Professional's Academy of Commerce IEF (CAF-02)

Chapter 2: Micro Economics

2.1. Goods & Types of goods:

In economics, goods refer to the products that satisfy human needs or wants and provide utility. Goods are
materials that satisfy human wants. A good is something one can touch and feel (a physical product).
Types of goods on the basis of consumption
Merit goods: Merit goods create positive externalities and contribute significantly to the social welfare. These
goods are assumed to be socially desirable. Education, health, parks etc. are all examples of merit goods.
Demerit goods: Demerit goods are the ones that are considered “bad” in the society because of their harmful
impacts. Consumption of demerit goods can lead to negative externalities. Alcohol is an example of the same.
Public goods: Public goods are readily available to all the people in a society. These goods enjoy the
characteristics of non-rivalry and non-excludability. For instance, national defense system, highway network,
measures taken to enhance public health etc are all the examples of public goods.
Private goods: Private goods are the goods that bear the characteristics of rivalry and excludability. These are
the goods that can be provided separately to different persons with no costs to be borne by others. For instance,
bread is a private good that can be distributed among individuals in different ways and the portion consumed by
one person cannot be eaten by others.
Club goods: Club goods have the characteristics of excludability but are non-rival till a point where congestion
takes place. Examples include private golf courses, services rendered by the clubs to their members etc.
Types of goods on the basis of income
Normal goods: Normal goods are those whose demand increases as the income increases such as milk. Most of
the goods come under this category.
Inferior goods: Inferior goods are those whose demand decreases as the income increases such as public
transport, second hand products etc. With the increase in income people tend to move from inferior goods to
normal goods.
Superior goods: Superior goods are those goods that tend to make up the larger proportion of an individual’s
consumption as the income rises. They can be taken as an extreme form of normal goods. It can also be termed
as a luxury good that is not bought below a certain level of income. e.g. a luxury car.
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2.2. Demand:
The quantity which buyers are willing and able to purchase of a product at the prevailing market price.
2.2.a. Individual demand vs. market demand
Individual demand: Individual demand is the demand of a single unit of economy; it could be a single
individual, a single household, a single family or even a single firm. This would show the quantity of a product
by an individual actor at a certain price and at a certain point in time.

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Market demand: Market demand represents the total quantity demanded by all the consumers. The sum of
total or the aggregate of all the individual demands. The concept of market demand is very important for the
organizations for the purpose of determining the profitability of its products.

2.2.b. Determinants of Demand

There are a number of factors which influence demand for a commodity. All these factors are not equally
important. Moreover, some of these factors cannot be easily measured or quantified. The important factors that
determine demand are given below.

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(i) Price of the commodity: Ceteris paribus i.e. other things being equal, the demand for a commodity is
inversely related to its price. It implies that a rise in the price of a commodity brings about a fall in the quantity
purchased and vice-versa. This happens because of income and substitution effects.
(ii) Price of related commodities: Related commodities are of two types:
(a) complementary goods: Complementary goods are those goods which are consumed together or
simultaneously. For example; tea and sugar, automobile and petrol and pen and ink. When two commodities are
complements, a fall in the price of one (other things being equal) will cause the demand for the other to rise. For
example, a fall in the price of petrol-driven cars would lead to a rise in the demand for petrol.
(b) competing goods or substitutes: Two commodities are called competing goods or substitutes when they
satisfy the same want and can be used with ease in place of one another. For example, tea and coffee, ink pen
and ball pen, are substitutes for each other and can be used in place of one another easily. When goods are
substitutes, a fall in the price of one (ceteris paribus) leads to a fall in the quantity demanded of its substitutes.
For example, if the price of tea falls, people will try to substitute it for coffee and demand more of it and less of
coffee i.e. the demand for tea will rise and that of coffee will fall. Therefore, there is direct or positive relation
between the demand for a product and the price of its substitutes.
(iii) Income of the consumer: Other things being equal, the demand for a commodity depends upon the money
income of the consumer. The purchasing power of the consumer is determined by the level of his income. In
most cases, the larger the average money income of the consumer, the larger is the quantity demanded of a
particular good. The nature of relationship between income and quantity demanded depends upon the nature of
consumer goods.
(iv) Tastes and preferences of consumers: The demand for a commodity also depends upon the tastes and
preferences of consumers and changes in them over a period of time. Goods which are modern or more in
fashion command higher demand than goods which are of old design and out of fashion. Consumers may
perceive a product as obsolete and discard it before it is fully utilised and prefer another good which is currently
in fashion.
(v) Consumers’ Expectations: Consumers’ expectations regarding future prices, income, supply conditions
etc. influence current demand. If the consumers expect increase in future prices, increase in income and
shortages in supply, more quantities will be demanded. If they expect a fall in price, they will postpone their
purchases of nonessential commodities and therefore, the current demand for them will fall.

Other factors: Apart from the above factors, the demand for a commodity depends upon the following factors:
(a) Size of population: Generally, larger the size of population of a country or a region, greater is the demand
for commodities in general.
(b) Composition of population: If there are more old people in a region, the demand for spectacles, walking
sticks, etc. will be high. Similarly, if the population consists of more of children, demand for toys, baby foods,
toees, etc. will be more.
(c) The level of National Income and its Distribution: The level of national income is a crucial determinant of
market demand. Higher the national income, higher will be the demand for all normal goods and services. The
wealth of a country may be unevenly distributed so that there are a few very rich people while the majority are
very poor. Under such conditions, the propensity to consume of the country will be relatively less, because the
propensity to consume of the rich people is less than that of the poor people.
d) Consumer-credit facility and interest rates: Availability of credit facilities induces people to purchase
more than what their current incomes permit them. Credit facilities mostly determine the demand for durable
goods which are expensive and require bulk payments at the time of purchase. Low rates of interest encourage

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people to borrow and therefore demand will be more. Apart from above, factors such as government policy in
respect of taxes and subsidies, business conditions, wealth, socioeconomic class, group, level of education,
marital status, weather conditions, salesmanship and advertisements, habits, customs and conventions also play
an important role in influencing demand.

2.2.c. Demand Function

A function is a symbolic statement of a relationship between the dependent and the independent variables. The
demand function states the relationship between the demand for a product (the dependent variable) and its
determinants (the independent or explanatory variables). A demand function may be expressed as follows:
Dx = f (PX, M, PY, PC, T)
Where
Dx is the quantity demanded of product X
PX is the price of the commodity
M is the money income of the consumer
PY is the price of its substitutes
PC is the price of its complementary goods
T is consumer tastes, and preferences
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2.3. Law of Demand
According to the law of demand, other things being equal, if the price of a commodity falls, the quantity
demanded of it will rise and if the price of a commodity rises, its quantity demanded will decline. The Law of
Demand may be illustrated with the help of a demand schedule and a demand curve.
Demand Schedule: A demand schedule is a table which presents the different prices of a good and the
corresponding quantity demanded per unit of time.

Demand curve: A demand curve is a graphical presentation of the demand schedule. It is obtained by
plotting a demand schedule.

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Assumptions of the law of demand:

• There is no change in the income of consumers.
• There is no substitute for the good.
• The prices of related goods are stable.
• There is no change in custom, taste or preference of consumers.
• The size of population is stable.
• The climate and weather conditions are as expected (when considering the demand for goods affected by
these).
• The tax rates are stable.

Limitations of the law of demand

• Change in trends – According to the law, demand increases when prices fall however, if the price of
products that have run out of fashion falls, the demand does not increase. A product in fashion will have
a greater number of customers even though the price is going up and a product out of fashion will have
lower demand no matter what amount of reduction is offered in the price.
• Change in income – The rise and decline in income of people also have a reverse effect on law of
demand. If a price of a commodity rises it is unlikely that the demand will rise, however it happens if the
income has increased because then the power of spending also increases.
• Shortage of goods – If there is a fear of shortage of a commodity in near future, people will buy more of
it in spite of higher prices.
• Expectation in price change – If there is a future expectation that the price of a certain product is likely
to be decreased people will not buy the product even if the prices are low at present. Similarly, people
will buy more
• of the product at higher prices even, if there is an expectation of further increase in the prices in the near
future.
• Basic necessities of life – The law of demand is not applicable to the basic necessities such as sugar,
rice, wheat because people will keep on buying these commodities regardless of the increase or decrease
in prices.

Practical importance of the law of demand

• The law of demand contributes to the determination of price of a certain commodity. Also, the producer
can see the effect on demand due to increase or decrease in price and can take decisions accordingly.
• The demand schedule helps the entities plan for future by analyzing the impact of change in prices on
the quantity demanded at both; the national and international level.
• It is of great help for the state as well in the due course of raising tax on certain commodities. If the
increased tax causes the price of a commodity to be increased to a level where the demand falls then
there would be no use raising the tax level as ultimately the overall amount of the taxable revenue would
remain almost the same.

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2.3.a. Why are demand curves downward sloping?

(a) Substitution effect: When the price of a commodity falls, it becomes relatively cheaper than other
commodities. Assuming that the prices of all other commodities remain constant, it induces consumers to
substitute the commodity whose price has fallen for other commodities which have now become relatively
expensive. The result is that the total demand for the commodity whose price has fallen increases. This is called
substitution effect.
(b) Income effect: When the price of a commodity falls, the consumer can buy the same quantity of the
commodity with lesser money or he can buy more of the same commodity with the same amount of money. In
other words, as a result of fall in the price of the commodity, consumer’s real income or purchasing power
increases. This increase in the real income induces him to buy more of that commodity. Thus, the demand for
that commodity (whose price has fallen) increases. This is called income effect.
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2.4. Changes in Demand

2.4.a. Expansion and Contraction of Demand
The demand schedule, demand curve and the law of demand all show that when the price of a commodity falls,
its quantity demanded increases, other things being equal. When, as a result of decrease in price, the quantity
demanded increases, in Economics, we say that there is an expansion of demand and when, as a result of
increase in price, the quantity demanded decreases, we say that there is contraction of demand.

The phenomena of expansion and contraction of demand are shown in Figure. The figure shows that when price
is OP, the quantity demanded is OM, given other things equal. If, as a result of increase in price (OP”), the
quantity demanded falls to OL, we say that there is ‘a fall in quantity demanded’ or ‘contraction of demand’ or
‘an upward movement along the same demand curve’. Similarly, as a result of fall in price to OP’, the quantity
demanded rises to ON, we say that there is ‘expansion of demand’ or ‘a rise in quantity demanded’ or ‘a
downward movement on the same demand curve.’

2.4.b. Increase and Decrease in Demand

Till now we have assumed that other determinants of demand remain constant when we are analysing demand
for a commodity. It should be noted that expansion and contraction of demand take place as a result of changes
in the price while all other determinants of price viz. income, tastes, propensity to consume and price of related
goods remain constant. The ‘other factors remaining constant’ means that the position of the demand curve
remains the same and the consumer moves downwards or upwards on it.

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We say that the demand curve for X has shifted [in this case it has shifted to the right]. The shift from DD to
D’D’ indicates an increase in the desire to purchase ‘X’ at each possible price. For example, at the price of ` 4
per unit, 15 units are demanded when average household income is ` 20,000 per month. When the average
household income rises to ` 25,000 per month, 20 units of X are demanded at price ` 4. A rise in income thus
shifts the demand curve to the right, whereas a fall in income will have the opposite effect of shifting the
demand curve to the left.

(a) A rightward shift in the demand curve (when more is demanded at each price) can be caused by a rise in
income, a rise in the price of a substitute, a fall in the price of a complement, a change in tastes in favour of this
commodity, an increase in population, and a redistribution of income to groups who favour this commodity.
(b) A leftward shift in the demand curve (when less is demanded at each price) can be caused by a fall in
income, a fall in the price of a substitute, a rise in the price of a complement, a change in tastes against this
commodity, a decrease in population, and a redistribution of income away from groups who favour this
commodity.

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2.4.c. Movements along the demand curve vs. Shift of demand curve
It is important for the business decision-makers to understand the distinction between a movement along a
demand curve and a shift of the whole demand curve.
A movement along the demand curve indicates changes in the quantity demanded because of price changes,
other factors remaining constant. A shift of the demand curve indicates that there is a change in demand at each
possible price because one or more other factors, such as incomes, tastes or the price of some other goods, have
changed.
Thus, when an economist speaks of an increase or a decrease in demand, he refers to a shift of the whole curve
because one or more of the factors which were assumed to remain constant earlier have changed. When the
economists speak of change in quantity demanded he means movement along the same curve (i.e., expansion or
contraction of demand) which has happened due to fall or rise in price of the commodity.
In short ‘change in demand’ represents shift of the demand curve to right or left resulting from changes in
factors such as income, tastes, prices of other goods etc. and ‘change in quantity demanded’ represents
movement upwards or downwards on the same demand curve resulting from a change in the price of the
commodity.
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2.5. Supply
The quantity which firms are willing and able to supply at the prevailing market price.

2.5.a. Determinants of Supply

(i) Price of the good: Other things being equal, the higher the relative price of a good the greater the quantity of
it that will be supplied. This is because goods and services are produced by the firm in order to earn profits and,
ceteris paribus, profits rise if the price of its product rises.
(ii) Prices of related goods: If the prices of other goods rise, they become relatively more profitable to the firm
to produce and sell than the good in question. It implies that, if the price of Y rises, the quantity supplied of X
will fall. For example, if price of wheat rises, the farmers may shift their land to wheat production away from
corn and soya beans.
(iii) Prices of factors of production: Cost of production is a significant factor that affects supply. A rise in the
price of a particular factor of production will cause an increase in the cost of making those goods that use a
great deal of that factor than in the costs of producing those that use relatively small amount of the factor. For
example, a rise in the cost of land will have a large effect on the cost of producing wheat and a very small effect
on the cost of producing automobiles. Thus, a change in the price of one factor of production will cause changes
in the relative profitability of different lines of production and will cause producers to shift from one line to
another and thus supplies of different commodities will change.
(iv) State of technology: The supply of a particular product depends upon the state of technology also.
Inventions and innovations tend to make it possible to produce more or better goods with the same resources,
and thus they tend to increase the quantity supplied of some products and to reduce the quantity supplied of
products that are displaced. Availability of spare production capacity and the ease with which factor substitution
can be made and the cost of such substitution also determine supply.
(v) Government Policy: The production of a good may be subject to the imposition of commodity taxes such
as excise duty, sales tax and import duties. These raise the cost of production and so the quantity supplied of a
good would increase only when its price in the market rises. Subsidies, on the other hand, reduce the cost of

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production and thus provide an incentive to the -rm to increase supply. When government imposes restrictions
such as import quota on inputs, rationing of input supply etc, production tends to fall.
(vi) Nature of competition and size of industry: Under competitive conditions, supply will be more than that
under monopolized conditions. If there are large number of -rms in the market, supply will be more. Besides,
entry of new -rms, either domestic or foreign, causes the industry supply curve to shift rightwards.
Other Factors: The quantity supplied of a good also depends upon government’s industrial and foreign
policies, goals of the -rm, infrastructural facilities, natural factors such as weather, floods, earthquake and man-
made factors such as war, labour strikes, communal riots and etc.
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2.6. Law of Supply
Other things remaining constant, the quantity of a good produced and offered for sale will increase as the price
of the good rises and decrease as the price falls.
Supply Schedule: Supply schedule is the tabular presentation of the law of supply. It shows the different prices
of a commodity and the corresponding quantities that suppliers are willing to offer for sale.
Price (per kg) Quantity supplied (kg)
1 5
2 35
3 45
4 55
5 65
Supply curve: A supply curve is a graphical presentation of the supply schedule. It is obtained by plotting a
supply schedule.

Assumptions of the law of supply:

• No change in the cost of production
• No change in technology (as this would affect the cost of production)
• No change in the climate (for the supply of goods affected by the climate)
• No change in the prices of substitutes
• No change in the availability and cost of natural resources
• No change in the price of capital goods
• Tax rates are stable
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2.7. Changes in Supply

2.7.a. Movements on the Supply Curve – Increase or Decrease in the Quantity Supplied
When the supply of a good increase as a result of an increase in its price, we say that there is an increase in the
quantity supplied and there is a upward movement on the supply curve. The reverse is the case when there is a
fall in the price of the good.

2.7.b. Shifts in Supply Curve – Increase or Decrease in Supply

When the supply curve bodily shifts towards the right as a result of a change in one of the factors that influence
the quantity supplied other than the commodity’s own price, we say there is an increase in supply. When these
factors cause the supply curve to shift to the left, we call it decrease in supply.

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2.8. Reservation Price

The minimum price a firm is willing to receive for its good.
Factors affecting reservation price:
Disposable income of the buyers: Disposable income varies from person to person therefore the buying
decisions too change accordingly. Every individual would have a different reservation price set for the same
commodity depending upon the amount of his disposable income. A firm has to observe analytically the buying
patterns and the disposable income of the buyers prevailing in the market in order to set a reservation price for
its commodities.

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Substitute goods: The availability of substitute goods and the buyers’ attention to the related information
available also impacts the reservation price a company sets for its products. If the substitutes are readily
available and if the buyer is rational and has a close watch on the information thus available, then the firm
might need to set lower reservation price for its product and vice versa.
Objectives: The nature of objectives also plays a key role in the determination of the reservation price for the
firms. For instance; consider two companies A and B. Both are in the same industry of garments. A is a well-
established market player whereas B has just entered the market. B has to penetrate into the market and is
offering heavy discounts on its products.
Cost of production: For manufacturers, the overall cost of production is also a major factor that determines the
level of the reservation price for their products. Higher cost of production would lead to a higher reservation
price and lower cost of production would result into a lower reservation price.
Other factors: Other factors might include the state laws, number of subsidies, taxes, inflation, economic
conditions etc.
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2.9. Market Equilibrium

Market equilibrium is a market state where the supply in the market is equal to the demand in the market. The
equilibrium price is the price of a good or service when the supply of it is equal to the demand for it in the
market. If a market is at equilibrium, the price will not change unless an external factor changes the supply or
demand, which results in a disruption of the equilibrium.

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2.9.a. Shift in demand: A shift in demand occurs when more or less of a quantity of good is demanded at each
price level. The diagram shows the effect of a rise in the price of butter on the market for margarine.

Here is how the new equilibrium is established:

• Equilibrium initially at P0Q0.
• Rise in price of butter causes a contraction in the demand for butter as consumers switch expenditure
towards margarine, a substitute.
• Rise in demand for margarine, shown by shift from D to D1, causes a shortage of Qd-Q0 at price P0.
• Price rises. Demand contracts and supply extends.
• New equilibrium at Q1P1

2.9.b. Shift in supply: The diagram shows the effect of a rise in the price of leather on the market for beef.

Here is how the new equilibrium is established:

• Equilibrium initially at P0Q0.

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• Rise in price of leather causes an extension in the supply for leather as suppliers increase production in
the more profitable product.
• Doing so also increases the supply of beef, as more cows are reared.
• Rise in supply of beef, shown by shift from S to S1, causes a surplus of Q0-Qs at price P0.
• Price falls. Demand extends and supply contracts.
• New equilibrium at Q1P1
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2.10. Price Mechanism

Price mechanism refers to the system where the forces of demand and supply determine the prices of
commodities and the changes therein. It is the buyers and sellers who actually determine the price of a
commodity. Price mechanism is the outcome of the free play of market forces of demand and supply. However,
sometimes the government controls the price mechanism to make commodities affordable for the poor people
too.
2.10.a. The market prices: There are two types of price that exist in markets.
1. Equilibrium market price: which is determined by market forces, i.e. demand and supply
2. Regulated market price: which is determined by the government

The equilibrium market price is one where both suppliers and consumers are willing and able to exchange a
quantity of goods for money. This is at the intersection of the downward sloping demand curve and the upward
sloping supply curve.

It can be seen that Pe and Qe are the price and quantity, respectively, which will prevail in this market.

2.10.b. Shortage: Where quantity demanded exceeds quantity supplied at prevailing market price.
• In the above diagram demand is initially at Qd1 and supply at Qs1.
• This causes a shortage of Qd1-Qs1 at price Pse.
• Consumers will bid up the price of the product in order to secure supplies for themselves.

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• As the price rises above Pse the firms will extend supply above Qs1 by transferring resources from
substitutes in production and towards the more profitable good.
• At the same time demand will contract below Qd1 as consumers switch expenditure away from the good
whose price is rising and towards substitutes which represent better value for money.
• The price will stop rising once quantity demanded equals quantity supplied at Q e and the equilibrium
price will be established at Pe.

2.10.c. Surplus: Where quantity supplied exceeds quantity demanded at prevailing market price.
• In the diagram above demand is initially at Qd with supply at Qs when price is Pss.
• This causes the surplus Qs-Qd at price Pss.
• Firms will allow their prices to fall to clear back stocks.
• As the market price falls below Pss consumers will extend their demand above Qd by switching
expenditure from substitutes because it represents better value for money.
• At the same time firms will contract supply of the less profitable good below Q s by transferring
resources to more profitable substitutes in production.
• The price will continue to fall until quantity demanded equals quantity supplied at Qe where the
equilibrium market price will be established at Pe.

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