The quantity demanded of any good is the amount of the good that buyers are willing and able to

purchase.

✓Desire to purchase ✓Ability to purchase ✓Willingness to purchase

✓Inverse relationship between price & demand

Demand depends upon price

Exception to Law of Demand

▪ Necessities of life ▪ Luxuries ▪ Conspicuous consumption (demonstration effect) = people buy more
of a costlier commodity to impress others i.e. Veblen effect ▪ In case of scarcity ▪ Inferior goods

Determinants of Demand (Shift Factors)

Buyers

▪ The demand curve shows how price affects quantity demanded, other things being equal. ▪ These
“other things” are things that determine buyers’ demand for a good, other than the good’s price.
They are: ✓Number of buyers ✓Income ✓prices of related goods ✓Tastes ✓expectations.

INCOME

▪ An increase in the number of buyers causes an increase in quantity demanded at each price, which
shifts the demand curve to the right

Demand for a normal good is positively related to income.

• An increase in income causes increase in quantity demanded at each price, shifting the D curve to
the right. (Demand for an inferior good is negatively related to income. An increase in income shifts
D curves for inferior goods to the left.)

PRICE OF RELATED GOODS

Two goods are substitutes if an increase in the price of one causes an increase in demand for the
other.

▪ Example: pizza and hamburgers. An increase in the price of pizza increases demand for
hamburgers, shifting hamburger demand curve to the right. ▪ Other examples: Coke and Pepsi,

Two goods are complements if an increase in the price of one causes a fall in demand for the other. ▪
Example: computers and software. If price of computers rises, people buy fewer computers, and
therefore less software. Software demand curve shifts left

Tastes, pref and fashion

Sometimes people prefer some goods as they are popular not because they are cheaper

▪ Some rich don’t buy popular goods. To prove extraordinary they prefer rare products during use

Expectations affect consumers’ today’s buying decisions.

▪ Examples: • If people expect their income to rise, their demand for meals at expensive restaurants
may increase now. • If the economy turns bad and people worry about their future job security,
demand for new autos may fall now.
SUPPLY
Supply comes from the behavior of sellers.

▪ The quantity supplied of any good is the amount that sellers are willing and able to sell.

Exceptions to the Law of Supply

▪ Labour Market ▪ Rare Collection ▪ Recession

Determinants of Supply (Shift Factors)

▪ The supply curve shows how price affects quantity supplied, other things being equal. ▪ These
“other things” are non-price determinants of supply. They are: ✓ input prices ✓technology ✓# of
sellers ✓expectations

INPUT PRICES

A fall in input prices makes production more profitable at each output price, so firms supply a larger
quantity at each price, and the S curve shifts to the right.

technology

▪ Technology determines how much inputs are required to produce a unit of output. ▪ A cost-saving
technological improvement has same effect as a fall in input prices, shifts the S curve to the right.

# of sellers

▪ An increase in the number of sellers increases the quantity supplied at each price,

Expectations

Suppose a firm expects the price of the good it sells to rise in the future……. ▪ The firm may reduce
supply now, to save some of its inventory to sell later at the higher price. ▪ This would shift the S
curve leftward.

Equilibrium price: The price that equates quantity supplied with quantity demanded

Disequilibrium : case 1-Surplus when quantity supplied is greater than quantity demanded

Facing a surplus, sellers try to increase sales by cutting the price.

Case 2 - Shortage: when quantity demanded is greater than quantity supplied

Facing a shortage, sellers raise the price which reduces the shortage.

ELASTICITY
Elasticity measures how much one variable responds to changes in another variable.

Calculating Percentage Changes

▪ We use the midpoint method:

end value – start value midpoint x 100%

What determines price elasticity?

EXAMPLE 1: Rice Krispies vs. Sunscreen

▪ The prices of both of these goods rise by 20%. For which good does Qd drop the most?

Why? • Rice Krispies has lots of close substitutes (e.g., Cap’n Crunch, Count Chocula), so buyers can
easily switch if the price rises. • Sunscreen has no close substitutes, so consumers would probably
not buy much less if its price rises.

▪ Lesson: Price elasticity is higher when close substitutes are available.

EXAMPLE 2: “Blue Jeans” vs. “Clothing”

▪ The prices of both goods rise by 20%. For which good does Qd drop the most?

Why? • For a narrowly defined good such as blue jeans, there are many substitutes (khakis, shorts,
Speedos).

• There are fewer substitutes available for broadly defined goods. (Can you think of a substitute for
clothing, other than living in a nudist colony?)

▪ Lesson: Price elasticity is higher for narrowly defined goods than broadly defined ones.

EXAMPLE 3: Insulin vs. Caribbean Cruises

▪ The prices of both of these goods rise by 20%. For which good does Qd drop the most?

Why? • To millions of diabetics, insulin is a necessity. A rise in its price would cause little or no
decrease in demand. • A cruise is a luxury. If the price rises, some people will forego it.

▪ Lesson: Price elasticity is higher for luxuries than for necessities.

EXAMPLE 4: Gasoline in the Short Run vs. Gasoline in the Long Run

▪ The price of gasoline rises 20%. Does Qd drop more in the short run or the long run? Why? •
There’s not much people can do in the short run, other than ride the bus or carpool. • In the long
run, people can buy smaller cars or live closer to where they work.

▪ Lesson: Price elasticity is higher in the long run than the short run.

According to the degree of change in demand for a given change in price EoD is divided into 5 kinds.
1. Perfectly Inelastic Demand – Demand is zero sensitive eg: salt, insulin

2. Inelastic Demand – Given change in price is more than change in q.demanded. Elasticity >1

3. Unit Elastic Demand – Change in price is equi-proportional to change in demand.

4. Elastic Demand – 1% change in price leads to more than 1% change in demand eg: clothing

5. Perfectly Elastic Demand – No change in price still leads to increase in q.demand. eg: By the
increase in price of substituted goods.

There are 5 kinds of elasticity of supply.

1. Perfectly Inelastic Supply 2.Inelastic Supply 3.Unit Elastic Supply 4.Elastic Supply 5.Perfectly Elastic
Supply
Utility = expected satisfaction
• Satisfaction= realised satisfaction

Marginal Utility of a good y

• additional utility that the consumer gets from consuming a little more of y

• i.e. the rate at which total utility changes as the level of consumption of good y rises

Total Utility

• Sum total of utilities from each unit • Aggregation of marginal utility derived from each unit

The law of diminishing marginal utility states that if the consumer buys successive units of same
commodity without any time gap, utility derived from successive units goes on diminishing.

STAGES

1st stage: TU increases , MU decreases

2nd stage: When MU is 0, TU is maximum

3rd stage: still consumer buys more MU becomes negative and TU decreases.

Assumptions of the law

• Rationality of consumer • Identical products • Continuous consumption • Constancy of income and

price • Utility is cardinal • MU of money is constant

Exceptions to the law

• Money • Rare collection • Alcoholic drinks

Managerial Perspectives of the Law

• Consumers are rational • Likes, preferences change • No repeated demand for identical product •
Improve & diversify the products • Research &development- Innovation of new goods, new uses of
the existing goods, modify the goods with more features, better looks etc.

COST OF PRODUCTION
Opportunity cost refers to the next best alternative use.

Sunk cost= expenditure is made & cannot be recovered- ignore while making decisions. Ex: purchase
equipment, later cannot be used for alternatives.

Marginal Cost (MC)= ∆TC/ ∆Q

Average Fixed Cost (AFC) =FC/Q

▪ Average Variable Cost (AVC) = TVC/Q

▪ Average Total Cost (ATC) ATC= AFC+AVC

Short Run Cost: cost has two componentsvariable and fixed Output varies with variation in variable
cost.

▪ Long Run Cost: all cost components are variable Output changes with a change in all inputs which
are variable

Economies of scale: ATC falls as Q increases.

Constant returns to scale: ATC stays the same as Q increases.

Diseconomies of scale: ATC rises as Q increases.

Economies of scale occurs when ▪

increasing production allows greater specialization: workers more efficient when focusing on a
narrow task. ▪ Provide flexibility- can organize the production process more effectively. ▪ May
acquire input at lower cost

Diseconomies of scale occurs due to:

▪ Coordination problems in large organizations. E.g., management becomes stretched, can’t control
costs. ▪ Available supplies may be limited, pushing up cost ▪ Limited factory space and machinery

Economies of Scope: Situation in which joint output of a single firm is greater than output that could
be achieved by two different firms when each produces a single product ( with equivalent inputs
allocated between them).

Diseconomies of Scope: Situation in which joint output of a single firm is less than could be
achieved by separate firms when each produces a single product.

Characteristics of Perfect Competition

❖ Many buyers and many sellers ❖ The goods offered for sale are homogenous. ❖ Firms can freely
enter or exit the market. ❖ Perfect Information

❖ Single price. Since products are homogenous. The sellers are all in the same place and so no
transportation cost. No creative advertisements because of homogeneity. Gneric advertisement will
continue.

▪ Because of 1 & 2, each buyer and seller is a “price taker” – takes the price as given. (depends on
market forces)

If MR > MC, then increase Q to raise profit.

▪ If MR < MC, then reduce Q to raise profit.

Fixed cost becomes sunk cost

▪ FC is a sunk cost: The firm must pay its fixed costs whether it produces or shuts down. ▪ So, FC
should not matter in the decision to shut down.

Why Do Firms Stay in Business if Profit = 0?

▪ Recall, economic profit is revenue minus all costs – including implicit costs, like the opportunity
cost of the owner’s time and money. ▪ In the zero-profit equilibrium, firms earn enough revenue to
cover these cost.
CHAPTER SUMMARY
▪ For a firm in a perfectly competitive market, price = marginal revenue = average revenue.

▪ If P > AVC, a firm maximizes profit by producing the quantity where MR = MC

If P < AVC, a firm will shut down in the short run.

▪ If P < ATC, a firm will exit in the long run.

▪ In the short run, entry is not possible, and an increase in demand increases firms’ profits.

▪ With free entry and exit, profits = 0 in the long run, and P = minimum ATC.

A monopoly is a firm that is the sole seller of a product. ▪ No close substitutes. ▪ A monopoly firm
has market power, the ability to influence the market price of the product it sells. ▪ Strong barriers to
entry. ▪ Single price or discriminating price

Profit-Maximization

▪ Like a competitive firm, a monopolist maximizes profit by producing the quantity where MR = MC. ▪
Once the monopolist identifies this quantity, it sets the highest price consumers are willing to pay for
that quantity. ▪ It finds this price from the D curve.

Price discrimination is the business practice of selling the same good at different prices to different
buyers. `

▪ The characteristic used in price discrimination is willingness to pay (WTP): • A firm can increase
profit by charging a higher price to buyers with higher WTP.

SUMMARY
A monopoly firm faces a downward-sloping demand curve for its product. As a result, it must reduce
price to sell a larger quantity, which causes marginal revenue to fall below price

Monopoly firms maximize profits by producing the quantity where marginal revenue equals marginal
cost. But since marginal revenue is less than price, the monopoly price will be greater than marginal
cost, leading to a deadweight loss.

▪ Policymakers may respond by regulating monopolies, using antitrust laws to promote competition,
or by taking over the monopoly and running it. Due to problems with each of these options, the best
option may be to take no action.

▪ Monopoly firms (and others with market power) try to raise their profits by charging higher prices
to consumers with higher willingness to pay. This practice is called price discrimination.