What

is the 'Law Of Demand' What is 'Price Elasticity Of Demand' 3. Marginal Revenue:

The law of demand is a microeconomic law that states, all other factors Price elasticity of demand is a measure of the relationship between a Marginal revenue is the net revenue obtained by selling an additional
being equal, as the price of a good or service increases, consumer change in the quantity demanded of a particular good and a change in unit of the commodity. Marginal revenue is the change in total
demand for the good or service will decrease, and vice versa. The law its price. Price elasticity of demand is a term in economics often used revenue which results from the sale of one more or one less unit of
of demand says that the higher the price, the lower the quantity when discussing price sensitivity. The formula for calculating price output. Ferguson. Thus, marginal revenue is the addition made to the
demanded, because consumers opportunity cost to acquire that good elasticity of demand is: total revenue by selling one more unit of the good. In algebraic terms,
or service increases, and they must make more tradeoffs to acquire the Price Elasticity of Demand = % Change in Quantity Demanded / % marginal revenue is the net addition to the total revenue by selling n
more expensive product. Change in Price units of a commodity instead of n 1.
BREAKING DOWN 'Law Of Demand' The chart below depicts the law of If a small change in price is accompanied by a large change in quantity Therefore,
demand using a demand curve, which is always downward sloping. demanded, the product is said to be elastic (or responsive to price
Each point on the curve (A, B, C) reflects a changes). Conversely, a product is inelastic if a large change in price is
direct correlation between quantity demanded (Q) and price (P) accompanied by a small amount of change in quantity demanded.

What is the 'Income Elasticity Of Demand'
Income elasticity of demand refers to the sensitivity of the quantity
demanded for a certain good to a change in real income of consumers
who buy this good, keeping all other things constant. The formula for

calculating income elasticity of demand is the percent change in A. Koutsoyiannis, The marginal revenue is the change in total revenue
quantity demanded divided by the percent change in income. With resulting from selling an additional unit of the commodity.
income elasticity of demand, you can tell if a particular good represents If total revenue from (n) units is 110 and from (n 1) units is 100.
a necessity or a luxury. in that case

MRnth = TRn TRn _ 1 = 100 100
What is the 'Law Of Supply' What is 'Cross Elasticity Of Demand' MRnth = 10
The law of supply is the microeconomic law that states that, all other Cross elasticity of demand is an economic concept that measures the MR in mathematical terms is the ratio of change in total revenue to
factors being equal, as the price of a good or service increases, the responsiveness in the quantity demand of one good when a change in change in output
quantity of goods or services that suppliers offer will increase, and vice price takes place in another good. Also called cross price elasticity of MR = TR/q or dR/dq = MR
versa. The law of supply says that as the price of an item goes up, demand, this measurement is calculated by taking the percentage
suppliers will attempt to maximize their profits by increasing the change in the quantity demanded of one good and dividing it by the What is a 'Normal Good'
quantity offered for sale. percentage change in price of the other good. A normal good is a good or service that experiences an increase
BREAKING DOWN 'Law Of Supply' : The chart below depicts the law of in quantity demanded as the real income of an individual or economy
supply using a supply curve, which is always upward sloping. A, B and C rises. A normal good is defined as having an income elasticity of
are points on the supply curve. Each point on the curve reflects a direct demand coefficient that is positive but less than one. A good can also
correlation between quantity supplied (Q) and price (P) be classified as a luxury good or inferior good.

What is an 'Inferior Good'
An inferior good is a type of good for which demand declines as the
level of income or real GDP in the economy increases. This occurs when
a good has more costly substitutes that see an increase in demand as
the society's economy improves. An inferior good is the opposite of
a normal good, which experiences an increase in demand along with
increases in the income level. Inferior goods can be viewed as anything
a consumer would demand less of if they had a higher level of real
income.

Law of Demand doesnt hold What is 'Consumer Theory'
Consumer theory is the study of how people decide what to spend
Why the marginal revenue curve is downward sloping? their money on given their preferences and their budget constraints.
The monopolist faces the downward-sloping market demand Consumer theory shows how individuals make choices given their
curve, so the price that the monopolist can get for each additional income and the prices of goods and services and helps us to
unit of output must fall as the monopolist increases its output.
understand how individuals tastes and incomes influence the demand
Consequently, the monopolist's marginal revenue will also be
falling as the monopolist increases its output. curve.


********************************** What is the 'Indifference Curve'
When marginal revenue is equal to zero? An indifference curve represents a series of combinations between two
different economic goods, between which an individual would be
In other words the profit maximizing quantity and price can be
determined by setting marginal revenue equal to zero, which theoretically indifferent regardless of which combination he received.
*****************************************************
occurs at the maximal level of output. Marginal Indifference curves are heuristic devices used in contemporary
Law of Supply doesnt hold
revenue equals zero when the total revenue curve has reached microeconomics to demonstrate consumer preference and the
its maximum value. limitations of a budget. Later economists adopted the principles of
indifference curves in the study of welfare economics.
Why is average revenue curve equal to the demand curve?
Diminishing marginal returns will make sure that the Why an indifference curve is convex to the origin?
marginal revenue goes down, which makes the average This is an important property of indifference curves. They are convex
revenue to go down, which makes the demand curvelook in its to the origin. As the consumer substitutes commodity X for commodity
standard form of negative gradient. This is only the case for a Y, the marginal rate of substitution diminishes as X for Y along
perfectly competitive market. Average revenue is an indifference curve. The Slope of the curve is referred as the
total revenue divided by output quantity. Marginal Rate of Substitution.

1. Total Revenue: What are the properties of an indifference curve?
If both laws do not hold The income earned by a seller or producer after selling the output is An indifference curve has a negative slope and is convex to the origin.
called the total revenue. In fact, total revenue is the multiple of price Two indifference curves cannot cross each other. A higher indifference
and output. The behavior of total revenue depends on the market curve indicates a higher satisfaction level. Indifference curves are
where the firm produces or sells. drawn in a graph to show the combination of two products that give a
Total revenue is the sum of all sales, receipts or income of a firm. consumer a given level of satisfaction.
Dooley
Total revenue may be defined as the product of planned sales (output) Can an indifference curve be a straight line?
and expected selling price. Clower and Due The degree of convexity of an indifference curve depends on the rate
Total revenue at any output is equal to price per unit multiplied by of fall in the marginal rate of substitution of X for Y. As stated above,
quantity sold. Stonier and Hague when two goods are perfect substitutes of each other, the indifference
curve is a straight line on which marginal rate of substitution remains

constant.
For Equilibrium (stable)
Sufficient condtions : both laws hold Can indifference curve cross each other?
Necessary conditions : At least one law holds The indifference curves cannot intersect each other. It is
because at the point of tangency, the higher curve will give as
much as of the two commodities as is given by the
Shift of equilibrium, How does equation change ?

lower indifference curve. This is absurd and impossible.

D&S can shift to either left or right (not up and down) because Q is the
What is the law of equi marginal utility?
variable. If buyers income increases, demand increases. So D shifts R. The law of equi-marginal utility states that the consumer will
So, D function shifts right, If D shifts left, (P,Q) both go down. 2.Average Revenue:
Average revenue refers to the revenue obtained by the seller by selling distribute his money income between the goods in such a way
the per unit commodity. It is obtained by dividing the total revenue by that the utility derived from the last rupee spend on each good is
If S function shifts to right -> Eqb P decreases & Eqb Q increases, equal. In other words, consumer is in equilibrium position
If S function shifts to left -> Eqb P Increases & Eqb Q decreases, total output.
when marginal utility of money expenditure on each goods is
The average revenue curve shows that the price of the firms product
is the same at each level of output.
the same.
If both shifts, Q increases, But P may inc or dec, because,
Demand shift -> +ve effect on price } both cancels What is the marginal utility?
Supply shift -> -ve effect on price } Marginal utility is the additional satisfaction a consumer gains
Similarly, if Q increases, both +ve. from consuming one more unit of a good or service. Marginal
utility is an important economic concept because economists use
What is Elasticity of Demand? it to determine how much of an item a consumer will buy.
Demand elasticity refers to how sensitive the demand for a good is to
changes in other economic variables, such as the prices and consumer What is the law of diminishing marginal utility?
income. Demand elasticity is calculated by taking the percent change in DEFINITION of 'Law Of Diminishing Marginal Utility' A law of
quantity of a good demanded and dividing it by a percent change in economics stating that as a person increases consumption of a
another economic variable. A higher demand elasticity for a particular product, while keeping consumption of other products constant,
there is a decline in the marginal utility that person derives from
economic variable means that consumers are more responsive to
changes in this variable, such as price or income. consuming each additional unit of that product.









What is the economic principle of opportunity cost? For example, car dealers may exercise first degree price discrimination Demand-pull inflation
Alternatively, if working is the best alternative, the opportunity by looking at how a potential car buyer is dressed. A consumer who has Demand pull inflation occurs when aggregate demand is growing at an
cost of studying economics is the $10 you could have earned the latest version of a phone and wears expensive clothes is more likely unsustainable rate leading to increased pressure on scarce
instead. The principle of opportunity cost can also be applied to be able to pay a premium for a new car. resources and a positive output gap
to decisions about how to spend money from a fixed budget. When there is excess demand, producers can raise their prices and
Companies practice second degree price discrimination by charging achieve bigger profit margins
What are increasing returns to scale? different prices based on the quantity demanded. Companies generally Demand-pull inflation becomes a threat when an economy has
An increasing returns to scale occurs when the offer special prices for consumers who buy in bulk. For example, experienced a boom with GDP rising faster than the long-run trend
output increases by a larger proportion than the increase in communications companies may offer special bulk discounts for buying growth of potential GDP
inputs during the production process. For example, if input a variety of their products. Many communications companies offer a Demand-pull inflation is likely when there is full employment of
is increased by 3 times, but output increases by 3.75 times, then
packaged deal for Internet, phone and TV services at a discount to resources and SRAS is inelastic
the firm or economy has experienced an increasing returns to
scale. what consumers would pay for all three services separately.

What are the main causes of Demand-Pull Inflation?
A depreciation of the exchange rate increases the price of imports and

Companies can also engage in third degree price discrimination by reduces the foreign price of a country's exports. If consumers buy
What are returns to scale?
offering different prices for different groups. Some companies may use fewer imports, while exports grow, AD in will rise and there may be a
The term returns to scale arises in the context of a firm's
production function. It explains the behavior of the rate of age to discriminate consumers and charge different age groups multiplier effect on the level of demand and output
increase in output (production) relative to the associated increase different prices. For example, students and senior citizens may be given Higher demand from a fiscal stimulus e.g. lower direct or indirect taxes
in the inputs (the factors of production) in the long run. discounts because they exhibit high price sensitivity.

or higher government spending. If direct taxes are reduced, consumers
have more disposable income causing demand to rise. Higher

What is the law of diminishing return? a.) Pure monopoly government spending and increased borrowing creates extra demand
In economics, diminishing returns is the decrease in the Monopoly is a market situation in which there is only one seller of a in the circular flow
marginal (incremental) output of a production process as the product with barriers to entry of others. The product has no close Monetary stimulus to the economy: A fall in interest rates may
amount of a single factor of production is incrementally increased, substitutes. He is a price maker who can set the price to his maximum stimulate too much demand for example in raising demand for loans
while the amounts of all other factors of production stay constant. advantage. This may occur because the firm has a patent on a product or in leading to house price inflation. Monetarist economists believe
or a license from the government to be a monopoly .Pure monopoly that inflation is caused by too much money chasing too few goods"
What is the definition of constant returns to scale? occurs when the producer is so powerful that he is always able to take and that governments can lose control of inflation if they allow the
Definition of constant returns to scale. A constant ratio the whole of all consumers income whatever the level of his output is. financial system to expand the money supply too quickly.
between inputs and outputs. Constant returns to scale occurs Fast growth in other countries providing a boost to UK exports
when increasing the number of inputs leads to an equivalent b) Oligopoly overseas. Export sales provide an extra flow of income and spending
increase in the output. Oligopoly is a market situation in which there are a few firms selling into the UK circular flow so what is happening to the economic cycles
homogeneous or differentiated products. It is difficult to pinpoint the of other countries definitely affects the UK
Production Function: links inputs to amont of output. Assume we number of firms in the oligopolist market. There may be three or five Cost Push Inflation Analysis Diagram
have 2 inputs: Labor (L) and Capital (K), and we use Y for output . Then firms. It is also known as competition among the few. With only a few Cost-push inflation
we write: Y = F (L , K) , where F ( ) is the production Function. We make firms in the market the action of one firm is likely to affect the others. Cost-push inflation occurs when firms respond to rising costs by
a number of assumptions about this function. Examples: (1) Y = L . K (2) An oligopoly industry may produce either homogenous or increasing prices in order to protect their profit margins.
Y = L + K (3) Y = L1/3 . K1/3 (4) Y = L1/2 . K1/2 heterogeneous products. There are many reasons why costs might rise:
Average Product and Marginal Product of a Particular Input Component costs: e.g. an increase in the prices of raw materials and
Labor: Average Product of Labor (APL): Y/ L c.) Monopolistic competition other components. This might be because of a rise in commodity prices
Marginal Product of Labor (MPL): changes in Y / Changes in L (for small Monopolistic competition refers to a market situation where there are such as oil, copper and agricultural products used in food processing. A
changes) = partial derivative of F(L, K) with respect to L. many firms selling a differentiated product. There is competition which recent example has been a surge in the world price of wheat.
Capital: Average Product of Capital (APK): Y/ K is keen, though not perfect, among many firms making very similar Rising labour costs - caused by wage increases, which are greater than
Marginal Product of Capital (MPK): changes in Y/ Changes in K (for products. No firm can have any perceptible influence on the price improvements in productivity. Wage costs often rise when
small changes) = partial derivative of F(L, K) with respect to K output policies of the other sellers nor can it be influenced much by unemployment is low because skilled workers become scarce and this
Returns to Scale: Percentage of change in Y when we change all inputs their actions. Thus monopolistic competition refers to competition can drive pay levels higher. Wages might increase when people expect
in the same proportion. among a large number of sellers producing close but not perfect higher inflation so they ask for more pay in order to protect their real
Increasing Returns to Scale (IRS) : % change in Y > % change in L = % substitutes for each other. incomes. Trade unions may use their bargaining power to bid for and
change in K Constant Returns to Scale (CRS) : % change in Y = % change achieve increasing wages, this could be a cause of cost-push inflation
in L = % change in K Decreasing Returns to Scale (DRS): % change in Y < d.) Pure Competition Expectations of inflation are important in shaping what actually
% change in L = % change in K. In pure competition the number of buyers and sellers is very large. happens to inflation. When people see prices are rising for everyday
There is a perfect competition among them. Price is determined for the items they get concerned about the effects of inflation on their real
A budget constraint represents all the combinations of goods and entire industry by the forces of demand and supply. All firms have to standard of living. One of the dangers of a pick-up in inflation is what
services that a consumer may purchase given current prices within his sell their product at that price. No firm can influence price by a single the Bank of England calls second-round effects" i.e. an initial rise in
or her given income. Consumer theory uses the concepts of a budget action. Thus every firm is a price taker and a quality adjuster. prices triggers a burst of higher pay claims as workers look to protect
constraint and a preference map to analyze consumer choices. their way of life. This is also known as a wage-price effect"
Higher indirect taxes for example a rise in the duty on alcohol, fuels
and cigarettes, or a rise in Value Added Tax. Depending on the price
What is the meaning of the slope of the budget constraint? B. Income Elasticity of Demand elasticity of demand and supply for their products, suppliers may
The slope of the budget constraint has special significance. The In the second factor outlined above, we saw that if price increases choose to pass on the burden of the tax onto consumers.
absolute value of the slope represents the relative prices of the two while income stays the same, demand will decrease. It follows, then, A fall in the exchange rate this can cause cost push inflation because
goods, X and Y. In Exhibit 1, the slope, or PX /PY, is equal to 1.25, that if there is an increase in income, demand tends to increase as well. it leads to an increase in the prices of imported products such as
indicating that the relative price of 1 unit of X is 1.25 units of Y. The degree to which an increase in income will cause an increase in essential raw materials, components and finished products
demand is called income elasticity of demand, which can be expressed Monopoly employers/profit-push inflation where dominants firms in
in the following equation: a market use their market power (at whatever level of demand) to
What is the marginal rate of transformation? increase prices well above costs
The marginal rate of transformation is the rate at which one good -------------
must be sacrificed in order to produce a single extra unit
(or marginal unit) of another good, assuming that both goods require Consequences of Inflation
the same scarce inputs. Many governments have set their central banks a target for a low but
positive rate of inflation. They believe that persistently high inflation
What is the marginal rate of substitution? can have damaging economic and social consequences.
In economics, the marginal rate of substitution (MRS) is the rate at Income redistribution: One risk of higher inflation is that it has
which a consumer is ready to give up one good in exchange for another a regressive effect on lower-income families and older people in
good while maintaining the same level of utility. At equilibrium society. This happen when prices for food and domestic utilities such as
consumption levels (assuming no externalities), marginal rates of water and heating rises at a rapid rate
substitution are identical. Falling real incomes: With millions of people facing a cut in their wages

or at best a pay freeze, rising inflation leads to a fall in real incomes.
What is the 'Theory Of The Firm' Negative real interest rates: If interest rates on savings accounts are
If EDy is greater than one, demand for the item is considered to have a
The theory of the firm is the microeconomic concept founded lower than the rate of inflation, then people who rely on interest from
high income elasticity. If however EDy is less than one, demand is
in neoclassical economics that states that firms (including businesses their savings will be poorer. Real interest rates for millions of savers in
considered to be income inelastic. Luxury items usually have higher
and corporations) exist and make decisions to maximize profits. Firms the UK and many other countries have been negative for at least four
income elasticity because when people have a higher income, they
interact with the market to determine pricing and demand and then years
don't have to forfeit as much to buy these luxury items. Let's look at an
allocate resources according to models that look to maximize net Cost of borrowing: High inflation may also lead to higher borrowing
example of a luxury good: air travel.
profits. costs for businesses and people needing loans and mortgages as

Another Definition financial markets protect themselves against rising prices and increase
What are the main causes of inflation?
Behavior of a firm in pursuit of profit maximization, analyzed in terms the cost of borrowing on short and longer-term debt. There is also
Inflation is a sustained rise in the general price level. Inflation can come
of (1) what are its inputs, (2) what production techniques pressure on the government to increase the value of the state pension
from both the demand and the supply-side of an economy
are employed, (3) what is the quantity produced, and (4) what prices it and unemployment benefits and other welfare payments as the cost of
Inflation can arise from internal and external events
charges. The theorysuggest that firms generate goods to a point living climbs higher.
Some inflationary pressures direct from the domestic economy, for
where marginal cost equals marginal revenue, and use factors of Risks of wage inflation: High inflation can lead to an increase in pay
example the decisions of utility businesses providing electricity or gas
production to the point where their marginal revenue
product is equal to the costs incurred in employing the factors. or water on their tariffs for the year ahead, or the pricing strategies of
the food retailers based on the strength of demand and competitive
claims as people look to protect their real incomes. This can lead to a
rise in unit labour costs and lower profits for businesses
Business competitiveness:If one country has a much higher rate of
pressure in their markets.
Cost Function : A cost function is a mathematical formula used to used inflation than others for a considerable period of time, this will make its
A rise in the rate of VAT would also be a cause of increased domestic
to chart how production expenses will change at different output exports less price competitive in world markets. Eventually this may
inflation in the short term because it increases a firm's production
levels. In other words, it estimates the total cost of production given a show through in reduced export orders, lower profits and fewer jobs,
costs.
specific quantity produced. and also in a worsening of a countrys trade balance. A fall in exports
Inflation can also come from external sources, for example a sustained
can trigger negative multiplier and accelerator effects on national
rise in the price of crude oil or other imported commodities, foodstuffs
How do companies use price discrimination? income and employment.
and beverages.
Price discrimination is a strategy that companies use to charge Business uncertainty: High and volatile inflation is not good for
Fluctuations in the exchange rate can also affect inflation for example
different prices for the same goods or services to different customers. business confidence partly because they cannot be sure of what their
a fall in the value of the pound against other currencies might cause
The three main types of price discrimination are first degree, second costs and prices are likely to be. This uncertainty might lead to a lower
higher import prices for items such as foodstuffs from Western Europe
degree and third degree. Companies use these types of price level of capital investment spending.
or technology supplies from the United States which feeds through
discrimination to determine the prices to charge different consumers.
directly or indirectly into the consumer price index

Demand Pull Inflation Analysis Diagram
Companies use first degree price discrimination to sell a product for the

maximum price a consumer will pay. For companies to use this

strategy, they must know what their consumers are willing to pay for a

good.










How is the rate of inflation measured?
The rate of inflation is measured by the annual percentage change in
consumer prices.
The British government has set an inflation target of 2% using
the consumer price index (CPI)
It is the job of the Bank of England to set interest rates so that
aggregate demand is controlled, inflationary pressures are subdued
and the inflation target is reached
The Bank is independent of the government with control of interest
rates and it is free from political intervention. The Bank is also
concerned to avoid price deflation

Falling inflation does not mean falling prices!
Please remember that a fall in the rate of inflation is not the same
thing as a fall in prices!
In 2009 there was a drop in inflation from 5 per cent to 1 per cent over
the course of the year. Inflation was falling but the rate remained
positive meaning that prices were rising but at a slower rate!
A slowdown in inflation is not the same as deflation!
For this to happen, the annual rate of price inflation would have to be
negative.
How is the rate of inflation calculated?
The cost of living is a measure of changes in the average cost of
buying a basket of different goods and services for a typical household
In the UK the main measure of inflation is the consumer price
index (CPI)

Calculating a weighted price index
CPI is a weighted price index. Changes in weights reflect shifts in the
spending patterns of households in the British economy as measured
by the Family Expenditure Survey.
---------

Inflation can be reduced by policies that slow down the growth of AD
and/or boost the rate of growth of aggregate supply (AS)



Fiscal policy:
Controlling aggregate demand is important if inflation is to be
controlled. If the government believes that AD is too high, it may
choose to tighten fiscal policy by reducing its own spending on public
and merit goods or welfare payments
It can choose to raise direct taxes, leading to a reduction in real
disposable income
The consequence may be that demand and output are lower which has
a negative effect on jobs and real economic growth in the short-term
Monetary policy:
A tightening of monetary policy involves the central bank
introducing a period of higher interest rates to reduce consumer and
investment spending
Higher interest rates may cause the exchange rate to appreciate in
value bringing about a fall in the cost of imported goods and services
and also a fall in demand for exports (X)
Supply side economic policies:
Supply side policies seek to increase productivity, competition and
innovation all of which can maintain lower prices. These are ways of
controlling inflation in the medium term
i.A reduction in company taxes to encourage greater investment
ii.A reduction in taxes which increases risk-taking and incentives to
work a cut in income taxes can be considered both a fiscal and a
supply-side policy
iii.Policies to open a market to more competition to increase supply
and lower prices
Rising productivity will cause an outward shift of aggregate supply
Direct controls - a government might choose to introduce direct
controls on some prices and wages
Public sector pay awards the annual increase in government sector
pay might be tightly controlled or even froze (this means a real wage
decrease).
The prices of some utilities such as water bills are subject to regulatory
control if the price capping regime changes, this can have a short-
term effect on the rate of inflation
Evaluation points how best can inflation be controlled?
The most appropriate way to control inflation in the short term is for
the government and the central bank to keep control of aggregate

demand to a level consistent with our productive capacity
AD is probably better controlled through the use of monetary policy
rather than an over-reliance on using fiscal policy as an instrument
of demand-management
Controlling demand to limit inflation is likely to be ineffective in the
short run if the main causes are due to external shocks such as high
world food and energy prices

The UK is an open economy in which inflation is strongly affected by
events in the rest of the world

In the long run, it is the growth of a countrys supply-side productive
potential that gives an economy the flexibility to grow without

suffering from acceleration in cost and price inflation.