to Produce, How to Produce and How to Distribute Output 29 3.1 Introduction Economics is usually defined as the study of the allocation of scarce resource among competing ends. Every economic society, whether rich or poor, ancient or modern, faces the basic problems of allocation of its resources which are scarce in relation to its unlimited wants. It has to solve the problem of allocation of scarce means among the competing ends of the achievement of maximum welfare of society. In short, the Optimal allocation of productive resources (like time, labour, land, capital, etc.) is the main economic problem. The economic problem of a society basically relates to the necessity of choosing what, how and for whom to produce, and how to achieve economic growth and maximise welfare of the community at large. To solve this problem in an organised way, some institutional arrangement is necessary. Such institutional arrangement provides the necessary mechanism for arriving at the decisions to solve the basic economic problem. The institutional arrangement and the accompanying mechanism constitute an economic system. Because of the economic problem, there is the emergency of an economic system. “In all economic system the basic problem is the allocation of scarce means competing ends for the achievement of maximum results,” says Prof. Halm. An economy or economic system of a country refers to the form of economic organisation constituted by the mode and method of production, kinds of economic entities and institutions, the objectives and functions of the economy directed towards satisfying people’s wants. 3.2 Business Problem: An Economic Problem Following are the basic business problems where managerial decision-making is based on economic-understanding towards.  What to produce?  How much to produce? CU IDOL SELF LEARNING MATERIAL (SLM)

30 Micro Economics - I  How to produce?  Where to produce? All these problems in gist involves allocation and utilisation of productive resource such as land, labour, capital, enterprise including finance or money in a modem economy. Five Ms: Men, Machines, Materials, Management and Money are important elements of input in production decision- making and these are scarce means need to be economised in use. Optimal utilisation of these resources is taught by the lessons of economics or business economic in particular. In a business activity, decisions about resource allocation have to be made in three stages:  Allocative Decision: What types of goods and services to be produced from the available productive resources which are relatively scarce.  Productive Decision: How much to be produced and how to combine or use the resources for the desired quantity and pattern of goods and services.  Distributive Decision: To whom these goods and services are to be distributed/marketed or supplied. The interrelationship between these decisions is portrayed in Fig. 3.1. BUSINESS DECISION Production Technology : Distribution : How to Produce? For whom to Produce? Allocation : What to Produce? Fig. 3.1: The Business Decision CU IDOL SELF LEARNING MATERIAL (SLM)

The Question of What to Produce, How to Produce and How to Distribute Output 31 Orientation of business economics lies in helping the process of rational decision-making for solving business problems which arise on account of scarcity of means or resources. Economics being a science which challenges scarcity. It is a subject that shows how to deal with the problem of scarcity of resources for the satisfaction of human wants. Business activity is essentially concerned with the use of scarce productive means in this context. Managerial or business economics, therefore, heavily leans on economics in drawing the techniques to deal with the problem of scarcity. As a matter of fact, Prof. Robbins while defining economics asserted that economics deals with economic problem – the problem of scarcity in economic and business life. The basic economic problems are, thus: 1. Allocation of Resources: It implies the decision as regards what goods and services are to be produced and in what quantities. This involves the organisation of a system for the production activity. It means that the concerned society has to devise methods and an institutional framework in order to mobilise and exploit resources in the desired direction. It seeks optimal use of the resources. 2. Exploitation of Resources by Whom and How: The institutional framework of the economic system determines who will produce the required goods and services and how for the satisfaction of its members’ wants. Here, there is the question of the organisation of production that involves the problem of choice of techniques. Right choice of technique is essential for the efficient use of the available resources. Basically, how to produce is a technical problem and who will produce is the problem of organisation, management and ownership of the means of production. The relevant decisions in this regard are governed by the institutional framework and the ideology of the particular economic society. This constitutes the economic system. Another related problem in the exploitation of resources is “where to produce”. It is fundamentally the problem of localisation, concentration and dispersal of industrial activity. An economic system also provides the necessary guidelines in determining “where to produce”. CU IDOL SELF LEARNING MATERIAL (SLM)

32 Micro Economics - I 3. The Problem of Distribution: Distribution of income or national product is another related task of an economic system. Once the goods are produced by an economic society, it has to decide as to who, among its members, will enjoy the material benefits of these goods. On ideological grounds, distribution must be just and fair. An economic system charts its course of arrangement within its broad framework for the functional as well as personal distribution of the national income. To solve the basic economic problem, an economy or economic system has to accomplish the following basic tasks: a. Production: Decisions are to be made regarding what goods and services are to be produced and in what quantities. These decisions involve allocation of resources to different channels of productive activity. The other related task is to determine ‘by whom and how’ the production is to be undertaken. The decision regarding ‘by whom’ pertains to the selection of agency — individual or government — which will take major decision about production. The decision about ‘how’ involves the choice of appropriate technique of production for the efficient utilisation of resources. b. Distribution: Decision about who will enjoy the benefits of the goods produced will also have to be taken. That is the decision regarding the distribution or sharing of the national income. For the maximum welfare of the people, distribution of the national product should be equitable and fair. In short, the basic economic problem of a society is that of harnessing the scarce resources for the satisfaction of maximum wants. The solution of the problem involves a series of decisions regarding production and distribution. The usual decisions are: 1. What goods and services are to be produced? 2. What quantity of the goods and services are to be produced? 3. Who is to undertake the task of production? 4. Which resources will be required and in what quantities? 5. How are these resources to be mobilised? 6. How are the resources to be allocated and diverted to the desired direction of the productive activity? CU IDOL SELF LEARNING MATERIAL (SLM)

The Question of What to Produce, How to Produce and How to Distribute Output 33 7. How should the resources be exploited efficiently? What techniques and methods of production are to be used for efficient utilisation of resources? 8. How, to whom and in what proportion are the goods produced to be distributed? 9. What is to be the level of employment in the society and the incomes and consumption of goods and services by the people? Depending upon the economic and political philosophy accepted by a society, every society will device the necessary institutional framework and will resort to ways and means or mechanisms to arrive at and implement these decisions. The institutional framework in the modern times may be in the form of a capitalist economy, a social economy, or a mixed economy. The ways and means or mechanisms to arrive at and implement the decisions are customs, command or central direction and market mechanism. Within the chosen framework, one or more of these mechanisms may be resorted to. But a specific mechanism is always dominant in a particular framework. For example, the market mechanism is dominant in a capitalist economy, while the mechanism of central direction is dominant in a socialist economy. 3.3 Alternative Mechanism of Resource Allocation towards Production: Output Allocation of scarce resources is the basic economic problem of a society. From time to time, different economic societies or systems have adopted different methods of mechanisms to solve their economic problem of resources adjustment. These mechanisms may be grouped as: (1) Customs, (2) Central direction, and (3) Market mechanism. 1. Customs: Customs refer to usual or old practices or traditions of a society. It is the oldest and most primitive method of solving the economic problem. In a custom-bound economy, economic status, relations and economic activities — regarding production and distribution — are governed by the procedures devised in the distant past by customs, traditions and conventions. These procedures became firmly established through long usage and began to be regarded as unwritten laws. Since the wants were few and villages were economically self-sufficient, economic activities were few and simple. So the economic problem of villages could be solved by custom through such economic activities. CU IDOL SELF LEARNING MATERIAL (SLM)

34 Micro Economics - I A custom-ruled economy works automatically. It provides security and stability by taking care of the minimum needs of the people in a traditional way. It is, however, static. It works only in a routine manner. It suppresses individual economic freedom. Jobs were mostly decided by castes. For example, in such a caste-ridden society, a blacksmith cannot change his profession for that of a carpenter or potter. Such a rigid economy cannot adjust itself to the needs of a modern industrial economy and cannot solve its economic problems. 2. Central Direction: Since ancient times, central direction or command mechanism has been practiced — to a more or less extent — for solving the economic problems. Under central direction or command mechanism, production and distribution activity is organised or directed by a supreme authority like a monarch, a director or the delegated authority like the central planning authority. Central direction implies a system of authoritarian economic organisation. Purposiveness, government intervention, economic security, planning and dynamism are the distinguishing features of a modern command-based economy. 3. Market Mechanism: Market mechanism or a freely fluctuating price mechanism is also an important method of solving the economic problems. The economy based on the market mechanism is referred to as market economy or free enterprise system of capitalism. It is favoured under democracy. In a market system, the adjustment between the forces of demand and supply is brought about by the free movement of prices. Movement of prices reflect the consumer decisions of what to consume. The movement of prices also provide guidelines to the private individuals regarding the major economic decisions as to what to produce, how much to produce and to whom to distribute. Thus, movements of prices co-ordinate the decisions of the consumers and producers, bring about the balance between demand and supply and thereby allocate productive resources of the society in the channels desired by consumers and distribute national income. The working of market mechanism is based on the incentive of private profit and is automatic. According to Adam Smith, invisible hands of market mechanism automatically bring optimum adjustments of resources. Right to poverty, free enterprise, freedom of consumption and production and perfect competition are the essential features of market mechanism. It also implies the policy of laissez-faire or non-intervention by the government. CU IDOL SELF LEARNING MATERIAL (SLM)

The Question of What to Produce, How to Produce and How to Distribute Output 35 Characteristically, production in a market-oriented economy is profit-oriented. The market economy is subject to inherent cyclical fluctuations. In practice, however, no economy is based purely on tradition, command or market mechanism. Several elements of all these mechanisms are present in some degree or the other in all the economies. Hence, all modern economies are mixed economies in a broad sense. But, categorically, an economy is named or described by its predominant element. 3.4 Summary  Optimal allocation resources is the basic socio- economic problem.  What to produce, how to produce, hoe much to produce, where to produce and for whom to produce are the basic business problems.  Socio customer, central direction, and market mechanism are instituted towards allocaton of productive resources.  Market economy is favored under democracy. 3.5 Key Words/Abbreviations  Five M’s: Men, machines, Materials, Management, Money.  Customs: Social traditions and rules  Central Direction: Command mechanism.  Market Mechanism: Automatic, market Economy. 3.6 Learning Activity 1. Enlist major developing economics in Asia and indicate their order of economic system. Collect information from interest or geography books. -------------------------------------------------------------------------------------------------------- -------------------------------------------------------------------------------------------------------- CU IDOL SELF LEARNING MATERIAL (SLM)

36 Micro Economics - I 2. Students can make a list of measures or solutions of the problems regarding production and distribution in todays economic. -------------------------------------------------------------------------------------------------------- -------------------------------------------------------------------------------------------------------- 3.7 Unit End Questions (MCQs and Descriptive) A. Descriptive Types Questions 1. What do you mean by an economic problem? 2. What are the alternative Socio-economic mechanism towards resource allocation? 3. Indicate the system of resource allocation in a business activity. B. Multiple Choice/Objective Type Questions 1. Which is the main economic problem? (a) Optimal allocation of resources (b) Productive activity (c) Business profits (d) Economic expansion 2. Allocate decision implies __________. (a) How to produce (b) What to produce (c) Whose to produce (d) When to produce 3. Productive decision implies __________. (a) Why to produce? (b) For when to produce (c) how much to produce (d) None of these 4. Market mechanism runs through __________. (a) Price mechanism (b) Government directives (c) capital (d) All of the above. CU IDOL SELF LEARNING MATERIAL (SLM)

The Question of What to Produce, How to Produce and How to Distribute Output 37 5. Invisible hands of market mechanism lead to economic optimation. Who indicated? (a) Robbins (b) Marshall (c) Pigon (d) Adam Smith Answers 1. (a), 2. (b), 3. (c), 4. (a), 5. (d) 3.8 References 1. Lekhi, R.K., Walia, H.S. & Talwar, S.J., 2003, “Micro Economics”, Kalyani Publishers, New Delhi. 2. Salvatore, D., 2003, “Micro Economics”, Oxford University Press, New York. Web Source 1. https://en.wikipedia.org/wiki/microeconomics CU IDOL SELF LEARNING MATERIAL (SLM)

38 Micro Economics - I UNIT 4 UTILITYANALYSIS AND INDIFFERENCE CURVE Structure: 4.0 Learning Objectives 4.1 Introduction 4.2 Basic Concepts and Postulates of the Marshallian Cardinal UtilityApproach 4.3 The Law of DiminishingMarginal Utility 4.4 The Law of Equi-Marginal Utility: The Proportionality Rule 4.5 Consumer Equilibrium 4.6 The Law of Equi-Marginal Utility and the Law of Demand 4.7 BasicAssumptions of Marshallian UtilityAnalysis 4.8 Limitations of the MarshallianApproach 4.9 Indifference CurveAnalysis Introduction 4.10 Indifference Schedule 4.11 Indifference Curve 4.12 Properties of Indifference Curves 4.13 The Marginal Rate of Substitution 4.14 The Budget Constraint: The Price-Income Line 4.15 The Consumer Equilibrium 4.16 The Income Effect: Income Consumption Curve CU IDOL SELF LEARNING MATERIAL (SLM)

Utility Analysis and Indifference Curve 39 4.17 The Substitution Effect 4.18 The Price Effect: Price Consumption Curve 4.19 Separation of Price Effect From Income Effect and Substitution Effect 4.20 Price Effect in the Case of ‘Inferior’Goods 4.21 Giffen’s Paradox 4.22 Superiority of Indifference CurveApproach 4.23 Shortcomings of the Indifference CurveApproach 4.24 Summary 4.25 Key Words/Abbreviations 4.26 LearningActivity 4.27 Unit End Questions (MCQs and Descriptive) 4.28 References 4.0 Learning Objectives After studying this unit, you will be able to:  Explain the meaning of term ‘utility’.  Discuss ten marshallian approach to cardinal measured of utility.  Elaborate the indifference technique.  Analyse price effect composed by income and substitution effects.  Describe the condition of consumer equilibrium.  Apply a comparison between Marshallian and Hicksian approaches in Demand Theory. CU IDOL SELF LEARNING MATERIAL (SLM)

40 Micro Economics - I 4.1 Introduction The term ‘utility’ refers to the capacity of a commodity to satisfy a human want. Economists have offered their theories of consumer behaviour on the ALFRED MARSHALL basis of the measurement of utility. There are two major approaches regarding the measurement of utility, viz., cardinal measurement and ordinal measurement of utility. Accordingly, we have: (i) cardinal utility theory of consumer behaviour, and (ii) ordinal utility theory of consumer behaviour, popularly known as the indifference curve analysis. The Marshallian approach in the theory of demand is based on the following postulates. 1. Concept of utility and its cardinal, i.e., numerical, measurements; 2. The law of diminishing marginal utility; and 3. The law of equi-marginal utility. Hence, Marshall’s theory of demand is commonly described as the ‘Marginal Utility Approach’. 4.2 Basic Concepts and Postulates of the Marshallian Cardinal Utility Approach 1. The Concept of Utility When the consumer consumes or buys a commodity, he derives some benefit in the form of satisfaction of a certain want. This benefit or satisfaction experienced by the consumer is referred to by economists as ‘utility’. Definition: Utility is something experienced by the consumer about the given commodity’s significance relating to its want-satisfying power. Utility is, an introspective or a subjective term. It relates to the consumer’s personal experience. Utility is the want-satisfying power of a product. CU IDOL SELF LEARNING MATERIAL (SLM)

Utility Analysis and Indifference Curve 41 2. Cardinal Measurement of Utility Marshall assumes cardinal measurement of utility. Cardinal measurement is a numerical expression. Marshall believed that utility could be measured in numerical terms in its own units called ‘utils’. To him, utility of commodity is quantifiable, hence measurable numerically. He assumes that, for instance, to a consumer an apple may yield 16 utils of satisfaction, while a mango may yield 30 utils of satisfaction. Thus, utility of a mango is proportionately three times the utility of an apple. Such a numerical measurement is imaginary. When a utility statement is tabulated as a schedule of utility, it is referred to as the cardinal measurement of utility. 3. Total Utility and Marginal Utility The concept of total utility and marginal utility are the basic concepts in the cardinal measurement of utility. Definition: Total utility means total satisfaction experienced or attained by the consumer regarding all the units of a commodity taken together in consumption or acquired at a time. Apparently, total utility tends to be more with a larger stock and less with a smaller stock. In mathematical terms, thus, total utility is a direct function of the number of units of a commodity in consideration. To put it symbolically, TUx = F(Qx), TUx where Qx > 0 (Read: Total utility of X is the increasing function of its quantity where TUx = total utility of a commodity X, F = functional relation, Qx = quantity of X. refers to a small change). Definition: Marginal utility is the additional utility obtained from an extra unit of any commodity consumed or acquired. In other words, marginal utility refers to the successive increment in total utility made by taking separately each unit of the commodity in a successive manner as an addition to its total stock. Thus, marginal utility may be measured as the difference between the utility of the total units of stock of consumption of a given commodity minus that of consuming one unit less in the stock CU IDOL SELF LEARNING MATERIAL (SLM)

42 Micro Economics - I considered. In symbolic terms, thus: MUn = TUn – TUn – 1 where, MUn stands for the marginal utility relating to n units of stock of a commodity. TUn = Total utility of n units taken together, TUn – 1 = total utility of n–1 units taken together. The computation of marginal utility has been illustrated in Table 4.1 below. Table 4.1: Total Utility and Marginal Utility Units of X Total Utility Marginal Utility n TU MUn = TUn – TUn – 1 00 1 35 35 – 0= 35 2 60 60 – 35 = 25 3 75 75 – 60 = 15 4 80 80 – 75 = 5 The schedule given above is imaginary. In this schedule, we have assumed a cardinal measurement of utility in terms of so many units expressed in numbers. It can be seen that when our consumer in the illustration buys 4 units of X, he derives 80 units of total satisfaction. Total utility, thus, measures the strength of the consumer’s demand for the entire stock of the given commodity. In short, marginal utility refers to the utility of the marginal unit of consumption. Marginal unit is the last unit in the sequence of consumption. 4.3 The Law of Diminishing Marginal Utility The law of Diminishing Marginal Utility (DMU) lies at the centre of the cardinalist approach. Statement of the Law: Other things being equal, as the quantity of commodity consumed or acquired by the consumer increases, the marginal utility of the commodity tends to diminish. In mathematical terms, the law implies a decreasing functional relationship between the quantity of a commodity consumed and marginal utility derived. dUx Thus: MUx = F(Qx) where, dQx < 0. CU IDOL SELF LEARNING MATERIAL (SLM)

Utility Analysis and Indifference Curve 43 This means each additional unit of consumption adds relatively less and less to the total utility obtained by the consumer. Illustration of the Law To illustrate the tendency of the diminishing marginal utility, let us review the hypothetical utility schedule computed through the introspective method of enquiry into consumer’s consumption experience, as given in Table 4.2. Table 4.2: Utility Schedule Units of Consumption Total Utility Marginal Utility of Commodity TUx MUx X (Units) (Units) 1 15 15 2 25 10 3 33 8 4 38 5 5 40 2 6 40 0 7 35 –5 From the schedule in Table 4.2, it appears that as units of commodity X consumed increase, the marginal utility derived from each successive unit tends to diminish. Eventually, the marginal utility implies the point of satiety, that is, there is complete satisfaction of a given want when marginal utility is zero. The marginal utility becomes zero only when the want’s intensity is nil, as it is fully satisfied. Negative marginal utility indicates disutility or dissatisfaction resulting from excessive consumption of a commodity. When the marginal utility schedule (given in Table 4.2) is plotted on a graph, we have a diagrammatic representation of the law through the curve we get, which is called ‘the marginal utility curve’ (see Fig. 4.1). In Fig. 4.1, the X-axis represents the units of commodity X, and the marginal utility is measured on the y-axis. The MU curve represents the marginal utility curve. The marginal utility curve slopes downward from left to right, indicating an inverse relationship between marginal utility and the stock of the commodity, i.e., as the stock increases, the marginal utility diminishes. CU IDOL SELF LEARNING MATERIAL (SLM)

44 Micro Economics - I The MU curve intersects at a certain point on the x-axis. This intersection point is the point of satiety, where the marginal utility is zero. After this, the curve slopes down further, denoting negative values. Y MARGINAL UTILITY 60 50 40 30 20 10 O 12345678 X UNITS OF COMMODITY Fig. 4.1: Marginal Utility Curve Assumptions of the Law The law of diminishing marginal utility is conditional. Its validity is subject to the following assumptions or conditions: (i) Homogeneity: The law holds true only if all the successive units taken in the process of consumption are homogeneous in character, like quality, size, taste, flavour, colour, etc. (ii) Continuity: The consumption or acquisition process is continuous at a given time, that is, units are taken one after another successively without any interval of time. Indeed, the first cup of tea in the morning and the second one in the evening will not result in the diminishing of marginal utility. (iii) Reasonability: The units of consumption are in reasonable size, of normal standard unit. For instance, we should think of a glass of milk, a cup of tea, etc., and not a spoon of milk or tea. CU IDOL SELF LEARNING MATERIAL (SLM)