What Is Economics?

Economics is a social science concerned with the production, distribution, and consumption of goods and
services. It studies how individuals, businesses, governments, and nations make choices about how to allocate
resources. Economics focuses on the actions of human beings, based on assumptions that humans act with
rational behavior, seeking the most optimal level of benefit or utility. The building blocks of economics are the
studies of labor and trade. Since there are many possible applications of human labor and many different ways
to acquire resources, it is the task of economics to determine which methods yield the best results.
 Economics can generally be broken down into macroeconomics, which concentrates on the behavior of the economy as a
whole, and microeconomics, which focuses on individual people and businesses.
 Economics is the study of how people allocate scarce resources for production, distribution, and consumption, both
individually and collectively.
 Two major types of economics are microeconomics, which focuses on the behavior of individual consumers and producers,
and macroeconomics, which examine overall economies on a regional, national, or international scale.
 Economics is especially concerned with efficiency in production and exchange and uses models and assumptions to
understand how to create incentives and policies that will maximize efficiency.
 Economists formulate and publish numerous economic indicators, such as gross domestic product (GDP) and the Consumer
Price Index (CPI).
 Capitalism, socialism, and communism are types of economic systems.

Macroeconomics explained in detail! Meaning, Scope, Nature and Importance

Introduction
Economics is a subject that deals with every situation that’s happening in the whole world. This subject finds its use at
many stances in our lives. For example, Your mother does all the work at your home. From doing all the household
chores, keeping a budget for the rations to fulfilling all your needs. Thus, it is one subject that deals in our day to day
working of our life. The same subject has two broad categories – microeconomics and macroeconomics. The former deals
with the individual units of an economy like the consumer or a household. But, the latter deals with an economy as a
whole. It deals with studies of national income and output. The understanding of this science is vast and at different
lengths. But for the sake of simplicity, this article will only focus on the scope of Macroeconomics and its need. Let us look
into the scope of Macroeconomics and Microeconomics.

Microeconomics
As mentioned above, Microeconomics is a branch of economics that deals with individual units of the economy. It
involves its field of study on individual units like the consumer, or the household. The subject deals with problems
associated with determining the price of a commodity. These direct or indirect factors affect the demand and supply of a
commodity and the procurement of the satiety level of an individual. The main aim of microeconomics is maximizing
profit and minimizing the costs incurred. This utilized in such a way that it is available to future generations and that there
is an equilibrium.
Macroeconomics
The term macroeconomics came into existence in 1933 by Ragnar Frisch. However, its approach towards economic
problems came in the 16th and 17th centuries. As a result, this originated with mercantilists.
It is that branch of science which deals with the economy as a whole or in totality including the Macro factors. The hope of
macroeconomics does not involve studying the individual units of an economy. But, the economy as a whole, studies the
total and average of the entire economy. Such as the national income, total employment, total saving and Investments, total
demand and supply, and the general price level.
The subject of macroeconomics revolves around the determination of income and employment. Therefore, it is known as
the “theory of income and employment.”
Control over the inflation and deflation cycle was only made possible by choosing the current economic policies. These
policies were formulated at the macro level. The study of individual units has also become impossible. Moreover,
governments’ participation through monetary and fiscal measures in the economy has increased. Therefore, the use of
macro analysis is irrefutable.
So now, we understand that macroeconomics is a specialized field of Economics. It focuses on the economy through the
aggregate of the individual units to determine there is a large impact on the complete nation. All the prominent policies and
measures are based on this concept. For example, the per capita income determines the National income. This is nothing
but an average of the total earnings of all the citizens in the nation.
Scope of Macroeconomics
Macroeconomics is an essential field of study for economists. Government, financial bodies and researchers
analyze the general national issues and economic well being of a nation. It mainly covers the measure
fundamentals which are macroeconomic theories and macroeconomic policies. Here the MacroEconomic
theories involve economic growth and development, the theory of national income, money, international trade,
employment, and general price level. In contrast, macroeconomic policies cover fiscal and monetary
policies. The study of problems like unemployment in India or the general price level or the problem of balance
of payment(BOP) is a part of the macroeconomic study because it relates to the economy as a whole.

Macroeconomic Theories
It is understood that the Government is the regulating body of a nation. It considers the various aspects which
are critical and have a direct impact on the lives of the citizens. There are six theories under the scope of
macroeconomics:
Theory of Economic Growth and Development
The growth of an economy also comes under the study of macroeconomics. The resources and capabilities of
an economy are evaluated based on the scope of macroeconomics. It schemes the increase in the level of
national income, output, and the environment level. They have a direct impact on the economic development
of an economy.
Theory of Money
Macroeconomics assesses the impact of the reserve bank in the economy, the inflow and outflow of capital,
and its effects on job rates. The frequent change in the value of money caused due to inflation and deflation
diversely affect the economy of a nation adversely. They can be aggravated by taking monetary, fiscal policies
and direct control measures for the economy as a whole.
Theory of National Income
It includes different topics related to the measurement of national income, including revenue, spending, and
budgeting. As a macroeconomic study, it is vital for assessing the overall performance of the economy in terms
of national income. At the onset of the Great Depression of the 1930s, it was essential to investigate the
triggers of general overproduction and general unemployment. This led to the creation of data on national
income. It helps to forecast the level of economic activity. It also helps in understanding the income distribution
among various classes of citizens.
Theory of International Trade
It is an area of study that focuses on the export and import of products or services. In brief, it points out the
effect on the economy through cross-border commerce and customs duty.
Theory of Employment
This scope of macroeconomics assists in determining the level of unemployment. It also determines the
conditions that lead to such conditions of unemployment. Hence, this affects the production supply, consumer
demand, consumption, and expenditure behavior.
Theory of General Price Level
The most significant of these is the study of commodity prices and how specific price rates fluctuate due to
inflation or deflation.

Macroeconomic Policies
The RBI and the Government of India together function to imply the macroeconomic policies, for the nation’s
improvement and development.It is classified into the following two sections:

Fiscal policy
It refers to how the expenditure meets over the deficit income which explains itself as a form of budget
decision under macroeconomics.
Monetary policies
The Reserve Bank is establishing monetary policy in coordination with the Government. These policies are
measures taken to maintain economic stability and growth in the country by regulating the different interest
rates.

Importance of macroeconomics
1. Macroeconomics is a vital concept that considers the whole nation and works for the welfare of the
economy.
2. It is helpful for the timing of economic fluctuations to prevent or be equipped for any financial crisis or any
long – term negative situations.
3. The system of fiscal and monetary policies depends entirely on the analysis of the widely held
macroeconomic conditions in the nation.
4. Macroeconomics mainly aims to help the Government and the financial bodies to prepare economic stability
in the country.
5. This stream of economics gives a broader perspective of social or national issues. The ones who want to
contribute to the welfare of society need to study macroeconomics.
6. It ensures or keeps a check over the proper functioning of the country’s economy and actual position.
7. The analysis of macroeconomics theories and issues helps the economists to figure out the causes and
possible solutions of such macro-level problems.
8. Dealing with various economic conditions through the use of macro-economic data opens the door for
growth in the country.
Issues Related to Macroeconomics
An economist needs to analyze the following problems while studying macroeconomics:
1. Business activities also result in societal costs like deforestation and land degradation. To regulate this social
expense, the Government carries out clear laws and legislation. These regulations serve as a barrier for
business organizations.
2. The economic conditions in a nation have an immense impact on the activities of every firm either directly or
indirectly. Different economic patterns or variables impacting industry include the GDP, job rates and
conditions, revenue, banking, and pricing policies.
3. Many organizations trade (either export or import of goods) in international markets. They are sensitive to
the fluctuations in the economy of other countries, exchange rates, prices, and other varied factors. Hence,
such changes may influence the economic conditions of the country. This might also end up affecting
business organizations.

Final Thoughts
Macroeconomics is the foundation of many economic policies. It lays the basis of a regional decision-making
mechanism in a nation. But, the policies underpinned by this concept usually have a double impact on society
as a whole and individual citizens. It requires an observational, logical, incredible approach.

Scope of Macroeconomics
Macroeconomics is much of theoretical and practical importance. Following are the points covered under the
scope of macroeconomics −
Nature of Macroeconomics
Macroeconomics is basically known as theory of income. It is concerned with the problems of economic
fluctuations, unemployment, inflation or deflation and economic growth. It deals with the aggregates of all
quantities not with individual price levels or outputs but with national output.
As per G. Ackley, Macroeconomics concerns itself with such variables −
 Aggregate volume of the output of an economy
 Extent to which resources are employed
 Size of the national income
 General price level

7 Limitations and Types of Macroeconomics Analysis (Explained)

Macroeconomics is that branch of economic analysis in which groups created to the whole economies, like
national income, Total production, total consumption, total savings, wage-level, general cost, and general price
level are studied.

Limitations of Macroeconomics
Followings are the limitations of macroeconomics:
1. Importance not given to Individual Units
It is not complete analysis because in it instead of the individual units’ whole economy is studied collectively, So by the
study of its importance is given to an undivided unit.
Bonus: 15 Importance and Limitations of Microeconomics.
2. Possibility of Wrong Predictions
Policies are framed on the basis of the whole economy sometimes maybe dangerous for some firms and commodities.
For example: If the general price level is fixed, then it cannot be said that the price of commodities will also remain
fixed because, by increasing the price of some commodities and a decrease in the price of some commodities, the general
price level can remain fixed.
3. Difficult to find out Macro Quantities
It is difficult to find out macro quantities. Index number, defective of giving weight to index no.
Thus, it is very difficult to find correct data of total investment total savings, total consumption, etc.
Related: 7 Scope and Types of Microeconomics Analysis (With Examples).
4. No Attention to Structure and Composition of Group
Macroeconomics attention is given only towards groups and totals not towards the structure and composition of the
group.

Features of Macroeconomics
Following are the characteristics of macroeconomics:
1. Changeability
In it, macro-units are considered as the variable (dynamic) whereas Micro units are considered as static.
2. Connectedness
Macro quantity is not always the total of Microquantities, nor we can get individual quantity by during Macro quantity by
individual units.
Determination of the quantity of Micro and Macro is done by different methods.
Related: 14 Principles of Planning – Explained with Examples.
The benefits of the whole society are kept in view during Macroeconomic analysis.
3. Study of the Whole Economy
Macroeconomics policies and problems related to the whole economy are studied. And the effects of these policies not
seen on individual units but on the whole society.
Thus, Now You Know about limitations and types of macroeconomics.
BASIC CONCEPTS
Principles of Managerial Economics
1. Economic principles assist in rational reasoning and defined thinking. They develop logical ability and strength of
a manager. Some important principles of managerial economics are: Marginal and Incremental Principle
This principle states that a decision is said to be rational and sound if given the firm’s objective of profit maximization, it
leads to increase in profit, which is in either of two scenarios-
 If total revenue increases more than total cost.
 If total revenue declines less than total cost.
Marginal analysis implies judging the impact of a unit change in one variable on the other. Marginal generally refers to
small changes. Marginal revenue is change in total revenue per unit change in output sold. Marginal cost refers to change
in total costs per unit change in output produced (While incremental cost refers to change in total costs due to change in
total output). The decision of a firm to change the price would depend upon the resulting impact/change in marginal
revenue and marginal cost. If the marginal revenue is greater than the marginal cost, then the firm should bring about the
change in price.
Incremental analysis differs from marginal analysis only in that it analysis the change in the firm's performance for a given
managerial decision, whereas marginal analysis often is generated by a change in outputs or inputs. Incremental analysis
is generalization of marginal concept. It refers to changes in cost and revenue due to a policy change. For example -
adding a new business, buying new inputs, processing products, etc. Change in output due to change in process, product
or investment is considered as incremental change. Incremental principle states that a decision is profitable if revenue
increases more than costs; if costs reduce more than revenues; if increase in some revenues is more than decrease in
others; and if decrease in some costs is greater than increase in others.
2. Equi-marginal Principle
Marginal Utility is the utility derived from the additional unit of a commodity consumed. The laws of equi-marginal utility
states that a consumer will reach the stage of equilibrium when the marginal utilities of various commodities he
consumes are equal. According to the modern economists, this law has been formulated in form of law of proportional
marginal utility. It states that the consumer will spend his money-income on different goods in such a way that the
marginal utility of each good is proportional to its price, i.e.,
MUx / Px = MUy / Py = MUz / Pz
Where, MU represents marginal utility and P is the price of good.
Similarly, a producer who wants to maximize profit (or reach equilibrium) will use the technique of production which
satisfies the following condition:
MRP1 / MC1 = MRP2 / MC2 = MRP3 / MC3
Where, MRP is marginal revenue product of inputs and MC represents marginal cost.
Thus, a manger can make rational decision by allocating/hiring resources in a manner which equalizes the ratio of
marginal returns and marginal costs of various use of resources in a specific use.
3. Opportunity Cost Principle
By opportunity cost of a decision is meant the sacrifice of alternatives required by that decision. If there are no sacrifices,
there is no cost. According to Opportunity cost principle, a firm can hire a factor of production if and only if that factor
earns a reward in that occupation/job equal or greater than it’s opportunity cost. Opportunity cost is the minimum price
that would be necessary to retain a factor-service in it’s given use. It is also defined as the cost of sacrificed alternatives.
For instance, a person chooses to forgo his present lucrative job which offers him Rs.50000 per month, and organizes his
own business. The opportunity lost (earning Rs. 50,000) will be the opportunity cost of running his own business.
4. Time Perspective Principle
According to this principle, a manger/decision maker should give due emphasis, both to short-term and long-term impact
of his decisions, giving apt significance to the different time periods before reaching any decision. Short-run refers to a
time period in which some factors are fixed while others are variable. The production can be increased by increasing the
quantity of variable factors. While long-run is a time period in which all factors of production can become variable. Entry
and exit of seller firms can take place easily. From consumers point of view, short-run refers to a period in which they
respond to the changes in price, given the taste and preferences of the consumers, while long-run is a time period in
which the consumers have enough time to respond to price changes by varying their tastes and preferences.
5. Discounting Principle
According to this principle, if a decision affects costs and revenues in long-run, all those costs and revenues must be
discounted to present values before valid comparison of alternatives is possible. This is essential because a rupee worth
of money at a future date is not worth a rupee today. Money actually has time value. Discounting can be defined as a
process used to transform future dollars into an equivalent number of present dollars. For instance, $1 invested today at
10% interest is equivalent to $1.10 next year.
FV = PV*(1+r)t
Where, FV is the future value (time at some future time), PV is the present value (value at t0, r is the discount (interest)
rate, and t is the time between the future value and present value.

Opportunity Cost and Societal Decisions

Opportunity cost also comes into play with societal decisions. Universal health care would be nice, but the
opportunity cost of such a decision would be less housing, environmental protection, or national defense.
These trade-offs also arise with government policies. For example, after the terrorist plane hijackings on
September 11, 2001, many proposals, such as the following, were made to improve air travel safety:
1. The federal government could provide armed “sky marshals” who would travel inconspicuously with the
rest of the passengers. The cost of having a sky marshal on every flight would be roughly $3 billion per
year.
2. Retrofitting all U.S. planes with reinforced cockpit doors to make it harder for terrorists to take over the
plane would have a price tag of $450 million.
3. Buying more sophisticated security equipment for airports, like three-dimensional baggage scanners and
cameras linked to face-recognition software, would cost another $2 billion.

Lost time can be a significant component of opportunity cost.

However, the single biggest cost of greater airline security doesn’t involve money. It’s the opportunity cost of additional
waiting time at the airport. According to the United States Department of Transportation, more than 800 million
passengers took plane trips in the United States in 2012. Since the 9/11 hijackings, security screening has become more
intensive, and consequently, the procedure takes longer than in the past. Say that, on average, each air passenger spends
an extra 30 minutes in the airport per trip. Economists commonly place a value on time to convert an opportunity cost in
time into a monetary figure. Because many air travelers are relatively highly paid businesspeople, conservative estimates
set the average “price of time” for air travelers at $20 per hour. Accordingly, the opportunity cost of delays in airports
could be as much as 800 million (passengers) × 0.5 hours × $20/hour—or, $8 billion per year. Clearly, the opportunity
costs of waiting time can be just as substantial as costs involving direct spending.

Economic Equilibrium
What is Economic Equilibrium?
Economic equilibrium is a condition or state in which economic forces are balanced. In effect, economic variables remain
unchanged from their equilibrium values in the absence of external influences. Economic equilibrium is also referred to as
market equilibrium.
 Economic equilibrium is the combination of economic variables (usually price and quantity) toward which normal
economic processes, such as supply and demand, drive the economy. The term economic equilibrium can also be
applied to any number of variables such as interest rates or aggregate consumption spending. The point of
equilibrium represents a theoretical state of rest where all economic transactions that “should” occur, given the
initial state of all relevant economic variables, have taken place.
 Economic equilibrium is a condition where market forces are balanced, a concept borrowed from physical
sciences, where observable physical forces can balance each other.
 The incentives faced by buyers and sellers in a market, communicated through current prices and
quantities drive them to offer higher or lower prices and quantities that move the economy toward
equilibrium.
 Economic equilibrium is a theoretical construct only. The market never actually reach equilibrium,
though it is constantly moving toward equilibrium.
What Is Economic Equilibrium?
Understanding Economic Equilibrium
Equilibrium is a concept borrowed from the physical sciences, by economists who conceive of economic processes as
analogous to physical phenomena such as velocity, friction, heat, or fluid pressure. When physical forces are balanced in a
system, no further change occurs. For example, consider a balloon. To inflate a balloon, you blow air into it, increasing the
air pressure in the balloon by forcing air in. The air pressure in the balloon rises above the air pressure outside the
balloon; the pressures are not balanced. As a result the balloon expands, lowering the internal pressure until it equals the
air pressure outside. Once the balloon expands enough so that the air pressure inside and out have are in balance it stops
expanding; it has reached equilibrium.
In economics we can think about something similar with regard to market prices, supply, and demand. If the price in a
given market is too low, then the quantity that buyers demand will be more than the quantity that sellers are willing to
offer. Like the air pressures in and around the balloon, supply and demand will not be in balance. consequently a
condition of oversupply in the market, a state of market disequilibrium.
So something has to give; buyers will have to offer higher prices to induce sellers to part with their goods. As they do, the
market price will rise toward the level where the quantity demanded equals the quantity supplied, just as a balloon will
expand until the pressures equalize. Eventually it may reach a balance where quantity demanded just equals quantity
supplied, and we can call this the market equilibrium.

Economic Equilibrium in the Real World

Equilibrium is a fundamentally theoretical construct that may never actually occur in an economy, because the
conditions underlying supply and demand are often dynamic and uncertain. The state of all relevant economic
variables changes constantly. Actually reaching economic equilibrium is something like a monkey hitting a
dartboard by throwing a dart of random and unpredictably changing size and shape at a dartboard, with both
the dartboard and the thrower careening around independently on a roller rink. The economy chases after
equilibrium with out every actually reaching it.
With enough practice, the monkey can get pretty close though. Entrepreneurs compete throughout the
economy, using their judgement to make educated guesses as to the best combinations of goods, prices, and
quantities to buy and sell. Because a market economy rewards those who guess better, through the mechanism
of profits, entrepreneurs are in effect rewarded for moving the economy toward equilibrium. The business and
financial media, price circulars and advertising, consumer and market researchers, and the advancement of
information technology all make information about the relevant economic conditions of supply and demand
more available to entrepreneurs over time. This combination of market incentives that select for better guesses
about economic conditions and the increasing availability of better economic information to educate those
guesses accelerates the economy toward the “correct” equilibrium values of prices and quantities for all the
various goods and services that are produced, bought, and sold.     
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UTILITY
Cardinal Utility
Definition: The Cardinal Utility approach is propounded by neo-classical economists, who believe that utility is
measurable, and the customer can express his satisfaction in cardinal or quantitative numbers, such as 1,2,3, and so on.
The neo-classical economist developed the theory of consumption based on the assumption that utility is measurable and
can be expressed cardinally. And to do so, they have introduced a hypothetical unit called as “Utils” meaning the units of
utility. Here, one Util is equivalent to one rupee and the utility of money remains constant.
Over the passage of time, it was realized that the absolute measure of utility is not possible, i.e. it was difficult to measure
the feeling of satisfaction cardinally (in numbers). Also, it was difficult to quantify the factors that cause a change in the
 moods of the consumer, their tastes and preferences and their likes and dislikes. Therefore, the utility is not measurable
in quantitative terms. But however, it is being used as the starting point in the consumer behavior analysis.
The consumption theory is based on the notion that consumer aims at maximizing his utility, and thus, all his actions and
doings are directed towards the utility maximization. The consumption theory seeks to find out the answers to the
following questions:
 How does a consumer decide on the optimum quantity of a commodity that he/she wishes to consume?
 How consumers allocate their disposable incomes between several commodities of consumption, such
that utility is maximized?

The cardinal utility approach used in analyzing the consumer behavior depends on the following assumptions to find
answers to the above-stated questions:
1. Rationality: It is assumed that the consumers are rational, and they satisfy their wants in the order of their preference.
This means they will purchase those commodities first which yields the highest utility and then the second highest and
so on.
2. Limited Resources (Money): The consumer has limited money to spend on the purchase of goods and services and
thus this makes the consumer buy those commodities first which is a necessity.
3. Maximize Satisfaction: Every consumer aims at maximizing his/her satisfaction for the amount of money he/she
spends on the goods and services.
4. Utility is cardinally Measurable: It is assumed that the utility is measurable, and the utility derived from one unit of
the commodity is equal to the amount of money, which a consumer is ready to pay for it, i.e. 1 Util = 1 unit of money.
5. Diminishing Marginal Utility: This means, with the increased consumption of a commodity, the utility derived from
each successive unit goes on diminishing. This law holds true for the theory of consumer behavior.
6. Marginal Utility of Money is Constant: It is assumed that the marginal utility of money remains constant irrespective
of the level of a consumer’s income.
7. Utility is Additive: The cardinalists believe that not only the utility is measurable but also the utility derived from the
consumption of different commodities are added up to realize the total utility.
Thus, the cardinal utility approach is used as a basis for explaining the consumer behavior where every individual aims at
maximizing his/her utility or satisfaction for the amount of money he spends on the consumption of goods and services.

What Is the Law of Diminishing Marginal Utility?

The law of diminishing marginal utility states that all else equal, as consumption increases, the marginal utility derived
from each additional unit declines. Marginal utility is the incremental increase in utility that results from the consumption
of one additional unit. The utility is an economic term used to represent satisfaction or happiness.
 The law of diminishing marginal utility says that the marginal utility from each additional unit declines as
consumption increases.
 The marginal utility can decline into negative utility, as it may become entirely unfavorable to consume
another unit of any product.
 The marginal utility may decrease into negative utility, as it may become entirely unfavorable to consume
another unit of any product.

Understanding the Law of Diminishing Marginal Utility

The marginal utility may decrease into negative utility, as it may become entirely unfavorable to consume another unit of
any product. Therefore, the first unit of consumption for any product is typically highest, with every unit of consumption
to follow holding less and less utility. Consumers handle the law of diminishing marginal utility by consuming numerous
quantities of numerous goods.
The law of diminishing marginal utility directly relates to the concept of diminishing prices. As the utility of a product
decreases as its consumption increases, consumers are willing to pay smaller dollar amounts for more of the product. For
example, assume an individual pays $100 for a vacuum cleaner. Because he has little value for a second vacuum cleaner,
the same individual is willing to pay only $20 for a second vacuum cleaner.
 Example of Diminishing Utility
An individual can purchase a slice of pizza for $2, and is quite hungry, so they decide to buy five slices of pizza. After doing
so, the individual consumes the first slice of pizza and gains a certain positive utility from eating the food. Because the
individual was hungry and this is the first food consumed, the first slice of pizza has a high benefit.
Upon consuming the second slice of pizza, the individual’s appetite is becoming satisfied. They are not as hungry as
before, so the second slice of pizza had a smaller benefit and enjoyment than the first. The third slice, as before, holds
even less utility as the individual is now not hungry anymore.
The fourth slice of pizza has experienced a diminished marginal utility as well, as it is difficult to be consumed because the
individual experiences discomfort upon being full from food. Finally, the fifth slice of pizza cannot even be consumed. The
individual is so full from the first four slices that consuming the last slice of pizza results in negative utility.
The five slices of pizza demonstrate the decreasing utility that is experienced upon the consumption of any good. In a
business application, a company may benefit from having three accountants on its staff. However, if there is no need for
another accountant, hiring another accountant results in a diminished utility, as there is a minimum benefit gained from
the new hire.

What is an example of diminishing marginal utility?

Diminishing marginal utility is the decline of enjoyment from consuming or buying one additional good. For example, a
consumer buys a bag of chocolate and after one or two pieces their utility rises, but after a few pieces, their utility will
start to decline with each additional piece that's consumed—and eventually, after enough pieces, will likely result in
negative equity.

What is marginal utility with example?

Marginal utility is the enjoyment a consumer gets from each additional unit of consumption. It calculates the utility
beyond the first product consumed. If you buy a bottle of water and then a second one, the utility gained from the second
bottle of water is the marginal utility.

Ordinal Utility
Definition: The Ordinal Utility approach is based on the fact that the utility of a commodity cannot be measured in
absolute quantity, but however, it will be possible for a consumer to tell subjectively whether the commodity derives
more or less or equal satisfaction when compared to another.
The modern economists have discarded the concept of cardinal utility and instead applied ordinal utility approach to
study the behavior of the consumers. While the neo-classical economists believed that the utility can be measured and
expressed in cardinal numbers, but the modern economists maintain that the utility being the psychological phenomena
cannot be measured theoretically, quantitatively and even cardinally.
The modern economist, Hicks, in particular, have applied the ordinal utility concept to study the consumer behavior. He
introduced a tool of analysis called “Indifference Curve” to analyze the consumer behavior. An indifference curve refers
to the locus of points each showing different combinations of two substitutes which yield the same level of satisfaction
and utility to the consumer.

Assumptions of Ordinal Utility Approach

1. Rationality: It is assumed that the consumer is rational who aims at maximizing his level of satisfaction for
given income and prices of goods and services, which he wish to consume. He is expected to take decisions
consistent with this objective.
2. Ordinal Utility: The indifference curve assumes that the utility can only be expressed ordinally. This means
the consumer can only tell his order of preference for the given goods and services.
3. Transitivity and Consistency of Choice: The consumer’s choice is expected to be either transitive or
consistent. The transitivity of choice means, if the consumer prefers commodity X to Y and Y to Z, then he
must prefer commodity X to Z. In other words, if X= Y, Y = Z, then he must treat X=Z. The consistency of
choice means that if a consumer prefers commodity X to Y at one point of time, he will not prefer commodity
Y to X in another period or even will not consider them as equal.
4. Nonsatiety: It is assumed that the consumer has not reached the saturation point of any commodity and hence,
he prefers larger quantities of all commodities.
5. Diminishing Marginal Rate of Substitution (MRS): The marginal rate of substitution refers to the rate at
which the consumer is ready to substitute one commodity (A) for another commodity (B) in such a way that his
total satisfaction remains unchanged. The MRS is denoted as DB/DA. The ordinal approach assumes that
DB/DA goes on diminishing if the consumer continues to substitute A for B.

Indifference Curve
A popular alternative to the marginal utility analysis of demand is the Indifference Curve Analysis. This is based on
consumer preference and believes that we cannot quantitatively measure human satisfaction in monetary terms. This
approach assigns an order to consumer preferences rather than measure them in terms of money. Let us take a look.
What is an Indifference Curve?
An indifference curve is a curve that represents all the combinations of goods that give the same satisfaction to
the consumer. Since all the combinations give the same amount of satisfaction, the consumer prefers them
equally. Hence the name indifference curve.
Here is an example to understand the indifference curve better. Peter has 1 unit of food and 12 units of clothing.
Now, we ask Peter how many units of clothing is he willing to give up in exchange for an additional unit of food
so that his level of satisfaction remains unchanged.
Peter agrees to give up 6 units of clothing for an additional unit of food. Hence, we have two combinations of food and
clothing giving equal satisfaction to Peter as follows:
1 unit of food and 12 units of clothing
2 units of food and 6 units of clothing
By asking him similar questions, we get various combinations as follows:
Combination Food Clothing
A 1 12
B 2 6
C 3 4
D 4 3

Graphical Representation:

The diagram shows an Indifference curve (IC). Any combination lying on this curve gives the same level of consumer
satisfaction. Another name for it is Iso-Utility Curve.
Indifference Map
An Indifference Map is a set of Indifference Curves. It depicts the complete picture of a consumer’s preferences. The
following diagram showing an indifference map consisting of three curves:

We know that a consumer is indifferent among the combinations lying on the same indifference curve. However, it is
important to note that he prefers the combinations on the higher indifference curves to those on the lower ones.
This is because a higher indifference curve implies a higher level of satisfaction. Therefore, all combinations on IC1 offer
the same satisfaction, but all combinations on IC2 give greater satisfaction than those on IC1.

Marginal Rate of Substitution

This is the rate at which a consumer is prepared to exchange a good X for Y. If we go back to Peter’s example above, we
have the following table:
Combination Food Clothing MRS

A 1 12 –

B 2 6 6

C 3 4 2

D 4 3 1

In this example, Peter initially gives up 6 units of clothing to get an extra unit of food. Hence, the MRS is 6. Similarly, for
subsequent exchanges, the MRS is 2 and 1 respectively. Therefore, MRS of X for Y is the amount of Y whose loss can be
compensated by a unit gain of X, keeping the satisfaction the same.
Interestingly, as Peter accumulates more units of food, the MRS starts falling – meaning he is prepared to give up fewer
units of clothing for food. There are two reasons for this:
1. As Peter gets more units of food, his intensity of desire for additional units of food decreases.
2. Most of the goods are imperfect substitutes for one another. If they could substitute one another perfectly, then
MRS would remain constant.

Properties of an Indifference Curve or IC

Here are the properties of an indifference curve:

An IC slopes downwards to the right

This slope signifies that when the quantity of one commodity in combination is increased, the amount of the other
commodity reduces. This is essential for the level of satisfaction to remain the same on an indifference curve.

An IC is always convex to the origin

From our discussion above, we understand that as Peter substitutes clothing for food, he is willing to part with less and
less clothing. This is the diminishing marginal rate of substitution. The rate gives a convex shape to the indifference curve.
However, there are two extreme scenarios:
1. Two commodities are perfect substitutes for each other – In this case, the indifference curve is a straight line,
where MRS is constant.
2. Two goods are perfect complementary goods – An example of such goods would be gasoline and water in a car.
In such cases, the IC will be L-shaped and convex to the origin.

Indifference curves never intersect each other

Two ICs will never intersect each other. Also, they need not be parallel to each other either. Look at the following
diagram:

Fig 3 shows two ICs intersecting each other at point A. Since points A and B lie on IC1, they give the same satisfaction level
to an individual. Similarly, points A and C give the same satisfaction level, as they lie on IC2. Therefore, we can imply that
B and C offer the same level of satisfaction, which is logically absurd. Hence, no two ICs can touch or intersect each other.

A higher IC indicates a higher level of satisfaction as compared to a lower IC

A higher IC means that a consumer prefers more goods than not.

An IC does not touch the axis

This is not possible because of our assumption that a consumer considers different combinations of two commodities and
wants both of them. If the curve touches either of the axes, then it means that he is satisfied with only one commodity
and does not want the other, which is contrary to our assumption.

Budget Line
Since a higher indifference curve represents a higher level of satisfaction, a consumer will try to reach the highest possible
IC to maximize his satisfaction. In order to do so, he has to buy more goods and has to work under the following two
constraints:
1. He has to pay the price for the goods and
2. He has limited income, restricting the availability of money for purchasing these goods
As can be seen above, a budget line shows all possible combinations of two goods that a consumer can buy within the
funds available to him at the given prices of the goods. All combinations that are within his reach lie on the budget line.
A point outside the line (point H) represents a combination beyond the financial reach of the consumer. On the other
hand, a point inside the line (point K) represents under-spending by the consumer.

Solved Question on Indifference Curve

Q: What are the assumptions underlying the indifference curve approach?

Ans: The assumptions are as follows,

 The consumer is rational. Also, he possesses full information about all the relevant aspects of the economic
environment in which he lives.
 The consumer can rank combination of goods based on the satisfaction they yield. However, he can’t quantitatively
express how much he prefers a certain good over the other.
 If a consumer prefers A over B and B over C, then he prefers A over C.
 If a combination X has more commodities than the combination Y, then X is preferred over Y.

Properties of Indifference Curves

If a good satisfies all four properties of indifference curves, the goods are referred to as ordinary goods. They can be
summarized as the consumer requires more of one good to compensate for less consumption of another good, and the
consumer experiences a diminishing marginal rate of substitution when deciding between two goods.
1. Indifference curves never cross. If they could cross, it would create large amounts of ambiguity as to what the
true utility is.
2. The farther out an indifference curve lies, the farther it is from the origin, and the higher the level of utility it
indicates. As illustrated above on the indifference curve map, the farther out from the origin, the more utility the
individual generates while consuming.
3. Indifference curves slope downwards. The only way an individual can increase consumption in one good without
gaining utility is to consume another good and generate the same amount of utility. Therefore, the slope is
downwards sloping.
4. Indifference curves assume a convex shape. As illustrated above in the indifference curve map, the curve gets
flatter as you move down the curve to the right. It illustrates that all individuals experience diminishing marginal
utility, where additional consumption of another good will generate a lesser amount of utility than the prior.

Consumer Equilibrium
The state of balance obtained by an end-user of products refers to the number of goods and services they can buy, given
their existing level of income and the prevailing level of cost prices. Consumer equilibrium permits a customer to get the
most satisfaction possible from their income.

(A) Meaning of Consumer’s Equilibrium means a state of maximum satisfaction.

  
consumer’s
equilibrium A situation where a consumer spends his given income purchasing one or more commodities so
that he gets maximum satisfaction and has no urge to change this level of consumption, given
the prices of commodities, is known as the consumer’s equilibrium.
The consumer will be in the state of equilibrium when the following condition is fulfilled:

 
 
The marginal utility of commodity X in terms of rupees is equal to the price of commodity
X in rupees. [MUx (in ₹) = Px (in ₹)]
(B) Condition of
consumer
 Or
equilibrium in
case of a single
 Mux (in utils) = Px (in ₹) or MU of Commodity X (in utils) = Px (in
commodity
₹)

 MUm (in utils) MU of Money (₹)(in utils)

Let us take the example of a fruit ice cream. The price of an ice cream scoop is ₹30 and MUm,
i.e., MU of money (₹1) = 1 util
Units  
Consumed MU of  
  money MU of  ice -  
MU of ice - cream scoop  Price of ice -cream
cream scoop  (Re. 1) scoop
 
(in ₹)
(C) Hypothetical (in utils) {a} (in utils) (₹)
Schedule/ = {a}/ {b}
Numerical {b}
Example 1 50 1 50 > 30

2 40 1 40 > 30

3 30 1 30 = 30

4 20 1 20 < 30

5 10 1 10 < 30
(D) Explanation In the given example, the level of consumer’s equilibrium is 3 units.
and conclusion
 

Where,

MU of ice cream in rupees = Price of ice cream in rupees, i.e., ₹30

 Before this level, e., at the first and the second level, MU > Price, i.e., benefit is more
than cost. So, the consumer increases the consumption to attain equilibrium.
 After this level, i.e., at the fourth and the fifth level, MU < Price, e., benefit is less than
cost. So, the consumer cuts or decreases the consumption to be in the state of
 equilibrium. Only at the level of 3 units, the condition of consumer’s equilibrium is
fulfilled.

A consumer consumes the quantity at which MUx = Px to be in the state of equilibrium.

What is the Marginal Rate of Substitution (MRS)?

The marginal rate of substitution (MRS) is the quantity of one good that a consumer can forego for additional units of
another good at the same utility level. MRS is one of the central tenets in the modern theory of consumer behavior as it
measures the relative marginal utility.
Marginal rates of substitutions are similar at equilibrium consumption levels and are calculated between commodity
bundles at indifference curves. Combinations of two different goods that give consumers equal utility and satisfaction can
be plotted on a graph using an indifference curve. The MRS is based on the idea that changes in two substitute goods do
not alter utility whatsoever

Summary
 The marginal rate of substitution (MRS) is the rate at which a consumer would be willing to forgo a specific
quantity of one good for more units of another good at the same utility level.
 MRS, along with the indifference curve, is used by economists to analyze consumer’s spending behavior.
 The marginal rate of substitution is represented as a slope on the indifference curve, and each point along the
curve shows the number of units of each good that would be substitutable for another.

Understanding the Marginal Rate of Substitution (MRS)

In economics, MRS is used to show the quantity of good Y and good X that is substitutable for another. Another way to
think of MRS is in terms of two commodity bundles that give a notion of compensation, which is founded in the feature of
the uniform property.
In the mathematical field of topology, the uniform property is an invariant property of uniform space considering uniform
isomorphism. The uniform property and MRS share a preference relation, which is represented by a differentiated utility
function.
MRS includes bounded rationality in which consumers make purchasing decisions to satisfy their needs rather than to
achieve an optimal solution. It is linked to the indifference curve, from where consumer behavior is analyzed.
 
MRS Formula
The marginal rate of substitution is calculated using this formula:

Understanding the Marginal Rate of Substitution (MRS)

In economics, MRS is used to show the quantity of good Y and good X that is substitutable for another. Another way to
think of MRS is in terms of two commodity bundles that give a notion of compensation, which is founded in the feature of
the uniform property.
In the mathematical field of topology, the uniform property is an invariant property of uniform space considering uniform
isomorphism. The uniform property and MRS share a preference relation, which is represented by a differentiated utility
function.
MRS includes bounded rationality in which consumers make purchasing decisions to satisfy their needs rather than to
achieve an optimal solution. It is linked to the indifference curve, from where consumer behavior is analyzed.
 
MRS Formula
The marginal rate of substitution is calculated using this formula:

 X and Y represent two different goods

 d’y / d’x = derivative of y with respect to x
 MU = marginal utility of two goods, i.e., good Y
and good X
 Where:
 MRS and Indifference Curve
The indifference curve is central in the analysis of MRS. Each point along the curve represents goods X and Y that a
consumer would substitute to be exactly as happy after the transaction as before the transaction.
Goods and services are divisible without interruption, according to the neoclassical economics’ assumption. Such a notion
implies that the direction of the indifference curve; notwithstanding, MRS will be the same and correspond to its slope.
Most indifference curves change slopes as one moves along them, rendering MRS a changing curve.
There are three common types of graphs that employ indifference curves to analyze consumer behavior:
1. The first graph is used to define the utility of consumption for a specific economic agent. MRS moves to zero as it
diminishes the number of units of good X, and to infinity, as it diminishes the number of units of good Y.
2. The second type of graph involves perfect substitutes of both goods X and Y. The MRS, along the indifference curve, is
equal to 1 because the lines are parallel, with the slopes forming a 45°  angle with each axis. MRS is defined as a
fraction because the slope is different when considering different substitutes of goods. MRS will be constant for
perfect substitutes.
3. The third type of graph represents complementary goods, with each indifference curve’s horizontal fragment showing
an MRS of 0.

 The Principle of Diminishing Marginal Rate of Substitution

In the case of substitute goods, diminishing MRS is assumed when analyzing consumers’ expenditure behavior using the
indifference curve. The assumption of diminishing MRS posits that when a consumer substitutes commodity X for
commodity Y, the stock of X decreases, and that of Y decreases, while the MRS decreases.
In other words, the consumer is prepared to forego commodity Y as he owns more of commodity X. The concept can be
illustrated by an indifference curve where the MRS of the two commodities continues to decrease along the indifference
curve. However, in the case of perfect goods and complementary goods, this law is not applicable.

Limitations of the Marginal Rate of Substitution

One of the weaknesses associated with the marginal rate of substitution is that in its evaluation, it does not account for a
combination of goods that a consumer would happily substitute with another combination. For this reason, analysis of
MRS is restricted to only two variables. Additionally, MRS treats the utility of two substitute goods equally even though
this might not be the case; hence, it does not examine marginal utility in the actual sense.

WHAT IS DEMAND?
Demand is the quantity of consumers who are willing and able to buy products at various prices during a given period of
time. Demand for any commodity implies the consumers' desire to acquire the good, the willingness and ability to pay for
it.

The demand for a good that the consumer chooses, depends on the price of it, the prices of other goods, the consumer’s
income and her tastes and preferences. Whenever one or more of these variables change, the quantity of the good
chosen by the consumer is likely to change as well. If the prices of other goods, the consumer’s income and her tastes and
preferences remain unchanged, the amount of a good that the consumer optimally chooses, becomes entirely dependent
on its price. The relation between the consumer’s optimal choice of the quantity of a good and its price is called the
demand function.

What is Law of demand?

The law of demand describes an inverse relationship between price and quantity demanded of a good. If the price of the
good increases, then the demand falls, because the consumer is usually reluctant to spend more and more money on her
purchase. If the price of the good decreases, the demand for the good increases because with price being less, the
consumer prefers to buy the good.
Law of Demand, along with Law of Supply is used to explain how market economies allocate resources and determine the
prices of goods and services in everyday transactions.
Determinants of Demand
Determinants of Demand Definition
The determinants of demand are factors that cause fluctuations in the economic demand for a product or a service.
A shift in the demand curve occurs when the curve moves from D to D₁, which can lead to a change in the quantity
demanded and the price. There are six determinants of demand.
These six factors are not the same as a movement along the demand curve, which is affected by price or quantity
demanded. A shift can be an increase in demand, moves towards the right or upwards, while a decrease in demand is a
shift downwards or to the left.

A Shift in the Demand Curve

In the diagram above, we see an increase in Demand. This results in the demand curve shifting from D1 to D2. This shift
can occur because of any of the determinants of demand mentioned below.
Because of this demand shift, we see an increase in quantity demanded from Q1 to Q2 and an increase in price from P1 to
P2.

Determinants of Demand

An increase or decrease in any of these factors affecting demand will result in a shift in the demand curve. Depending on
whether it is an inward or outward shift, there will be a change in the quantity demanded and price.

1. Normal Goods
When there is an increase in the consumer’s income, there will be an increase in demand for a good. If the consumer’s
income falls, then, there will be a fall in demand.
2. Change in Preferences
If there is a change in preferences, then there will be a change in demand. For example, yoga became mainstream a
couple of years ago, and health enthusiasts promoted its benefits. This trend led to an increase in demand for yoga
classes.
3. Complementary Goods
When there is a decrease in the price of compliments, then the demand for its compliments will increase. Complementary
goods are goods you usually buy together, like bread and butter, tea and milk. If the price of one goes up, the demand for
the other good will fall. For example, if the price of yoga classes fell, then there would be an increase in demand for yoga
mats.
4. Substitutes
An increase in the price of substitutes will affect the demand curve. Substitutes are goods that can consumers buy in
place of the other like how Coca-Cola & Pepsi are very close substitutes. If the price of one goes up, the demand for the
other will rise. For example, if meditation classes became more expensive, then there would be an increase in demand for
yoga classes.
5. Market Size
If the size of the market increases, like if a country’s population increases or there is an increase in the number of people
in a certain age group, then the demand for products would increase. Simply put, the higher the number of buyers, the
higher the quantity demanded. For example, if the birth rate suddenly skyrocketed, then there would be an increase in
demand for baby products.
6. Price Expectations
When there is an expectation of a price change, this means that people expect the price of a good to increase shortly.
These people are then more likely to purchase sooner, which would increase demand for the product. For example, if
people are expecting the price of a laptop to fall, then they will delay their purchase until the price lowers.

What is the Law of Demand?

The law of demand states that the quantity demanded of a good shows an inverse relationship with the price of a good
when other factors are held constant (cetris peribus). It means that as the price increases, demand decreases.
The law of demand is a fundamental principle in macroeconomics. It is used together with the law of supply to determine
the efficient allocation of resources in an economy and find the optimal price and quantity of goods.
 

Figure 1. Demand Curve Approximation

 Graphical Representation of the Law of Demand

The law of demand is usually represented as a graph. The graphical representation of the law of demand is a curve that
establishes the relationship between the quantity demanded and the price of a good.
The shape of the demand curve can vary among different types of goods. Most frequently, the demand curve shows a
concave shape. However, in many economics textbooks, we can also see the demand curve as a straight line.
The demand curve is drawn against the quantity demanded on the x-axis and the price on the y-axis. The definition of the
law of demand indicates that the demand curve is downward sloping.
It is important to distinguish the difference between the demand and the quantity demanded. The quantity demanded is
the number of goods that the consumers are willing to buy at a given price point. On the other hand, the demand
represents all the available relationships between the good’s prices and the quantity demanded.
 
Exceptions to the Law of Demand
Unlike the laws of mathematics or physics, the laws of economics are not universal. For example, the law of demand
comes with a few exceptions. Some goods do not show an inverse relationship between the price and the quantity.
Therefore, the demand curve for these goods is upward-sloping.
 
1. Giffen goods
These are inferior goods that lack close substitutes that represent a large portion of the consumer’s income. Scottish
economist Sir Robert Giffen proposed the existence of such goods in the 19th century. Giffen goods violate the law of
demand because the prices of these goods increase with the increase in the quantity demanded. However, Giffen goods
remain mostly a theoretical concept as there is limited empirical evidence of their existence in the real world.
 
2. Veblen goods
Certain types of luxury goods violate the law of demand. Veblen goods are named after American economist Thorstein
Veblen. Generally, they are luxury goods that indicate the economic and social status of the owner. Therefore, consumers
are willing to consume Veblen goods even more when the price increases. Some examples of Veblen goods include luxury
cars, expensive wines, and designer clothes.
 
The Law of Demand in the Real World
The law of demand comes with important applications in the real world. It is an economic principle that guides the actions
of politicians and policymakers. The law of demand is quintessential for the fiscal and monetary policies that are
undertaken by governments around the world. The policies generally intend to increase or decrease demand to influence
the country’s economy.
 
Additional Resources
CFI offers the Financial Modeling & Valuation Analyst (FMVA)® certification program for those looking to take their
careers to the next level. To keep learning and advancing your career, the following CFI resources will be helpful:
Law of  Supply
Market Economy
Opportunity Cost
Price Elasticity