STUDY NOTES /ECONOMICS/ IIIT Course Instructor: Dr.

Pradipta Bhattacharya

UNIT I: POINT OF INITIATION

All the economics problems which are most popularly considered to be challenges in front of any
country, e.g., unemployment or inflation are merely the manifestations of the most fundamental
problem, the problem of scarcity. The problem of Scarcity arises because of two fundamental facts
of human life:

a) Human wants are virtually unlimited, which hardly needs any further explanation, and
b) Resources that satisfy human wants are limited in supply in nature.

This was the problem of scarcity faced by our ancestors from time immemorial of history of
mankind, which led to conscious effort to add to the stock of nature. Prime need was for food in
those early days of mankind and thus the problem of scarcity forced human to undertake activities
to produce food, to supplement the nature’s supply or stock, in order to counter the problem. Thus
the earliest concept of Production was born and it was mainly agricultural production of food. Ages
went by and human wants being ever-changing over ages the mismatch between wants and supply
persisted. Now we face the problem of scarcity in a slightly complicated manner, due to the
shortfall of economic resources compared to the unlimited human wants. By economic resources
we refer to all natural, human and man-made resources that go into production of goods and
services. These economic resources are usually classified under the following categories:
a) Land – By Land economists refer to all natural resources, which are often taken as free gifts
of nature, which are usable in production processes, such as arable land, water resources,
forests, mineral and oil deposits.
b) Labour – Physical toil of human, considered as primary resource in production of all goods
and services.
c) Capital – It refers to all man-made means of production, that is, tools, machinery, and
equipment. The broadest definition also includes financial assets like money.
d) Entrepreneurship or Organization or Enterprise – It is defined as the pool of special human
talents which are different from crude physical labour, e.g, Leadership, management skills,
risk-taking ability, analytical & calculative prowess etc.

THREE FUNDAMENTAL PROBLEMS

Given the backdrop of scarcity, the three central problems faced by an economy are : -

a) What to produce ? The answer to this question refers the domain of (relative) demand
pattern of the consumers (e.g., the relative importance of having more wheat than motor
cars in an economy), stock of resources, state of technology available etc.
b) How to produce ? The economic resources have their prices (whether those prices are
always paid or not, is a separate question which would lead to broader horizons and deeper
into the subject of economics). Let us concentrate (for the time being) on only two such
resources, Labour and Capital. Now stocks of such resources are limited at a particular time
point. The state of technology which will enable using these resources to produce

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STUDY NOTES /ECONOMICS/ IIIT Course Instructor: Dr. Pradipta Bhattacharya

commodities would determine the immediate answer to this question, along with the
prices of the resources.
c) For whom to produce ? This is perhaps the core of all the three questions. If the economy
can (somehow) identify the classes (or, sections) of consumers for whom it has to primarily
produce commodities, then it must ensure that such targeted group(s) should be able to
pay for those commodities. Since in general the pattern of wants of different groups of
consumers of an economy usually vary (with some common items of course; the want-
pattern of relatively poorer sections may comprise items of basic need, while that of the
relatively opulent class comprise of items of luxurious consumption), identification of the
group(s) for whom to produce will in effect solve question a) and thus question b) as well.

Unlimited Wants Limited Resources

Scarcity

What to produce? How to produce? For whom to produce?

Prices

Thus the universal set of the goods’ world may be seen as comprising of two broad subsets – that
of FREE GOODS, for which scarcity is still not felt, take the example of atmospheric oxygen; and the
subset of ECONOMIC GOODS, for which scarcity forces to acknowledge that these items are
valuable and thus to undertake consumption and production as conscious economic activities.
Value of an economic good is most simply indicated by its price in the market. However, there are
non-market mechanisms as well to determine value and price of goods (Think of atmospheric
Oxygen, or refreshing beauty of hilly forest, the flowing river water etc.).

CIRCULAR FLOW OF ECONOMIC ACTIVITIES

We primarily consider a free enterprise economy without Government and foreign trade relations.
For simplicity, we consider a 2-sector economy where we sub-divide the entire economy in two
subsets or sectors, viz., Household sector comprising all the consumers who aim at maximization
of satisfaction (utility) they derive from consuming commodities; and Firm sector or Private
Business Sector whose goal is maximization of profits they earn. The household sector is in
possession of factors of production which they provide to the firm sector against factor payments
(incomes). The firm sector, on the other hand utilizes the factor inputs in the production processes
to produce various goods and services to be sold in the market. The sale proceeds they receive is
known as Revenue. Interactions (flows) between these two sectors are shown by arrows with their
heads indicating direction of such flows.
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STUDY NOTES /ECONOMICS/ IIIT Course Instructor: Dr. Pradipta Bhattacharya

Factor services (Land, Labour, Capital & Enterprise)

Factor Payments

Household Sector Firm Sector

Goods & Services

Expenditure / Revenue

This chart needs further extension for 3-Sector (with Govt.) and 4-Sector (with Foreign Trade)
models.

MICROECONOMICS v/s MACROECONOMICS

Microeconomics is the study of microscopic elements of an economy, i.e., how the individual
economic agents (consumers & producers or firms) behave. It studies how individuals and firms
make themselves as well off as possible in a world of scarcity and the consequences of those
individual decisions for markets and the entire economy. In studying microeconomics, we examine
how individual consumers and firms make decisions and how the interaction of many individual
decisions affects markets. Microeconomics is often called price theory to emphasize the important
role that prices play. Microeconomics explains how the actions of all buyers and sellers determine
prices and how prices influence the decisions and actions of individual buyers and sellers.

On the contrary, Macroeconomics is the study of the economy taken as a whole, as an aggregate
of all the constituent sectors; Or, studying the behavioral pattern of a group of economic agents
taken together, viz., consumers of a particular market or cluster of firms forming an industry. The
features of such an aggregate or group are noted and believed to be closely true for the individual
agents comprising the group.

Using Economic Models

Models based on economic theories are used to predict the future or to answer questions about
how some change, such as a tax increase, affects various sectors of the economy. Most
microeconomic models are based on maximizing behavior. Economists use models to construct
positive hypotheses concerning how a cause leads to an effect. These positive questions can be
tested. In contrast, normative statements, which are value judgments, cannot be tested.
Individuals, governments and firms use microeconomic models and predictions to make decisions.
For example, to maximize its profits, a firm needs to know consumers’ decision-making criteria, the
trade-offs between various ways of producing and marketing its product, government regulations,
and other factors. For large companies, beliefs about how a firm’s rivals will react to its actions play
a critical role in how it forms its business strategies.

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STUDY NOTES /ECONOMICS/ IIIT Course Instructor: Dr. Pradipta Bhattacharya

UNIT II: PRELIMINERIES: INTRODUCING DEMAND & SUPPLY

Demand

Need – Want – Demand: Need and Want are psychological matters, while Demand is the want
backed by purchasing power of the consumer. Thus Demand is always expressed as actual
expenditure incurred by the consumer to purchase certain goods and services. Purchasing power
is derived (a quotient of) from consumer’s money income and prices of the commodities available.

Demand Function

Quantity demanded of a good i (Di) is a multivariate relationship, that is to say, is affected by a host
of variables as, own price (Po), price of substitute good if any (Ps), price of complementary* good if
any (Pc), consumer’s money income (M), consumer’s tastes & preferences (T) etc.

Di = Di ( Po , Ps , Pc , M, T) is a typical demand function for i-th commodity.

Normally quantity demanded of a good and its price (own price) are inversely related which is
calibrated in MARSHALLIAN LAW OF DEMAND, i.e.

∂Di /∂Po < 0

The good demand for which obeys Marshallian Law of Demand is known as Normal Good. And the
demand function for such goods may be explicitly written as

Di = a – bPo; a, b > 0 and other remaining unaltered.

Demand Curve

Assuming Ps, Pc, and M & T to remain constant for the time being, i.e. treating them as parameters
in the model. Demand curve depicts the relation between own price and quantity demand of the
commodity. The following table would help us in conceptualizing the basic premise of ‘Demand’.

Own price Price of Price of Complementary Income of Quantity

Po (Rs) Substitute Ps Good Pc (Rs) individual M (Rs) Demanded Di
( Rs) Suppose in Kgs.
25 30 20 1000 36
23 30 20 1000 40
21 30 20 1000 44
19 30 20 1000 48
17 30 20 1000 52
15 30 20 1000 56
13 30 20 1000 60
12 30 20 1000 62
10 30 20 1000 66

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STUDY NOTES /ECONOMICS/ IIIT Course Instructor: Dr. Pradipta Bhattacharya

P0

D (Ps, Pc, and M & T unchanged)

Di

DD represents a typical Demand Curve with negative slope (Di = a – bPo; a, b > 0) and when Ps, Pc,
and M & T remain unaltered, i.e., treated as parameters.

While substitute good for a particular good can easily be conceived as another good having
features or properties to substitute a particular good in the consumption basket of a consumer,
e.g., Tea and Coffee, the idea of complementary goods perhaps needs a line of clarification.
Complements are goods consumed together in definite proportion, e.g., a bicycle and two tyres
(1:2) or more childish to think, the left shoe to the right one (1:1) in a pair of shoes. Worth noting
that, any change in the values of the parameters (Ps, Pc, and M & T) would cause the demand curve
to shift.

Change in Quantity demanded as values of various explanatory variables change :

Change in Variable Effect on Quantity Remarks

(ceteris paribus) Demanded
Rise in Own Price - ve, for Normal Goods -vely sloped demand curve
+ve, for Giffen Goods +vely sloped demand curve
Change in Parameter Effect on Quantity Remarks
(ceteris paribus) Demanded
Rise in Price of Substitute Good +ve Rightward shift in demand
curve
Rise in Price of Complementary -ve Leftward shift in demand
Good curve
Rise in Consumer’s Money +ve , for Superior goods Rightward shift in demand
Income curve
-ve, for Inferior goods Leftward shift in demand
curve

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STUDY NOTES /ECONOMICS/ IIIT Course Instructor: Dr. Pradipta Bhattacharya

Exceptions of Marshallian Law

a) Giffen Goods – named after economist Robert Giffen. Demand for such a good is directly
proportional with the price of that good. Thus the demand curve for Giffen good is positively
sloped.
b) Goods for conspicuous consumption – e.g., purchase of gems and jewelries, antic items.
c) Goods whose prices are taken as the indicator of quality, e.g., Medicines

Types of Goods
a) Normal Good – Demand and own price are inversely related, ∂ Di /∂Po < 0
b) Giffen Good – Demand and own price are directly related, ∂ Di /∂Po > 0
c) Superior Good –Demand and Consumer’s money income (M) are directly related,
∂Di /∂ M > 0
d) Inferior Good – Demand and Consumer’s money income (M) are inversely related.
∂Di /∂ M < 0

Worth noting that, Normal and Superior goods are two sides of the same coin. But Giffens only
form a special class among Inferior goods. Thus there may be some goods which are Normal goods
(demand rises with fall in price and vice-versa) and inferior simultaneously (as Consumer’s money
income rises, quantity demand falls & vice-versa) for some consumers.

Derivation of Market Demand Curve from Demand curves of Individual consumers

The total volume of demand of a number of consumers who are in demand of a particular
commodity in the market, is called the Market Demand for that commodity. Market demand for a
particular commodity is obtained from horizontal summation of demand curves of the individual
consumers of that commodity. Suppose there are three individuals A, B & C constituting a market.
In the following table we are presenting their demand for mutton at different prices of mutton.

Price of Demand of Demand of Mutton Demand of Mutton Market Demand of

Mutton Rs./Kg. Mutton by B ( In Kgs) by C ( In Kgs) Mutton ( In Kgs)
by A ( In Kgs)

205 2.00 3.00 1.75 6.75

220 1.75 2.75 1.50 6.00
230 1.50 2.50 1.25 5.25
240 1.25 2.25 1.00 4.50
250 1.00 2.00 0.75 3.75
260 0.50 1.50 0 2.00
270 0 1.20 0 1.20

This can be explained with the help of the following diagram –

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STUDY NOTES /ECONOMICS/ IIIT Course Instructor: Dr. Pradipta Bhattacharya

Price

Db

Da Market Demand Curve

Dc

Quantity

Quantity of Demand of different individuals and the Market demand

Major factors causing shifts in Market Demand

 A change in population: An increase in population causes increase in market demand in

each price, thus market demand shifts to the right and similarly a decrease in population
causes decrease in market demand in each price leading to a leftward shift in market
demand.
 An increase or decrease in National Income also causes shifts in market demand; moreover,
a redistribution of income may also lead to a shift in market demand.
 ‘Demonstration Effect’ may also cause a shift in market demand.
 Change in demographic composition may also cause a shift in market demand.

Elasticity of demand

Elasticity means responsiveness, that is to say, how a particular dependent variable responds
(effect) to change in the value of another (independent) variable which may affect the value of the
dependent variable (cause). A typical formula of an index for measuring Elasticity in economics is
Elasticity Measure = Effect / Cause
We have already discussed that there are three important determinants of demand for the
commodity say X, namely, own price (Px), prices of other commodities (say another commodity
consumed together with X is Y; its price is PY ) and income of consumer (M). This implies that the
demand responds to change in the value of any determinant, for example, a fall/rise in own price
would be responded by change in demand of that commodity, normally in opposite direction. But
the degree of response of quantity demanded is not unique for all commodities. These differences
in degree of response can be conceptualized by:-

(Own) Price Elasticity of demand (EPX) for a commodity, say commodity X is given by
EPX = (∆ Dx/Dx) / (∆Px / Px), ∆ representing small change in value of the respective variable.

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STUDY NOTES /ECONOMICS/ IIIT Course Instructor: Dr. Pradipta Bhattacharya

Thus, ∆Dx/Dx represents how Demand for commodity X responds (effect) to a given change in price
of X. i.e., ∆Px / Px(cause, for which demand has changed).

In calculus notation then, EPX = (∂Dx/Dx)/ (∂px/ Px) = (∂Dx/∂Px) . (Px / Dx)

Price

D D1

D2
D5 D3
D4
0
Quantity Demanded
D1, D2, D3, D4, D5 all are Demand Curves and as the slope of the curve gets steeper, value of price
elasticity falls, and demand becomes less price-elastic. D1 is the perfectly elastic demand curve
while D5 represents another extreme, a perfectly inelastic demand curve.

Determining the Value of EPX at a particular point on a downward sloping demand curve

Price (P) EPX = ∞

A I EPX I > 1
I EPX I = 1

C D

M I EPX I < 1

EPX = 0

O F B Quantity (Q)

We have considered a normal good with usual negatively sloped demand curve AB. Since price and
quantity demanded are inversely related in this case, the value of price elasticity of demand (E PX)
would be negative. Point M is the midpoint of AB. The value of EPX at a point D on AB can be derived
as:
Think of change in price and quantity from point A to point D, i.e., thus (∆ D/∆P) = (-) OF/AC
At point D, (P/D) = OC/OF
Hence EPX at D = (∆ D/∆P).(P/D) = (-) OC/AC

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STUDY NOTES /ECONOMICS/ IIIT Course Instructor: Dr. Pradipta Bhattacharya

⸫ EPX at D = (-) BD/DA = Lower segment of AB below D/ Upper segment of AB above D

Using this formula we may derive the (absolute) values of EPX at A (Upper segment dropping to 0),
at B (Lower segment dropping to 0) and at the midpoint M (both segments are equal). The range
of (absolute) values of EPX are shown for the upper and the lower segment with respect to the
midpoint M on AB.

Similarly the degree of response of quantity demanded of a commodity say X, with respect to the
unit proportional change in the price of other commodity (say, commodity Y ; ceteris paribus) is
measured by Cross Price Elasticity (CPE) of Good X for (price of) Good Y as
Cross Price Elasticity of demand (CPE) Exy = (∂Dx/∂Py)/(Dx/Py) = (∂Dx/∂Py) . (Py / Dx)

Based on the values of CPE (Exy) we classify the following :-

a) Exy>0 :- X & Y are mutually substitute goods, since as price of one rises (falls), quantity
demanded of the other increases (decreases). Why? Because, as PY rises, DY falls (Y being a
Normal Good), and fall in DY essentially raises the demand for substitute good X (DX).
b) Exy<0 :-X & Y are Complements, by reverse logic clearly.
c) Exy = 0:- X & Y are unrelated goods, viz., computers & shirts.

And similarly the degree of response of quantity demanded of a commodity with respect to the
unit proportional change in income of the consumer (ceteris paribus) is measured by the

Income elasticity of demand for the commodity ηx = (∂Dx/∂M)/(Dx/M) = (∂Dx/∂M). (M / Dx)

Some important points to be noted regarding the values of elasticities

 Normally own price elasticity of demand of a commodity is negative.
 The mod. value (absolute value) of elasticity may vary from zero (0) to infinity (∞), i.e.,
0 ≤I EPX I ≤ ∞
 If I EPX I = 0 then Demand is said to be perfectly inelastic
 0 <I EPX I < 1 then Demand is said to be inelastic
 I EPX I = 1 then Demand is called unitary elastic
 1 <I EPX I <∞ then Demand is said to be elastic
 I EXXI →∞ then it is the case of perfectly elastic demand
 Cross price elasticity of demand for a substitute commodity is positive.
 Cross price elasticity of demand for a complementary commodity is negative.
 Income elasticity of demand is positive for a ‘Superior/ normal’ good.
 Income elasticity of demand is negative for an ‘Inferior good’.

Demand Forecasting

Demand Forecasting refers to the activity of estimating the quantity of a product or service that
consumers will purchase. Demand forecasting involves techniques including both informal

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STUDY NOTES /ECONOMICS/ IIIT Course Instructor: Dr. Pradipta Bhattacharya

methods, such as educated guesses, and quantitative methods. Basic Methods of Demand
Forecasting:

a. Consumer Survey Techniques

b. Test Market signals
c. Econometric methods (Trend projections, Regression Analysis)
d. Barometric Method

BASIC CONCEPTS OF SUPPLY CURVE

In economics, supply refers to the amount of a product that producers and firms are willing to sell
at a given price all other factors being held constant. Usually, supply is plotted as a supply curve
showing the relationship of price to the amount of product businesses are willing to sell.

Supply schedule
A supply schedule is a table which shows how much one or more firms will be willing to supply at
particular prices under the existing circumstances. Some of the more important factors affecting
supply are the good's own price, the prices of related goods, production costs, technology and
expectations of sellers.

Factors affecting supply

Innumerable factors and circumstances could affect a seller's willingness or ability to produce and
sell a good. Some of the more common factors are:
a) Good's own price
b) Prices of related goods
c) Conditions of production: The most significant factor here is the state of technology. If
there is a technological advancement in one good's production, the supply increases.
Other variables may also affect production conditions. For instance, for agricultural
goods, weather is crucial for it may affect the production outputs.
d) Expectations: Sellers' concerns about future market conditions can directly affect supply.
e) Price of inputs: Inputs include land, labor, energy and raw materials. If the price of inputs
increases the supply curve will shift left as sellers are less willing or able to sell goods at
any given price.
f) Number of suppliers: The market supply curve is the horizontal summation of the
individual supply curves. As more firms enter the industry the market supply curve will
shift out driving down prices.
g) Government policies and regulations: Government intervention can have a significant
effect on supply.
This list is not exhaustive. All facts and circumstances that are relevant to a seller's willingness or
ability to produce and sell goods can affect supply. For example, if the forecast is for snow retail
sellers will respond by increasing their stocks of snow sleds or skis or winter clothing or bread and
milk.

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STUDY NOTES /ECONOMICS/ IIIT Course Instructor: Dr. Pradipta Bhattacharya

Supply function and equation

The supply function is the mathematical expression of the relationship between supply and those
factors that affect the willingness and ability of a supplier to offer goods for sale. An example would
be the curve implied by Qs = f (P; Prg) where P is the price of the good and Prg is the price of a
related good. Prg is taken as unchanged when quantity supplied (QS) is plotted against the good's
own price (P). The supply equation is the explicit mathematical expression of the functional
relationship. A linear example is Qs = 325 + P – 30 Prg. Here 325 is the repository of all non-specified
factors that affect supply for the product. The coefficient of P is positive following the general rule
that price and quantity supplied are directly related. Prg is the price of a related good. Typically its
coefficient is negative because the related good is an input or a source of inputs whose price
inversely affects quantity supplied of the subject good.

Supply curve

An example of a nonlinear supply curve

The relationship of price and quantity supplied is depicted in the supply curve. The curve is
generally positively sloped. The curve depicts the relationship between two variables only; price
and quantity supplied. All other factors affecting supply are held constant. However, these factors
are part of the supply equation and are implicitly present in the constant term.

Movements versus shifts

Movements along the curve occur only if there is a change in quantity supplied caused by a change
in the good's own price. A shift in the supply curve, referred to as a change in supply, occurs only
if a non-price determinant of supply changes. For example, if the price of an ingredient used to
produce the good, a related good, were to increase, the supply curve would shift left.

Elasticity of supply
The price elasticity of supply (PES) measures the responsiveness of quantity supplied to changes in
price, as the percentage change in quantity supplied induced by a one percent change in price. It

is calculated for discrete changes as and for smooth changes of differentiable supply

functions as . Since supply is usually increasing in price, the price elasticity of supply is
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STUDY NOTES /ECONOMICS/ IIIT Course Instructor: Dr. Pradipta Bhattacharya

usually positive. For example if the PES for a good is 0.67 a 1% rise in price will induce a two-thirds
increase in quantity supplied.

EQUILIBRIUM

Equilibrium is a state of affair where there is no tendency to change whatsoever. In effect, for a
market structure, it is a situation where the plans of relevant decision makers, i.e., the buyers
(consumers) and the sellers (suppliers) are fulfilled.
Let D = D (P) and S = S (P) be the market demand and industry supply equations of a commodity.
We just impose restriction on P and Q as, 0 <P <∞ and 0 < Q <∞, which are quite logical.
Thus Equilibrium (of a market) can be represented by the following equation

D (P*) = S (P*), market equilibrium occurs at price P = P*, (0 ≤ P* ≤ ∞)

P S

P*

0 D(P*) = S (p*) D, S

Understandably, for prices higher than P*, S(P) > D(P), indicating excess supply in the market. For
prices less than P*, quantity demanded in the market would exceed quantity supplied, leading to
an excess demand situation.

REVENUE

Revenue is the sale proceeds of the supplier (seller). Total revenue (TR) is thus calculated simply as
the product of the price per unit and units of the commodity sold.

Price (P)

Pa A

D(P) (= AR)

0 Qa Quantity (Q)

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STUDY NOTES /ECONOMICS/ IIIT Course Instructor: Dr. Pradipta Bhattacharya

In the above diagram, corresponding to the point A on Demand Curve D(P), Qa units are bought*
by the consumer (hence sold by the seller) at price Pa . Hence Total Revenue (TR) earned by the
seller at A is = OPa . OQa = Area APaOQa

(* We make use of the common sense idea that, seller would sell precisely the quantity demanded
by the buyer or consumer).

Clearly, Average revenue (AR) is the revenue earned by the seller from unit sale (= TR /Q) and that
is nothing but the price of the product, hence AR = Price (P) always. That means the demand curve
is the Average Revenue curve (AR).

Marginal revenue (MR) is defined as change in Total Revenue (TR) due to unit change in sale (Q),
i.e., MR = ∂TR/∂q

Relation between Marginal Revenue, Average Revenue and Price Elasticity of demand (EPX):

Marginal revenue MR by definition = ∂TR/∂q = ∂(P.q)/∂q

= P. ∂q /∂q + q. ∂P/∂q
= P [1 – {(1/∂q/∂P).(p/q)}]
⸫ MR = P {1 – (1/EPX)}, Where EPX is the price elasticity of demand.
or, MR = AR {1 – (1/EPX)}, since P = AR always.



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