E-LESSON-4 MICRO ECONOMICS-1 ENG

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B.A.English 2 All right are reserved with CU-IDOL Microeconomics-I Course Code: BAQ108 Semester: First e-Lesson: 4 SLM Unit: 4 www.cuidol.in Unit-4(BAQ108)

MICRO ECONOMICS 33 OBJECTIVES INTRODUCTION Students will be able to Describe the concept of In this unit we are going to learn about Utility utility, total and marginal. Student will be able to understand the concept of Indifference Curve. Student will be able gain knowledge about consumer Under this you will be able to understand equilibrium the concept of indifference curve. Student will be able to know about how can maximum Students will be able to understand the satisfaction be achieved from monetary income concept of consumer equilibrium www.cuidol.in Unit-4(BAQ108) INSTITUTE OF DISTANACEll ArNigDhtOaNrLeINreEsLeErAvRedNIwNiGth CU-IDOL

TOPICS TO BE COVERED 4 Ordinal Utility Analysis Indifference Curve. Properties of Indifference curve. Budget line Consumer Equilibrium www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

Concept of Utility 5 Definition:It is a measure of satisfaction an individual gets from the consumption of the commodities. In other words, it is a measurement of usefulness that a consumer obtains from any good. A utility is a measure of how much one enjoys a movie, favourite food, or other goods. It varies with the amount of desire. Utility: is want satisfying power of a commodity www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

ORDINAL UTILITY ANALYSIS 6 The concept of Cardinal Utility was used by Marshal to define Consumer's Equilibrium. Cardinal Utility means consumer could measure the satisfaction derived by the consumption of any goods or services in terms of number and unit of that measurement is “Utils” or the Money. Where as Ordinal Utility means giving the rank to the utility derived by the consumption of goods and services. This Concept was given by J.R. Hicks. This is more realistic and better than cardinal utility. This is totally based on Introspection. Ordinal utility function is a function representing the preferences of an agent on an ordinal scale. Ordinal utility theory claims that it is only meaningful to ask which option is better than the other. www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

Total Utility and Marginal Utility 7 Total utility : It is the sum of satisfaction/utility a consumer gets from consumption of all the units of a commodity at a given time. Marginal Utility : It is a net increase in total utility by consuming an additional unit of a commodity. www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

Difference between Total Utility 8 and Marginal Utility. Basis of Comparison Total Utility Marginal Utility Definition The aggregate of satisfaction that a The amount of satisfaction derived Rate of Increase consumer derives from the by a consumer by additional Result consumption of any particular goods consumption of a unit of any www.cuidol.in or services particular goods or services Total Utility rises as more Marginal utility diminishes with an consumption are done increase in total utility Suffers from diminishing returns Marginal utility reduces with the consumption of each additional unit Unit-4(BAQ108) All right are reserved with CU-IDOL

Law of Diminishing Marginal 9 Utility:  The law of diminishing marginal utility is comprehensively explained by Alfred Marshall. According to his definition of the law of diminishing marginal utility, the following happens:  “During the course of consumption, as more and more units of a commodity are used, every successive unit gives utility with a diminishing rate, provided other things remaining the same; although, the total utility increases.” Explanation for the Law of Diminishing Marginal Utility: We can briefly explain Marshall’s theory with the help of an example. Assume that a consumer consumes 6 apples one after another. The first apple gives him 20 utils (units for measuring utility). When he consumes the second and third apple, the marginal utility of each additional apple will be lesser. This is because with an increase in the consumption of apples, his desire to consume more apples falls. Therefore, this example proves the point that every successive unit of a commodity used gives the utility with the diminishing rate www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

Schedule for Law of Diminishing 10 Marginal Utility: The total utility obtained from the first apple is 20 utils, which keep on increasing until we reach our saturation point at 5th apple. On the other hand, marginal utility keeps on diminishing with every additional apple consumed. When we consumed the 6th apple, we have gone over the limit. Hence, the marginal utility is negative and the total utility falls. www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

Saturation Point: The point where the desire to consume the 11 same product anymore becomes zero. All right are reserved with CU-IDOL Disutility: If you still consume the product after the saturation point, the total utility starts to fall. This is known as disutility. When the first apple is consumed, the marginal utility is 20. When the second apple is consumed, the marginal utility increases by 15 utils, which is less than the marginal utility of the 1st apple – because of the diminishing rate. Therefore, we have shown that the utility of apples consumed diminishes with every increase of apple consumed. Similarly, when we consumed the 5th apple, we are at our saturation point. If we consume another apple, i.e. 6th apple, we can see that the marginal utility curve has fallen to below X-axis, which is also known as ‘disutility’. www.cuidol.in Unit-4(BAQ108)

Assumptions of the Law 12 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. www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

13 (iv) Constancy: The law presumes that there is no change in income, taste, habit or preference of the consumer. Similarly, the price of the commodity is also assumed to be given. (v) Rationality: The consumer is assumed to be a rational economic man whose behaviour is normal and one who is aiming at maximisation of satisfaction. vi) Constancy of Marginal Utility of Money: Throughout the operation of the law, it is assumed that not only the money income of the consumer is given, but its marginal utility remains constant so that the consumer’s preference remains unchanged. (vii) Cardinal Measurement of Utility: Marshallian exposition of the law of diminishing marginal utility is based on the cardinal measurement of utility. It is assumed that utility can be numerically expressed by the consumer, i.e., he is capable of mentioning the quantum of utility derived from each additional unit consumed or acquired by him www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

The Law of Equi-Marginal Utility: 14 Other things being equal, a consumer gets maximum total utility from spending his given income, when he allocates his expenditure to the purchase of different goods in such a way that the marginal utilities derived from the last unit of money spent on each item of expenditure tends to be equal. The law essentially means, the consumer maximises his satisfaction when he obtains equi marginal utilities from all the goods purchased at a time. In a more analytical way, to consider the condition of consumer’s equilibrium with respect to maximum total satisfaction, a proportionality rule (the behavioural rule) in terms of equi-marginal utility has been .formulated by Marshall www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

The Proportionality Rule 15 When the ratios of marginal utility to prices of different goods are equalised with the given marginal utility of money income of the consumer, total utility so derived would be the maximum. It follows that so long as the ratios of marginal utility of money are not equalised, the consumer will go on redistributing his expenditure from one commodity to another, buying less of one and more of the other, i.e., substituting one for the other, till there ratios become equal. www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

Assumptions of the Law 16 The law of equi-marginal utility is based on the following assumptions: 1. The consumer is a rational economic man who seeks maximum total satisfaction. 2. Utility is measurable in cardinal terms. 3. The consumer has a given scale of preferences for the goods in consideration. He has perfect knowledge of utilities derived. 4. Prices of goods are unchanged. 5. Income of the consumer is fixed. 6. The marginal utility of money is constant. The law of equi-marginal utility is based on the following assumptions 7. The wants and goods are substitutable. www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

Limitations of the Law 17 The law has been subject to certain criticisms and it also has certain limitations. Such as: 1. The law is based on unrealistic assumptions. It being an extension of the law of diminishing marginal utility, it, too, involves all the unrealistic ceteris paribus assumptions and conditions such as homogeneity, continuity, constancy, etc., 2. The proportionality rule presumes cardinal measurement of utility, which is unrealistic. 3. The law cannot be applied to indivisible goods. On practical grounds, it looks ridiculous to equate utility of a TV set to coffee per rupee. 4. The consumer does not behave rationally all the time. Quite often, his behaviour is influenced by habit, social customs, fashions, advertising, propaganda, occasional requirements, etc. 5. To critics, it is wrong to assume that marginal utility of money will remain constant. Actually, when money is spent, the remaining units of money will tend to have a greater marginal utility. 6. Ignorance on the part of consumer about market prices and utilities of different goods and the uncertain scale of preferences due to his wavering mind also pose a limitation. www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

INDIFFERENCE CURVE ANALYSIS 18 In microeconomic theory, an indifference curve is a graph showing different bundles of goods between which a consumer is indifferent. That is, at each point on the curve, the consumer has no preference for one bundle over another. One can equivalently refer to each point on the indifference curve as rendering the same level of utility (satisfaction) for the consumer. • In other words an indifference curve is the locus of various points showing different combinations of two goods providing equal utility to the consumer. www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

ASSUMPTIONS INDIFFERENCE 19 CURVE ANALYSIS 1. Consumer is rational or Rationality 2. Utility is ordinal 3. Consistence in choice 1. If A > B, then never become B > A 4. Consumer’s Preference is Transitive: 1. If A > B and B > C, then A > C 5. Diminishing Marginal Substitution of goods: 6. Dependent Utility 7. A Large bundle of goods preferred to small bundle www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

INDIFFERENCE SCHEDULE 20 According to Watson, “An indifference schedule is a list of combinations of two commodities the list being so arranged that a consumer is indifferent to the combinations, preferring none of any other.” The following is an imaginary indifference schedule representing the various combinations of goods X and Y. Combination Oranges Apples MRS A 1 10 10:1 B 2 6 4:1 C 3 3 3:1 D 4 1 2:1 www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

INDIFFERENCE CURVE 21 An indifference curve is a graph showing combination of two goods that give the consumer equal satisfaction and utility.  Each point on an indifference curve indicates that a consumer is indifferent between the two and all points give him the same utility. www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

MARGINAL RATE OF 22 SUBSTITUTION Marginal Rate of Substitution: The rate at which one good must be added when the other is taken away in order to keep the individual indifferent between the two combinations. Why MRS diminishes? MRS falls because of the law of diminishing marginal utility. In the given example of apples and bananas, Combination ‘P’ has only 1 apple and, therefore, apple is relatively more important than bananas. Due to this, the consumer is willing to give up more bananas for an additional apple. But as he consumes more and more of apples, his marginal utility from apples keeps on declining. As a result, he is willing to give up less and less of bananas for each apple. www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

INDIFFERENCE MAP 23  An indifference map is a complete set of indifference curves.  It indicates the consumer’s preferences among all combinations of goods and services.  The farther from the origin the indifference curve is, the more the combinations of goods along that curve are preferred. www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

PROPERTIES OF INDIFFERENCE CURVES 24 Indifference curves are always convex to the origin: An indifference curve is convex to the origin because of diminishing MRS. MRS declines continuously because of the law of diminishing marginal utility. When the consumer consumes more and more of apples, his marginal utility from apples keeps on declining and he is willing to give up less and less of bananas for each apple. Therefore, indifference curves are convex to the origin. It must be noted that MRS indicates the slope of indifference curve. www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

Properties of Indifference Curve 25 Indifference curves have the four basic characteristics:  Indifference curves have a negative slope  Indifference curves are convex to the origin  Indifference curves do not intersect nor are they tangent to one another.  Upper indifference curves indicate a higher level of satisfaction. www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

PROPERTIES OF INDIFFERENCE 26 CURVES The indifference curves are not likely to be vertical, horizontal, or upward sloping.  A vertical or horizontal indifference curve holds the quantity of one of the goods constant, implying that the consumer is indifferent to getting more of one good without giving up any of the other good.  An upward-sloping curve would mean that the consumer is indifferent between a combination of goods that provides less of everything and another that provides more of everything.  Rational consumers usually prefer more to less. www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

PROPERTIES OF 27 INDIFFERENCE CURVES The slope or steepness of indifference curves is determined by consumer preferences.  It reflects the amount of one good that a consumer must give up to get an additional unit of the other good while remaining equally satisfied.  This relationship changes according to diminishing marginal utility—the more a consumer has of a good, the less the consumer values an additional value of that good. This is shown by an indifference curve that bows in toward the origin. www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

PROPERTIES OF INDIFFERENCE 28 CURVES Indifference Curves: No Crossing Allowed!  Indifference curves cannot cross.  If the curves crossed, it would mean that the same bundle of goods would offer two different levels of satisfaction at the same time.  If we allow that the consumer is indifferent to all points on both curves, then the consumer must not prefer more to less.  There is no way to sort this out. The consumer could not do this and remain a rational consumer  Higher indifference curve represents higher satisfaction . This is because the combinations lying on higher indifference curve contain more of either one or both goods and more is always preferred to less. More is preferred to Less Indifference map www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

PROPERTIES OF INDIFFERENCE 29 CURVES Higher Indifference Curves Are Preferred to Lower Ones  Consumers will always prefer a higher indifference curve to a lower one. This is due to the basic economic assumption that “more is always better“.  Just think about it, if someone were to ask you if you wanted a free slice of pizza or an entire pizza for free, what would you say? Who says no to free pizza, right?  Now, of course it’s not always that simple, but in basic economic theory we can assume that consumers have a preference for larger quantities. This is reflected in the indifference curves. The higher the indifference curves are, the larger the quantities of both goods. And thus, the more preferable the indifference curve becomes. www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

CONSUMER EQUILIBRIUM 30  \"The term consumer’s equilibrium refers to the amount of goods and services which the consumer may buy in the market given his income and given prices of goods in the market, that give maximum satisfaction to consumer\".  The aim of the consumer is to get maximum satisfaction from his money income. Given the price line or budget line and the indifference map: www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

BUDGET LINE 31  The indifference map only reveals the ordering of consumer preferences among bundles of goods. It tells us what the consumer is willing to buy. It does not tell us what the consumer is able to buy. It does not tell us anything about the consumer’s buying power.  A budget line or price line represents the various combinations of two goods which can be purchased with a given money income and assumed prices of goods\". Combination Biscuit Coffee Income (Y)= 60 A 10 0 Price of Biscuit (Px) = 6 B8 1 Price of Coffee(Py) = 12 C6 2 D4 3 All right are reserved with CU-IDOL E2 4 F0 5 www.cuidol.in Unit-4(BAQ108)

SHIFTS IN THE BUDGET LINE 32 www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

BUDGET LINE SHOULD BE TANGENT 33 TO THE INDIFFERENCE CURVE. www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

INDIFFERENCE CURVE SHOULD BE 34 CONVEX TO THE ORIGIN AT THE POINT OF TANGENCY. www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

Price Effect 35 A price effect represents change in consumer’s optimal consumption combination on account of change in the price of a good and thereby changes in its quantity purchased, price of another good and consumer’s income remaining unchanged. The consumer is better-off when optimal consumption combination is located on a higher indifference curve and vice versa. The effect on the quantity demanded of a change in its own price is called the price effect. Change in price, in general, exerts two influences on quantity demanded. These two are: Income effect (IE), and the substitution effect (SE). Price Effect = Substitution Effect (SE) + Income Effect (IE). www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

What are Income and Substitution 36 Effects? When the price of q1, p1, changes there are two effects on the consumer.  First, the price of q1 relative to the other products (q2, q3, . . . qn) has changed.  Second, due to the change in p1, the consumer's real income changes. Income effect occurs due to increase (decrease) in real income resulting from a decrease (increase) in the price of a commodity. Substitution effect occurs due to the consumer’s inherent tendency to substitute cheaper goods for relatively expensive ones. www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

Multiple Choice Questions 37 1. Indifference curve shows combinations of two goods that: a) would provide the consumer with the same level of satisfaction. b) a consumer could buy with their given income. c) could provide the consumer with similar levels of satisfaction. d) could be available to the consumer in a given time period. 2. Which of the following statements is NOT TRUE of indifference curves? a) They could intersect. b) They are convex to the origin. c) They exhibit higher levels of utility as you move from the origin. d) They are downward sloping. Answers: 1.a) 2.b) www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

Multiple Choice Questions 38 3. An indifference curve between two commodities where one is a ‘bad’ and the other a ‘good’ would: a) be upward sloping. b) remain downward sloping. c) be vertical to the axis measuring units consumed of the ‘bad’. d) be vertical to the axis measuring units consumed of the ‘good’. Answers: 3.a) www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

Summary 39  Indifference curve :shows all combinations of two goods which yield the same level of satisfaction to the consumer. The consumer is indifferent about any two points lying on this curve.  Budget line: represents different combinations of two goods X and Y which the consumer can buy by spending all his income.  Ordinal Utility Analysis: ordinal utility function is a function representing the preferences of an agent on an ordinal scale. Ordinal utility theory claims that it is only meaningful to ask which option is better than the other.  Consumer Equilibrium :The state of balance obtained by an end-user of products that refers to the number of goods and services they can buy given their existing level of income and the prevailing level of cost prices. Consumer equilibrium permits a customer to get the most satisfaction possible from their income www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

Frequently Asked Questions 40 Q1.Define Marginal Rate of Substitution? Ans : Marginal Rate of Substitution: The rate at which one good must be added when the other is taken away in order to keep the individual indifferent between the two combinations. Q2.Discuss the properties of Indifference curve? Ans:-Indifference curves have a negative slope ,Indifference curves are convex to the origin ,Indifference curves do not intersect nor are they tangent to one another,Upper indifference curves indicate a higher level of satisfaction. Q3.Why is an Indifference curve convex to the point of origin? Ans: An indifference curve is convex to the origin because of diminishing MRS. MRS declines continuously because of the law of diminishing marginal utility. When the consumer consumes more and more of apples, his marginal utility from apples keeps on declining and he is willing to give up less and less of bananas for each apple. Therefore, indifference curves are convex to the origin. It must be noted that MRS indicates the slope of indifference curve. www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

REFERENCES 41 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. www.cuidol.in Unit-4(BAQ108) All right are reserved with CU-IDOL

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