Chapter 1: Basics of Microeconomics
DEMAND SIDE OF THE ECONOMY
Law of Demand
The Law of Demand says: when the price of a good rises, its quantity demanded falls — and when
price falls, demand rises. This inverse relationship holds ceteris paribus (all other factors unchanged).
For instance, if the price of an Ola/Uber ride drops during off-peak hours, more people book
cabs. If surge pricing kicks in, demand contracts.
The law works neatly for normal goods — but certain goods defy it.
Exceptions to the Law of Demand
Inferior Goods
These are goods whose demand falls as income rises. People upgrade to better substitutes when
they can afford them.
Example: Bajra/jowar as staple grains may be replaced by wheat and rice as incomes rise.
Packaged local biscuits give way to branded cream biscuits.
Giffen Goods
Named after Sir Robert Giffen, these are a rare breed. Demand actually increases when price rises,
and falls when price drops. Why? Because they are essential staples with almost no close
substitutes, and they eat up a large share of a poor household's budget.
Example: Imagine a household surviving on potatoes and meat. If potato prices shoot up,
they can't afford meat at all — so they end up buying more potatoes just to fill stomachs.
The demand curve slopes upward for such goods.
Giffen vs Inferior — every Giffen good is inferior, but not every inferior good is Giffen. The key
distinction: absence of close substitutes + large budget share.
Determinants of Demand
Price of the commodity itself
Consumer's income
Tastes and preferences (think: millet revival after awareness campaigns)
Prices of related goods (substitutes and complements)
Future price expectations
Demographic changes, seasonality, and even government policy nudges
Types of Related Goods
Relationship Definition Examples
Substitute goods Goods that can replace each other Tea and coffee; Jio and Airtel; Ola and
Uber
Complementary Goods used together — demand for one Petrol and cars; Smartphone and
goods triggers demand for the other mobile data; Printer and ink cartridges
Elasticity of Demand
Elasticity measures how much quantity demanded changes when price changes.
Elastic Demand (>1): A small price drop triggers a large demand surge. Example: Airline flash
sales during lean season.
Inelastic Demand (<1): Price changes barely move demand. Example: Insulin for diabetic
patients — life-saving, no close substitute.
Unitary Elastic (=1): Change in price = proportionate change in quantity demanded. Total
revenue stays unchanged.
Unusual Demand Curves (Sloping Upward)
Normally, demand curves slope downward left to right. But some defy this:
1. Veblen Effect (Conspicuous Consumption): The higher the price, the higher the snob value.
Demand rises with price because owning it signals status.
o Example: A Louis Vuitton handbag or an iPhone Pro Max is bought because it
screams premium. Lower the price, lower the exclusivity — demand can actually
drop.
2. Speculative Effect: If people expect prices to rise further, current demand spikes even when
prices are already climbing.
o Example: Real estate in an upcoming metro corridor. If buyers sense rates will rise
after metro completion, they buy now — fueling a demand surge even at higher
prices. Stock market rallies, gold during uncertainty.
SUPPLY SIDE OF THE ECONOMY
Law of Supply
A direct relationship: as price rises, quantity supplied rises. Producers are profit-motivated.
Example: When onion prices shoot up due to supply disruption, farmers with stored stock
flood the market to cash in. When prices crash, they hold back — or even dump produce in
protest.
Determinants of Supply
Price of the commodity
Cost of inputs (raw materials, labour, energy)
Technology used
Taxes and subsidies
Number of firms in the market
Government policy (export bans, MSP, etc.)
Elasticity of Supply
Measures responsiveness of quantity supplied to price changes.
Elastic Supply: Quick to ramp up production when prices rise. Example: Mass-produced
goods like packaged snacks, generic medicines.
Inelastic Supply: Supply doesn't change much despite price spikes. Example: Organically
grown crops — cultivation time can't be compressed. Skilled neurosurgeons — training takes
years.
COVID-19 Example: Mask production scaled rapidly (elastic supply). ICU beds and ventilators
couldn't be scaled equally fast (relatively inelastic supply).
MARKET EQUILIBRIUM AND COMPETITION
Market Equilibrium
The sweet spot where quantity demanded = quantity supplied. Price is stable because there's no
surplus or shortage pressure.
Example: At a local chai stall, equilibrium hits when the day's tea is fully sold, with neither
wastage nor extra demand left unsatisfied.
Price above equilibrium → Surplus: Shirt company overprices → unsold inventory piles up
→ forced discounts.
Price below equilibrium → Shortage: Ticket prices for a blockbuster movie kept artificially
low → black market emerges.
Market Structures
Structure Key Features Demand Curve Real-Life Hint
Perfect Many sellers, identical Perfectly Elastic Rare in pure form. Close:
Structure Key Features Demand Curve Real-Life Hint
agricultural mandis for
product, free
Competition (Horizontal) uniform-grade produce,
entry/exit, perfect info
some forex segments
Downward Indian Railways (passenger
Single seller, unique
Monopoly sloping, but seller segment), patented life-
product, high barriers
is price-maker saving drug
Many sellers, product Restaurants in a food
Monopolistic Highly elastic but
differentiation, low street, salons, toothpaste
Competition not horizontal
barriers brands
Few dominant firms, Telecom (Jio, Airtel, Vi), oil
Kinked demand
Oligopoly interdependent marketing companies,
curve (often)
decisions, entry barriers aviation
Monopoly may be natural (single firm serves market efficiently, like utilities), statutory (government-
granted, like patent), or created through cartels (OPEC-style).
MARKET INTERVENTION IN CAPITALIST SYSTEMS
Even free-market economies intervene, especially for public goods and to protect vulnerable
consumers/producers.
Price Ceiling (Maximum Price)
Set below equilibrium → protects consumers
Effect: Quantity demanded > Quantity supplied → shortage
Example: Rent control in cities like Mumbai — caps rent on old buildings → artificially low
rents, but landlords stop maintaining properties; new tenants can't find homes.
Fallout: Black markets, rationing, quality deterioration.
Price Floor (Minimum Price)
Set above equilibrium → protects producers
Effect: Quantity supplied > Quantity demanded → surplus
Example: India's MSP (Minimum Support Price) for wheat and rice. If MSP exceeds market-
clearing price, FCI has to buy surplus — leading to godown overflow and wastage concerns.
Another classic: Minimum wage laws — floor for labour price, can create unemployment if
set too high.
ELASTICITY
Price Elasticity of Demand (PED)
Formula: (% change in quantity demanded ÷ % change in price)
Elastic (>1): Price cuts raise total revenue
Inelastic (<1): Price hikes raise total revenue
Unitary (=1): Revenue unchanged
Price Elasticity of Supply (PES)
Formula: (% change in quantity supplied ÷ % change in price)
Same categories: elastic, inelastic, unitary, perfectly elastic, perfectly inelastic.
Beyond Price Elasticity
Income Elasticity: How demand responds to income changes.
o Positive for normal goods (travel, quality education)
o Negative for inferior goods (coarse grains, used clothes)
o 1 for luxury goods (vacation abroad)
Cross Elasticity: How demand for Good X responds to price change in Good Y.
o Positive → substitutes (paneer price up → tofu demand up)
o Negative → complements (printer price down → ink demand up)
KEY TERMS
Term Meaning Quick Example
Marginal Utility Extra satisfaction from consuming one Third samosa gives less joy than first
more unit (diminishing)
Opportunity Cost Value of next best alternative foregone Choosing to prepare for UPSC full-time
means sacrificing a salary from a
potential job
Externalities Costs/benefits affecting a third party Factory pollution harms nearby residents
outside the transaction (negative); beekeeper's bees pollinate
neighbour's orchard (positive)
Substitution Effect When price rises, consumers switch to Coffee price up → switch to tea
relatively cheaper option
Income Effect Price drop increases real purchasing power Petrol price cut → effective income rises
→ buy more → may buy more petrol or other things
Diminishing Adding more of one input while others Extra workers on a fixed-size farm →
Marginal Returns fixed eventually yields smaller increments beyond a point, each adds less output
Capital Good Used to produce other goods, not Machinery in a textile factory
consumed directly
Depreciation Wear and tear of fixed assets over time A delivery van losing value each year