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Microeconomics

CA Gurbinder Singh Kathuria

RV(SFA), IP, Independent Director
7888399347
[email protected]
 The Syllabus
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Principles of Economics - Microeconomics - Consumption: Indifference curve,
consumer surplus, elasticity
Price mechanism: determinants of price mechanism; individual and market
demand schedules; conditions, exceptions, and limitations of law of demand;
individual and market supply schedules; conditions and limitations of law of
supply; highest, lowest and equilibrium price; importance of time element -
Pricing of products under different market conditions: perfect and imperfect
competition, monopoly etc. - Factors of production and their pricing: land, labour,
capital, entrepreneur, and other factors - Theory of rent - Capital and interest:
types of capital, gross interest, net interest - Organisation and profit: functions of
entrepreneur; meaning of profit and theories of profit
3 What is Micro Economics Theory of
Product demand
Pricing Theory of
Micro Economics deals with individual
behaviour such as markets, firms and Supply
households.
Rent
Microeconomics shows how and why different Micro Factor
goods have different values, how individuals and Economics pricing
Wages
businesses conduct and benefit from efficient
production and exchange, and how individuals
best coordinate and cooperate with one another. Interest
Economics
welfare
Profit

Adam Smith is regarded as the father of Economics

4 Utility & Indifference Curve (IC)
It is a line that shows all possible Combinations of Two
Goods between which a person is Indifferent.
Every combination at each point of the curve gives her the
equal satisfaction. That is why she is indifferent to any
particular choice and the curve is called indifference
curve.
An IC is defined as one which joins all those combinations
of two goods such as ‘x’ and
‘y’ goods which yield same level of satisfaction to the
consumer.
IC never intersect and never touches the axis as if it were
to touch it , it imply that the consumer is satisfied with
one , which is opposite to the basic assumption of IC
5 Assumptions of IC’s
Rationality : Rationality implies that the consumer possesses all the relevant information to
make her rational decision of maximization of satisfaction.

Continuity : Continuity implies the consumer is capable of ordering or ranking all the
possible combinations of two goods in accordance with satisfaction they yield to her.

Transitivity : It implies that if the consumer prefers ‘A’ combination of two goods to B and B
to C it means he prefers A to C. Similarly if she is indifferent between A and B. B and C, it
means that she is indifferent between A and C.
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IC Map
An Indifference Map is a set of Indifference Curves. It depicts the
complete picture of a consumer’s preferences.

Consumer is indifferent among the combinations lying on the same

indifference curve. However, She prefers the combinations on the higher
indifference curves Vis-a-Vis those on the lower side of IC. The reason is as
she get more satisfaction when the combination IC2 is above the IC1
7 Consumer Surplus
Consumer surplus occurs when the price that consumers pay for a product or service is
lesser than the price they're willing to pay. It's a measure of the additional benefit that
consumers receive because they're paying less for something than what they were
willing to pay.
The concept is based on the law of marginal utility which states that the satisfaction
keeps declining with increased consumption of same product/services. The consumer
keeps on buying the goods as long as the utility gained is higher than the price paid. A
rational consumer shall buy the goods as long as the utility of the same exceed the price
of the product/service.
According to Dr. Alfred Marshall, “the excess of the price which he would be willing to pay
rather than go without the thing over that which he actually does pay, is the economic
measure of this surplus satisfaction. It may be called consumer’s surplus.”
The concept is widely used in taxation where Govt. impose higher taxes on luxury goods.
8 Price Mechanism
The price mechanism is a system of determination of prices and resource
allocation.

It operates in a free market situation where forces of demand and supply

determine prices.

The price mechanism will determine: “WHAT IS PRODUCED, HOW MUCH

IS PRODUCED AND FOR WHOM A GOOD OR SERVICE IS PRODUCED
FOR.”
9 Determinants of
Price Mechanism
Price is based on two invisible factors ; demand & supply.
Demand is what we are willing to buy at a specific time at certain
price
.
For an effective demand two conditions needs to be met : Desire
to Purchase and Power to Purchase. In any one of them is
missing then there is no effective demand.

Price and Quantity demanded are inversely related ; as the

price increase the quantity demanded decrease .

If the demand increase due to price , it is called extension of

price & opposite is called contraction of demand.
10 Demand Schedule
The demand curve reflects the demand of the product at various price points
i.e., the interaction of quantity demanded and its price. The price is depicted on
vertical axis and demand on x-axis.

The market demand schedule can be represented using the demand schedule ,
as it shows the demand at various point on a table rather than a graph.

Price Quantity demanded

20 100
25 90
30 80
11 Laws of Demand The law states that there is a negative correlation between
the price of a commodity and quantity demanded i.e. the
demand of goods goes up as the price goes down and vice-
versa.

The chief assumption of the law are :

a) No change in the taste & preference b) Consumer income

remain the same c) price of related commodity do not change
d) the commodity is a normal one.
12 Limitation of Laws of Demand

Few of the exceptions to the laws of demand are :

a) Ignorance of Consumer : Ignorance of consumer leads her to buy more as price
increases
b) Necessary Goods : Demand is inelastic i.e it does not show any sign of contraction with
increase in the price
Conspicuous and Consumption : If consumers measure the desired ability of the utility of a
commodity, solely by its price and nothing else, then they tend to buy more of the
commodity at higher price and less of it at lower price. Hence, there is a direct relationship
between price & quantity demanded. For example: Gold ornaments, Diamonds, hair
paintings..
13 Supply Schedule
Supply Schedule is a table that list of quantities that are supplied at EACH
different price. A graphical representation of the table shall be called Supply
Curve

This concept is particularly important for businesses because they have to

understand what happens to their inventory and units sold as the sales price
changes
14 Law of Supply
The Law of Supply asks: “How much of a good or service is a company
willing to produce at ? price?”. When the price of a good rises, the supplier
increases the supply in order to earn a profit because of higher prices.
Determinants of Supply are :
Productivity
Inputs
Government actions/ policy
Technology
Output
Expectations
Size of Industry
 Assumptions & Exceptions of law of
15 Supply

Assumptions : Exceptions :

No change in the income Expected future price

No change in technique of production: Availability of labour
There should be no change in transport cost
Cost of production be unchanged
There should be fixed scale of production
The prices of other goods should remain
constant
 Equilibrium Price
16 The equilibrium price is the only price where the plans of consumers and the plans of
producers agree—that is, where the amount consumers want to buy of the product,
quantity demanded, is equal to the amount producers want to sell, quantity supplied.
This common quantity is called the equilibrium quantity

If at a price, market supply is greater than market demand, we say that there is an
excess supply in the market at that price and if market demand exceeds market supply
at a price, it is said that excess demand exists in the market at that price.

In case the market is not at equilibrium then the economic pressure arise and market
gets toward the equilibrium point.
 Markets
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The modern definition of market is that "it (market) implies the whole area over which
buyers and sellers are in such touch with each other, directly or through middlemen, that
the price of the commodity in one part influences it in the other parts of it". Different type
of market on the basis of Competition are :

Market Structure Number of Nature of Elasticity of Control over

players product price price
Monopoly One Unique Small Considerable
Oligopoly Few Firms Homogeneous Small Some
or differentiated
Monopolistic Large Differentiated Large Some
Perfect Large Homogeneous Large Some
18 Factors of Production

labour

Land : Natural resources to create supply

Labour : the work efforts of people with
wages as rewards
Entrepreneur
Factors of
Production capital Capital : Capital goods i.e man made
products used in productions
Entrepreneurship : the drive to develop an
idea in to business
Land
19 Characteristics Land

Fixed in Quantity
Original and indestructible property
Different fertility
Multiple uses
20 Characteristics of Labour

Cant be separated from Labourer i.e., the labour has to sell his labour in person
Highly Perishable : The labour cant be preserved , is either sold or lost
Low bargaining power : because of the perishable nature , it is low on bargaining
Low mobility : Labour is challenged for mobility
The increment/decrement of labour is at a very low pace.
 21 Profit and its theories
Risk Theory of Profit was propounded by Hawley. The theory is based on the
Profit of an organization
assumption that profit arise from the factor ownership , as long as the ownership
or firm is usually
involve risk. Entrepreneur must assume risk to earn profit.
defined as total revenue
over total cost. This is Uncertainty bearing theory :This theory was propounded by an American
the amount of factor economist Prof. Frank H. Knight. This theory, starts on the foundation of Hawley’s
earning enjoyed by the risk bearing theory. Prof. Knight agrees with Hawley that profit is a reward for
entrepreneur class. risk-taking.
There are two types of risks viz. foreseeable risk and unforeseeable risk.
According to Knight profit arises due to non-insurable risk or unforeseeable risk.
Dynamic Theory : Dynamic theory of profit was advocated by J.B Clark. He stated
that profits rise in that of type of economy where the things change. No profits will
be generated n the static economy, where everything remains constant.

Innovative theory :propounded by Prof. Schumpeter ,this theory, profit is the

reward for innovations. Innovation refers to all those changes, in the production
process with an objective of reducing the cost of commodity so as to create gap
between the existing price of the commodity and its new cost.
22 Capital
Capital is a passive factor of production. This is so because capital is ineffective
without the cooperation of labor.
Capital is a man-made thing. Its production and supply is controlled by the efforts of
man.
Capital is not an indispensable factor of production like labour and land. This would
mean that production can be possible even without capital.
Capital has the highest mobility. The land is immobile and labour has the least
mobility, while capital has both ‘place mobility’ and ‘occupational mobility’.
Capital depreciates over time. For example, if a machine is used again and again its
efficiency goes down and it may not be suitable for further use due to depreciation
Capital helps in increasing production. When labor is given adequate capital, it
effectively increases production
23 Classical theory of rent
David Ricardo, an English classical economist, first developed a theory in 1817 to
explain the origin and nature of economic rent.

Rent of land arises due to the differences in the fertility or

situation of the different plots of land.
land, being a gift of nature, has no supply price and no cost of
production.
The law of diminishing marginal returns holds in the case of
cultivation of land.
Ricardo looks at the supply of land from the standpoint of the
society as a whole.
It arises owing to the original and indestructible powers of the
soil
24 Modern theory of rent
According to modern theory, economic rent is a surplus which is not peculiar to land
alone. It can be a part of income of labour, capital, entrepreneur. Rent is the surplus
which arises due to difference between actual earning and transfer earnings
Rent is a type of income produced through a difference of
actual earnings and transfer earning.
a worker earns Rs.6000/- per
month in a factory. In the next Rent comes from income of all the production factors.
best employment, he can get
Rs.5000/- only per month. The The law of diminishing marginal returns holds in the case of
surplus or excess of Rs1000/- cultivation of land.
which a worker is earning over
and above the minimum Ricardo looks at the supply of land from the standpoint of the
payment necessary for
inducting him to work in the
society as a whole.
present occupation is the
economic rent.
-It arises owing to the original and indestructible powers of the
soil

That is: Rent = Actual Earning-Transfer Earning.

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EXAM QUESTIONS
 A market which has only one seller selling a homogeneous product to many buyers is
26 known as:

1. Monopoly
2. Oligopoly
3. Monopolistic
4. Imperfect market
27 Theories of factor of production consider _____ to be the reward for the entrepreneur.

1. Rent
2. Wages
3. Interest
4. Profit
 The frequency at which one unit of currency is used to purchase domestically produced
28 goods and services within a given time period is known as:

1. Velocity of money
2. Speed of money
3. Speed of Money
4. Momentum of money
29 Which of the following is not true about Ricardian theory of rent?

1. Rent increases with increase in population

2. Rent is surplus above cost
3. arises owing to the original and indestructible powers of the soil
1. Rent arises only in the short run.