Phan” piel rey renin 4 TAG 2500 3300 3500 Equilibr 3100 2400 Saturati on mu 4 30 MU and TU: Purchasing Hilsa Fish by the Consumer Saturation point¢ INTRODUCTION [cusap. commodity wher its price rst. :+2cause the producer's profits increase se would then accept the hypothesis of part (b) as a theory. (As we will see in Chapter 6, however, a complete theory of production involves much more than this.) 1.3 Distinguish between (a) a hypothesis, (b) a theory, and (c) a law. (@) A hypothesis, is an “if-then” proposition usually constructed from a casual observation of real-world event which represents a tentative and yet untested explanation of the event. (®) A theory implies that some successful tests of the corresponding hypothesis have already been ‘undertaken. Thus, a theory implies a greater likelihood of truth than a hypothesis. The greater the umber of successful tests (and ick ot unsucceesin ones), the greater the degree of confidence we have in the theory. (©) Alaw is a theory which is always true under the same set of circumstances, as, for example, the law of gravity. THE PROBLEM OF SCARCITY 1.4 Distinguish between (a) economic resources and (b) noneconomic resources. (@) Economic resources, factors of production, or inputs refer to the services of the various types of labor, capital equipment, land (or natural resources), and (in a world of uncertainty) eatrepreneur- ship. Since in every society these resources are not unlimited in supply but are limited or scarce, they command a priae (i.e, they are economic resources). (6) Economic resources can be contrasted with noneconomic resources such as air, which (in the absence of pollution) is unlimited in supply and free. In economics, our interest lies with economic resources, rather than with noneconomic resources. 5) (0) Why is “what to preauce” + :roblew in every economy? (6) How does the price .) teshanisc: solve this rrobiem wv a free-enterprise economy? (c) in a mixcd- enterprise economy? (4) in a centralized economy? (@) “What to produce” refers to those goods and services and the quantity of cach that the economy should produce. Since resources are scarce or limited, no economy can produce as much of every ‘good or service as desired by all members of society. More of one good or service usually means less of others. Therefore, every society must choose exactly which goods and services to produce and how much of each to produce. (®) Ina free-enterprise economy, the “what to produce” problem is solved by the price mechanism. Only those commodities for which consumers are willing to pay a price per unit sufficiently high to cover at least the full cost of producing them will be supplied by producers in the long run. By paying a higher price, consumers can normally induce producers to increase the quantity of a ‘commodity that they supply per unit of time. On the other hand, a reduction in price will normally result in a reduction in the quantity supplied. © Ina mixed-enterprise economy such as ours, the government (through taxes, subsidies, etc.) modifies and, in some instances (through direct controls), replaces the operation of the price mechanism in its function of determining what to produce. @ Ina completely centralized economy, the dictator, or more likely a planning committee appointed by the dictator or the party, determines what to produce. We in the West believe that this is inefficient. Even the Soviet Union (never a completely centralized economy) has been moving recently toward more decentralized control of the economy and toward greater reliance on the Price mechanism to decide what to produce. ! 1.6 (a) Why is “how to produce” a problem in every economy? (6) How does the pricecar. 1) INTRODUCTION “7 mechanism solve this problem in a free-enterprise economy? (c) In a mixed- enterprise economy? (d} i:: a centralized economy? “ produce” choice bination of factors and the particular technique to (© aera predsnga good or sre, Sort god or serc can normal be produced ith ier! factor combinations and different techniques, the problem arises as to which of these to use. Sec resources are limited in every economy, when more of them are used to produce some goods re services, less are available to produce others. Therefore, society faces the problem of choosing technique which results in the least possible cost (in terms of resources used) to produce each unit of the good or service it wants. . | (6) Ima free-enterprise economy, the “how to produce” problem is solved by the price mechanism. Because the price of a facir normally cepreseuls its relative scarcity, the best technique to use iz producing a good or service is the one that results in the least dollar cost of production. If the price of a factor rises in relation to the price of others used in the production of the good or service, Producers will switch to a technique which uses less of the more expensive factor in order to ‘minimize their costs of production. The opposite occurs when the price of a factor falls in relation to the price of others. : (© In mixed-enterprise economy, the operation ‘of the price mechanism in solving the “how to produce” problem is modified and sometimes replaced-by a government action. @) Ina centralized economy, this problem is solved by a planning committee. (@) Why is “for whom to produce” a problem in every economy? (b) How does the Price mechanism solve this problem? (¢) Why does the government in a mixed- enterprise echnomy modify the operation of the price mechanism in its function of determining for whom to produce? (@) “For whom to produce” refers to how the total output is to be di ided among different consumers. ‘Since resources and thus goods and services are scarce in every ¢ onomy, no society can satisfy all the wants of all its people. Thus, a problem of choice arises. (©) In the absence of government s-gulation or control of the econon y, the problem of “for whom produce” is ais’: solved ivy ti rice meclianism. The economy will :zuduce those comm: ‘iti. satisfy the wants of those peop vho hav- the money to pay for thm, ‘The higher the income ot an individual, the more the economy will be geared to produce the commodities the consumers want (f they are also willing to pay for them). (©) In the name of equity and faimess, governments usually modify the workings of the price mechanism by taking from the rich (through taxation) and redistrubuting to the poor (through subsidies and welfare payments). They also raise taxes in order to provide for certain “public” ‘g00ds, such as education, law and order, and defense. (@) Identify the two types of rationing that the price mechanism performs over the time in which the supply of ‘a commodity is fixed, (6) explain how the price mechanism performs the first of these two rationing functions, and (c) explain how the price mechanism performs its second rationing function (@) Ina free-enterprise economy, the price mechanism performs two clusely related types of rationing. First, it restricts the total level of consumption to the available output. Second, it restricts the current level of consumption so the commodity will last for the entire time period over which its supply is fixed, i () “The price mechanism performs the first rationing function as follows: If the prevailing price of a Commodity would lead to a shortage of the commodity, that price would rise. At higher prices, consumers would buy less and producers would supply more of the commodity nti} the total level of consumption equaled the available output. The opposite would occur if the prevailing price of ‘the commodity would lead to a surplus of the commodity. Thus, the price mechanism restricts the total level of consumption to the available production.2. Theory of Demand The purpose of the theory of demand is to determine the various factors that affect demand. One often reads that the raison d’étre of the theory of demand is the establish- ment of the ‘law of demand’ (that the market demand is negatively related to the price) but this is misleading in that it concentrates on price as the sol mand, .: ceteris paribus. Demand is a multivariate relationship, that is, it is determined by many factors simul: ' taneously. Some of the most important teterminants of the market demand for a par- ticular product are its own price, consumers’, income, prices of other commodities, consumers’ tastes, income distribution, total population, consumers’ wealth, credit availability, g.:vernment policy, past levels of demand, and past levels of income. The ‘rac 1honal theory of demand has concentrated on four of the above determinuics, , es the price of the commodny, other prices, income and tastes. Some of the other factors:;..31 have been introduced in the theory of demand recently. We will first examine the tradi- “a tional static theory of demand and subsequently we will briefly discuss some recent developments in this field. It should be noted that the traditional theory of demand examines only the final consumers’ demand for durables and non-durables. It is partial in its approach in that it examines the demand in one market in isolation from the conditions of demand in. other markets. An important implicit assumption of the theory of demand is that firms sell their products directly to the final consumers. This is not the general case in the. modern business world (as we will sec in ‘section LV), and this has serious implications for the determination of prices. Another shortcomingof the traditional theory is that it does :° not deal with the demand for investment goods, nor with the demand for intermediate products. Total demand includes final demand and intermediate demand. Final demand is subdivided into consumers’ demand and demand for investment goods. Traditional | = theory of demand deals only with consumers’ demand, which is only a fraction! of the total demand in the economy as a whole. In this section we examine the traditional ..2 theory of consumers’ demand, In section IV we look at the demand of the individual firm, and Wwe discuss the various sources of demand for the product of manufacturing firms in particular. This analysis will cover some aspects of the demand for intermediate commodities and for investment goods. I. THEORY OF CONSUMER BEHAVIOUR The traditional theory of demand starts with the examination of the behaviour of the -.* consumer. since the market demand is assumed to be the summation of the demands of/ fr . Basic Tools of Analysis individual consumers. Thus we will first examine the derivation of demand for an in- dividual consumer. The consumer is assumed to be rational. Given his income and the market prices of the various commodities, he plans the spending of his income so as to attain the highest possible satisfaction or utility. This is the axiom of utility maximisation. In the traditional theory it is assumed that the consume? has full knowledge of all the information relevant to his decision, that is he has complete knowledge of all the available commodities, their prices and his income. In Grder to attain this Sbjealive tie onsumer must be able to Oompa the utility (satisfaction) of the various ‘baskets of goods’ which he can buy with > is income. There are two basic approaches to the problem of comparison of utilities, the cardinalisapproach and the gFdinalisPapproach. : The cardinalist school postulated that utility can be measuied. Various suggestions have been made for the measurement of utility. Under certainty (complete knowledge of market conditions and income levels over the planning period) some economists have suggested that utility can be measured in monetary units, by the amount of money the consumer is willing ifice for another unit of a commodity. Others suggested the meas\ t of utility in si units, called(uti . — idinalist school postulated that utility magnitude. The consumer need ‘not know in specific units the utility of various c modities to make his choice. It suffices for him to be able to rank the various ‘baskets of goods’ according to the satisfaction that each ‘bundle gives him. He must be able to determine his order of preference aimong the different bundles of goods. The main ~ seca theories are the indifference-curves approach’and the revealed preference hy- pothesis. . ~ Tu examining the above zppcvaches we will first state the assumptions underlying each apptuach, derive the equilibrium of the cousismer, and from this determine his demand for the individual products. Finally we point out the weaknesses of each approach. not measurable, but is an ordinal A. THE CARDINAL UTILITY THEORY! ‘Assumptions 1. Rationality. The consumer is rational. He aims at the maximisation of his utility subject to'the constraint imposed by his given income. 2. Cardinal utility. The utility of each commodity is measurable. Utility is a cardinal concept. The most convenient measure is moncy: the utility is tneasured by the monetary units that the consumer is prepared to pay for another unit of the commodity. 3. Constant marginal utility of money. This assumption is necessary if the monetary unit is used as the measure of utility. The essential feature of a standard unit of measurement _ ds that it be constant. If the margifial utility of moncy changes-as income increases (or decreases) the measuring-rod for utility becomes like an elastic ruler, inappropriate for measurement. . 4. Diminishing marginal utility. The utility gained from successive units of acommodity diminishes. In other words, the marginal utility of a commodity diminishes as the con- sumer acquires larger quantities of it. This is the axiom of diminishing marginal utility. The concept of subjective, measurable u i, attributed to Gossen (1854), Jevons 1871) and Walras’(1874). Marshall (1290) ales se oeTheory of Demand 15 5. The total utility of a “basket of goods’ depends on the quantities of the individual commodities. If there are n commodities in the bundle with quantities x1, X2..-- »%n» uit tuiai utility is U = fy Xn) In very early versions of the theory of consumer behaviour it was assumed that the total utility is additive, U = Ux,) + U(x) + + Use) The additivity assumption was dropped in later versions of the cardinal utility theory. Additivity implies independent utilities of the various commodities in the bundle, an assumption clearly unrealistic, and unnecessary for the cardinal theory. Equilibrium of the consumer We begin with the simple model of a single commodity x. The consumer can either buy x or retain his money income Y. Under these conditions the consumer is in equili- brium when the marginal utility of x is equated to its market price (P,). Symbolically we have _—_— . MU, =P, Ef the marginal utility of x is greater than its price, the consumer can increas” bis wel~ fare by purchasing more units of «<. Similarly if the marginal utility c* x is less than its price the consumer can increase his total satisfaction by cutting dows: .he quantity of, x and keeping more of his income unspent. Therefore, he attains the maximisation of his utility when MU, = P,! If there are more cdmmodities, the condition for the equilibrium of the consumer is the: ality of the ratios of the marginal utilities of the individual commodities to. their 8 aU AP ,4,) 24, 04, Rearranging we obtain6 Basic Tools of Analysis The utility derived from spending an additional unit of money must be the same for all commodities. If the consumer derives greater utility from any one commodity, he can increase his welfare by spending more on that commodity and less on the others, until tive above equilibrium condition is fulfilled. Derivation of the demand of the consumer The derivation of demand is based on the axiom of diminishing marginal utility. The marginal utility of commodity x may be depicted by a line with a negative slope (figure 2.2). Geometrically the marginal utility of x is the slope of the total utility function U = f(q,). The total utility increases, but at a decreasing rate, up to quantity 4 Figure 2.1 Figure 22 x, and then starts declining (figure 2.1). Accordingly the marginal utility of x declines continuously, and becomes negative beyond quantity x. If the marginal utility is measured in monetary units the demand curve for x is identical to the positive segment of the marginal utility curve. Atx, the marginal utility is MU, (Ggurc 2.3). This is equal to P,, by definition. Hence at P, the consumer demands %4 quantity (figure 2.4), Similarly at x; the marginal utility is MU, which is equal to P,. Hence at P the consumer will buy x2, and so on. The negative section of the MU curve does not form part of the demand curve, since negative quantities do not make sense in economics. MU, x Xp oeTheory of Demand 7 Critique of the cardinal approach These are three basic weaknesses in the cardinalist approach. The assumption of cardinal utility is extrenucly doubiful. Ti: satisfaction derived from various commodities cannot be measured objectively. The attempt by Walras to use subjective units (utils) for the measurement of utility does not provide any satisfactory solution. The assump- tion of constant utility of money is also unrealistic. As income increases the marginal utility of money changes. Thus money cannot be used as a measuring-rod since its own utility changes. Finally, the axiom of diminishing marginal utility has bccn ‘established’ from introspection, it is a psychological law which must be taken for granted. B. THE INDIFFERENCE-CURVES THEORY! ~ Assumptions 1, Rationality. The consumer is assumed to be rational — he aims at the maximisation of his utility, given his income and market prices. It is assumed he has full knowledge (certainty) of all relevant information. 2: Utility is ordinal. It is taken as axiomatically true that the consumer can rank his’ . | preferences (order the various ‘baskets of goods’) according to the satisfaction of each 2 basket. He need rot know rzscisely the amount of satisfaction. It suffices that he ex-, presses his preference for = variou. buwdles of commoditic: It is not necessary td” assume that utility is cardis, ‘'v measurable. Only ordinal measurenwnt is required. 3. Diminishing marginal rate of substitution. Preferences are ranked in terms of i difference curves, which are assumed to be convex to the origin. This implies that the. slope of the indifference curves increases. The slope of the indifference curve is called the: marginal rate of substitution of the commodities. The indifference-curve theory is based thus, on the axiom of diminishing marginal rate of substitution (see below). s 4. The total utility of the consumer depends on the quantities of the. commodities consumed * : . U = $de Gayo + Ger ype Ge) , , §¢ Consistency and transitivity of choice. It is assumed that the consumer is consistent’ § -in his choice, that is, if in one period he chooses bundle A over B, he will not choose’ Bover A‘in another period if both bundles are available to him. The consistency assump-. 'y be symbolically written as follows: IfA > B, then B >A ly, it is assumed that consumer's choices is sitivity: i Hy, u are characterised by transitivity: if ‘A is. preferred to B, and B is preferred to C, then bundle A, is preferred ia C.. lly. we may Write the transitivity assumption as follows: IfA> B,and B> C,thenA>C